Liquidated damages provisions are commonplace in construction contracts. One would think that given the strong Texas public policy favoring freedom of contract, bargained for liquidated damages would be easily enforceable in litigation. But Texas law on this issue is counterintuitive and can render a liquidated damages provision unenforceable if not carefully drafted. And even when enforceable, liquidated damages provisions can lead to unintended consequences for owners and contactors alike. This blog post provides drafting tips on how to avoid these legal pitfalls and draft liquidated damages provisions that accomplish the desired result.
The Texas Legal Standard for the Enforceability of Liquidated Damages
A typical liquidated damages provision provides for a negotiated or “liquidated” amount of damages in the event of a future breach of contract. In construction contracts, liquidated damages are commonly used for: (1) delays to completion of the project (often referred to as “delay liquidated damages”), and (2) on industrial EPC projects for failure to achieve specified performance guarantees (often referred to as “performance liquidated damages”). But enforcing a liquidated damages provision is tricky, because as the party asserting liquidated damages (usually the Owner), you would need to show at the time the liquidated damages provision was drafted that:
(1) “the harm caused by the breach is incapable or difficult of estimation;” and
(2) “the amount of liquidated damages called for is a reasonable forecast of just compensation.”
Atrium Med. Ctr, LP v. Houston Red C LLC, 595 S.W.3d 188, 192 (Tex. 2020). If the party asserting liquidated damages meets this burden, the party opposing liquidated damages (usually the Contractor) can defeat the liquidated damages provision by presenting evidence that there is an “unbridgeable discrepancy” between the actual damages and liquidated damages (i.e., that the actual damages would be significantly less than the liquidated damages).
Tips for Drafting Enforceable Liquidated Damages Provisions
The Texas legal standard for enforcing liquidated damages is somewhat contradictory. One first needs to show that the actual damages are “difficult to estimate,” but also that the liquidated damages were a reasonable forecast of those “difficult to estimate” actual damages. Below are some drafting and negotiating tips that may help thread this needle and give you better arguments for enforceability.
- Do
- Explain specifically why actual damages for the breach are difficult to estimate in the liquidated damages provision itself. For instance, on a commercial office project, note that it is difficult to estimate lost rental income in advance.
- Document how you come up with the liquidated damages amounts at the time you are drafting and negotiating the provision. For example, estimate additional Owner supervision costs, construction loan costs, and lost rental income that would likely be incurred in the event of a delay, use that information to come up with a daily liquidated damages rate, and write down how you did that. Having such contemporaneous documentation will be very helpful if there is a dispute.
- If there is a consequential damages waiver in the contract, exclude liquidated damages from it. With such a waiver, the party opposing liquidated damages may be able to argue that consequential damages (such as lost profits on other contracts) can’t be considered in coming up with a reasonable forecast of compensation because such damages have been waived. Texas courts have not addressed this issue, leaving room for argument on both sides.
- Don’t
- Just recite in the liquidated damages provision that “the harm caused by the breach is difficult of estimation” without explaining why.
- Just plug in liquidated damages amounts used on past projects even if the same parties were involved. In the event of a dispute, testimony that “we just copied and pasted the LD amounts from the last project we did” or “we always use that amount in our contracts” will be unhelpful to a party trying to enforce a liquidated damages provision.
- Describe the liquidated damages as a “penalty” when negotiating the provision. Worse still, put the word “penalty” in the liquidated damage provision itself. Texas courts will refuse to enforce a liquidated damages provision if the court concludes it is a penalty and not a reasonable forecast of potential damages at the time the provision was drafted. Calling the liquidated damages provision a penalty makes it easier for a court to conclude it is.
Other Liquidated Damages Problems to Avoid
1. Setting the liquidated damages cap too low (or not having a cap at all).
Caps on the total amount of liquidated damages are common in construction contracts and make sense as a commercial decision to allocate risk. From the contractor’s perspective, omitting a cap on liquidated damages can leave the contractor exposed to significant risk. But while a cap on liquidated damages is reasonable and market, liquidated damages capped at the contractor’s fee or at too small a portion of the fee may not adequately compensate the owner for delays or motivate the contractor to finish on time. And if the contractor hits the liquidated damages cap before the project is finished, there is reduced incentive for the contractor to mitigate delays. One option to mitigate this issue is to negotiate for a smaller per-day liquidated damages amount but a higher cap.
2. Making liquidated damages the “exclusive” remedy for delays.
Liquidated damages provisions are typically written to be the only damages available for delay or for failure to meet performance guarantees. But if the clause goes further and makes the liquidated damages the exclusive “remedy,” it can make it harder for the owner to terminate the contractor for cause or exercise other remedies if the project is delayed. Consequently, contractors may want to negotiate for “exclusive remedy” language in liquidated damages provisions to limit their risk if the project is significantly delayed.
3. Performance liquidated damages that don’t address the situation where the facility is a complete failure.
In theory, performance liquidated damages on industrial projects should compensate the Owner if the project fails to pass the performance tests. But rather than the project merely functioning at a reduced capacity, what if the project completely fails to produce a sellable product? In such cases, performance liquidated damages rarely come close to compensating the owner for its actual losses. Owners should consider negotiating for a minimum threshold that facility performance must meet for performance liquidated damages to apply, and for the owner’s ability to recover actual damages if the facility does not meet the minimum performance threshold.
[View source.]
