Many contracts in the construction industry include clauses relating to liquidated damages, a form of damages where the amount liable upon breach can be found in the contract itself. Liquidated damages are meant as a fair representation of losses in situations where actual damages are difficult to determine. Liquidated damages allow the parties to know, in advance, what they will be liable for in the event they breach the contract. However, they can feel more akin to a fine or penalty for failing to live up to your promises. Importantly, even though liquidated damages may appear punitive in nature, they are not, and are designed to be a fair of assessment of damages when actual losses are difficult or impossible to ascertain.
IS A LIQUIDATED DAMAGES CLAUSE VALID?
Because liquidated damages are different from actual or compensatory damages, the first question to ask is whether they can be enforced in a court of law. Generally speaking, liquidated damages have been found valid in contract law. They operate by making the ramifications of breach considered and expressed before the breach occurs. In most contracts including a liquidated damages clause, the contract itself will expressly state what the damages will be in the event of a breach. For example, if a subcontractor’s delays are the cause of a project being delayed, liquidated damages would typically be determined through a formula considering the length of the delay. The subcontractor would know what they would owe if they were in breach, and this certainly gives the subcontractor an incentive to perform. And because this type of breach would typically be withheld from a contractor’s final payment, it also serves as an informal insurance policy for the project owners.
The term ‘substantial completion’ is likely to eventually become the proper metric for what may be a breach, so your contract should include accurate and complete definitions of all important time-based terms. Generally speaking, however, ‘substantial completion’ means the point in time where the project is completed enough so that the owner be able to use or occupy the project for its intended purpose. Of course, the definition of ‘intended purpose’ then becomes the discussion, but these moments in a timeline of a project are paramount when it comes to contractual analysis. As a general rule in home construction, this moment of substantial completion occurs when the localities’ certificate of residency is issued.
A liquidated damages clause is not valid 100% of the time.
A liquidated damages clause is not valid 100% of the time. In fact, an improperly drafted liquidated damages clause might not be enforced by the courts at all. This typically happens when the liquidated damages can be shown to be substantially disproportional to the actual damages incurred. In other words, courts typically require that the parties involved be reasonable in assessing the liquidated damages clause at the time the contract is signed. This requirement of reasonability also helps provide a sense of understanding and reassurance of what is at stake if the contract is breached.
Determining THE DAMAGES Amount
The benefits of using a liquidated damages clause come from the fact that the amount of damages is known and easily enforced. If a contractor is running late, it is impossible to accurately determine the money lost due to that delay. This is the kind of issue that can cause simple litigation to take years to complete. However, a liquidated damages clause can detail a specific amount due if a contractor is behind schedule, or better yet, a formula calculating the duration of the delay against other relevant metrics to determine a more certain damage assessment. It can be difficult to avoid comparing these kinds of liquidated damages to penalties or fines, but while they are similar in terms of calculation, their purposes are vastly different. A fine is designed to punish, whereas contractual damages, whether actual or liquidated, are designed to make the parties whole.
Am I better of without this clause?
Interestingly, in practice, liquidated damages are typically less expensive for the breaching party than a calculation for actual or compensatory damages. In order to prove actual damages, the calculation would require an assessment of the actual impacts of the breach on the project based on theoretical economic principles. The question becomes one of the actual amount of money lost due to a party’s breach of the contract, a determination far more complicated than it seems. In home construction, these actual economic losses are typically determined on the cost of the owner to reside somewhere else due to the delay. For a business, this analysis becomes more difficult but remains quite feasible through a comparison of similarly situated business’ revenues and expenses. A simple liquidated damages clause in the contract could have simplified any proof requirement for damages, replacing them with a simple, determinable formula.
Construction contracts are bound by statutes and regulations under state law. Differences from jurisdiction to jurisdiction can affect your rights and obligations under the contract, but more importantly, can affect the validity of the contract itself. The type of project and the type of parties involved can also change the impact of a contract, and liquidated damages clauses, from locality to locality. It is very important that you know the rules in your location so that your contracts are simple and enforceable.
This blog is for educational purposes only and not intended for legal advice.