Where a design-builder (“contractor”) was assessed liquidated damages by the Contracting Officer under a U.S. Coast Guard contract for the design and construction of prefabricated metal buildings, the contractor filed suit against the Government seeking remission of the liquidated damages based on its argument that the amount set for the LDs was arbitrary and not consistent with actual damages.  The court denied the contractor’s motion for summary judgment on the issue of liquidated damages, concluding that there was no evidence that when the amount of the liquidated damages was established during contract formation that the LDs were without reasonable relation to any probable damage which may follow from delay or breach of contract.   The contractor sought to prove that the LD rate was arbitrary by showing that different rates had been used by the Coast Guard on different similar projects, and also that certain components of damages included with the LDs (e.g., Govt personnel costs and administrative costs) were inappropriately included.  In rejecting the contractor’s argument, the court stated that just as a contractor can recover its own personnel and administrative costs as part of damages claimed against the Government in various claims, so likewise the Government can claim its personnel and administrative costs when it has a claim against the contractor.  As far as different rates being applied by the Government on other projects, the court said the only relevant matter was whether the rate on this particular project was appropriate – and that is judged principally by what appeared reasonable at the time of contract execution.  K-Con Building Systems, Inc. v. United States, 97 Fed.Cl. 41 (2011).

The court’s analysis of the matter is so well stated (with supporting case law) that it will be quoted herein at length as follows:

Liquidated damages are used “to allocate the consequences of a breach before it occurs,” Jennie–O Foods, Inc. v. United States, 580 F.2d 400, 412 (Ct.Cl.1978) (per curiam), which “save[s] the time and expense of litigating the issue of damages,” DJ Mfg. Corp. v. United States, 86 F.3d 1130, 1133 (Fed.Cir.1996). Liquidated damages “serve a particularly useful function when damages are uncertain in nature or amount or are unmeasurable, as is the case in many government contracts.” Priebe & Sons, Inc. v. United States, 332 U.S. 407, 411, 68 S.Ct. 123, 92 L.Ed. 32 (1947). Thus, “[w]here parties have by their contract agreed upon a liquidated damages clause as a reasonable forecast of just compensation for breach of contract and damages are difficult to estimate accurately, such provision should be enforced.” Jennie–O Foods, Inc., 580 F.2d at 413–14; see also FAR 11.501 (noting that use of a liquidated damages clause is proper if damages “would be difficult or impossible to estimate accurately or prove” and that the “rate must be a reasonable forecast” of the anticipated damages).

 On the other hand, courts will not enforce a liquidated damages clause when the amount of liquidated damages is “plainly without reasonable relation to any probable *50 damage which may follow a breach,” Kothe v. R.C. Taylor Trust, 280 U.S. 224, 226, 50 S.Ct. 142, 74 L.Ed. 382 (1930), or is “so extravagant, or so disproportionate to the amount of property loss, as to show that compensation was not the object aimed at or as to imply fraud, mistake, circumvention, or oppression,” Wise v. United States, 249 U.S. 361, 365, 39 S.Ct. 303, 63 L.Ed. 647 (1919). In these circumstances, liquidated damages amount to a penalty. Priebe & Sons, Inc., 332 U.S. at 413, 68 S.Ct. 123; United States v. Bethlehem Steel Co., 205 U.S. 105, 118–21, 27 S.Ct. 450, 51 L.Ed. 731 (1907).

When presented with a challenge to a liquidated damages clause, a court must judge the clause “as of the time of making the contract” and without regard to the amount of damages, if any, actually incurred by the nonbreaching party. Priebe & Sons, Inc., 332 U.S. at 412, 68 S.Ct. 123; accord Bethlehem Steel Co., 205 U.S. at 119, 27 S.Ct. 450 (noting that courts will enforce liquidated damages clauses “without proof of the damages actually sustained”); Steve Kirchdorfer, Inc. v. United States, 229 Ct.Cl. 560, 565–67 (1981) (upholding an award of liquidated damages although no actual damages were sustained); Young Assocs., Inc. v. United States, 471 F.2d 618, 622 (Ct.Cl.1973) (“It is enough if the amount stipulated is reasonable for the particular agreement at the time it is made.”). The party challenging a liquidated damages clause—typically, in government procurement cases, the contractor—bears the burden of proving that the clause is not a penalty. DJ Mfg. Corp., 86 F.3d at 1134; Jennie–O Foods, Inc., 580 F.2d at 414. The burden is a heavy one “because when damages are uncertain or hard to measure, it naturally follows that it is difficult to conclude that a particular liquidated damages amount or rate is an unreasonable projection of what those damages might be.” DJ Mfg. Corp., 86 F.3d at 1134. And because of this difficulty, it is generally improper for a court “to inquire into the process that the contracting officer followed in arriving at the liquidated damages figure that was put forth in the solicitation and agreed to in the contract.” Id. at 1137; see also id. at 1136 (noting that courts will enforce a liquidated damages clause, “regardless of how the liquidated damage figure was arrived at,” if the amount of liquidated damages is reasonable).

          The court further stated that if the contractor’s position is that the LD rate is unreasonable because a component of the rate is improper, the contractor must prove that the component amount is improper as it relates to the particular contract at issue.  And that determination is based on what was reasonable when the contract was entered into rather than what may look reasonable in hindsight.   As stated by the court:

In other words, it is plaintiff’s burden to demonstrate that the Coast Guard could not have expected, at the time the parties executed the Elizabeth City contract, to spend $8,444 per month on inspection services if the project was delayed. Merely asserting that $8,444 per month is unreasonable because the Coast Guard used different amounts for different projects does not suffice.

          On the issue of whether the contractor should be excused from paying liquidated damages because it was delayed due to defective specifications, the court found the contractor did not prove either that as a design-builder, the contractor did not prove that the Government was legally responsible for the specifications, but that even if Contractor had established that the Coast Guard caused a delay through the provision of defective specifications, the contractor had not proved that the Coast Guard affected the critical path of performance and thereby delayed the overall contract completion.  For these reasons, the court denied the design-builder’s motion for summary judgment.

Comment:  This case reiterates an important point that needs to be understood by contractors and that is that it is difficult to challenge the Liquidated Damages rate after they are imposed – arguing that the actual damages are lower or that in hind-sight the LD’s are unreasonable.  The key as stated by the court is whether the amount set for the LDs was reasonable based on information available to the Contracting Officer at the time the contract was executed.

About the author: Article written by J. Kent Holland, Jr.,  a construction lawyer located in Tysons Corner, Virginia,  with a national practice (formerly with Wickwire Gavin, P.C. and now with Construction Risk Counsel, PLLC) representing design professionals, contractors and project owners.  He is founder and president of a consulting firm, ConstructionRisk, LLC, providing consulting services to owners, design professionals, contractors and attorneys on construction projects.  He is publisher of ConstructionRisk.com Report and may be reached at Kent@ConstructionRisk.com or by calling 703-623-1932.  This article is published in ConstructionRisk.com Report, Vol. 14, No.2 (Feb 2012).