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Kenneth A. Viscarello
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Construction Law

The Use of Liquidated Damages Clauses in Construction Contracts

Friday, March 31, 2006

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Unless you are in the development business, whether you are renovating your existing headquarters or moving to new space, one of the most time-consuming and anxiety producing experiences is undertaking a construction project. A deadline requiring you to vacate your current space by a certain date only heightens the anxiety.

Owners can protect themselves from construction delays by utilizing a liquidated damages clause in their agreement with the contractor. A liquidated damages clause fixes the amount of damages to be paid by one party to another upon the occurrence of specified events. Delay by one party is a typical triggering event. The liquidated damages clause can protect the owner from delay by stipulating that for every day the contractor goes over the scheduled completion date, he will be charged a sum certain. Such a clause forces the contractor to stay on schedule to avoid the per diem charge. A typical liquidated damages clause may read as follows:

Time is of the essence of this Contract. If the Contractor shall neglect, fail, or refuse to complete the Work within the time specified for Substantial Completion in the Contract, then the Contractor does hereby agree, as a part consideration for the awarding of this Contract, to pay to the Owner, as liquidated damages and not as a penalty, the sum of $_______________ per day for each calendar day beyond the dates set forth in the Agreement that the Contractor fails to achieve Substantial Completion for the Project. The said amount is fixed and agreed on by and between the Contractor and the Owner because of the impracticability and extreme difficulty of fixing and ascertaining the true value of the damages which the Owner will sustain by failure of the Contractor to complete the Work on time, such as loss of revenue, service charges, interest charges, delays caused to other construction activities of Owner by failure to perform this Contract, and other damages, some of which are indefinite and not susceptible of easy proof, said amount is agreed to be a reasonable estimate of the amount of damages which the Owner will sustain and said amount shall be deducted from any monies due or that may become due to the Contractor, and if said monies are insufficient to cover said damages, then the Contractor shall pay the amount of the difference.

Not all liquidated damages clauses are enforceable, however. For a liquidated damages clause to be enforceable in New Hampshire, it must satisfy a three-part test. First, the parties must intend to liquidate (i.e., stipulate to the amount) the damages in advance. Second, the damages anticipated as a result of the contract breach (such as a contractor's delay) must be uncertain in amount or difficult to prove. Third, the amount stipulated must be reasonable, that is to say, not greatly disproportionate to the anticipated loss or injury.

The first prong is fairly easy to satisfy. Including a liquidated damages clause in your contract should suffice. The second prong, although more nebulous than the first part, is also fairly easy to satisfy. In most cases, at the time of contracting, anticipated damages as a result of delay are uncertain and difficult to prove. Depending on the degree of delay, an owner may have relocation/rental costs, storage costs, carrying costs, lost profits, manufacturing delays, loss of goodwill, etc., all of which can be uncertain and difficult to prove. The most difficult part of the test is the third prong. Unfortunately, in determining whether a stipulated amount is reasonable there is no magic percentage of the total contract price that will provide a safe harbor. Courts will generally look to whether the presumed loss was a reasonable estimate of potential loss at the time the clause was agreed to. If so, courts then analyze whether the liquidated damage sum is grossly and unreasonably disproportionate by examining the actual damages.

In light of the above, if you are an owner, the question becomes: "Ok, so what number should I use in the liquidated damages clause?" The answer to this question is more art than science. Owners should consider all of the possible elements that may be occasioned by a delay. Elements such as the difference between construction period interest and permanent loan interest, temporary rental and relocation costs, lost profits, loss of the ability to manufacture (if applicable), damages payable for holding over at a prior location, and costs associated with multiple moves should all be considered.

A downside to having a liquidated damages provision is that it may change the relationship between the owner and the contractor. Because an owner cannot utilize the benefits of a liquidated damages clause if he is the cause of the delay, a savvy contractor will immediately begin to send accusatory letters to the owner anytime the contractor believes there is deviation from the schedule that is even remotely related to the actions of the owner or those under his control (e.g, the architect). Many critics of liquidated damages provisions correctly assert that these provisions foster finger-pointing between the parties and result in an unnecessarily antagonistic relationship between the owner and contractor from day one of the project.

This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.