WHEN ARE "LIQUIDATED DAMAGES" ENFORCEABLE

By Henry L. Goldberg,

Managing Partner & STA Legal CounselIt is common for parties to insert provisions in construction contracts that govern the issue of damages. However, if courts determine that a provision is a "penalty," rather than a fair calculation of possible downstream damages, then such a provision will not be enforced in New York.

In a recent decision, a New York court was called upon to decide whether a provision in a rider to an American Institute of Architects (AIA) agreement constituted an estimate of actual damages that might be incurred or was an unenforceable "penalty."

Underlying Facts

A general contractor entered into an agreement to perform roofing and façade construction for a co-operative corporation (the "Owner"). A rider to the AIA contract between the parties included a provision stating:

Project must be completed within four calendar months (120 days) of the start date. If the work is not fully completed within that period, then a penalty equaling Two Hundred Fifty Dollars ($250) per calendar day will be imposed upon the contractor by the owner until final completion is attained.

While the per diem liquidated damages of $250/day is hardly shocking as compared to many others much higher that we have seen, particularly in heavy/highway construction, the measure of "reasonableness" must be assessed in each particular circumstance. The damage to the public and the government, for example, for a major bridge or tunnel project not being opened on time certainly could far exceed delay damages caused to a residential co-op project.

The construction company in this case commenced an action against the Owner for non-payment and the Owner subsequently filed a counterclaim seeking $45,500 in damages per the aforementioned provision of the rider. The Owner in this case asserted that the construction company missed the contract completion date by 302 days.

The plaintiff contractor asserted that the provision in the rider was a penalty and was unenforceable on public policy grounds. Plaintiff further argued that the Owner failed to demonstrate such damages were due to plaintiff's delay of the project and that the amount of compensation sought by the Owner was grossly disproportionate to whatever actual damages the Owner may have sustained.

The court addressed the distinction between unenforceable penalties and fully enforceable liquidated damage provisions. It held that "to constitute a penalty, the stipulated sum must be disproportionate to the injury or the damages flowing from the breach must be readily ascertainable." Penalties, as the court affirmed, are not enforceable because they are contrary to public policy in a breach of contract action and are punitive in nature.

In this instance, the court observed that normally a liquidated damages provision in a contract is enforceable as a matter of law and is not necessarily an unenforceable penalty, provided: (1) liquidated damages provision provides for a reasonable measure of anticipated probable harm, and (2) that damages flowing from an alleged breach were, at the time the parties entered into the agreement, difficult to calculate or ascertain.

Applying this two-part standard to the facts presented, the court held that the attempted liquidated damages provision in the rider was not an enforceable contract clause because the per diem calculation was grossly disproportionate to actual losses. It also noted, as an aside, that the provision expressly provided the term, "penalty." While this is not determinative in the view of the well accepted two-part standard, it does appear to reflect the intent of the parties. In any event, the court found that the provision was not enforceable.

Nevertheless, the Owner could still recover actual damages for delay if it could prove the actual damages flowing from said delays. The court ruled, however, that in this case the Owner failed to offer any evidence of actual damages in its counterclaim, simply relying on the liquidated damages provision in the agreement.

G&C Commentary

Generally, "liquidated damages" provisions are enforceable if they reflect a reasonable measure of anticipated damages and the calculation of damages are difficult to otherwise calculate. The provision need not use the word "penalty" to be unenforceable. If the damages provided in the liquidated damages provision are not a reasonable estimate or the calculation of damages would not be particularly burdensome, courts will not enforce such provision.

The time to address the fairness of a liquidated damages contract provision, of course, is during pre-contract negotiations. It is not difficult to detect a clearly unreasonable per diem charge.

Frankly, in our experience, it is surprising how infrequently liquidated damage provisions are challenged either because they are patently inaccurate estimates or because actual damages could otherwise be readily calculated. This case demonstrates that, where appropriate, such a challenge can be successfully made.

As this case also demonstrates, the unenforceability of a liquidated damages provision can also be raised in subsequent litigation as a defense to the provision's attempted enforcement. This will not fully protect you if you are otherwise liable for a breach of contract and have caused actual damages. Nevertheless, it might protect you from having to accept a wholly unfair, formulaic calculation of damages, amounting to a penalty, that poor, or absent, pre-contract negotiations failed to avoid. As always, your first line of risk management defense is at the contract formation stage.

Henry L. Goldberg may be contacted by email, hlgoldberg@goldbergconnolly.com or by telephone, 516-764-2800.

Jeffrey I. Scott, an associate with Goldberg & Connolly, assisted in the preparation of this article.

©Goldberg & Connolly 2015

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