Frederick Cohen
John S. Wojak
In construction contracts, liquidated damages clauses are a common way for a project owner/developer to protect against delays in completion by the contractor. In their basic form, such clauses typically provide that for each day of delay beyond the contractually mandated completion date, the contractor will pay to the owner a stipulated, or "liquidated," sum in lieu of actual damages. These clauses are favored by owners as seemingly providing guaranteed financial protection for delayed completion by eliminating the challenges involved in recovering actual damages, such as financing costs, lost rent or lost sales opportunities. Not only can these costs be difficult to prove, but they also may be unrecoverable in litigation as speculative or not foreseeable at the time the contract was entered. However, while liquidated damages clauses might on the surface seem simple and ironclad—after all, what could be difficult about counting the days the contractor was late—they are fraught with pitfalls and their assumed protection can be elusive.
Exclusive Remedy
One potential pitfall is the "belt and suspenders" approach of contract drafting, i.e., providing for both actual and liquidated damages. While in many cases providing for duplicative protections might be prudent, this is not one of them. Liquidated damages are intended to take the place of actual damages as a reasonable estimation when actual damages would be potentially difficult to calculate,[1] and thus are an exclusive remedy which must be used in lieu of, and not in addition to, actual damages.[2]
Even if an owner's provable actual damages exceed the stipulated daily amount, the owner's recovery will be limited to the stipulated amount.[3] Where a contract expressly provides for both liquidated and actual damages, the liquidated damages clause will be read out of the contract as an unenforceable penalty, thereby forcing the owner to prove its actual damages and depriving it of the ease of relying upon the stipulated sum.[4]
The lessons of the "belt and suspenders" mistake are twofold: liquidated damages must be an exclusive remedy, and they must not be an impermissible penalty. While the liquidated damages in the above example were deemed a penalty because they accrued in addition to actual damages, liquidated damages alone can be deemed an unenforceable penalty based upon the stipulated amount. Despite the fact that the underlying justification for liquidated damages is the parties' recognition of the difficulty in calculating actual damages, the liquidated damages amount must nevertheless be a reasonable estimate of the contracting party's anticipated actual damages.[5]
A clause that does not meet this standard (such as one providing for recovery of both actual and liquidated damages, or one with a sum that is disproportionate to anticipated actual damages, and therefore serving more as coercion than compensation) will be stricken as an unenforceable penalty, as will also a liquidated damages clause where the actual damages are easily ascertainable.[6] These interpretations are made as of the time the agreement is entered into, not the time of breach.[7]
Timing and Nature of Delay
Other potential bars to the enforceability of liquidated damages revolve around the timing and nature of the delay. The typical liquidated damages clause is tied to the project's "substantial completion date" (usually defined as the point at which the project may be used by the owner for its intended purpose); thus, liquidated damages are not enforceable or recoverable for subsequent delays of the remaining work following substantial completion.[8] This especially may be the case if the owner has beneficially occupied the substantially completed project before the delayed final completion date.[9]
Liquidated damages also may not be recoverable if a contractor abandons the project; since the contractor never achieved substantial completion, liquidated damages would theoretically continue to accrue for an infinite number of days, an illogical result.[10] In such a case, the owner nevertheless may still recover its provable actual damages for delay.[11] While there is no case addressing whether in such a situation the owner's recovery of actual damages would be limited to a daily amount not exceeding the agreed-to liquidated damages amount, this would seem to be the expected result in order to prevent the owner from enjoying a windfall beyond its negotiated bargain.
Similarly, if the contractor never substantially completes the project because the contractor is terminated by the owner "for cause" before achieving substantial completion (in general, a contract cannot be terminated for cause after the contractor has achieved substantial completion unless it specifically allows for such a termination), a liquidated damages provision may be unenforceable unless such provision explicitly includes terminations within its scope.[12]
Conversely, in another frequent scenario, a contractor that has delayed substantial completion may be allowed to continue performing beyond the specified date until the contractor achieves a delayed substantial completion. This is often the case since the cost to the owner of replacing the late-performing contractor with a new contractor can be prohibitive. However, if the owner permitted the contractor to continue working beyond the contractual substantial completion date without assessing or expressly reserving its right to assess liquidated damages for the delayed completion, the owner may be deemed to have unintentionally waived its right to enforce the liquidated damages clause. The failure to achieve the contractual substantial completion date is a material breach, and the owner's acceptance of the non-conforming performance may be a waiver of that breach.
Responsibility for Delay
Yet another potential bar to the enforceability of liquidated damages is the common scenario where both the owner and contractor bear some responsibility for the delay. In such cases, the general rule is that liquidated damages are unenforceable because the delay may not be apportioned between the parties for the purposes of the liquidated damages clause, and the owner instead must prove actual damages[13] but with such damages capped at a daily rate equaling the liquidated damages amount (to prevent the owner from using its own contribution to the delay to recover damages in excess of the liquidated amount).[14] However, this seemingly harsh result rarely occurs because this general rule applies only to contracts that do not provide a mechanism for extensions of the contract time for causes of delay beyond the contractor's control.
Since nearly all construction contracts now expressly provide a mechanism for such extensions, they fall into an exception: Where the contract provides for time extensions for "excusable" delay, the days of delay can be apportioned between those caused by the contractor and those caused by the owner (or other excusable causes outside of the contractor's control), and liquidated damages can be assessed against the contractor for those days for which it bears responsibility (offset against any contractually allowable recovery by the contractor for its own delay-related costs allocable to the days of excusable delay).[15]
Performance Bond
What if the contractor has provided the owner with a performance bond from a surety company? Are liquidated damages recoverable from the surety under the terms of the bond? This can be problematic, depending upon the express terms of both the bond and the construction contract. In the first instance, several commonly used performance bond forms require that the owner take the key step of actually terminating the contractor before the surety has any performance obligations, yet paradoxically, liquidated damages may not be recoverable once the contract has been terminated unless it specifically provides that liquidated damages survive termination.
Since a surety's liability is generally coextensive with that of its principal,[16] this may also prevent recovery of liquidated damages from the surety. Such a requirement in the bond requiring the termination of the contract would essentially bar any recovery of liquidated damages for post-substantial completion delays, even if they were allowed under the contract, since a contract may not be terminated for default once the contractor has achieved substantial completion.[17]
Furthermore, case law is not clear-cut as to whether liquidated damages are recoverable from a surety in the absence of language in the bond itself explicitly including this liability in the surety's obligations. Any recovery of liquidated damages will be capped by the penal limit of the performance bond.[18] However, depending upon the language in the bond, the surety may be liable for actual damages (not limited to the daily stipulated liquidated sum) for additional delays caused by the surety in responding to the owner's bond claim, separate and apart from the delays caused by the contractor.[19]
Subcontract Agreements
While the discussion above has focused on construction contracts between owners and contractors, such clauses also frequently appear in subcontract agreements. In general, such clauses serve a dual purpose: (i) allowing the general contractor to pass along to the responsible subcontractor any liquidated damages liability assessed against the general contractor by the owner due to late performance by a subcontractor and (ii) allowing the general contractor to recover its own internal and external costs resulting from the delay. However, these subcontract clauses raise the question of whether a general contractor may assess liquidated damages against a subcontractor when the owner has not assessed them against the general contractor.
It is unknown how New York courts would rule, and such recovery may depend upon the express language of the contract; however, in at least one other jurisdiction, recovery by a general contractor from a subcontractor of a stipulated daily liquidated damage on top of a pass-through of delay damages assessed against the general contractor by the owner was barred as constituting a windfall to the general contractor.[20] New York State's Prompt Payment Law, N.Y. Gen. Bus. Law 756-a(3)(b)(iii), further complicates the issue as it appears to prohibit a general contractor from assessing liquidated damages against payments to a subcontractor when the owner has not similarly assessed them against the general contractor, but this statutory provision has yet to be interpreted by the courts.
Conclusion
A liquidated damages clause can be a powerful remedy for an owner/developer to protect itself against delayed completion by its contractor. However, its protection is not foolproof. A liquidated damages clause should be carefully drafted to avoid it being construed as an unenforceable penalty and to ensure that it is applicable to the broadest range of circumstances. Moreover, the owner should consider how its actions and other circumstances during the life of the project may impact its ability to recover these seemingly ironclad damages; otherwise, it may find that what seems definitive may be, in fact, illusory.
Endnotes:
1. J.R. Stevenson Corp. v. County of Westchester, 113 A.D.2d 918, 920 (2d Dept. 1985); X.L.O. Concrete Corp. v. John T. Brady and Company, 104 A.D.2d 181, 183-4 (First Dept. 1984), affirmed on opinion below, 66 N.Y.2d 970 (1985).
2. X.L.O. Concrete at 184-185; Babylon Associates v. County of Suffolk, 101 A.D. 207, 217 (2d Dept. 1984).
3. X.L.O. Concrete at 184-185.
4. Jarro Building Industries v. Schwartz, 54 Misc.2d 13 (Appellate Term, 2d Dept., 1967); see also Food Management Group v. Matrix Realty Group (In re Food Management Group), 2007 Bankr. LEXIS 4193, *8-9 (Bankr., S.D.N.Y., Dec. 10, 2007).
5. Stevenson at 920; X.L.O. Concrete at 183-184.
7. Stevenson at 921; X.L.O. Concrete at 184.
8. Schloss v. Troman, 154 A.D. 645, 648 (1st Dept. 1913). At least one currently commercially available contract form, the ConsensusDocs 850—Standard Agreement Between Owner and Trade Contractor—explicitly provides for liquidated damages for delays in achieving final completion in addition to liquidated damages for delays in achieving substantial completion.
10. City of Elmira v. Larry Walter, Inc., 76 N.Y.2d 912, 913-914 (1990); Savoy Little Neck Associates v. Halpern Construction, 1 A.D.3d 129, 130 (1st Dept. 2003).
12. Village of New Paltz v. Merlex Contracting, 12 A.D.3d 745, 746 (3d Dept. 2004); Savoy at 130.
13. Blue Heron Construction Company v. Village of Nunda, 63 A.D.3d 1694, 1696 (4th Dept. 2009); Stevenson at 921; Babylon Associates at 217.
15. Blue Heron at 1696; Mars Associates v. Facilities Development Corporation, 124 A.D.2d 291, 292-293 (3d Dept. 1986); Stevenson at 921-922; X.L.O. Concrete at 104.
16. Babylon Associates at 218.
17. 845 Un Limited Partnership v. Flour City Architectural Metals, 28 A.D.3d 271, 272 (1st Dept. 2006); F. Garofalo Electric Co. v. New York University, 300 A.D.2d 186, 189 (1st Dept. 2002).
18. Land Mine Enterprises v. Sylvester Builders, 74 F.Supp.2d 401, 408 (S.D.N.Y. 1999), aff'd, 234 F.3d 1262 (2d Cir. 2000).
19. International Fidelity Insurance Company v. County of Chautauqua, 245 A.D.2d 1056, 1057-1058 (4th Dept. 1997).
20. P & C Thompson Bros. Construction Company v. Rowe, 433 S.2d 1388 (Fla. D.C. 5 Dist. 1983).
Reprinted with permission from New York Law Journal, © ALM Media Properties LLC. All rights reserved.