#48: The Use and Abuse of Liquidated Damages
Getting a project completed on time is often crucial to a commercial owner, who must forego the efficiencies or even the business opportunities which motivated him to build the longer the project is incomplete. Making delayed completion a breach of contract is all well and good, but proving the damages that will flow from such a breach can be difficult; the legal standard for recovery of damages requires proof by a preponderance of the evidence that profits would have been realized or increased but for the delay, as well as reasonable certainty as to their probable amount.
It is precisely for such situations that liquidated damages clauses are used in many construction contracts. Damages are agreed to, or “liquidated,” in advance, usually in a particular amount per day of delay, thereby relieving the owner of the burden of proving actual damages. But because the law aims to make the non-breaching party whole and not give him a windfall, courts impose restrictions on the ability to recover liquidated damages – as a check against the possibility that the amount fixed by agreement may be wildly divergent from actual damages, thereby constituting a penalty. A liquidated damages will be enforceable if “(1) the damages anticipated as a result of the breach are uncertain in amount or difficult to prove; (2) the parties intended to liquidate damages in advance; and (3) the amount agreed upon is reasonable and not greatly disproportionate to the presumable loss or injury.” Holloway Automotive Group v. Lucic, 163 N.H. 6, 9-10 (2011).
The first two of these elements are rarely problematic in a construction contract. Almost always, the fight will be over the third element: was the liquidated amount reasonable? Our courts “employ a two-part test to determine whether a liquidated sum is reasonable. First, we assess whether the amount 'was a reasonable estimate of difficult-to-ascertain damages at the time the parties agreed to it.' Next, we ask whether actual damages are 'easily ascertainable' after a breach. '[I]f the actual damages turn out to be easily ascertainable, we must then consider whether the stipulated sum is unreasonable and grossly disproportionate to the actual damages from a breach.' If the stipulated sum is grossly disproportionate to easily ascertainable, actual damages, the provision is an unenforceable penalty, and the aggrieved party will be awarded no more than the actual damages.” Holloway, 163 N.H. at 10.
Let's break this down. The first inquiry is prospective as judged at the time of contracting: was the amount chosen a reasonable estimate of what appeared at the time to be hard to prove with precision? The second inquiry is retrospective: have subsequent events shown that actual damages are easy to prove – and if so, was the original estimate in the ballpark? Thus, the reasonableness of the estimate is judged both prospectively and retrospectively.
Most liquidated damages clauses are premised on delays in substantial completion rather than final completion. The reason is not hard to see: substantial completion is the stage of progress at which the project can be used by the owner for its intended purposes, and once the owner can use it, damages for delay no longer accrue. Nevertheless, I have seen contracts purporting to impose liquidated damages for late final completion, and even for late completion of interim milestones. Whether such provisions are enforceable in court is another matter. My guess is that these are likely to be deemed unenforceable penalties.
If a liquidated damages clause is unenforceable, the non-breaching party can still recover any proveable actual damages. General Linen Services, Inc. v. Franconia Investment Associates, L.P., 150 N.H. 595, 600 (2004). The more interesting question is whether a nonbreaching party can choose to sue for actual damages in the face of a valid liquidated damages clause. As long as the contract expressly gives an option to pursue either, the answer appears to be Yes – although “where an election is permitted, the election of one remedy bars pursuit of the other,” because “the right to recover liquidated damages and the right to recover actual damages are mutually exclusive remedies,” Orr v. Goodwin, 157 N.H. 511, 517 (2008).