When to Have the Hard Talk About Setting Liquidated Damages

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on September 17, 2020.

Before a project begins, leadership for both contractors and owners want to build trust and focus on delivering a successful project that meets everyone’s expectations. Establishing a positive relationship is hard, however, if the focus of discussions is on who pays the other, and how much, when things go wrong. Besides, there are more important things to figure out first, such as pricing, schedule, and entitlements. Risk allocation can come later when the lawyers are involved, right?

Maybe. But maybe not, especially when it comes to liquidated damages, which is one of the top five heavily negotiated (and litigated) clauses in a construction contract, at least in this author’s experience.

As most in the industry know, because an owner’s potential delay damages are often difficult to ascertain with certainty at the beginning of the project, the parties stipulate what those damages will be in advance through their contract – in other words, they liquidate the amount of the owner’s delay damages. Liquidated damages are in lieu of actual damages and ordinarily shouldn’t be a penalty, depending on state law. In theory, at least, the benefit of this approach is that it provides both sides with certainty for a risk that is highly uncertain: late delivery. A contractor will know its risk for being late (and may later need to weigh that risk/cost against the cost of acceleration), and the owner may take comfort in the fact that, at the very least, it has a tool to motivate the contractor to stay on task.

There are a number of ways to craft this important risk-shifting clause. Contractors usually try to front load a grace period into the calculation, before being charged some amount per day (possibly tiered) on a moving forward basis. Contractors will also try to cap the total amount of liquidated damages to a sum certain (e.g., the amount of their fee) as a liability limitation. Owners, on the other hand, will want a large liquidated number that captures their lost revenue, lost financing, extended architect fees, insurance, and other carrying costs, among other things. Market forces (namely, contractor leverage) often preclude owners from capturing all of their losses in a liquidated damages clause. But sophisticated owners know that if they don’t capture those losses to a large degree, and the contract includes a broad mutual waiver of consequential damages, they may have no meaningful recovery for contractor-caused delay.

Given the importance of this clause, when should liquidated damages be discussed?

One school of thought (for private owners) is that liquidated delay damages should be discussed only after the contractor has produced a schedule, which usually evolves until the drawings reach about 90% construction documents. Otherwise, the thought is the contractor could submit a schedule with excessive float (intended to absorb contractor-caused delays) that pushes out the substantial completion date beyond what it reasonably should be. In other words, the schedule is pushed so far out the contractor will likely never be assessed liquidated damages in the first place.

Another school of thought is that if an owner waits too long to negotiate a liquidated delay damages clause, the owner could face a closing deadline without a contract in place. This may leave the contractor with more leverage in negotiating delay damages, knowing the owner has no other contractor in the wings if negotiations fail (at least in a busy contractor market). A typical contractor response to the late introduction of a hefty liquidated damages clause is, “I didn’t factor that amount of risk in my fee or GMP. If you want that, my fee will increase.” And that very well could be true. This puts the owner in a pinch because agreeing to a liquidated damages sum that is too small or capped too low can put the owner in a worse position than having no liquidated damages at all. If the amount of liquidated damages is too small, for instance, the contractor may build the entire loss into its fee (or built-up rates) and then have no real contractual motivation to finish on time.

With that risk in mind, some owners address liquidated damages very early on. When issuing a request for proposals (RFP) from contractors during the pre-construction phase, owners frequently request a breakdown of the contractor’s proposed fee, estimated guaranteed maximum price (GMP), general conditions costs (fixed or capped), general requirements/fixed negotiated support services (if different), and schedule. In addition, some owners also include an anticipated range for liquidated damages in the RFP and ask contractors to include a proposed liquidated damage amount in their RFP response. They would argue that this approach gives them the benefit of competition, while giving the contractor a reasonable opportunity (and transparency) to develop a competitive fee.

Of course, there is nothing wrong with an “actual delay damages” clause. While proving actual damages may be harder than a liquidated damages calculation, there are many advantages to relying on actual damages. These include less risk of underestimating or overestimating the damages, less haggling up front in contract negotiations, and avoidance of the view by some that liquidated damages “aren’t real.”

There is no “right” approach to delay damages, but timing alone can create leverage in discussions over this important risk.