By Joseph S. Voboril
When representing owners on construction contracts, I often ask the owner whether they want to include a liquidated damages provision in the contract. A liquidated damages provision describes an amount of money, agreed upon by the parties when the construction contract is signed, that establishes the damages that can be recovered by the owner in the event the contractor fails to complete its work by an agreed upon date (typically, the “substantial completion date”). The provision is usually written as a formula, for example: “Contractor shall pay Owner $5,000 per day for each day following the scheduled Substantial Completion Date until Contractor achieves Substantial Completion of the Project.”
The purpose of such a provision is to motivate the contractor to complete the work on time and to protect the owner if the contractor fails to do so. Without such a provision in the contract, the owner has the right to bring an action against the contractor for damages suffered by the owner due to the delay, but proving such damages is often difficult and expensive. A liquidated damages provision eliminates that problem. The owner must still prove that the delay was not the owner’s fault, but the amount of damages is determined.
So, why not include such a provision in all construction contracts? A number of reasons are often given: some valid, some not:
- Timing Isn’t Important. In some instances, the owner cares more about the cost of the project and the quality of construction than the substantial completion date. If such is the case, it makes sense not to include a liquidated damages provision.
- Uncertainty about Enforceability. There is no guarantee that the liquidated damages provision will be enforced by a court (or arbitrator) if contested at a later date. In my view, this is not a good reason to avoid use of such a provision. If properly drafted, with attention given to the local statutes and case law, there is a high probability that the provision will be enforced. As a general rule, if the amount established is reasonable, calculated on what the owner is anticipated to lose if the project is finished late, and not a penalty, the provision will be enforced.
For this reason, it is important to analyze what the owner’s actual damages would be. Such items as lost revenue, extended financing costs, additional rental expenses, lost reputation damages, and lost opportunity costs should be considered. I recommend that the items included in the calculation of liquidated damages be written down and shared with the contractor. Having such information makes it more difficult for the contractor to challenge the agreed upon amount at a later date.
- Adverse Relationship with Contractor. Some owners fear that raising the issue of liquidated damages may sour the owner’s relationship with the general contractor. While it is true that negotiations over the liquidated damages provision can become heated, that is not a valid reason to shy away from such a provision. The parties can simply agree to disagree. Even if no agreement is reached, the discussion is likely to have a salutary effect—emphasizing to the general contractor the importance of the substantial completion date to the owner.
Furthermore, many contractors welcome the discussion of a liquidated damages provision. They like the predictability. Agreeing to a predetermined amount at the outset that is fair and reasonable is far better than the time and expense of litigating the actual damages suffered by the owner as a result of the contractor’s delay.
- Fear of Reoccurring Change Orders. Some owners believe that including a liquidated damages provision will lead to excessive change order requests. The concern is that the general contractor will request a change order extending the substantial completion date every time the owner or a third party does something—or fails to do something—that the general contractor believes will cause a delay. While there may be some validity in this concern, the following should be considered:
(i) The general contractor is contractually obligated to complete its work by the substantial completion date whether or not a liquidated damages provision is included in the construction contract. If the general contractor is entitled to additional time due to delay caused by others, it should be asking for a change order.
(ii) If the presence of the liquidated damages provision makes the general contractor more attentive to the substantial completion date, then that is the desired result. Furthermore, if the action (or inaction) of the owner or others outside of the general contractor’s control is causing delay, it is better to sort that out during construction rather than to wait until the end when the general contractor has missed the substantial completion date.
- Better to Retain the Right to Sue. In order for the liquidated damages provision to be enforceable, it cannot be punitive in nature. It has to be a reasonable amount that is anticipated to compensate the owner for the loss the owner will suffer as a result of the delay. Some owners express concern that liquidating the amount of damages may make it easier—or, at least less painful—for the contractor to miss the substantial completion date. Their concern is that the contractor may elect to simply pay the liquidated damages rather than marshal resources in order to meet the substantial completion date. These owners contend that they are better off by retaining the right to bring an action for actual damages suffered as a result of the delay.
In certain circumstances—especially large projects—this may be the right decision. On large projects, the time and expense of proving actual damages may be justified. And, on large projects, the threat of such an action may be sufficient to incentivize the contractor to complete the job on time. On smaller projects, however, retaining the right to bring an action against the contractor is generally misguided. The amount of actual damages suffered by the owner in most instances is just not significant enough to merit litigation.
There are many reasons for including, or not including, a liquidated damages provision in a construction contract. Based on my experience, this decision is often made near the end of the contract negotiation process, almost as an afterthought. It should be considered early on in the negotiation, together with the discussion of the contractor’s fee, the cost of the work, and the substantial completion date. Leaving it to the end minimizes the importance of the provision.