Legal ease

A liquidated-damages provision in a contract exists when a specific sum of money has been stipulated as the amount of damages to be recovered for a breach of contract. Construction contracts frequently contain liquidated-damages provisions stating a contractor will be liable for liquidated damages of a certain amount per day if construction is not completed by a specified date.

Contractors frequently question whether liquidated-damages provisions in contracts are enforceable. When entering into a contract with a liquidated-damages clause, assume the clause will be enforced if you breach the contract requirement to which the liquidated-damages clause applies.

The states

Through statutes and case law, state legislatures and courts have established criteria to determine whether a liquidated-damages provision will be enforced or found contrary to public policy.

For example, a Georgia statute states, "if the parties agree in their contract what the damages for a breach shall be, they are said to be liquidated and, unless the agreement violates some principle of law, the parties are bound thereby."

In Alabama, liquidated-damages provisions are enforceable as long as the contractual stipulation is reasonable and measure of damages at the time of the contract was conjectural and uncertain.

In South Carolina, if liquidated damages are reasonably intended by the parties as the predetermined measure of compensation for nonperformance, the provision will be enforced.

California has a statute specifically authorizing government entities and agencies to include contract provisions establishing the time within which work shall be completed and providing that for each day completion is delayed beyond the specified time, a contractor will pay the agency a specified sum of money. The sum is valid as liquidated damages unless "manifestly unreasonable" under the circumstances existing at the time the contract was made.

For federal government contracts, liquidated damages are enforceable unless the amount the contract stipulates for failure of performance bears no relation to actual damages that reasonably may be anticipated from such a failure.

Enforcement

A liquidated-damages provision that has been thoughtfully considered when a contract was formulated likely will be valid and enforceable. Liquidated damages intended to constitute reasonable compensation for actual damages that are difficult or impossible to calculate are well-recognized as legitimate contract objectives.

The typical test to distinguish between enforceable and unenforceable liquidated-damages clauses is whether a clause is a reasonable estimate of actual anticipated damages that are difficult to quantify or a penalty for failure to comply with the applicable contract requirement.

State statutes and prior case decisions in the pertinent state must be examined to ascertain the specific test that will be applied. However, the general principles used to determine whether a liquidated-damages clause will be enforced are fairly uniform throughout the United States. These principles generally apply regardless of the type of contract or specific breach. The fundamental principle is whether the liquidated-damages provision is compensatory or punitive.

Fair compensation to an injured party for damages resulting from the other party's breach is the objective of contractual remedies; punishing the breaching party is not a valid objective of a contract clause, and a liquidated-damages provision found to constitute a penalty is unenforceable on grounds of public policy.

The Georgia Supreme Court has, for instance, prescribed the following three criteria, each of which must be satisfied, to have an enforceable liquidated-damages clause: the injury caused by the breach must be difficult or impossible to estimate; the contracting parties must intend to provide for damages rather than a penalty; and the stipulated sum must be a reasonable pre-estimate of the probable loss.

With regard to the first criterion, if actual damages resulting from a breach easily could be calculated or a stipulated sum was chosen arbitrarily, the liquidated-damages provision might not be enforced.

Similarly, if no effort was made at the time the contract was consummated to estimate the likely loss, the clause might not withstand judicial scrutiny.

The purpose of a penalty is to secure performance by penalizing a contractor if he breaches the contract. When a building owner threatens to assess liquidated damages to induce a contractor to accelerate performance, the owner inadvertently may have provided the contractor with evidence the contractor could use to further the argument that the liquidated-damages provision was included in the contract to prod the contractor into compliance. Courts have ruled when a stipulated sum is inserted into a contract for the purpose of deterring a breach of contract, the liquidated-damages provision is unenforceable.

Usually, the party challenging a liquidated-damages provision will have the burden of persuading a court that what might appear to be a permissible liquidated-damages provision is an impermissible penalty. However, when there is doubt as to whether a purported liquidated-damages clause is enforceable, state courts, such as those in Georgia, favor finding the stipulated sum is a penalty and limit recovery to the amount of damages actually shown.

The dollar amount of the stipulated damages does not determine whether a liquidated-damages clause will be enforced. A large dollar amount might be enforced in one case and a lower number might be found unenforceable in another instance depending on the facts and circumstances of the case. The reasonableness of the dollar amount in relationship to the estimated actual damages is a critical factor.

Examples

In the 2003 case Wright v. Bassinger, the Court of Appeals of Ohio concluded the failure of the party to show how the amount stated in the liquidated-damages clause was calculated required the court to find the clause was nothing more than a penalty and, therefore, unenforceable.

If the liquidated-damages amount is grossly disproportionate to a reasonable estimate of the probable damages resulting from a breach, the clause will not be enforced. A lack of correlation between the stipulated sum and anticipated actual damages frequently is cited in court decisions refusing to enforce a liquidated-damages provision.

If a liquidated-damages provision is intended to penalize the breaching party or coerce compliance with the contract, the provision will not be enforced. Often, the party drafting the liquidated-damages provision will state the stipulated sum is intended to be a reasonable estimate of anticipated losses resulting from a breach and not a penalty. The party undoubtedly will refer to this language to support upholding the provision, but the language will not save the provision if the provision is a penalty and fails to satisfy the criteria distinguishing a reasonable pre-estimate of anticipated damages from an impermissible penalty intended to deter a breach.

In the 1991 Ohio case Fuschino v. Smith, the plaintiff, a homeowner named Frank Fuschino, brought suit against a defaulting construction contractor, Ron Smith, as a result of Smith's failure to complete an outdoor deck on time pursuant to a construction contract that specified time was of the essence. The contract was dated May 11, 1998, with a specified completion date of May 31, 1998. The contract called for Smith to be paid $6,000 for his labor (Fuschino was responsible for purchasing the materials). The contract contained a liquidated-damages clause requiring Smith to pay Fuschino $50 per day for each day after May 31 the deck was not completed. The work was not completed on time, and Fuschino sought to impose $7,050 as liquidated damages against the contract amount sought by Smith.

In Ohio, the first criterion to determine whether a liquidated-damages provision is valid is whether the damages would be uncertain and difficult to prove. The Ohio Court of Appeals, based on undisputed evidence, found the liquidated-damages clause was created to compensate Fuschino for the loss of use and enjoyment of the deck for each day its construction exceeded the assigned completion date. Based on this finding, the court concluded the damages were uncertain as to amount and difficult to prove.

Nevertheless, the Ohio Court of Appeals ruled the liquidated-damages clause was an unenforceable penalty. The court relied on the fact that the amount of the liquidated-damages clause was set by the architect and there was no evidence regarding the basis for the amount. In addition, the court concluded Fuschino's claim for liquidated damages bore no reasonable relationship to his actual damages and was disproportionate to actual damages he suffered. Undoubtedly, the $7,050 Fuschino sought to collect, when viewed in relation to the total amount of the contract and actual damages sustained, influenced the court's decision to refuse to enforce the liquidated-damages provision.

Some courts will consider what percent of the contract price is the liquidated-damages amount when evaluating the reasonableness and enforceability of a liquidated-damages provision. But the reasonableness of a stipulated amount usually is viewed at the time of a contract's inception and does not depend on the damages that were sustained after the contract has been breached.

In the case Fred A. Arnold Inc. v. United States, the U.S. Claims Court reversed a decision of the Armed Services Board of Contract Appeals that refused to enforce the government's claim for $689,472 in liquidated damages because of a delay in completing construction of Marine Corps bachelor-enlisted quarters at Camp Pendleton, Calif. The contract was for $1.9 million. Work was to begin June 17, 1975, and the contractually required completion date was Oct. 18, 1976. The completion date was Nov. 21, 1977—399 days later. The contract provided for liquidated damages of $1,728 per day.

During the first round of litigation between the contractor and government, the Armed Services Board of Contract Appeals ruled the liquidated-damages clause was unenforceable as a penalty because the government failed to show the stipulated amount was based on the losses the government expected to suffer if the contractor failed to complete the work on time. Because of a lack of evidence, the board concluded the losses reflected by the $1,728 per day assessment bore no relationship to the actual damages experienced and reasonably anticipated.

On appeal, the U.S. Court of Claims focused its attention on the Naval Facilities Command Construction Manual, which called for the inclusion of liquidated-damages clauses in contracts for construction of living quarters. The manual included a table identifying the daily rates per resident to be used to calculate liquidated damages for each type of military housing, which was to be multiplied by the number of residents, to determine the per day liquidated-damages amount. The manual stated the rates were based on the expenses the government expected to incur if a contractor failed to complete the work on time; these included the cost of substitute facilities, rental of buildings and continued payment of quarters' allowances.

For the Camp Pendleton project, the daily rate per resident stated in the manual was $6 and the number of residents was 288, so the daily rate was $1,728. Multiplied by the 399 days of delay, liquidated damages were $689,472. The court believed the use of the formula in the manual was sufficient to show there was a reasonable basis for the $1,728 per day liquidated damages in the contract and the government did not need to "reinvent the wheel" each time it entered into a contract for military housing that included liquidated damages. Therefore, the decision of the Armed Services Board of Appeals was reversed.

What it means

In the Fuschino case, the Ohio Court of Appeals refused to enforce $50 per day liquidated damages, but in the Fred A. Arnold case, the U.S. Court of Claims enforced $1,728 per day liquidated damages. Although the courts in these cases came to opposite conclusions regarding the enforceability of liquidated-damages provisions, both cases illustrate the significance of there being a well-founded basis to set the amount of liquidated damages as a reasonable estimate of anticipated losses versus choosing the amount of liquidated damages arbitrarily or without regard to actual losses. If proper steps are taken when a liquidated-damages clause is formulated, expect a liquidated-damages provision to be enforced and binding.

Stephen M. Phillips is a partner with the law firm Hendrick, Phillips, Salzman & Flatt, Atlanta.

How to avoid liability

There are a number of steps you should take to avoid being assessed for liquidated damages at the end of a job that was not completed by the date stated in the contract. Establishing reasonable deadlines, engaging in careful prejob planning and performing a job as planned should prevent a liquidated-damages claim. Just like other aspects of a successful job, preparation and actions taken long before the time liquidated damages might be assessed are critical to avoiding liability.

Following are specific recommended actions to reduce the liability posed by liquidated-damages provisions:

• Review a contract carefully to ascertain whether it contains a liquidated-damages provision, and gain a thorough understanding of when and how liquidated damages would apply and be calculated.
  
  
• If the proposed liquidated-damages amount seems questionable, ask how it was determined, make known you do not consider it a reasonable amount and seek to negotiate a more reasonable amount if you cannot eliminate the provision.
  
  
• Try to negotiate elimination or modification of the liquidated-damages provision so the provision states explicitly it does not apply if the reason for missing the contractual completion date was because of circumstances beyond your control.
  
  
• Check the job's start date. Often, the allowed duration to complete a job is based on the contract date even though a mutually agreeable contract or notice to proceed was not executed or received until several weeks after the date printed in the contract.
  
  
• Make sure the completion date is realistic and provides ample time for you to complete the job, taking into account your other obligations, customary weather conditions, performance of work by preceding trades, obtaining materials and complications that are likely to arise. Then, add time for unexpected contingencies. If the proposed date does not allow a sufficient margin, negotiate a different date or modify or add language so you are afforded sufficient time to perform your work.
  
  
• Include an explicit contract provision stating the number of work days with suitable conditions needed to perform the work.
  
  
• Educate your customer that roofing work cannot prudently take place on days when precipitation is forecast even if no rain or snow occurs. Include a contract provision so that days when roofing is not performed because of the forecast of inclement weather are not counted against you when determining whether liquidated damages are justified.
  
  
• Check that the time period for liquidated damages to be assessed stops when you have obtained substantial completion. Check that the customary definition of substantial completion—when the work or designated portion is sufficiently complete so the owner can occupy or use the building for its intended use—has not been changed to a later date, such as after completion of all punch-list items.
  
  
• Whenever you are requested to perform extra work or changed work that will require more time than the originally specified work, request additional time even if there is no increase in compensation and you do not foresee a problem meeting the contract completion date. Those additional days may be needed later. Each change order should consider the effect on the contract sum and contract time. If there is an increase in the contract sum, there should be an increase in the contract time. Too frequently, contractors sign change orders adjusting the contract sum without regard to the effect on time and waive their rights to claim additional time.
  
  
• During the course of a job, keep careful track of lost work days and days when you could not perform as intended because of weather or other conditions beyond your control. Keep your customer informed of these conditions. Follow contractually required procedures to record these days and obtain additional days.
  
  
• Document all delays and incidents that affect your work that were caused by the owner or others beyond your control. If completion of your work was delayed—even in part—by the owner, general contractor or architect, you might not be liable for liquidated damages or the amount of liquidated damages would be reduced in proportion to who was responsible for the delay.
  
  
• Be vigilant of contract deadlines that trigger liquidated damages. Actively manage the scheduling of personnel and resources to avoid imposition of liquidated damages.