Construction contracts often contain liquidated damages clauses. These clauses allow parties to limit or quantify their exposure by stipulating in advance to the amount of damages available in the event of a breach. Liquidated damages clauses are generally enforceable provided, however, the stipulated amount represents a good faith estimate of damages flowing from the breach and does not operate to punish the breaching party. Courts in New York and New Jersey employ similar tests to determine the clause’s enforceability.
“Liquidated Damages” Defined: A liquidated damages clause specifies a predetermined amount of damages that must be paid in the event of a breach. The purpose of the clause is not to compel performance through threat of penalty, but rather to compensate the non-breaching party for the breaching party’s default. Liquidated damages clauses are particularly useful, and typically employed, when the damages caused by a breach are uncertain. For example, construction contracts may assess a liquidated damage amount for each day a project remains incomplete.
New Jersey’s Take: Properly drafted liquidated damages clauses are generally enforced under New Jersey law. To be enforceable, the liquidated damages amount must constitute a reasonable forecast of the provable injury resulting from the breach. This analysis is a question of law to be decided by the court. In doing so, courts presume that the stipulated amount is reasonable, but the breaching party can rebut the presumption with evidence that enforcement would be unreasonable (i.e., the stipulated amount of damages is disproportionate to the actual harm). Reasonableness is judged as of the time of making the contract and is not defeated by proof that the damages actually suffered are less than the contracted for amount. Generally, courts are more likely to enforce a liquidated damages clause when the damages caused by the breach are more uncertain or difficult to estimate. As an example, New Jersey courts have found that contractual late fees are reasonable to the extent they seek to cover the administrative costs associated with a late payment. With this reasoning in mind, a court enforced a 5% fixed late charge but invalidated an enhanced default rate (from 17% to 32.87%) because the rate increase suggested a punitive intent.
Notably, New Jersey courts prohibit project owners from recovering daily liquidated damage amounts after occupancy because the stipulated damages are designed to approximate the owner’s loss before occupancy. With that purpose, courts reason that allowing liquidated damages to
accrue after occupancy is unreasonable and would only serve to punish the contractor. For similar reasons, where a construction contract requires the contractor to “substantially complete” the Project by a certain date, courts will generally not allow liquidated damages to accrue after substantial completion. In addition, New Jersey courts will not enforce a liquidated damages clause where the non-breaching party contributed substantially to the delayed performance of the construction contract. Courts reason that doing so would unfairly punish the contractor for delays it did not cause.
New York’s Take: Liquidated damages clauses are enforceable under New York law if: (i) the predetermined amount bears a reasonable proportion to the probable loss, and (ii) the amount of actual loss is incapable of precise estimation. Enforceability is a question of law to be decided by the court, with due consideration to the nature of the contract and surrounding circumstances at the time the parties entered the contract. The party seeking to avoid liquidated damages bears the burden of proving the clause is unenforceable.
Just as in New Jersey, New York courts will not assess liquidated damages after the owner beneficially occupies a substantially completed project. Similarly, where there are concurrent delays (i.e., caused by the mutual fault of both parties), a liquidated damage clause is abrogated and each party must resort to an action to recover its actual damages. Under these circumstances, however, courts reason that the damages must be capped at the liquidated damages amount in order to prevent owners from intentionally delaying the project so that they avail themselves to a claim for actual damages when preferable. These situations are uncommon because most construction contracts provide for extensions of time for delays beyond the contractor’s control. Where a construction contract contains such a clause, New York courts do not abrogate the liquidated damages clause but instead assess liquidated damages for only those days the breaching party bears responsibility. For example, if an owner contributes towards seventy (70) of one hundred (100) days in delay, the owner will only recover liquidated damages for the days it was not at fault (30 days).
Takeaway: The enforceability of liquidated damages provisions is contingent upon whether the stipulated amount represents a reasonable non-punitive approximation of damages that would result from a breach. Contractors should be mindful of the law prior to entering into contracts that have a liquidated damages provisions and when adding such provisions to their subcontracts.