Managing Risk: Handling Liquidated Damages. Ross C. Wecker. Kenney & Sams

Transcription

1 Managing Risk: Handling Liquidated Damages Ross C. Wecker Kenney & Sams Old City Hall 45 School St Boston, MA (508)

2 Ross C. Wecker is a director at Kenney & Sams, P.C., in Boston. Ross is a civil trial lawyer with a focus in tort and business litigation, construction law and risk management, and real estate related litigation. Before becoming a lawyer, Ross obtained a Civil Engineering/Construction Management degree and worked for several years as a Project Engineer for a large general contractor.

3 Managing Risk: Handling Liquidated Damages Table of Contents I. An Introduction to Liquidated Damages...5 II. Defenses to Liquidated Damages...6 III. Risk Considerations with Respect to Liquidated Damages...7 A. Mutual Evaluation of Potential Loss...7 B. Exclusivity of Remedy...8 C. Concurrent Delay...8 IV. Conclusion...8 Endnotes...9 Managing Risk: Handling Liquidated Damages Wecker 3

4

5 Managing Risk: Handling Liquidated Damages Although the idea of liquidated damages in a construction contract may have been relatively uncommon not that long ago, today most parties to the construction process have had some experience with a liquidated damages provision. As such clauses become more and more commonplace within the construction industry, it is only logical that parties take an active approach in managing risks associated with liquidated damages. This article provides a basic overview of liquidated damages provisions, defenses to those provisions, and some basic strategies for managing the risks associated with liquidated damages. I. An Introduction to Liquidated Damages Liquidated damages are the sum that parties to a contract agree shall be paid when one of the parties fails to satisfy some specified portion of their agreement. In construction contracts, liquidated damages typically are a daily specified amount backcharged to the contractor for every unexcused day it takes to substantially complete the project after the contractually defined substantial completion date. The following is a typical liquidated damages provision: [i]f the Contractor shall fail to achieve Substantial Completion within the Contract Time, it shall be liable to pay the Owner the daily amount specified in the Agreement, not as a penalty, but as fixed and agreed upon damages for breach of contract. As referenced above, liquidated damages provisions are now common in both private and public construction project contracts. Both the AIA A General Conditions and ConsensusDOCS 200 provide that the waiver of consequential damages as specified in those documents does not preclude recovery of liquidated damages. 1 Accordingly, it is important to understand what a liquidated damages provision is, the defenses that might be applicable to such a clause, and what should be considered in managing the risk associated with such clauses. As an initial matter, it is important to understand the requirements for the creation of a valid liquidated damages clause. Massachusetts case law indicates that liquidated damages are viewed as an equitable remedy and that, therefore, such provisions cannot be enforced where doing so violates equity principles. See Peabody N.E., Inc. v. Town of Marshfield, 426 Mass. 436 (1998); Morgan v. Town of Burlington, 316 Mass. 413 (1944). In further developing these equitable principals, [i]t has long been the rule in Massachusetts that a contract provision that clearly and reasonably establishes liquidated damages should be enforced, so long as it is not so disproportionate to anticipated damages as to constitute a penalty. TAL Financial Corp. v. CSC Consulting, Inc., 446 Mass. 422, 431 (2006). Liquidated damages must be calculated to reasonably compensate the injured party for its loss, rather than simply to punish the breaching party. Kimco v. Cliftex Co., No , 1998 WL , at *2 (Mass.Super. July 6, 1998). More specifically, two criteria must be established if a liquidated damages clause is to be enforced. First, it must be established that at the time of contracting that the actual damages flowing from a breach were difficult to ascertain. Second, it must be shown that the sum agreed on as liquidated damages represents a reasonable forecast of damages expected to occur in the event of a breach. The reasonableness of the measure of anticipated damages depends on the circumstances of each case. NPS, LLC v. Minihan, 451 Mass. 417, 420 (2008), quoting Cummings Properties, LLC v. National Communications Corp., 449 Mass. 490, 494 (2007). Managing Risk: Handling Liquidated Damages Wecker 5

6 Thus, whether actual damages were reasonably ascertainable and whether the agreed upon liquidated sum was reasonable at the time the parties entered into their contract, determine whether the provision is valid. Kelly v. Marx, 428 Mass. 877 (1999). The Supreme Judicial Court has concluded that this approach is appropriate because it most accurately meets the parties expectations when they agreed to the contract at issue. Even where the liquidated damages are ultimately disproportionate to actual damages, the provision usually still will be enforced if the liquidated damages amount agreed to was reasonable at the time the parties contracted. In addition to the foregoing basic requirements, if the liquidated dama 1 ges clause relates to a delay in the completion of the construction work, which is often the case, the owner is not entitled to recover liquidated damages if both the contractor and the owner are to blame for delayed project completion. Peabody N.E., Inc. v. Town of Marshfield, 426 Mass. 436, 443 (1998) (emphasis added), citing Morgan v. Burlington, 316 Mass. 413, 418 (1944); 5 Williston, Contracts, 789 at 754 (3d ed. 1961). Where a party seeking enforcement of a liquidated damages provision either directly or through one of its agents, was a cause of delayed completion, it cannot enforce the liquidated damages provision. Id. at Again, the Peabody decision indicates the view that liquidated damages are an equitable remedy which is not applicable where the party seeking enforcement has unclean hands. II. Defenses to Liquidated Damages Understanding the basic requirements for a valid liquidated damages clause, and that the party seeking enforcement must have clean hands, we now turn to specific defenses that can be used to invalidate a liquidated damages clause. These basic defenses are important for purposes of developing considerations for managing the risk associated with liquidated damages going forward. Given that one of the requirements for a valid liquidated damages clause is that the amount of the damages be reasonable, a key defense to such clauses is that the liquidated damages are actually a penalty. More specifically, where the liquidated damages sum is unreasonably and grossly disproportionate to the real damages from a breach, or is unconscionably excessive, the court will award the aggrieved party no more than its actual damages. Shapiro v. Grinspoon, 27 Mass. App. Ct. 596, 603 (1989). Whether a liquidated damage clause is unreasonable and grossly disproportionate to actual damages, however, depends on the circumstances of each case, and customarily presents a question of fact for a trial court. U.B. Vehicle Leasing, Inc. v. Bender, 1993 WL , at *2, quoting A-Z Servicenter, Inc. v. Segall, 344 Mass. 672, 675 (1956). Although there are innumerable examples of reasonable assessments of liquidated damages, it is more useful to look at examples of liquidated damages that have been held to be grossly disproportionate or otherwise unenforceable. In Security Safety Corp. v. Kuznicki, 350 Mass. 157 (1966) a liquidated damages provision in the amount of one-third of the contract price was found to be unreasonable and unrelated any actual damages. However, in holding the clause invalid, it was key to note that the property owner executed the contract at issue one night and canceled it the very next morning. There was no evidence of any actual damages and, apparently, the fact that the contract was so quickly rejected highlighted the unreasonableness of assessing liquidated damages. Id. at 158. Similarly in Schrenko v. Regnante, 27 Mass. App. Ct. 282 (1989) the Court rejected a liquidated damages clause that permitted a real property seller to keep a $16,000 deposit where the purchaser breached the contract. 27 Mass. App. Ct. at 284. The Court held that this provision constituted a penalty because, in addition to this liquidated amount, the contract permitted the seller to seek additional actual damages from the buyer. Thus, the parties essentially acknowledged that actual damages could be calculated, and recovered, and the liquidated damages were nothing more than a penalty arising out of the breach. 6 Construction Law March 2017

7 Schrenko highlights a key defense and issue that will be discussed in further detail below. More specifically, liquidated damages should not be used in addition to actual damages. In other words, the parties must select one form of damages or the other at the time that they contract. They must acknowledge that actual damages can be calculated and recovered, which therefore precludes liquidated damages, or they must select liquidated damages based on the difficulty in ascertaining actual damages, and therefore forego actual damages. Allowing recovery of both forms of damages for the same injury is, by definition, a penalty that defeats the purpose of placing the non-breaching party in the position it would have been in, but for the breach. 2 Finally, as mentioned above, the issue of concurrent delay and/or owner caused delay can also be a defense to liquidated damages provisions that deal with delay. Where liquidated damages are, at their core, an equitable remedy, the party seeking to enforce the remedy must not have caused the event that triggered the liquidated damages. III. Risk Considerations with Respect to Liquidated Damages With the foregoing as an understanding of the basic elements and considerations in any liquidated damages clause, one can now turn to specific risk issues associated with such clauses. Much like the outline of this article, any liquidated damages analysis should look at the following issues from start to finish: 1. Mutual Evaluation of Potential Loss (reasonable amount of the liquidated damages); 2. Exclusivity of Remedy (no double recovery); 3. Concurrent Delay (responsibility for changes and delays); A review of these three issues at the time of contracting should provide a good starting point for the negotiation of a reasonable and enforceable liquidated damages clause. A. Mutual Evaluation of Potential Loss As detailed above, any legitimate liquidated damages clause should be based on a realistic evaluation of the potential damages at issue. While the subject damages will, by definition, be difficult to calculate at the time of contracting, that does not mean that the parties should not perform an evaluation to arrive at a reasonable measure of potential damages. In performing such an evaluation under the typical Owner-Contractor agreement, the parties should consider damages sources such as lost net revenue or profit from the project, expenses for an alternate facility, extended design or project management fees, additional finance charges, etc. Such amounts should also be reviewed within the context of any early completion bonus as well. If early completion results in a positive net benefit for the owner under damages sources outlined herein, the risk allocation between the parties should reflect such a swing. After reviewing such damages issues, the parties should also weigh the impact of the potential liquidated damages on the cost of the project. A high liquidated damages figure is an added risk for contractors with a corresponding increase in cost/required reward. Unreasonably high liquidated damages will impact contract price from contractors, and particularly subcontractors, as well as the availability of competitive bids. One method for addressing a potentially high liquidated damages figure is the use of an overall cap on liquidated damages. In other words, a relatively high daily liquidated damages amount might create appropriate motivation to complete the project on time, but be more economically feasible for contractors if it is paired with a cap on the total amount of liquidated damages charged. These issues should all be weighed by the owner and contractor as part of the negotiation of any liquidated damages provision. Managing Risk: Handling Liquidated Damages Wecker 7

8 B. Exclusivity of Remedy Understanding that a liquidated damages provision could be held to be unenforceable if it allows for a double recovery type penalty, parties should make it clear that they are agreeing to a risk allocation that will be the sole method of recovery for an entire category of damages. While we often view liquidated damages provisions as a negative for contractors, it should be noted that when this issues is properly addressed, a liquidated damages clause can actually be an effective risk management tool for contractors. In particular, where liquidated damages often seek to quantify damages that would otherwise be considered consequential damages, parties should consider paring any liquidated damages clause with a waiver of consequential damages. Paring these two types of clauses together avoids the potential for an impermissible double recovery and can be a meaningful risk mitigation procedure for all parties. There are numerous scenarios where a contractor could actually mitigate his exposure for consequential damages by agreeing to a reasonable liquidated damages provision with a corresponding waiver of consequential damages. 3 It is important to consider the various categories of damages when negotiating a liquidated damages clause and how those categories of damages should/must interplay with the liquidated damages. C. Concurrent Delay Finally, it is important for the parties to acknowledge the possibility of concurrent delay when considering a liquidated damages clause. Much like the concept of parring a waiver of consequential damages with a liquidated damages clause, the change order provisions of a contract should work in harmony with any liquidated damages clause. Indeed, the liquidated damages clause itself should acknowledge the possibility of owner cause delay and indicate that liquidated damages will only be assessed for unexcused delays which are solely caused by the contractor. From the contractor s perspective, in addition to making sure the liquidated damages clause is drafted properly, the contractor can mitigate its risk exposure by requesting extensions of time as part of applicable change order requests and documenting owner caused delays when they occur. Additionally, a contractor that is considering accepting a significant liquidated damages provision should also consider carrying a contingency amount within its contract price that can be used for acceleration of work if unexcused delays become an issue. Finally, it is important to utilize flow down provisions in applicable subcontracts to further mitigate the risk of liquidated damages that might be caused by a subcontractor s failure to perform. IV. Conclusion As with most risk mitigation strategies, the key to controlling liquidated damages starts with understanding the concepts. With the foregoing understanding of the purpose and legal requirements of liquidated damages, parties to a construction contract should be able to craft a reasonable and enforceable liquidated damages provision that addresses the parties expectations. Such a properly drafted liquidated damages clause should not be viewed as a singularly negative risk, but as a reasonable method for allocating and controlling risk within a comprehensive construction contract. 8 Construction Law March 2017

9 Endnotes 1 Section of AIA A201 provides that it does not preclude the recovery of liquidated damages as provided for elsewhere in accordance with the Contract Documents. Section 3 of AIA A allows for the insertion of a provision for liquidated damages relating to failure to achieve Substantial Completion on time. Paragraph 6.6 of ConsensusDOCS 200 similarly provides that it does not preclude the recovery of liquidated damages. Consensus- DOCS 200 does contain a liquidated damages provision at Paragraph See BDO Seidman Financial Services v. Gorman, 1994 WL , *5 (J. Lauriet, 1994) (liquidated damages are not typically a supplemental damages element, added to actual damages). But see Carol v. Barberry Homes, Inc., 1999 WL , *2 (Mass. Super., October 22, 1999) (party can recover liquidated damages and any actual damages that were not subject to the liquidated damages assessment). In other words, parties can recover both liquidated damages and damages that were not liquidated as part of the agreement. For example, an owner may be able to recover liquidated damages for a delay in the completion of the project and damages arising out of destruction or damage to property. The delay related claim was liquidated, but the property claim was not; thus both types of damages can be recovered. 3 Liability for consequential damages on a commercial project that is significantly delayed can far exceed the amount of the general contract or any amount the contractor might have reasonably anticipated. Accordingly, by negotiating a waiver of consequential damages in exchange for a reasonable liquidated damages figure or cap, the contractor can actually control its risk exposure for an area of damages that could otherwise be unlimited. Managing Risk: Handling Liquidated Damages Wecker 9

10