Beware of the liquidated damages clause

Jul 10, 2022

More owners (or their lawyers) have tried to insert these clauses into design contracts, and this should be a red flag for AEC firms.

Owner/contractor agreements typically contain a liquidated damages clause, which is designed to protect the owner from the financial consequences of project delays caused by the contractor. While these arrangements are understandable as completion dates are significant to owners, new efforts to insert the clauses in design contracts represent potentially significant uninsured exposures for AEC firms.

When contractors submit a price for their work they also contractually agree to the completion date. So, by the time the contractor is awarded the contract, it usually has the contract documents and has used them to price the job and complete a construction schedule. Once a notice to proceed is issued to the contractor, the contractor essentially controls the schedule.

Liquidated damages clauses in construction contracts were first initiated – and quickly became widespread – because actual damages are difficult to establish in the case of a delay. To avoid the likelihood of disagreements and related litigation, the owner and contractor agree upfront to a reasonable daily amount that will substitute for actual damages. The daily amount will generally be assessed against the contractor for every day or business day the project is late.

Nonetheless, even with the presence of a liquidated damages clause, delay damages can still be costly to prosecute and defend. In effect, the daily amount stipulated in the contract must be reasonably consistent with what actual damages might be. If the amount selected is deemed excessive, a court may decide the clause is not enforceable. Generally, however, liquidated damages are the exclusive remedy if the project is late.

As mentioned, during the past several months, more owners (or their lawyers) have tried to insert liquidated damages clauses into design contracts. This should be a red flag for AEC firms as liquidated damages are not covered under professional liability policies. In some cases, these clauses relate specifically to design completion dates.

Of course, a number of factors can contribute to delays in the completion of design documents, including: consultants’ and owner’s consultants’ timely completion of work; permit reviews and comments; and redesign by owners. In the latter circumstances, owners might view their adjustments as minor, but they may in fact have broader impacts.

As recent experiences that arose during the pandemic illustrate, there are many intangibles. Furthermore, there typically are low actual damages associated with design delay; a notice to proceed with the construction has not been issued, and no construction has been priced or scheduled. Thus, any actual damages may potentially be less than the amount stipulated in the contract.

In other situations, however, the liquidated damages provisions relate to all aspects of the contract, including the construction completion date.

Even though the design professional has no responsibility for construction and no control over the schedule, there still are time-related aspects of a design professionals’ performance during contract administration. They include submittal review turnaround, RFI responses, change order review, and review of the payment certifications. If not completed on a timely basis, these issues can affect the contractor. Nonetheless, they generally do not constitute a valid cause of delay.

That stated, suppose a contractor claims the design professional failed to meet these time aspects of the contract and delayed construction. In that case, nothing precludes the owner from making a negligence claim against the design firm, passing on the contractor’s claim.

Without a liquidated damages clause, this type of claim should not result in significant insurance coverage issues if there is an alleged breach of the standard of care. Professional liability coverage is tied to negligence; claims are paid when it is established that there are breaches of the standard of care and resulting damages.

Most professional liability policies specifically exclude liquidated damage claims, as they are not available to the owner unless they are in the contract. However, in that case even if the professional liability policy doesn’t contain a specific liquidated damages exclusion, the contractual liability exclusion will apply, so coverage may be denied on that basis.

The only time a design firm’s obligation to pay liquidated damages might fall under their professional liability coverage is if it can be established there were actual and measurable damages to the client caused by a delay attributable to the firm’s negligence in providing professional services. In these situations, the owner would have to allege negligence and prove damages. Depending on the policy language, even these circumstances could be problematic for design firms.

Rather than face potentially serious coverage implications because of a liquidated damages clause in a contract, go into contract negotiations well prepared to explain why they are appropriate for contractors, but not for design professionals.

Your arguments may include citing the different nature of the design firm’s responsibilities in the contract, as well as the contractor’s role in the preparation and control of the schedule. You can also point out the different sizes of contracts involving design firms versus those for contractors. Make sure the client understands that a liquidated damages provision represents an uninsurable obligation and that taking on uninsured risk is not contemplated in establishing design fees.

Take time to remind clients that they require your firm to have professional liability insurance so there will be coverage in the event of negligent performance. Certainly, it isn’t in the owner’s interest to insert obligations that won’t be covered by insurance you’re contractually required to have in place.

Finally, you might consider entering contract negotiations ready to suggest a replacement clause as an alternative that recognizes the client’s milestone expectations and ties meeting those milestones to the standard of care. The clause can stipulate that any services be performed as expeditiously as is consistent with professional skill and care and the project’s orderly progress. 

Lauren Rhodes Martin is a risk manager and claims specialist at Ames & Gough. Connect with her on LinkedIn.

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