The Liquidated Damages Clause—When is it just a Penalty?
By Sarita Smithee
Construction contracts often contain a liquidated damage clause that provides for payment a stipulated amount in the event that work is not completed within a specified period. Owners often impose these clauses against contractors to ensure the timely performance by penalizing the contractor if the work is not completed on time.
Purpose of Liquidated Damages Clauses
Construction contracts include liquidated damages clauses for project delays because damages caused by delays are often difficult to foresee. Liquidated damages may be assessed by owners for failure to timely complete a project, or, less commonly, they may be claimed by contractors when owner delays increase the costs of project completion.
Typically, a liquidated damages clause specifies an amount per day that the owner is entitled to recover in damages if the contractor fails to complete the project by the contracted completion date. The term “liquidated” is used to signify the agreed amount of damages an owner will recover in the event of a delay, and eliminates what can be a lengthy and expensive process of proving the actual damages.
However, the inclusion of a liquidated damages clause does not always mean that provision is enforceable. Although competent parties generally have the right to make their own bargains, this right is not unlimited.
The enforceability of a liquidated damages clause depends on multiple factors
Generally, a liquidated damages clause will be be upheld if it was created by the parties in an attempt to estimate, in advance, the actual damages that would be suffered in the event of a material breach. However, if the only rationale for enforcement of the clause is that the project was not completed on time, the Court will likely view the clause as a penalty and unenforceable if it is challenged, absent some other evidence that late completion caused actual damages.
In evaluating whether a liquidated damages clause is enforceable, Texas courts have generally looked to the following factors:
- Whether the amount stipulated in the contract was a reasonable forecast, at the time the parties contracted, of just compensation for the harm that is caused by the breach;
- Whether the harm that was caused by the breach is one that is incapable or very difficult of accurately estimating;
- Whether the amount of liquidated damages to be assessed was disproportionate to the amount of actual damages incurred;
- Whether the liquidated damage provision applies equally to both material and minor breaches; and
- Whether the liquidated damage provision was not intended to provide fair compensation for the breach but instead to secure timely performance of the contract.
Owners may attempt to address these factors by specifically drafting the liquidated damage clause to state that it is not intended to be a penalty. If the clause was negotiated by the parties, as opposed to boilerplate language inserted by the owner, this language can help the owner prove the parties’ intent.
If an owner uses the same amount for liquidated damages in all of its contracts, courts will often find that the provision was intended as a penalty and, therefore, unenforceable. The liquidated damage provision therefore should be tailored to the particular contract. Similarly, if the same amount of liquidated damages will be triggered by either a material or minor breach, courts have held that the liquidated damage provision is unenforceable even if there has been a material breach.
A party who is seeking to craft a liquidated damage provision that would be upheld by the Texas courts should consider a pre-contract analysis as to what the potential damages could be if the work were not completed on time, and should document it in the file.
Provisions should be crafted so that they do not apply equally to both a minor and material breach. A liquidated damage provision that applies equally to “the failure to perform any obligation required by the contract” should be avoided.
As noted above, the inclusion of liquidated damages clauses is commonplace in construction contracts. Knowing what is required for those clauses to be enforced is useful information for either party to a construction contract, whether attempting to enforce a liquidated damages clause or trying to defeat its enforcement.
Sarita Smithee is an associate with The Beckham Group in Dallas, Texas. The Beckham Group has extensive experience with, and specializes in, business litigation both as a Plaintiff and a Defendant. The firm drafts and prosecutes/defends civil cases involving numerous types of contracts, and has just about seen it all.
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