By: Scott Cahalan and Darren Rowles, Smith, Gambrell & Russell, LLP
This article examines liquidated damages clauses, clauses providing incentives for early completion, and the commonly held misconception that a construction contract that includes a liquidated damages clause must also include an incentive for early completion. As explained below, these clauses are independent and, as a result, are not required to operate together. Either clause can be included in a contract with or without the other.
Liquidated damages are predetermined damages the parties designate during the formation of a contract for an injured party to collect as compensation upon a specific breach.1 In the construction context, you’ll most often see liquidated damages apply when a contractor breaches the contract by not finishing its work on time. An example of a liquidated damages clause follows:
In the event that Substantial Completion is not achieved by the Substantial Completion Date, except as a result only from delays for which the Owner is chargeable under the Contract Documents, Contractor agrees that Owner shall have the right to deduct from any sums due to Contractor
hereunder the sum of ____________ Dol- lars ($ _______ .00) for each day that Substan- tial Completion is delayed. Owner and Contractor agree and acknowledge that (i) this clause provides for damages rather than a penalty; (ii) Owner’s damages for the failure to achieve Substantial Completion by the Substantial Completion date would be substantial but extremely difficult to ascertain and (iii) such sum represents a fair and reasonable estimate of the costs Owner will incur as a result of such late achievement of Substantial Completion.
To be enforceable, a liquidated damage provision cannot be a “penalty” to deter from breaching a contract.2 To determine whether a liquidated damages provision is truly liquidated damages or a penalty, the court considers three factors: (l) the injury caused by the breach must be difficult or impossible of accurate estimation at the time the parties agree to the liquidated sum; (2) the parties must intend to provide for damages rather than a penalty; and (3) the sum stipulated must be a reasonable pre-estimate of the probable loss.3 If these three factors are present, a liquidated damages provision is enforceable.4
The example liquidated damages clause provided above references all three factors, but that does not mean it is automatically enforceable. Courts give varying weight to the contract language used by the parties. In fact, the Restatement (Second) of Contracts § 356 (1981), provides that “(n]either the parties’ actual intention as to its validity nor their characterization of the term as one for liquidated damages or a penalty is significant in determining whether the term is valid.” The validity of the clause depends on its effect as interpreted according to the three factors.
The third factor for determining whether a liquidated damages clause is enforceable – the sum stipulated must be a reasonable preestimate of the probable loss – is often the most difficult to prove.
The number chosen cannot be arbitrary, or the clause will be viewed as an unenforceable penalty to deter a breach of the contract.5
Attorneys are frequently asked to provide a reasonable or “market” number for their clients to insert into their liquidated damages clause. For example, an owner client that is building a manufacturing plant for a construction cost of $15 million might ask: what is a reasonable number for liquidated damages for a plant of this size? The answer is that there is no reasonable or “market” number.
To determine the liquidated damages amount, the owner of the manufacturing plant should consider how he might be damaged if the contractor completes the project late. Factors to consider before arriving at a liquidated damages amount might include the product being manufactured, market conditions, project location, customer demands, and any other facts unique to the project that could affect the damages the owner can reasonably anticipate if the project is completed late.
One method parties can use to arrive at a liquidated damages amount is to prepare a spreadsheet documenting all potential damages for late completion. The parties should save all written assumptions, negotiations, and calculations used to arrive at the liquidated damages amount in case the issue of enforceability arises in the future.
In contrast to a liquidated damages clause, an incentive/ early completion bonus clause rewards the contractor for doing more than is required by the contract; particularly, finishing the project early. An example of an incentive/ early completion bonus clause follows:
If Final Completion is attained on or before the Substantial Completion date (the “Bonus Date”), Owner shall pay Contractor at the time of Final Payment an early
completion bonus of _____________ _ Dollars ($ _____ ) for each day that Substantial Completion is attained earlier than the Bonus Date.•
The early completion bonus can be a stipulated amount for completing early or an agreed sum per each day of early completion. The amount of the bonus and how the bonus is paid does not need to be equal to or based on the liquidated damages provision.
Many construction professionals wrongly believe that liquidated damages clauses are only enforceable if there is a corresponding incentive or bonus clause for early completion. While the origins of this misconception are unclear, the following Georgia statute providing for the use of these clauses in public works construction contracts could lead some to incorrectly believe you need to have one to have the other:
Public works construction contracts may include both liquidated damages provisions for late construction project completion and incentive provisions for early construction project completion when the project schedule is deemed to have value. The terms of the liquidated damages provisions and the incentive provisions shall be established in advance as a part of the construction contract and included within the terms of the bid or proposal.
The fact that both types of clauses are mentioned together in the same statute does not mean they must be used together.
While liquidated damages and incentive clauses are not required to operate together, they are often found together when it is very important to achieve timely completion. Liquidated damages protect the owner, but they are a negative incentive for the contractor to achieve timely completion. A positive incentive, such as an incentive/ early completion bonus clause, reinforces the importance of timely completion, provides mutuality, and adds focus and extra incentive for the contractor.
1 See, e.g., O.C.G.A. § 13-6-7 (“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.”).
2 Ryder Truck Lines, Inc. v. Goren Equipment Co., Inc., 576 F. Supp. 1348, 1357 (N.D. Ga. 1983)(finding that “a liquidated damages provision in a contract
will be upheld if it is truly in the nature of liquidated damages and is not a penalty. If the liquidated damages provision is found to be a penalty, that provision is void and unenforceable.”).
3 Id. at 1357.
5 Id. at 1358 (“The court finds that a preestimate of probable loss in the amount of $37,500 more than the amount due under the Contract is highly unreasonable, even in a fluctuating market. Moreover, it appears that the figure chosen was arbitrary, leading the court to again suspect that the amount may have been a penalty to deter defendant from breaching the Contract.”).