What Are Liquidated Damages and How Do They Apply to the Construction Industry?
Every contractor knows that construction contracts can be intimidating, fearsome creatures.
Filled with a diverse assortment of clauses, most contracts are loaded with enough potentially harmful language to make the toughest contractor quake in his work boots.
Liquidated damages clauses are one such beast.
Used to guard against any damages that a contractor or owner may suffer if a project is delayed beyond the agreed-upon completion date, they can either be a life-saver or your worst nightmare.
In this article we will answer the question, “What are liquidated damages,” explain why they exist, and show how the right cash flow management solution can put your liquidated damages fears to rest.
Flexbase: Streamlining Payment Processes to Maintain Positive Cash Flow
At Flexbase, our goal is to help construction companies like yours streamline and improve their cash flow.
And being cash flow positive means you can continue to pay your employees regularly.
They’ll stay on the job and get work done on time, so you shouldn’t ever have to pay liquidated damages.
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In a Construction Contract, What Does ‘Liquidated Damages’ Mean?
What are liquidated damages?
“Liquidated damages” is a term that is used in contracts for a variety of industries, including construction.
Basically, it refers to a clause added to the contract that assigns an amount of money, previously agreed on by both parties, that outlines what damages can be recovered in the event of a potential breach of contract.
In the construction industry, the most common breach of contract in a liquidated damages clause is failure to complete work by a time agreed upon by both the contractor and the owner.
Before beginning a project, the contractor and owner will typically agree on a “substantial completion date,” or the date the construction project will be complete and ready to use.
Once the project has been determined to be generally complete, the timer for potential liquidated damages stops running, provided that none of the project’s remaining agreed-upon finishing touches do not prevent usage or occupancy.
Perfection, in the case of a liquidated damages clause, is not the standard, but rather that the majority of the project is complete and ready for use.
The amount listed in the clause should reflect the best estimate of potential damages at the time of signing.
The purpose for liquidated damage funds is to cover the cost for each day the project continues past the previously agreed upon date of completion.
Generally, these funds are deducted from what the owner owes the contractor for the work they have agreed to complete.
In legal terms, liquidated damages are, “Monetary compensation for a loss, detriment, or injury to a person or a person's rights or property, awarded by a court judgment or by a contract stipulation regarding breach of contract.”
And if you are in the construction business you know that having to pay liquidated damages erodes into an already thin profit margin.
How Are Liquidated Damages Clauses Typically Written?
Liquidated damages clauses generally go something like this:
If a contractor fails to successfully fulfill the work originally agreed upon or fails to reach any of the contract milestones, said contractor agrees to pay the owner $[X] per day in the form of liquidated damages for each day the project remains incomplete.
The amount owed in liquidated damages will then be taken out of the original contract price in order to cover expenses, losses, and/or damages that may be incurred by the owner due to the delay in the project’s completion.
In other words:
A certain dollar amount is multiplied by the number of days the project is late, and that amount is then subtracted out from the contract price.
As they are drafting liquidated damages clauses, it is important for contractors and owners to keep in mind that these determinations are legally binding.
If it sounds intimidating, there’s no need to worry.
At Flexbase we partner with construction attorneys who can make sure any liquidated damages clauses in your contracts are reasonable.
Qualifying Factors
The purpose of liquidated damages is to assist the owner by providing compensation for any real or perceived losses they may incur as a result of a project delay.
In order for liquidated damages to be legal, they must meet certain qualifying legal and procedural factors.
First, liquidated damages aren't meant to punish contractors, so they can't be an amount that would be considered excessive or punitive.
$25 per day for every $100,000 of the contract price would be considered reasonable in most instances.
Second, in order to be written into the contract, the amount of compensation awarded per day must be agreed upon, ahead of time, by both parties.
Substantial Completion
Liquidated damages should only apply up to the substantial completion date that was established by the contract.
This means that as long as the building can be used or occupied by the originally agreed-upon date, liquidated damages can no longer be sought by the owner.
Finishing touches do not impact the substantial completion date.
Milestone Deadlines
Depending on how specific the contract is, some contracts may include agreed-upon milestone deadlines which must be completed by specific dates, to better track progress and communication.
Should a contractor fail to meet any of the agreed-upon milestone deadlines, they may be subject to paying liquidated damages.
And it is important to note that a contractor may be subject to paying the cumulative cost of liquidated damages, in the event that they miss multiple milestone dates.
On some occasions, a court may choose to grant a contractor an extension before the liquidated damages begin to accrue if they feel the reason for the delay is deemed reasonable and excusable.
Additionally, if the court makes the decision to uphold the milestone deadlines, the owner will be required to reasonably estimate the cost of damages for the liquidated damages clause to hold up in court. Failure to do so, could result in the judge invalidating the liquidated damages clause.
Why Are Liquidated Damages Clauses Beneficial in Construction?
The most important advantage of a liquidated damages clause in construction is that it sets a predictable tone for the project.
The clause gives the two parties the opportunity to negotiate and settle on both a time frame and an amount that they feel is reasonable and fair.
The inclusion of a liquidated damages clause in construction provides some specific benefits to both the owner and the contractor.
For the Owner
From the point of view of the owner, a liquidated damages clause acts as an inexpensive form of insurance that can give them protection from a project delay, along with any inconvenience or monetary loss that could result if such a delay were to occur.
If the contract is breached, the owner can easily calculate the cost of the damages without having to go through the trouble of actually proving the damages.
This is handy since the process of proving actual damages can be extensive, as well as costly.
When Liquidated Damages Clauses Are Enforced, How Are Funds Paid?
Funds are typically deducted from the total amount an owner is scheduled to pay a contractor.
Since profit margins already tend to be thin in the construction industry, avoiding liquidated damages is crucial.
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The Legality of Liquidated Damages: Are They Enforceable?
You might be wondering how well liquidated damages clauses hold up from a legal standpoint.
The fact is, although they seem great in practice, if they are not done properly, liquidated damages clauses can potentially prove to be unpredictable and difficult to enforce in a court of law.
Let's take a quick look at the main elements the courts look for when determining the legal enforceability of liquidated damages clauses.
Determining Fault
When dealing with liquidated damages, law requires the need to ascertain which party is at fault for any delays and if the project delay is considered to be reasonable.
Delays can be the fault of:
- The contractor
- The owner
- A combination of the two
If it is discovered that the owner is at fault or that they have in any way directly contributed to the delay, it may prove to be much more difficult, if not impossible, for them to collect liquidated damages should the dispute wind up in court.
Provisions Must Be Reasonable
Additionally, the amount stipulated in the liquidated damages clause must be considered reasonable.
Since the purpose of a liquidated damages clause is to provide compensation for the owner, rather than to punish contractors, the total for damages can not be an amount that might be considered punitive or excessive.
For this reason, the owner wants to be certain not to choose an amount that is so high it could never stand up if challenged in court.
Additionally, if the case goes to court, the owner may be called on to show how they initially calculated the amount in the contract and to prove that the amount in the clause is proportionate with their actual or anticipated loss of income due to the breach of contract conditions.
The statutes governing the use of liquidated damages clauses in construction contracts vary from state to state.
Some states allow the clauses to be fairly general, while others tend to be considerably more specific and require certain language.
As always, you will want to carefully familiarize yourself with your state-specific statutes when it comes to dealing with liquidated damages clauses.
Avoid Liquidated Damages by Managing Your Cash Flow With Flexbase’s Free Platform and Keep Your Team on Schedule
When it comes down to it, one of your top priorities as a contractor is to meet your deadlines to avoid having to pay liquidated damages.
If you're worried about missing deadlines in your construction schedule, Flexbase can help.
We have the exact capabilities you need to create a construction schedule that perfectly fits your needs, no matter how large or how small the project.
Our automated system takes care of all of it, keeping the task of scheduling stress-free, productive, and at top efficiency.
Get in touch with us today and let us help you put your concerns about liquidated damages to rest.
