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January 30, 2023

Understanding Liquidated Damages in Construction Contracts: A Guide to Risk Management 

Entering into a construction contract involves more than just agreeing on a price and timeline. One crucial aspect that both parties must clearly understand is their exposure to liquidated damages. These provisions play a significant role in defining the risks each party assumes if a breach occurs. Whether you’re just starting the contracting process or are already knee-deep in negotiations, having a solid understanding of liquidated damages is essential. 

In construction contracts, liquidated damages are predetermined sums that a breaching party agrees to pay if certain project milestones, such as substantial completion or occupancy, are missed. These sums are typically expressed as a daily fee for each day the project fails to meet the agreed-upon milestone. 

What Are Liquidated Damages? 

Liquidated damages provisions are designed to offer clarity and define risk in construction projects. They specify a set amount of damages that must be paid by the party in breach if a project milestone is delayed. The amount is usually calculated on a per-day basis and begins accruing when a milestone is missed. 

For example, if the parties agree to liquidated damages at a rate of $1,000 per day for every day the project surpasses the agreed substantial completion date, the breaching party will owe that amount for each day the milestone is not met. The damages will continue to accrue until the milestone is reached. 

Why Are Liquidated Damages Important in Construction Contracts? 

Liquidated damages provisions are essential for both owners and contractors because they: 

• Define Risk: They help both parties understand the financial consequences of a delay and manage their risk accordingly. 

• Avoid Complex Calculations: Determining the actual damages caused by delays can be complex and costly. Liquidated damages simplify this process by establishing a predetermined sum. 

• Minimize Disputes: By defining the penalties in advance, liquidated damages prevent lengthy and expensive disputes over breach consequences. 

How Liquidated Damages Are Calculated 

Liquidated damages are typically calculated as a sum per day or per unit of time. For instance, if a contractor misses the deadline for substantial completion, liquidated damages might accrue at a fixed rate of $500 per day. This rate is agreed upon by both parties in advance and is intended to be a reasonable estimate of the potential harm caused by the delay. 

Liquidated Damages Caps and Limits 

Sometimes, parties agree to cap the total amount of liquidated damages. This cap means that once the maximum amount is reached, no further damages will be assessed, even if the delay continues. For example, if the total liquidated damages cap is set at $50,000, the contractor will only owe that amount, regardless of how many days the project is delayed. 

When Do Liquidated Damages Begin to Accrue? 

Liquidated damages typically begin to accrue when a milestone is missed. The milestone could be something like substantial completion, final completion, or occupancy. The amount of damages continues to accrue until the milestone is achieved, at which point the damages cease. 

Avoiding Ambiguity in Liquidated Damages Claims 

It’s important to not only define how liquidated damages will be calculated but also to outline the process for claiming and recouping them. For example, the contract may specify whether liquidated damages will be deducted from progress payments or if they need to be asserted as a separate claim. Without clear guidelines, misunderstandings can arise, leading to disputes and legal challenges. 

Best Practices for Handling Liquidated Damages Claims 

To avoid confusion and ensure smooth project execution, parties should: 

• Explicitly Outline the Process: Agree on the process for claiming and recovering liquidated damages, whether it involves withholding from progress payments or submitting a formal claim. 

• Include a Cap: If possible, include a cap on the total amount of liquidated damages to prevent excessive penalties. 

• Be Clear on Milestones: Define the project milestones clearly so there is no ambiguity about when liquidated damages will begin to accrue. 

The Benefits of Liquidated Damages 

For both contractors and project owners, liquidated damages provisions provide: 

• Clarity: Clear guidelines on how to handle delays, penalties, and breaches. 

• Risk Management: A clear financial penalty for missed milestones helps both parties understand the potential risks involved. 

• Reassurance: Both parties are reassured that in case of delays, there will be a predefined solution, avoiding the need for complex damage calculations. 

Final Thoughts 

Liquidated damages provisions are a crucial component of construction contracts. By including clear and detailed liquidated damages clauses, both contractors and owners can protect themselves from unforeseen risks, ensure projects remain on track, and avoid costly disputes. Before signing a contract, it’s essential for all parties to fully understand their exposure to liquidated damages, including how they are calculated, when they begin to accrue, and how claims will be asserted. 

AIA Contract Documents has provided this article for general informational purposes only. The information provided is not legal opinion or legal advice and does not create an attorney-client relationship of any kind. This article is also not intended to provide guidance as to how project parties should interpret their specific contracts or resolve contract disputes, as those decisions will need to be made in consultation with legal counsel, insurance counsel, and other professionals, and based upon a multitude of factors.