Construction contracts commonly contain language providing for a stipulated sum of money as damages for each day of delay the project fails to meet a specific milestone, such as substantial completion. These are referred to as liquidated damages clauses, and their enforceability varies state by state.
The theory behind a liquidated damages clause is that the contractor and owner have agreed, at the time of the contract’s formation, on the method of calculating the owner’s damages in the event the project is delayed. In reality, there is likely very little negotiation on the stipulated sum, due to the contractor’s inherently less bargaining power and inferior knowledge of the owner’s damages. In evaluating this stipulated sum, courts will attempt to determine its reasonableness by examining the parties’ knowledge and position at the time of contract execution as opposed to the time of the breach itself.
While the modern trend is for courts to review liquidated damages provisions with candor, and even with favor, courts will reject liquidated damages provisions when they are deemed a penalty for a party’s breach of the contract. This stems from the idea that contract damages are designed to reimburse the non-breaching party for the damages suffered as a result of the breach of contract. These damages are not designed to create a windfall for the nonbreaching party, allow the recovery of unearned profits, or otherwise put the nonbreaching party in a better position than had the contract been performed as the parties originally anticipated.
While liquidated damages are always unenforceable when they constitute a penalty, every state varies with its requirements for a liquidated damages provision to be enforceable. The Florida Supreme Court has created a two-pronged test to determine the enforceability of a liquidated damages provision. A proper liquidated damages provision in Florida must satisfy two parts:
In addition to the requirement that the damages not be readily ascertainable and not grossly disproportionate to the damages that may be reasonably expected to follow, a Florida liquidated damages provision will be rendered unenforceable if the contract provides the nonbreaching party with the option to choose between recovering its actual damages or the liquidated damages amount. The liquidated damages provision will not be rendered unenforceable if the contract also permits the nonbreaching party to elect specific performance.
The reason that Florida courts do not permit parties to stipulate to a liquidated damages amount and sue for the recovery of their actual damages is that it frustrates the purpose of a liquidated damages clause. By permitting parties to recover actual damages in addition to liquidated damages, courts would disincentivize parties from attempting to accurately estimate their loss at the time of contract formation.
Liquidated damages provisions will also not be enforced if the circumstances at the time of the breach would make it unconscionable to do so. For example, Florida courts have determined that a liquidated damages provision is unconscionable, and thus unenforceable, when the amount to be retained as liquidated damages would amount to over 55% of the overall contract price.
When courts attempt to determine whether the damages were readily ascertainable, the court will evaluate this at the time of the contract’s formation, not the ultimate breach. Courts will uphold a liquidated damages provision where the damages were not ascertainable at the time of the contract’s formation even if the damages are easily ascertainable at the time of the contract’s breach.
When challenging the enforceability of a liquidated damages provision, the party seeking to have the provision struck as a penalty bears the burden of proof. This means that when a contractor seeks to invalidate such a provision, the contractor must affirmatively demonstrate and prove that either (1) the damages were readily ascertainable at the time of contract formation; (2) the damages are grossly disproportionate to the damages that would be expected upon a breach of the contract; or (3) the enforcement of the liquidated damages provision would be unconscionable. A contractor who pleads and proves these facts may avoid the imposition of liquidated damages by having the provision struck. If the court strikes a liquidated damages provision, the nonbreaching party will be entitled to recover the actual damages that were sustained as a result of the breach.
A party who contributes to a project’s delay will also not be entitled to recover any liquidated damages that are associated with the delay. An owner may not recover liquidated damages if they are the cause of the delay, or the delay is the result of the actions of both parties. The best way for general contractors to protect themselves against liquidated damages is to draft their subcontractor agreements with language permitting them to pass through liquidated damages imposed against them to the responsible subcontractor. This is because the liquated damages that are assessed against a general contractor may serve as evidence of actual damages against a responsible subcontractor when the subcontractor is solely responsible for the delay.
If you have specific questions regarding the development of a liquidated damages clause, or the enforcement of a specific liquidated damages clause, please reach out or seek further advice from a competent construction attorney.