What Are Liquidated Damages in a Construction Contract?

Many construction contracts include clauses relating to liquidated damages, a form of damages where the amount owed upon breach is set in the contract itself. Liquidated damages are meant as a fair representation of losses in situations where actual damages are difficult to determine. They allow the parties to know, in advance, what they will be liable for if they breach the contract. They can feel more like a fine or penalty for failing to live up to your promises, but even though liquidated damages may appear punitive, they are not. They are designed to be a fair assessment of damages when actual losses are difficult or impossible to ascertain.

Is a Liquidated Damages Clause Valid?

Because liquidated damages differ from actual or compensatory damages, the first question is whether they can be enforced in court. Generally, liquidated damages have been found valid in contract law. They work by making the consequences of a breach considered and expressed before the breach occurs. In most contracts that include a liquidated damages clause, the contract states what the damages will be in the event of a breach. For example, if a subcontractor's delay causes the project to run late, liquidated damages would typically be determined through a formula tied to the length of the delay. The subcontractor knows what it would owe if it were in breach, which gives it an incentive to perform. Because this type of breach is typically withheld from the contractor's final payment, it also serves as an informal insurance policy for the owner.

Substantial Completion

The term substantial completion is often the proper metric for what may be a breach, so your contract should include accurate, complete definitions of all important time-based terms. Generally, substantial completion means the point when the project is complete enough that the owner can use or occupy it for its intended purpose. The definition of intended purpose then becomes the discussion, but these moments in a project's timeline are paramount for contractual analysis. As a general rule in home construction, substantial completion occurs when the locality's certificate of occupancy is issued.

A Liquidated Damages Clause Is Not Always Valid

A liquidated damages clause is not valid one hundred percent of the time. An improperly drafted clause might not be enforced by the courts at all. That typically happens when the liquidated damages are shown to be substantially disproportionate to the actual damages incurred. Courts generally require that the parties be reasonable in setting the liquidated damages at the time the contract is signed. This requirement of reasonableness also helps provide a clear sense of what is at stake if the contract is breached.

Determining the Damages Amount

The benefit of a liquidated damages clause comes from the fact that the amount is known and easily enforced. If a contractor is running late, it is difficult to accurately determine the money lost to that delay, and that kind of issue can cause simple litigation to take years. A liquidated damages clause can fix a specific amount due if a contractor is behind schedule, or better yet, a formula that measures the duration of the delay against other relevant metrics for a more certain assessment. It is tempting to compare these damages to penalties or fines, but while they are similar in terms of calculation, their purposes differ. A fine is designed to punish, whereas contractual damages, whether actual or liquidated, are designed to make the parties whole.

Am I Better Off Without the Clause?

In practice, liquidated damages are often less expensive for the breaching party than a calculation of actual or compensatory damages. Proving actual damages requires an assessment of the real impact of the breach on the project. The question becomes the actual amount of money lost, a determination far more complicated than it seems. In home construction, those losses are typically measured by the owner's cost to reside elsewhere during the delay. For a business, the analysis is harder but still feasible through a comparison of similarly situated businesses. A simple liquidated damages clause can replace that proof requirement with a determinable formula.

Conclusion

Construction contracts are governed by state statutes and regulations. Differences from one jurisdiction to another can affect your rights and obligations under the contract and, more importantly, the validity of the contract itself. The type of project and the parties involved can also change how a contract, and a liquidated damages clause, is treated from place to place. It is important to know the rules where you work so that your contracts are simple and enforceable. Contact us with questions about a clause in your contract.