Shapiro, LifschitzEnforcing Liquidated Damages Clauses

By Judah Lifschitz, James McMichael and Alexis Lockshin 

 An owner's damages resulting from delay in completion of construction can take varying forms depending on the project's nature and type of financing. Lost rental revenues are common with respect to apartments, shopping centers and office buildings; delayed condominium closings can cause lost value; and lost operating revenues are common with respect to industrial facilities. Additional interest during construction, cost of owner's equity, and additional owner's general and administrative costs also are common.

 Because it's difficult to prove the various types of delay damages suffered by an owner, liquidated damages clauses typically are included in construction contracts. These clauses usually specify a dollar amount of liquidated damages for each day of inexcusable delay beyond a contractually specified date for achieving substantial completion.

 When assessed with liquidated damages, contractors can avoid liability by proving the amount of liquidated damages specified in the contract is a penalty, and therefore the clause is unenforceable as a matter of law.

 Currently, courts and arbitrators use two different approaches to determine the reasonableness of the amounts of liquidated damages and the enforceability of liquidated damages clauses. In each approach, the clause is held enforceable if the amount of liquidated damages specified in the contract constitutes reasonable compensation to the owner for delay damages suffered, and the clause is held unenforceable if the specified amount of liquidated damages is unreasonable and should not result in penalty to the contractor for late completion.

 The two approaches differ in how they distinguish between reasonable compensation versus an unreasonable penalty, and whether the amount of actual delay damages the owner ultimately suffers should have any bearing on the enforceability of the clause.

 The more established approach, called the prospective approach, determines the reasonableness of the specified amount of liquidated damages according to when the contract was signed. This approach requires the judge, jury or arbitrator to determine whether the specified amount of liquidated damages constitutes a reasonable forecast of the owner's delay damages when considered as of the date the contract was entered into. Under the prospective approach, the contractor may be able to have the liquidated damages clause held unenforceable by proving the specified amount of liquidated damages does not reflect a reasonable forecast of the owner's delay damages that might occur in the future.

 In some jurisdictions, such as Texas, an alternative or retrospective approach is employed. Here, the reasonableness of the specified amount of liquidated damages is evaluated by comparison to the actual delay damages the owner ultimately suffers. Under this approach, the contractor can have the liquidated damages clause held unenforceable by proving the amount of the owner's actual delay damages is much less than the amount of the specified liquidated damages.

 In Athens Generating Co. et al. v. Bechtel Power Corp. et al., a construction contract stipulated liquidated damages of $147,000 per day of delay, with the liquidated damages totaling $26.9 million. The Athens contractor argued this amount far exceeded the owner's actual delay damages but the arbitrators held that the owner's actual delay damages were of no legal on sequence, and awarded the owner $26.9 million in liquidated damages.

 In this case, the arbitrators used the prospective approach and determined that, at the time the contract was signed, the specified amount of liquidated damages was a reasonable forecast of the owner's delay damages.

 When faced with a potential liquidated damages liability, contractors should have experienced legal counsel carefully review the facts and laws of the relevant jurisdiction in order to determine the enforceability of the liquidated damages clause. Additionally, contractors should consult experienced legal counsel when negotiating a liquidated damages clause.

Judah Lifschitz is co-president, James McMichael is vice president and Alexis Lockshin is an attorney at Shapiro, Lifschitz & Schram, P.C., Washington, D.C. For more information, call (202) 689-1900 or visit www.slslaw.com. This article originally appeared in the June 2011 issue of Construction Executive Magazine and was reprinted with the authorization of the articles authors.