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A Legally Binding Carrot And Stick: Drafting Effective Liquidated Damages Clauses In Construction Contracts

On Behalf of | May 12, 2013 | Construction Insurance |

Owners of construction projects are typically under pressure to meet stringent deadlines for project completion, whether motivated by a construction loan’s looming deadlines, strict terms of a regulatory agreement, demanding lease and/or sales goals or a combination of the above. Accordingly, when an Owner negotiates its contract with the project’s General Contractor (“GC”), establishing, maintaining and incentivizing the GC to abide by a strict construction schedule often tops the list of Owner’s priorities.

One method which savvy Owners may employ in ensuring timely project completion is the inclusion of a legally enforceable liquidated damages for delay clause in the Owner-GC contract. A liquidated damages clause with respect to GC delay is meant to be a pre-set settlement, invoked by the Owner, in the event that the GC does not perform on time. Most often, the amount of liquidated damages is stipulated in the contract in a per diem, weekly or monthly dollar amount, and often there is an aggregate cap on damages payable. Because liquidated damages are essentially a “shortcut” replacement for the tedious mathematical work the Owner would be required to perform in order to plead actual or consequential damages, the inclusion of a liquidated damages clause for delay precludes Owner’s double-dipping (i.e. collection of actual or consequential damages for delay in addition to liquidated damages for delay) and is therefore essential to draft correctly.

A liquidated damages clause serves as a carrot-and-the-stick method to push the GC’s timely project completion; in other words, the clause acts as both a motivator and a deterrent. In fact, the predictability of the amount of damages offered by the inclusion of a liquidated damages clause offers a win-win for both parties. With respect to the GC, the amount represents its maximum exposure. As for the Owner, that amount represents the avoidance of potentially lengthy and costly litigation (hiring of attorneys, experts, etc.) in order to come up with a theory and a number for actual damages, some of which may be hard for the Owner to quantify.

One pitfall of including a liquidated damages clause in a contract is that it may be easily challenged as a “penalty” in court, thereby leaving a gaping risk to an Owner. While an Owner entering into an Owner-GC contract may resort to utilizing the most well-known quick-and-easy form, the AIA template (A101-2007), Owners should be advised that the form does not provide any stock language on collection and enforcement of liquidated damages. Rather, Section 3.3 of the form contemplates the general possibility of the parties crafting and inserting their own liquidated damages provision. Because of the susceptibility of these clauses to legal challenge, users of this form and other similar templates must be especially cautious about inserting a do-it-yourself liquidated damages clause without the assistance of counsel.

While at first blush, the concept of liquidated damages for delay may sound like a punishment or a penalty, if properly drafted they are enforceable as a rational alternative to proving what can be elusive damages. However, any such clauses construed by a court as a penalty will not be enforceable. Under New York law, liquidated damages clauses are enforceable as a remedy for breach of contract if: (1) the parties intended to liquidate damages and not to provide for a penalty (i.e. truly accomplish a pre-set value of damage suffered by the Owner); (2) the liquidated damages clause fixes an amount that bears a reasonable relationship to the anticipated loss suffered by the non-breaching party; and (3) actual damages are challenging to determine or not practical to estimate. (See G3-Purves St., LLC v. Thomson Purves, LLC, 101 A.D.3d 37, 953 N.Y.S.2d 109, 2012 NY Slip Op 06919 (App Div, 2d Dept 2012)). In proving whether the parties truly intended to liquidate damages, a New York court will often look at the relative sophistication of the parties in order to determine whether there existed disparity of bargaining power or unconscionability. (See e.g. Best Metro. Towel & Linen Supply Co. v. Deck Mar. & Aviation Serv., Inc., 27 Misc. 3d 1201, 910 N.Y.S.2d 403, 2010 NY Slip Op 50508[U] (Dist. Ct. 2010)). In addition, the legality of a contract’s liquidated damages clause will be interpreted by the court as of the date of its execution, not the date of its breach.

Therefore, at the outset of the Owner’s contract negotiation with a GC, the Owner should consider a variety of factors when stipulating a liquidated damages number, which may include but not be limited to the following factors: the difference between construction period interest and permanent loan interest, the liquidated damages the Owner may owe to a regulatory body in the event of delayed completion, lost profits, temporary rental and relocation costs, and additional project administration costs. Furthermore, because a GC’s late project completion may cause incrementally more financial damage to the Owner as more time passes without resolution, specifying graduated damage amounts instead of a one-size-fits-all amount may work in an Owner’s favor to show that the parties carefully considered realistic financial consequences in the event of breach.

Because GCs frequently challenge the validity of liquidated damages clauses on the basis described above, a properly crafted liquidated damages clause is absolutely essential to protect an Owner seeking to manage the risks of construction delay. For further assistance and/or representation on this matter or any other construction matter, please contact us at Greenberg, Trager & Herbst, LLP.