by James J. Ison, Associate

A liquidated damages clause is a contractual provision that sets in advance the measure of damages a party will recover in the event of a breach of the agreement.  In most states, such clauses are generally enforced provided two requirements are satisfied:  (1) at the time of contracting, damages that would be caused by a breach are incapable or nearly incapable of accurate estimation; and, (2) the established rate of damages constitutes a fair and reasonable attempt to fix in advance what will be just compensation in the event of breach.  In the absence of a reasonable relationship between the established rate of liquidated damages and the anticipated actual damages, a contractual clause purporting to predetermine damages will be construed as a penalty.  A contractual provision imposing such a “penalty” is, as a matter of law, unenforceable and the wronged party can recover only the actual damages it sustained.  See e.g., Ridgley v. Topa Thrift and Loan Ass’n. (1998) 17 Cal.4th 970, 977.  (Some states, such as Virginia, will also look to the actual damages incurred, and if the agreed liquidated damages amount is grossly in excess of actual damages, the liquidated damages clause may be an unenforceable penalty.  See Gordonsville Energy, L.P. v. Virginia Electric and Power Company, 257 Va. 344 (1999).)

In light of these general legal principles, enforcement of a liquidated damages clause is often viewed as an all-or-nothing proposition, i.e., the predetermined rate of damages is either a reasonable estimation of actual damages and fully enforceable or it is not, thereby rendering it void.  On multi-million dollar construction projects, where the rate of liquidated damages for a contractor’s late completion is often set at many thousands of dollars per day, an owner’s claim for liquidated damages often will be hotly contested, especially when strict enforcement of a liquidated damages clause results in damages that appear to exceed any harm the owner has actually sustained.

In lieu of enforcing a liquidated damages provision that would operate inequitably or invalidating a contractually agreed liquidated damages clause altogether, various federal Boards of Contract Appeals (collectively “Boards”) have carved out a middle ground that, in certain circumstances, allows for the proration of the agreed upon rate based on the project’s percentage of completion.  In some cases, this approach could be used to diffuse the contentious issue of liquidated damages in settlement negotiations, or provide a court or Board with an equitable, contract-based alternative to calculating damages.  This article reviews some of the decisions that have addressed this issue and, based on these cases, offers suggestions as to how an argument for proration could be presented to an opposing party, judge, arbitrator or mediator.

Boards of Contract Appeals Allow for the Proration of Liquidated Damages When Apportionable on a “Rational Basis”

A majority of Boards that have addressed this issue have allowed the proration of liquidated damages, even though not expressly allowed by the contract at issue.  For example, in J.D. Redin Construction Co., VABCA No. 253, (July 19, 1960), the contract called for alterations to a hospital’s buildings and utilities and provided for the government’s recovery of liquidated damages in the event the contractor “delayed possession” of contract work.  Although not all contract work was completed by the contractually-prescribed date, the Contracting Officer (“CO”) assessed liquidated damages only on those buildings that had not been accepted by the government.  Based on these facts, the Board concluded that “[t]his was consistent with decided cases and was proper.” Id.

In another case involving replacement of controls on two elevators, the government was contractually entitled to recover liquidated damages if the contractor “delayed possession” of the elevators.  Elser Elevator Co., VABCA No. 298 (July 6, 1960).  One elevator was completed on time and one was not.  Even though the contract did not “specifically provide for a reduction in or proration of liquidated damages in the event one elevator was accepted in advance of the other,” the Board decided that the government was entitled to “apportioned liquidated damages” at one half the contract rate.  Id.

In Sierra Construction Co., IBCA No. 1145-3- 77,78-2 B.C.A. ¶ 13,268 (June 7, 1978), the contractor constructed and/or modified sewage treatment facilities at five different sites.  The contract provided for liquidated damages for late completion at a rate of $125 per day, but was “silent as to proration if 4, or 3, or 2, or 1 of the five sites were completed on time.” Id.   Because one site was late, the government determined that it was due liquidated damages of $40 dollars per day.  The Board adjusted the government’s rate, but affirmed the basic concept of proration, stating liquidated damages of that “[i]n these circumstances, we conclude a reasonable proration of the latently ambiguous liquidated damages clause is $125 per day divided by the five work sites or $25/per day for each of the five work sites.” Id.

In Triad, Inc., VABCA. No. 1174, 88-1 B.C.A. ¶ 20,261 (October 29, 1987), the contractor agreed to replace windows in three government-owned buildings.  The contract assessed liquidated damages at the rate of $50.00 per day of delay.  The contractor argued that because it had completed a significant percentage of the work, the liquidated damages provision was an unenforceable penalty, or should be prorated accordingly.

After evaluating the decisions discussed above, the Triad Board noted that in previous cases its predecessor Boards had found that “prorating of liquidated damages is authorized, in lieu of invalidating the liquidated damage provision entirely.” Id.  Ultimately, it remanded the matter back to the CO because it did not have enough information with which to decide whether proration was consistent with the parties’ basis for the predetermined rate.  In so doing, the Board made clear that if “the facts demonstrate there is some rational basis for prorating and apportioning the stated liquidated damage rate, the Board may ultimately take such action consistent with the cases discussed above.” Id.

At least two Boards, however, have rejected proration of liquidated damages in the absence of an express term authorizing such a reduction.  As one of those Boards reasoned, such proration “would be rewriting the contract so as to modify the plain meaning of the provision in question.” Appeal of American Ligurian Co., Inc., IBCA No. 492-4-65, 66-1 IBCA 1 ¶ 5326 (Jan. 21, 1966).  As noted by the Board in Triad, however, such decisions refusing to prorate liquidated damages are “in the distinct minority,” as the weight of authority tips heavily in favor of allowing proration under appropriate circumstances.

Application

When threatened with liquidated damages that are disproportionate to actual harm, a contractor’s first line of defense should almost always be that the provision constitutes an unenforceable penalty.  While the law could present plausible legal arguments in favor of enforcement, the seemingly unfair result that strict enforcement would produce may be taken into account by a Court or Board before deciding this issue.

In some cases, however, it may be worthwhile to assert as a backup position that the rate of liquidated damages should be prorated in accordance with the percentage of work completed.  In making such an argument, it is important to recognize that the Boards that have allowed proration did not claim to have done so on equitable grounds.  Rather, they tied their rulings to the contracts themselves, despite the complete absence of any contract language authorizing proration.  For example, the contracts at issue in J.D. Hedin Construction Co. and Elser Elevator Co. required the contractor to compensate the government at the contractually specified rate in the event of “delayed possession” of the work.  These Boards decided that the parties intended that the damages be assessed against only those components of the work that were not accepted by the government by the date triggering liquidated damages.  Similarly, in Sierra Construction Co., the Board determined that the liquidated damages clause’s silence on proration rendered it “latently ambiguous.” Thus, in the Board’s view, it was not adding a new term, but merely resolving an ambiguity in the contract itself.

Moreover, the Board in Triad noted that in past cases, Boards had found that “prorating liquidated damages is authorized, in lieu of invalidating the liquidated damages provision entirely.” As this passage suggests, the proration of liquidated damages is more likely to be found proper by a Court or Board when done in the name of preserving and effectuating part of the contract that might otherwise be stricken.  Additionally, for proration to be feasible, in most cases the contract work would probably need to be, as the Triad Board put it, severable on a “rational basis.” Although determining whether contract work can be reasonably apportioned is a factually driven inquiry, this generally can be said of any project comprised of components whose usefulness to the owner is not impaired by the late completion of the project’s other parts.

Finally, although the Boards’ decisions are not binding on state or federal courts, they are “persuasive precedent” that can be cited in these forums.  For instance, in a California case involving issues pertinent to a plaintiff’s bid on a state contract, the California Court of Appeal noted that it was “strongly persuaded by decisions relating to federal procurement” and cited various decisions from the Armed Services Board of Contract Appeals in support of its holding.  Pacific Architects Collaborative v. State of California (1979) 100 Cal.App.3d 110, 125.

Conclusion

In some cases, proration may provide a fair and reasonable alternative to strict enforcement of a liquidated damages provision that would produce an inequitable result.  If a party determines that arguing for proration would be advantageous to its interests, the cases discussed in this article do not provide authority binding on state or federal courts.  Those cases do, however, provide citable precedent and describe an approach that might persuade a judge, arbitrator or, during settlement negotiations, an opposing party or mediator that applying a prorated rate would be the fairest measure of damages consistent with the contract’s terms.


The information or opinion provided in this article is the author's own and not necessarily that of Watt, Tieder, Hoffar & Fitzgerald, LLP. The author is solely responsible for the information and opinion that he or she has provided. The information contained herein does not replace seeking specific legal counsel to directly address individual client needs.

Watt, Tieder, Hoffar & Fitzgerald is one of the largest construction law firms in the world, with a practice that encompasses all aspects of construction contracting, claims and disputes resolution, and transactional legal services. WTHF principally represents large general contractors, design firms, and sureties throughout the country and internationally.