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Construction contracts can be overwhelming when you’re not looking at them every day. That’s why it’s important to understand your contract and the types of classification damages that could be written in it. Even though disputes are inevitable, understanding your contract will ultimately give you a leg up during the claims process. Let’s explore how liquidated damages and consequential damages interact in a contract.
Contracts that contain a provision for liquidated damages must clearly articulate that consequential damages are uncertain and difficult to determine at the time of contract execution. The time of contract execution is an important factor in the provision for liquidated damages. The enforceability of this provision is whether the parties are able to reasonably approximate the anticipated loss at the time the contract was entered into. If the amount cannot be reasonably calculated, liquidated damages will be enforced.
The clause for liquidated damages needs to clearly state that the parties stipulate the number of liquidated damages is fair and reasonable. Furthermore, liquidated damages cannot be disproportionate to a potential loss, and it is not considered a penalty. However, such language is not conclusive.
Liquidated damages are premised on the fact that actual damages cannot be reasonably calculated at the time of contract execution. The parties should be careful to guard against the recovery being overly disproportionate to actual damages. Thus—should the agreed amount of liquidated damages be in gross excess of actual consequential damages—courts have generally construed the provision for liquidated damages to be an unenforceable penalty.
As an example, a Contractor enters into a $1,000,000 contract with an Owner of a proposed new Retail Center building. The provision for liquidated damages in the contract is $500,000 per day. Since the number of liquidated damages is disproportionate to the contract value, it is likely courts will view the provision as an unenforceable penalty. There is no rule of thumb as to what courts consider a penalty. The determination is done on a case-by-case basis.
Sole and Exclusive Remedy
A good method for a Contractor to protect itself financially in a construction contract is to expressly state that liquidated damages are the sole and exclusive remedy in the event of a breach. It should further state all claims for consequential damages should be waived.
However, the contract must contain clear and unambiguous language stating that consequential damages are difficult to determine and cannot be reasonably calculated at the time of contract execution. Otherwise, the Project Owner has the option of pursuing either direct, liquidated, or consequential damages during a dispute resolution proceeding. Without clear language, it’s possible the Contractor may face an adverse award in excess of the contract amount.
Clauses for liquidated damages are an attempt to avoid disputes—determining the amount of consequential or actual damages long after the contract was executed. These disputes can be extremely costly and time-consuming. As the previous example showed, the failure to have a clearly enumerated clause for liquidated damages in a contract can be disastrous. Unless the language of liquidated damages states it is the sole and exclusive remedy, the provision becomes meaningless.
Fair Cost Recovery
There are inherent risks to both parties when undertaking a construction contract, even if liquidated damages are made to be the sole and exclusive remedy. The possibility exists that the Project Owner may not recover enough to be made whole. Likewise, liquidated damages may result in the Contractor making a payment larger than would have been due if damages had been based on the actual damages the delay caused.
Risk does not provide the benefit of certainty. However, the provision for liquidated damages should result in fairness to both parties to a construction contract. The Project Owner is assured that it will recover some amount for damage incurred by the delay, while the Contractor limits its exposure to an extremely adverse award. Under these circumstances, parties can seek to avoid or substantially reduce the probable cost of dispute resolution. While it is not necessary, it is highly recommended a Contractor seek advice from legal counsel to best protect itself when entering into a contract—especially complex ones.
Every construction contract is different; that’s why it’s important to understand your contract and how liquidated damages and consequential damages interact. Ultimately, you want to make sure your company is protected in case there is an incident. It’s always best to talk to your legal counsel regarding your specific contract. For additional answers regarding your insurance and surety bonding needs, reach out to TSIB today!