Thought Leadership

Liquidated Damages in Construction Contracts: Some clauses are more equal than other clauses.

Posted by Beth Jones | Nov 09, 2020

One of my favorite books of all time is Animal Farm.  In the book a group of farm animals rebel against the farmer, take over the farm, install a communal system, and declare that all animals are equal.  It works well for a while; but eventually the pigs commandeer the farm for themselves replacing the farmer and leaving the other animals in a worse situation than they were under the farmer's rule.  They do so gradually, overtime.  First, under the guise that all animals are equal, they assign work all animals must do.  Eventually, the work becomes more than the animals did under the farmer.  Then the pigs install governance rules and systems; each with a particular purpose which appears reasonable at the time.  Eventually, the rules and systems installed by the pigs burden the other animals more than the farmer's ways.  Finally, the pigs eliminate the other animals' participation in how the farm is run and, instead, create a committee of pigs to make the decisions.  Along the way, each action the pigs take results in incremental benefit to the pigs at the expense of the other animals.  In the end, the pigs declare:  All animals are equal, but some animals are more equal than others.

If you look at the animal farm at the end of the book, it makes no sense that the other animals actually fought to throw out the farmer.  In fact, the animals were better off under the farmer than they were under the pigs.  Only once you understand how the pigs got to be in charge, can you understand why the animal farm is the way it is.

The operation of some contract clauses reminds me of the animal farm.  For example, look at liquidated damages.  Courts generally state that liquidated damages are enforceable only if the following requirements are met:

  • The clause has a valid purpose–that is it is not intended as a penalty or spur for the contractor's performance;
  • The amount of the liquidated damages is reasonable in light of anticipated loss caused by breach; and
  • It would be very difficult to determine the actual loss caused by the breach.

Looking at these rules, it would only be natural to scratch your head and wonder, why does this make sense; why doesn't the clause just mean what it says?  Courts don't find other clauses require a valid purpose before they can be enforced.  They don't look at the reasonableness of other clauses before they hold parties to those terms.  Nor do they typically look at the difficulty of determining something controlled by other contract clauses; courts generally are left only to interpret what is written, not read additional restrictions into a clause.  So why are liquidated damages any different.  Doesn't the existence of that clause in the contract indicate that the parties have freely agreed to it?  Why don't courts just blindly hold the parties to their bargain?  In my opinion, the best way to understand why these rules exist is to understand how they, like the pigs at the animal farm, came into power.  The story begins long, long ago ….

In old England, contracts were typically secured by a penal bond.  If owner contracted with builder to construct a new barn, owner typically would require builder to guarantee his performance by a penal bond.  That bond's penal sum was usually twice the amount of the contract.  If builder failed to perform, even in the slightest, owner could sue on the bond and receive a judgment for the penal sum.

The court system back then looked very different than our courts do today.  There were actually two court systems:  Courts of law and courts of equity.  If owner sued builder on a penal bond, that action would be in a court of law.  However, after owner got his judgment, builder could go to the court of equity and ask for relief from that judgment.  The court of equity was said to exist to ensure justice was done.  Thus, when a court of law gave owner a judgment, builder could get relief from that judgment if the judgment was not considered fair by the chancellor who ran the court of equity.  And that is exactly what started to happen back in old England.  Courts of equity basically said that requiring builder to pay owner twice the value of the barn just because builder failed in some minor respect to satisfy the terms of the contract was unfair.  It was unfair because owner didn't actually suffer that much damage and was getting a windfall at the poor contractor's expense.  (It bears noting that during this time, the owners would have been wealthy land barons and builders would have been the far less well-off).  Instead, the courts of equity would generally only allow owner to collect his actual damages resulting from builder's breach, regardless of the penal sum of the bond guaranteeing builder's performance.  As this became known by owners overtime, they stopped wasting their time suing on penal bonds and began simply suing for what they would be able to collect, actual damages.  The rule that emerged was a breach of contract only entitles the non-breaching party to his or her actual damages, regardless of what the bond (or the contract) provided.

Fast forward to America.  American courts didn't start with a clean slate.  Instead, they incorporated a lot of the rules from our founders homeland, including the rule that disfavored penalties for breaching a contract.  At the same time, Americans were a rugged bunch who valued there freedom.  In particular, they valued the ability to make a deal and hold the other party to it without interference from the king.  (A side note here is that the court of equity was, essentially, the kings court which is why America never had a federal court of equity, though many states did at one time).  And there is a natural tension between the freedom of contract (to make whatever deal the parties agree to without interference from the government) and courts refusal to enforce a penal provision in a contract.  Thus, American courts were in a bind:  On one hand, the courts existed to ensure parties lived up to the deal they made and on the other hand they were bound by common law rules which disfavored penal contract provisions.  American courts were in a pickle they had to resolve.

The resolution of this tension is why liquidated damages clauses have a peculiar set of rules.  First, American courts in the early twentieth century decided they would enforce liquidated damages clauses in construction contracts, but only if the parties intended the clause to compensate the non-breaching party for its damages.  The courts would not, however, be used as a tool to, for example,  punish the contractor and provide the owner a windfall.

Second, the courts decided that they would only enforce a liquidated damages clause that set a reasonable amount in light of what was contemplated.  Although courts have gone back and forth on how to implement this rule, the majority have settled on what is known as the “first look” rule.  Under that rule, courts will look at the order of magnitude of damages anticipated when the contract was formed and compare that to the liquidated damage amount in the contract.  If the two numbers are in the same ballpark, the amount will pass muster.  A minority, however, require the actual damages suffered by the owner after the contractor breaches be in reasonable proportion to the liquidated damages in the contract.

Third, American courts came to hold that if the damages sought to be compensated through the liquidated damages clause were difficult to determine, enforcing the clause would actually help the parties.  It would help, for example, because without specifying an amount in the contract, a prudent contractor giving a price to an owner might be forced to raise its price to cover potential liability if it was unable to perform perfectly–liability that may never occur resulting in the contractor receiving a windfall.  In the end, these three general rules have permeated most jurisdictions in America and are the rules of decisions usually used when courts are called to decide whether a liquidated damages clause is enforceable.

Not all contract clauses have such a rich history.  Those that do, however, often result in good contract drafters incorporating relevant recitals into the contract clauses.  Thus, you can see this storied development of the liquidated damages clause when you read most standard form construction contract's liquidated damages clause.  For example, the contracts include such phrases as the liquidated damages are “not as a penalty” (AIA); the owner's damages “are just damages that are proportionate” (EJCDC), and that the damages provided “are difficult to determine” (ConsensusDOCS).

Contractors, owners, and designers often believe the contract is the sole and exclusive basis for judging disputes on construction projects.  There's a lot of truth to that–especially when the contract is well written and includes, for example, the rules governing liquidated damages.  Drafting a contract this way, assists the project personnel in using the contract effectively.  But there is often more than meets the eye.  Looking at a liquidated damages clause or hearing a lawyer explain to you that your liquidated damages clause might or might not be enforceable based on the purpose of the clause, the reasonableness of the amount, and the difficulty to determine actual damages will certainly drive that point home.  My point with this brief post is simply that while you may believe all clauses are equal, the reality is that some clauses may be more equal than other clauses.

About the Author

Beth Jones

Firm Administrator and Paralegal

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