Type: Law Bulletins
Date: 02/15/2016

The Perils of Liquidation

Liquidation is one of those odd legal terms that has multiple meanings, some intuitive and others unexpected. In non-legal parlance, liquidation is what happens when you don’t pay your loan shark, or when you cross James Bond. Legal terminology has an analogous usage, such as liquidation of a business in bankruptcy proceedings. But it also has an entirely different meaning that is of great importance in the construction industry — liquidation of damages. Ironically, liquidation of damages is one of the ways that a contractor may prevent liquidation of its business.

Management of consequential damages must be a cornerstone of every contractor’s risk management program since consequential damages can pose an existential risk to even a strong contractor. While the dividing line in court decisions between the two main types of recoverable damages — direct and consequential — is anything but clear or consistent, generally direct damages are those that always result from a particular kind of breach, such as the cost of replacing work that was not performed correctly. Consequential damages arise from particular circumstances affecting the damaged party, such as lost profits and other economic damages suffered by the project owner from loss of use of the project when it is not completed on time.

Consequential damages may arise in various circumstances but by far the most common is delay in achieving substantial completion (the point in time at which the owner may use the work for its intended purpose). Since delays are not a rare occurrence on construction projects, contractors ignore this risk at their grave peril. Any deficiency in a contractor’s performance can be financially painful to the contractor, but consequential damages carry unique risks because of the potential for the loss to be entirely out of proportion with the size of the project and any profit that the contractor could have expected to earn. In one notorious case involving delay in completion of an access point to an Atlantic City casino, the contract was for $24 million and the contractor’s fee was 2.5% ($600,000). After the work was delayed and the contractor was found to be responsible, the owner was awarded almost $15 million in consequential damages — dozens of times the contractor’s fee. Fortunately, in that case the contractor was relatively large and the loss did not result in its liquidation, but other contractors and subcontractors have not been so lucky.

This result — unlimited consequential damages — was the norm in standard form contracts, including AIA, until 1997. Since then, all AIA forms have contained mutual waivers of consequential damages, and other forms, including ConsensusDocs, have followed suit, with modest differences (e.g., ConsensusDocs does not waive consequential damages covered by the contractor’s insurance).

But such a complete waiver creates a risk in the opposite direction. If the owner’s facility cannot be occupied on time, the owner may incur serious business losses with no avenue of recovery against the contractor. Owners became concerned that under a complete waiver, contractors did not have any real incentives, other than their reputations, to complete projects on time. The contractor would not be liquidated, but maybe the owner would!

So it was time for the other kind of liquidation to make an entrance — to take an uncertain sum of money and fix it at a specific number. When an accident victim files a suit the claim is unliquidated, but it becomes liquidated when a jury assigns a specific dollar value to it. Similarly in the construction industry, when parties agree in advance on the dollars that an owner will receive due to any future delay in completion that is the fault of the contractor, it is known as liquidated damages ("LDs"). LDs are often negotiated on a per-day basis but may also specify cliff dates when a lump-sum amount is payable if the contractor’s delay prevents the owner from achieving a major business milestone like the holiday selling season or a scheduled performance.

The law relating to liquidated damages is very technical and varies substantially among the states. While most states have abandoned earlier general hostility toward liquidated damages, such clauses are still found to be unenforceable with some frequency. If an owner sets liquidated damages higher than actual expected losses in order to penalize the contractor for late performance, enforcement is unlikely, as one of the criteria used by most courts is that the specified damages cannot exceed a reasonable estimate of what the actual damages will be, determined at the time of contracting (a prospective approach). Some states look retrospectively, however, to see if the specified damages are in the same range as the actual damages turned out to be.

On the other hand, what if the LDs are very low compared to the owner’s actual damages? There is a theoretical risk that an owner might be able to defeat the LDs since they don’t represent a reasonable pre-estimate of actual damages. Since an invalid attempt to specify liquidated damages allows the owner to recover actual damages, it is prudent for a contractor to specify in the clause that if the LDs are not enforceable for any reason, the owner’s recovery of actual damages is limited to the specified amounts. It is also important for a contractor not to be lulled into omitting a consequential damages waiver due to the presence of liquidated damages, since this could lead to unlimited damages recovery if the LDs are found to be unenforceable.

While an owner may be motivated to seek very high liquidated damages if it anticipates a high cost in case of delay, the practical consequences of doing so must be considered. Prudent contractors may walk away from projects where the exposure to delay damages is so great that it threatens their financial strength and bonding capacity. The impact on subcontractors, which are threatened with losses even more out of proportion to their contract size, is even greater when a contractor seeks to flow down a large damages exposure, and the best subs may decline to participate in the project or may substantially pad their bids to account for the risk, neither of which is a good result for the owner. 

Thus, liquidated damages amounts tend to become one of the most highly negotiated terms between owners and contractors. The result of success in this endeavor is that the parties can look to a type of liquidation that is much less perilous than the other kind.

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