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LIQUIDATED DAMAGES AND

PENALTY IN CONSTRUCTION
INDUSTRY
COMPARATIVE STUDY

12/1/2008
ISLAMIC UNIVERSITY - GAZA
BY : ARCH. INA’AM J. EL TAWIL.
SUPERVISOR : DR. KAMALAIN SHA’AT.

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Liquidated Damages And Penalty In Construction Industry

Abstract
Delay can cause incalculable damages to an owner on a construction project. Such damages, however,
may be very difficult to quantify with reasonable accuracy. Thus, in order to help avoid the uncertainty and
expense of long evidentiary battles to establish the owner's actual damages, parties to a construction
contract may agree in advance to liquidate those damages. A "liquidated damages" clause is a negotiated
clause to establish in advance a reasonable estimate of the damages that would be incurred by reason of
a breach of contract or unexcused delays. The issue of liquidated damages that should be fixed by making
a reasonable estimate of the losses that might flow from a delay is highlighted. This paper gives a brief of
the Liquidated damages and the corresponding legal stand in connection with construction delays. It will
discuss also whether a high level of liquidated damages stipulated in a contract make a particular provision
an unenforceable penalty. A case study is included to understand the dimensions of this subject.

Introduction:
There are few businesses for which the saying "time is money" is more appropriate than the construction
industry. Construction contracting is extremely time sensitive. Owners lose opportunity and profits waiting
for completion of late projects. Similarly, when projects are late to complete, contractors carry the financial
burden of maintaining field and office personnel beyond dates anticipated at the time the project was
priced. In today's competitive marketplace, few owners or contractors can afford the cost of late projects.

For many projects, owners shift at least part of the risk of late completion onto contractors. The most
common form of risk shifting is the inclusion of a liquidated damages provision in the construction
agreement. Liquidated damages are damages defined in the construction contract and chargeable against
funds due to the contractor for each day the contractor fails to complete the project beyond the contract
completion date. Hence, a liquidated damage provision provides a straight forward method of calculating
damages recoverable by an owner in the event of late completion.

METHODOLOGY:
I will use the comparative method to discuss the research problem, mention the definition of liquidated
damages, and the penalty, and discuss when the liquidated damages are enforceable by using a case
study.

Liquidated damages:
Liquidated damages are specified daily charges deducted from moneys otherwise payable to the
contractor for each day the contractor fails to meet a milestone and/or contract completion date. Another
way of looking at liquidated damages is that it is the price the contractor must pay per day for working
beyond the required completion dates.
Liquidated damages are a contract based remedy for late completion of the contract. It must be agreed to
by the parties in the construction contract and normally takes the following or similar form:
"If the contractor fails to complete the work within the contract time or fails to achieve any of the contract
milestones, the contractor agrees to pay the owner $X per day as liquidated damages to cover losses,
expenses and damages of the owner for each and every day which the contractor fails to achieve
completion of the milestone work or the entire project." Richard K. Allen P.E. of Gadsby Hannah LLP
The key then to liquidated damages is the value assigned to the per diem cost "X".

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Liquidated Damages And Penalty In Construction Industry

Contract Completion Date:

The original contract completion date is that date set in the contract at which time the project is required to
be "complete."

Liquidated Damages Clause:

A clause in a contract which sets out the compensation to be paid in the event of a breach or a default of
the terms of the contract. The compensation set out in a liquidated damages clause should be a genuine
pre-estimate of the loss suffered as a result of the non-completion of the contract. An example would be an
amount payable per day in the event of the non-completion of a building project.

To be enforceable, the owner must establish


(a) The actual damages would be difficult to ascertain,
(b) The liquidated damages bear a reasonable relationship to the actual damages,
and
(c) The contract provision evidences that the parties intended to consider and adjust
the damages that might occur from delays or other breaches.

Types of Liquidated Damages Clauses

1. BREACHES OF CONTRACT & RISK EVENTS


If the clause does not create a contractual duty then it simply operates to allocate risk and/or
determine the measure of payment and strictly such a clause is not a liquidated damages
clauses - the principles of penalties do not apply.

2. FAILURE TO COMPLETE
Failure to complete by a specified date is the most common breach of contract for which LD
clauses are used in the construction industry. The damages are usually expressed in Standard
Forms as an amount per day or per week of delay to completion to be paid by the Contractor to
the Purchaser.
In some commercial developments there may be a critical delay beyond which the damages
change – such as a critical date for supply or opening a development. In such cases a limit is
usually stated for the overall amount of LDs or another rate is stated to apply after the critical
date. It may be necessary in specific situations to stipulate a maximum delay beyond which the
LD provision is no longer an adequate remedy and the contractor’s performance is considered
and agreed as no performance at all.
If sections of the works have different importance to the Purchaser, sectional completion dates
should be stated with different LD rates together with a rate for the remainder of the works..
Standard Forms usually allow the Purchaser the flexibility to take over parts of the works. The
entitlement to LDs should be modified in that case to reflect the reduced damages for any delay
caused by the contractor, so that the right to LDs for the remainder of the works is not lost.

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Liquidated Damages And Penalty In Construction Industry

3. FAILURE TO PAY
Failure to pay by a certain date is a breach of contract not usually associated with liquidated
damages clauses, but such a clause could provide for payment of interest at an increased rate
for the period of delay.

4. FAILURE TO MEET PERFORMANCE CRITERIA


Failure to provide a plant which gives the required throughput is the breach of contract for which
LD clauses are used in contracts for industrial and/or mechanical plant. A measurable
performance target is required. It may be necessary to stipulate a minimum level of performance
required. If performance falls below this level the Plant may be considered and agreed no longer
to be a viable plant, the LD provision no longer an adequate remedy and the contractor’s
performance not to be performance at all.
In order to establish the threshold for levy of liquidated damages the required performance
needs to be prescribed by measurable parameters. It is necessary to specify the duration of the
tests, performance criteria and method of assessment by reference to standards together with
tolerances. It may be necessary to specify correction factors if the operating conditions required
for the tests cannot be created.
The specified performance may include plant throughput, energy or feedstock useage, quality of
product and extent of waste or byproduct. These performance criteria may be inter-related, so
that some criteria should be grouped if a realistic measure of the benefit to the Purchaser is to
be measured.

5. EXPRESS TERMS STANDARD FORMS


The Standard Forms of contract do not adopt the same approach to liquidated damages for
delay. Some forms make the liquidated damages clauses part of the contract with no discretion,
but provide an option for section liquidated damages. In that case it is important to ensure that a
rate is entered for liquidated damages. Some forms make liquidated damages an option.

The advantages of liquidated damages clauses

 The advantages of stipulating in advance a sum payable as damages are money fold.
 For both parties, it may facilitate the calculation of risks and reduce the cost of proof.
 For the injured party, it may afford the only possibility of compensation for loss that is not
susceptible of proof with sufficient certainty.
 For society as a whole, it may save the time of judges, juries, and witnesses as well as
the parties, and may cut the expense of litigation.
These advantages are of special significance when the amount is controversy is small.

The difference between the liquidated damages and the penalty


If, however the stipulated sum is significantly larger than the amount required to compensate the
injured party for his loss, the stipulation may have quite a different advantage to him – an
interrorim effect on the other party that will diterpreach by compelling him to perform.
Enforcement of such a provision would allow the parties to depart from the fundamental principle
that the law’s goal on breach of contract is not to deter breach by compelling the promiser to
perform but rather to redress breach by compensating the promisee. It is this departure that is
proscribed when a court characterizes such a provision as a penalty .

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Liquidated Damages And Penalty In Construction Industry

But is the liquidated damages clause enforceable?

The legal stand

For courts and lawyers, the problem of having either of the following cases has not been dealt
with consistently
 An actual loss, as a result of late completion, being nil or less than the amount stipulated in the
Liquidated Damages clause.
 An actual loss, as a result of late completion, being far greater than the amount stipulated in the
Liquidated Damages clause.
In the United States, the courts tend not to enforce the Liquidated Damages clauses when the
stipulated amount exceeds the actual loss, as it has seemed to them that in the case of breach
of contract, Justice requires nothing more than compensation by the amount of the harm
suffered...therefore, courts have created a limitation on freedom of contract. (CORBIN on
Contracts Vol.5, PAR1057)
The courts in England and Australia are more inclined to honor freedom of contract, enforce the
clauses of the contract regardless of the actual loss, after testing foreseeability of the "genuine
pre-estimate of loss"

If the Liquidated Damages clauses are held to be a penalty and therefore void, the general rule
in England is that the clause may be completely disregarded, and the Employer may sue for actual
damages, which may exceed the sum stated in the Liquidated Damages clause. Famous Delay Cases:

Liquidated Damages Clause will be enforced where the court finds that the harm caused by
the breach is difficult to estimate, but where the amount of liquidated damages is reasonable

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Liquidated Damages And Penalty In Construction Industry

compensation and not disproportionate to the actual or anticipated damage. The intent of
liquidated damages is simply to measure damages that are hard to prove once incurred.

If the liquidated damages are disproportionate, they can, however, be declared a penalty. The
clause is then void, and recovery will be limited to the actual damage that results from the
breach.

The treatment of liquidated damage clauses varies slightly among different jurisdictions within
the United States, but generally the courts consider two elements to determine whether a
liquidated damage clause is enforceable:
The first is the uncertainty element; whether the harm caused by the breach is difficult to
calculate.

The second element is whether the amount of the liquidated damages is reasonable in
proportion to the actual or anticipated harm. If it is not, then it is a penalty, which is against public
policy, and therefore the clause is unenforceable.

At common law, a liquidated damages clause will not be enforced if its purpose is to punish
the wrongdoer/party in breach rather than to compensate the injured party (in which case it is
referred to as a penal or penalty clause). One reason for this is that the enforcement of the term
would, in effect, require an equitable order of specific performance. However, courts sitting in
equity will seek to achieve a fair result and will not enforce a term that will lead to the unjust
enrichment of the enforcing party.

In order for a liquidated damages clause to be upheld, two conditions must be met. First, the
amount of the damages identified must roughly approximate the damages likely to fall upon the
party seeking the benefit of the term. Second, the damages must be sufficiently uncertain at the
time the contract is made that such a clause will likely save both parties the future difficulty of
estimating damages. Damages that are sufficiently uncertain may be referred to as unliquidated
damages, and may be so categorized because they are not mathematically calculable or are
subject to a contingency which makes the amount of damages uncertain.

For example, suppose Joey agrees to lease a storefront to Monica, from which Monica intends
to sell jewelry. If Joey breaches the contract by refusing to lease the storefront at the appointed
time, it will be difficult to determine what profits Monica will have lost because the success of
newly created small businesses is highly uncertain. This, therefore, would be an appropriate
circumstance for Monica to insist upon a liquidated damages clause in case Joey fails to
perform.
In the case of construction contracts, courts have occasionally refused to enforce liquidated
damages provisions, choosing to following the Doctrine of Concurrent Delay when both parties
have contributed to the overall delay of the project.

FIDIC 1999 edition says is Sub-clause 8.7:

“If the Contractor fails to comply with Sub-Clause 8.2 [Time for Completion], the Contractor shall
subject to Sub-Clause 2.5 [Employer's Claims] pay delay damages to the Employer for this
default. These delay damages shall be the sum stated in the Appendix to Tender, which shall be
paid for every delay which shall elapse between the relevant Time for Completion and the date
stated in the Taking-Over Certificate.

However, the total amount due under this Sub-Clause shall not exceed the maximum amount of
delay damages (if any) stated in the Appendix to Tender.

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These delay damages shall be the only damages due from the Contractor for such default, other
than in the event of termination under Sub-Clause 15.2 [Termination by Employer] prior to
completion of the work .These damages shall not relieve the Contractor from his obligation to
complete the works , or from any other duties, obligations or responsibilities which he may have
under the contract .

In civil law countries, the attitude toward contractual penalties is quite different from the
common law approach. The Napoleonic Code, upon which most civil codes are based, allowed
for penalties to encourage performance of contractual obligations. In recent years, however,
there has been a widespread trend in civil law countries toward narrowing the scope of such
penalties, and allowing courts to reduce the amount if they find it excessive. Traditionally, in civil
code countries, no distinction was made between liquidated damages clauses and penalty
clauses. Recently, a more common approach seems to distinguish between liquidated
damages clauses that are used to estimate damages in case of non-performance, based on the
concept that there has been an actual harm to the plaintiff, and penalty clauses that are used to
establish a penalty to be paid in case of non-performance with the intent to encourage
performance. The latter does not require proof of any real damage. Penalty clauses in civil law
jurisdictions can be described as the kind of liquidated damages that would not be enforceable
in the United States because of public policy prohibiting liquidated damages designed to punish
the nonperformer.
Although penalty clauses have been generally enforceable in civil law countries, they can now
be mitigated by the court in most jurisdictions.

The Council of Europe issued a “Resolution on Penalty Clauses” in 1971, with the aim of
recommending a uniform application of penalty clauses for the member states to use. The
resolution allows penalty clauses, but the penalty amount may be reduced by the courts if they
are manifestly excessive, or if part of the main contractual obligation of the contract has been
performed. The explanatory memorandum to the Resolution provides a list of factors in
determining whether a penalty is manifestly excessive. They include the comparison of the pre-
estimated damages to the actual harm; the legitimate interest of the parties, including non-
pecuniary interests of the promise ; what category of contract it is and under what
circumstances it was concluded, with emphasis on the relative social and economic position of
the parties; whether it was a standard-form contract; and whether the breach was in good or
bad faith.
Many, but not all, civil codes seem to have followed the precedent of the Resolution to allow
courts to reduce an excessive penalty.

How should a court decide when a clause providing for a liquidated damages is “penalty” and
therefore unenforceable?

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Case study

on October 5 Dave Gustafson & Co.v. State of South Dakota


Supreme Court of South Dakota
83 S.D160,156 N.W.2d 185(1968)
Hanson ,Presiding Judge.
In this action by a contractor againt the State of South Dacota and its Highway Commission the
single question is whether a provision in a state highway construction contract is one for
liquidated damages ,as a trial court found , or is a penalty.
On October 5, 1963 plaintiff Dave Gustafson and company, entered into a contract with the state
highway commission of the construction of the sub-base, and bituminous surfacing of a new
public highway between Wessington springs and Woonsocket. Plaintiff performed a total dollar
amount of work in the amount of $ 530,724.14 . upon completion the new highway replaced the
pre-existing portion of state trunk highway NO.34 between the 2 towns. During construction the
old portion of highway 34 remained open for travel by the public in substantially the same
manner it had been in the past 5 years. After the new highway was completed , the old portion
of the road was also left open for use as a public highway. Plaintiff failed to complete the new
highway on the date fixed. There was a delay of 67 working days for which there was no
extension if time requested or granted. Therefore the state with held $ 14,070.00 as liquidated
damages from the amount due plaintiff computed according to the contract scale of daily
damages for delay in construction. As this project totaled $ 530,742.14, the per diem delay
damage was $ 210. This daily damage multiplied by the 67 day delay equals the sum with
held .According to an interrogatory answered by the state any damage, loss, or expense in
carried by reason was “unknown”. This didn’t necessarily mean there were no damages .
The pertinent contract provision reads :

The failure to complete the work on time :---Time is an essential element of the contract and it is
important that the work be pressed vigorously to completion .
1. The cost to the department of the administration of the contract including engineering ,
inspection, and supervision , will be increased as the time occupied in the work is
lengthened .
2. The public is subject to determine and inconvenience when full use cannot be made of
an incomplete project.
Should the contractor fail to complete the work within the time agreed upon in the
contract or within such extra time as may have been allowed by increases in the
contract there shall be deducted from any monies or amount due or that may become
due the contractor ,the sum set forth in the schedule shown below , for each and every
weather working , day that the work shall remain uncompleted.
3. This shall be considered and treated not as penalty but as fixed , agreed liquidated
damage due the state from the Contractor by reason of inconvenience to the public ,
added cost of Engineering and supervision , and other items which have caused an
expenditure of public funds resulting from his failure to complete the work within the
time specified in the contract.

Original contract amount amount of liquidated


damages
per day
From more than To and including

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Liquidated Damages And Penalty In Construction Industry

0 25,000 42
25,000 50,000 70
25,000 100,000 105
50,000 500,000 140
100,000 1,000,000 210
500,000 2,000,000 280
1,000,000 ------------ 420
2,000,000

Graduated scale of per diem liquidated damages

An unexecuted delay in performing a contract after the time fixed for performance constitutes a
breach of contracts for which damages are recoverable. The measure of damages except as
otherwise provided by statute is the amount which would “compensate” the party aggrieved for
all the determent proximately caused thereby, would be likely to result there from. such actual
damages would have to be alleged and proved.
Stipulated sums in the nature of “Penalties imposed by contract...Are void”, and unenforceable.
However, parties to a contract may agree “upon an amount resumed to be the damage for beach
in cases where it would be impartibly or extremely difficult to fix actual damages.
The provision must be considered to be one for liquidated damages rather than a penalty for the
following reasons :
I. Damages for delay in constructing a new highway are possible of measurement.
II. The amount stated in the contract as liquidated damages indicates an endeavor to fix
fair compensation for the loss, inconvenience, added costs, and deprivation of use
caused by delay. Delay is graduated according to total amount of work to be performed.
It may be assumed that a large project involves more loss than a small one and each
day of delay adds to loss, inconvenience, cost and deprivation of use.
The provision must be considered to be one for liquidated damages rather than a
penalty tor the following reasons: 1. Damages for delay in constructing a new highway
are impossible of measurements. 2. The amount stated in the contract as liquidated
damages indicates an endeavor of fix fair compensation for the loss, inconvenience,
added costs, and deprivation of use caused by delay. Daily damage is graduated
according to total amount of work to be performed. It may be assumed that a large
project involves more loss than a small one and each day of delay adds to the loss,
inconvenience, cost and deprivation of use.

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Liquidated Damages And Penalty In Construction Industry

Conclusion

As a result of this investigation we can determine that:


There is a difference between the LDS and Penalty.

Liquidated damages are used when the calculation of actual damages is complex and difficult to
determine.

In the majority of the laws the liquidated damages is enforceable but the penalty is not.

For an owner deciding whether to include a liquidated damages provision in its construction
contract, then, there are several factors to consider--especially whether such damages will likely
compensate the owner for late completion, etc. But where such damages are reasonable (at
least on their face) and are fairly applied, they will be enforced.

Damages are two parts: loss profits and suffering loss.

A liquidated damages provision essentially limits the amount of recovery by the owner for late
project delivery. Additional claims by the owner, if the amount of liquidated damages is less than
the actual costs incurred, may not be honored.

The amounts charged per day vary between owners even for contract values are the same but
tend to be comparable in general magnitude.

The contract may stipulate that the liquidated damages will be reduced to 50% of the stated
amount per day if the project can be used by the public (for example, a highway or street) even
though the project is not otherwise completed.

Permitting the contractor to continue and finish the work or any part of it after the time fixed for
its completion, or after the date to which the time for completion may have been extended, shall
in no way operate as a waver in the part of the owner of any of it rights under the contract.

If a liquidated damages clause is unenforceable because it is construed as a penalty, then the


owner will have lost the right to liquidated damages.

Liquidated damages are meant to accurately and fairly reflect the measure of compensation that
would be required to place the employer in a position as if the delay had not occurred.

Liquidated damage in civil law is an agreed remedy which estimated before the
contract is signed and before any breach occurred.

The possibility of a penalty (bonus clause) gives contractors greater incentive to


complete the work in time.

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References:
 Charles L. Knapp ,and Nathan M.Crystal 1987 ,Problems in Contract Law, Cases and Materials
,Second Edition , professor of Law New York University & South Carolina, p 967-971
 Lindsey, Susan 2005 , Business, international . 0003-8466 Architects' Journal. EMAP
Architecture.
 Brian M. Samuels , Construction Law.
 FIDIC,1999 , Condition of Contract for CONSTRUCTION.
 INTRNET WEBSITES.
 William G. Morris , an attorney , at 247 North Collier Boulevard on Marco Island.
 Greenburg Traurig , January ,2008,Construction Law Litigation.
 ‫مهندس استشاري‬,‫المطالبات و محكمة التحكيم في المنازعات الهندسية و قوانين التحكيم العربية‬, ‫محمد ماجد‬, ‫خلوصي‬
 CHARLES S PHELLIPS,P.E.,1999 ,Construction Contract Administration, Society for Minning,
Metallurgy, and Exploration, inc.(SME),p 63.
 Hinze, Jimmie, University of Florida, 2nd ED. P 214, 215

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