By Michael C. Loulakis and Lauren P. McLaughlin
While most readers are likely familiar with the concept of liquidated damages, here’s a quick refresher: LDs are a remedy established in a contract to address what happens if something goes wrong. In construction contracts, LDs are most closely associated with late completion of projects, where the LD amounts are expressed in terms of a dollar value per day of delay. An example is a clause that requires the contractor to pay the owner $1,500 per day for each day the contractor is late in achieving substantial completion.
LDs are not only used for delays but for other types of failures. On some large projects, contracts require the payment of LDs if contractors fail to keep their key personnel on the projects. On some industrial projects, LDs are used to compensate owners for shortfalls in performance guarantees, such as guaranteed electrical capacity for a power project. The bottom line is that if the parties want to establish in a contract an agreed-upon remedy for a potential problem, LDs are the way to do it.
However, even though the contract may establish LDs for a given issue, that does not mean a court will find the clause enforceable. There are some common rules associated with recovering LDs, and the party seeking to recover them has to prove entitlement. The case of City of Brookhaven v. Multi-plex LLC provides an excellent reminder of these rules and what happens if they are not followed.
The city of Brookhaven, Georgia, contracted with Multiplex LLC for the construction of a new park. The contract had a delay clause that stated:
(Multiplex) shall have 180 days from the notice to proceed to complete the project. Failure to complete the required construction as specified will result in the assessment of Liquidated Damages at the rate of $1,000.00 per calendar day.
The project fell behind schedule, and the city notified Multiplex it was in breach of the contract’s timeline for completion. The city also warned Multiplex it would enforce the delay clause if the project was not completed on time.
After the project was substantially completed, the city filed suit against Multiplex in a Georgia state court, alleging that Multiplex delayed the project by 271 days and that the city was entitled to LDs in the amount of $271,000. Multiplex argued that the delay clause was unenforceable and filed a motion for summary judgment on the city’s LD claim. The trial court agreed with Multiplex and granted the motion. The city appealed to the Court of Appeals of Georgia.
The appeals court cited Georgia law that states parties are free to agree in their contracts what the damages for a breach shall be, and “unless the agreement violates some principle of law, the parties are bound thereby.” In assessing whether the LD clause violated some principle of law (i.e., was unenforceable), the court re-cited the three-factor test under Georgia law: (1) the injury must be difficult to estimate accurately, (2) the parties must intend to provide damages instead of a penalty, and (3) the amount must be a reasonable estimate of the probable loss.
The appeals court stated that Multiplex had the burden of proving that the LD clause was an unenforceable penalty. However, Multiplex could meet this burden by proving that any of the three factors was lacking. Multiplex did not contest the first factor, but it argued that the second and third factors had not been met. The appeals court agreed with Multiplex and found the LD clause was unenforceable.
As to the second factor, the appeals court examined the contract language to determine the intent of the parties regarding the purpose of the LD clause. The court observed that the clause lacked any language indicating that the $1,000 per day LD amount was not intended to be a penalty. While this in and of itself was not dispositive of the issue, the court stated that the absence of such language enabled it to consider evidence about the effect the provision was intended to have.
After examining the evidence, the court concluded that the LD clause was inserted into the contract for the purpose of deterring Multiplex from breaching the contract and was therefore a penalty. The key evidence was deposition testimony from the city’s designated representative. The representative testified that timely construction of the new park was important because the existing park would have to be demolished before construction could start on a new elementary school, and residents in the area would have to go to other parks outside their neighborhood for recreation if the new park was still under construction. The representative agreed that the intent of the delay clause was to “disincentivize delays” because Multiplex was “going to have to pay $1,000 a day out of (its) net profits if (it did not) get the project done on time.”
As to the third factor, the court found that the LD clause failed because there was no evidence that the $1,000 per day amount was a reasonable estimate of the probable loss resulting from a delay in the park’s construction, according to the court summary. “(T)he touchstone question is whether the parties employed a reasonable method under the circumstances to arrive at a sum that reasonably approximates the probable loss.”
The city offered no evidence it had made a reasonable pre-estimate of the probable loss prior to the execution of the Multiplex contract. Instead, it argued that the LD clause should be upheld because the LDs were less than 0.0004% of the $3 million project cost for each day of delay. The city also argued that LD clauses are “‘very’ common in its construction contracts and that the $1,000 per day number was not project specific, but was instead a ‘standard’ number.”
Because there was no evidence the city had reasonably pre-estimated the $1,000 per day amount, the court found that the LD clause was unenforceable. In fact, the court cited the city’s standard number argument as evidence the city had not pre-estimated the damages and that the $1,000 per day amount “plainly has no reasonable relation to any probable actual damage which may follow a delayed completion of the project.”
There are several important takeaways from this case. At the outset, do not consider this to be a case unique to Georgia. Almost every state has legal precedent similar to the three-factor test expressed in the Brookhaven case. This means, among other things, that there should be something in the precontract record that explains how the LD dollar value and formula were developed and why they are reasonable. Our experience is that many owners do not go through this exercise and instead use standard figures like the city of Brookhaven did. Do so at your peril.
Another interesting takeaway was the question of the party’s intent — i.e., was the clause truly a measure of damages, or was it there to motivate the contractor to finish on time? Many well-drafted LD clauses will expressly say that the LDs are not considered penalties. However, what happens if the court, arbitrator, or jury sees evidence that the clause was really intended as a “stick” to prod the contractor to finish on time? Query whether that clause will be considered a penalty, even though it says it is not.
Michael C. Loulakis ([email protected]) is the president and CEO of Capital Project Strategies LLC in Reston, Virginia. Lauren P. McLaughlin ([email protected]) is a partner of Smith, Currie & Hancock LLP in Tysons, Virginia.
This article first appeared in the November/December 2023 print issue of Civil Engineering as “To Recover Liquidated Damages, Make Sure You Do the Basics.”