Liquidated Damages Clause

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J. Kent Holland, J.D. © 2012
ConstructionRisk Counsel, PLLC

Liquidated damages provisions of contracts are often enforced in ways that seem to surprise the party that they are enforced against. What is the proper use of a liquidated damages clause and when will liquidated damages provisions be enforced?

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. The Federal Acquisition Regulation at FAR 11.501 notes that the 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.

Because of this difficulty in showing unreasonableness as of the date the amount was set, 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).

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.

In a case where a 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., Government 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).

This K-Con Building 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.

Other recent cases demonstrate the importance of the contractor following the procedural requirements of the contract if it desires to avoid the consequences of LDs. For example, in the case of Greg Opinski Constr. v. City of Oakdale, 132 Cal.Rptr.3d 170 (2011), the court found that a contractor failed to follow contract procedures to submit a time extension request, and the city was entitled to collect liquidated damages from the contractor despite the fact that the city caused the delay. Since the contractor failed to follow the procedures to claim an extension of time, the trial court would not even consider the evidence of whether the late completion was caused by actions of the city. The appellate court affirmed that parties are permitted to contractually require a contractor, who intends to assert that delay was caused by the owner, must give written notice of its intention to assert such a claim within a reasonable time, otherwise it will be subject to the specified LDs even if it might have otherwise proved that the Owner delayed the project.

The court explained that “To alter the contract by time—regardless of reason—the contract required the party seeking the alteration to obtain a change order either by mutual agreement or by submitting a claim to the engineer with a request for a formal decision in writing.” Since neither procedure was used, “the time was not extended, regardless of which party was to blame for the late completion.”

The holding of this case should be a powerful reminder that contract terms establishing procedural conditions for changes are generally enforced by courts even when the results may seem unfair – such as imposing liquidated damages when the delays were not necessarily caused by the contractor. When a schedule is starting to slip because of conditions or changes beyond the control of the contractor, a contractor is well advised to promptly advise the owner in writing of the reasons for the schedule slippage and to follow the contractual requirements for promptly submitting a written request for a change order seeking a time extension.

NOTE: This paper was originally published in National Ground Water Association’s, “The Risk Management Report,” Vol. 7, 2012.