What are Liquidated Damages?


Liquidated Damages: The Owner’s Side

Liquidated damages are financial penalties that are levied upon the contractor based upon contractual failures. In most cases, the penalties apply to failure to properly accomplish and meet construction scheduling dates, which are established within the construction schedule for the project.

What is the majority of owner’s initial reaction to the inclusion of a liquidated damage clause?
In most situations, the owner is immediately in favor of the establishment of liquidated damages within the contract. The owner will initially react in a very positive fashion, citing issues such as leverage, schedule emphasis, hitting the contractor where it counts, etc. Unless the owner is an accomplished builder and experienced in the more intimate reactions that occur, due to clauses that are included within a construction contract, there will initially be a very positive response. Basically, the owner will feel that the inclusion of penalties ( liquidated damages ), will stimulate the contractor regarding clarity in scope identification as well as scheduling impetus. This will force the contractor to comply to the schedule as well as the budget. If the owner is an accomplished builder who is aware of the other side of this liquidated damage clause, then the reaction will be different.

There is another reaction to consider, regarding the inclusion of a liquidated damage clause within a construction contract. It is recommended that the owner think about this alternate reaction, prior to insisting on the inclusion of a liquidated damage clause in the contract.
I recommend another avenue of negotiation and thought processing, when it comes to the inclusion of a liquidated damage clause in the contract. This opinion is based upon many years of managing very difficult and complicated liquidated damage claims on construction projects, as well as witnessing the mismanaged techniques, used by some owners, who find themselves having the liquidated damage clause within the contract used against them.
What could occur, if the contractor proceeds as follows, when confronted by an owner that insists on a construction contract with a liquidated damage clause.
1.) The contractor reluctantly accepts the liquidated damage clause. This reluctant and negative acceptance is based upon the contractor assuming that the owner, on the other side of the contract, is expecting the contractor to resist a liquidated damage clause. What if the contractor is merely playing the system? It is important that you, as the owner, understand that there could be contractors that are skilled in turning the liquidated damage clause, in their favor.

2.) What if the contractor, by reluctantly accepting the liquidated damage clause in the contract, has now injected a level of mistrust, and a lack of team play into the equation, based upon this liquidated damage insistence by you, the owner? What would occur, if these theoretical negative characteristics, caused by the inclusion of the liquidated damage clause in this contract agreement, simply provided the exact type of environment for the contractor to stimulate more financial opportunity. Remember, the contractor is performing this contract for one reason, to make money! If the inclusion of a liquidated damage clause, shifts the entire atmosphere surrounding this project, from one of team cooperation, to a more aggressive environment, did the inclusion of the liquidated damage clause make sense? This is an important decision for any owner to make.

3.) The owner must consider the negative aspects of the introduction of a liquidated damage clause, if this action insinuates that there is now a more negative environment, surrounding the management of the project. Does it makes sense to introduce a liquidated damage clause, if by this action, the contractor feels that the owner, as the leader of the team does not have the contractor’s back, nor do they exhibit the trust in the contractor necessary to solve field problems, resolve cost issues, and efficiently manage and schedule the project? Will this attitude cause the contractor to play according to all of the rules, as well as perform the work in the best manner possible, for the benefit of the entire project. Or will this turn the contractor and their subcontractors into animals, ready to pounce on any type of financial opportunity available on the project?

4.) If the final negotiations result in the insistence on a liquidated damage clause, could this cause the contractor to push back with the insistence on a positive incentive clause. If the owner is insisting on the negative liquidated damage clause, then it may stimulate the contractor to insist on a positive incentive clause.
What is a positive incentive clause?

A positive incentive clause can take many different forms. There can be a reward type clause that rewards the contractor, if the project is completed prior to the formal completion date, if the budget is reduced, or if cost saving incentives is suggested and implemented. There are different types of positive incentives that can be included within the construction contract. The important aspect of this concept is the tradeoff of liquidated clause with a positive incentive clause. The reason that the owner should carefully consider their insistence on the inclusion of a liquidated damage clause, is that it provides an opportunity to insert a positive incentive clause. This liquidated damage clause could turn the entire concept of the project around; if owner feels inclined to insist on the liquidated clause, then the contractor could take this opportunity to insist on the positive incentive clause.

The owner should consider a defensive strategy if the liquidated damage clause is included, and the contractor takes some of the following management steps to counter any liquidated damages.
1.) As I have repeatedly insisted upon, throughout this website, the need for proper documentation of all issues on the project is mandatory, especially if there is a liquidated damage clause in the contract. Document, document and more documentation. As the owner it is imperative that every piece of correspondence, RFI, Change Order Request, etc. be met with an answer via email, letter, phone call ( that is then documented ) etc.

a.) RFI’s are a sacred piece of documentation. Each Request for Information must be carefully and accurately answered with the reason the RFI originated, the date, as well as a full and complete documentation of the timing of all responses. A follow up email or piece of correspondence that acknowledges that the RFI has been answered in a timely manner and that there are no delays in the schedule due to this RFI must be clearly identified. The contractor will use every opportunity to issue RFI’s and claim delay. These must be countered with the answers and a response to any alleged delays.

b.) RFI’s must include the time that the answer was issued. Each RFI must clearly and accurately indicate what type of effect the question has on the project and the minimization on the project schedule and cost. If the question holds up the submission of the reinforcing documents, if the RFI delays the layout of any of the actual construction, each situation MUST be clearly identified, answered and a defensive position taken. Lack of a defensive position at the time of the RFI being questioned is opening up the contractor for legitimate delays .

c.) Change Orders are as important as the RFI’s in a project that has a liquidated damage clause. Each change order must be clearly developed to enable future understanding of the effects of the change order on the schedule as well as the budget of the project. A precise and accurate management system of Change Orders is imperative to the success of the project, especially if there are liquidated damages. The owner is obligated to respond to each and every change order, no matter how insignificant they appear. The contractor will use every change order to claim delays, and will accumulate all change orders in a package of delays and additional costs. Once this is accomplished by the contractor, the effectiveness of any liquidated damage clause within the contract is severely diminished.

d.) Daily reports. The importance of your owner representative’s daily reports is critical to the proper management of the liquidated damage clause. Each owner rep’s daily report must properly account for each RFI and Change Order that has been issued and the effect of each of these documents on the project. The owner’s rep must be cognizant of the importance of clearly and accurately reporting every daily issue. It is imperative that the owner’s rep understand that each and every daily report, if the contractor’s superintendent is any good, will contain every opportunity to allude or claim delay and additional cost and work. The owner’s representative must be clearly aware that this is occurring and must defend against every claim of delay and added cost.

2.) It is extremely important that all team players, on the owner’s side, understand the importance of communication and documentation regarding the existence of a liquidated damage clause in the contract. I recommend that this becomes a game, that the players on the owner’s side become intimately involved in the competition. I have been extremely open, when it comes to the offensive side of a contract that has liquidated damages in it. I do not hesitate to indicate that the insistence of a liquidated damage clause could indicate a negative opinion as well as a lack of confidence on the owner’s behalf toward the contractor. The owner must understand this and manage against this acknowledgement. The contractor will use this negative incentive to stimulate the energy required to properly and confidently manage the communications required, to properly defend against any liquidated damage claim that the owner might consider.

3.) It is imperative that all management personnel on the owner’s side of the agreement understand the importance of defending the liquidated damage clause. Each position, from the owner to the owner’s field representative, must understand that any item that could be considered a delay, or additional cost, will be clearly documented by the contractor. Overdue the response! Each individual must understand the importance, as well as the dangers, that the inclusion of a liquidated damage clause could have on the final completion of the project. Once there is a liquidated damage clause, the so-called gloves must be off by the owner, because they are already off on the contractor’s side.

4.) What are some particular field issues that could evolve during construction, that the contractor could maneuver into substantial supportive defensive information, defending any claims that the owner has of liquidated damages?

a.) Shop drawing and submittal scheduling. The owner must ensure that all of the shop documents or the formal submittals are returned or acted upon in accordance with the contract documents. This is a MUST! No matter how incidental or non-consequential to the overall outcome of the project, the owner must make the team of architects, engineers, etc. understand that every element of the contract must be clearly and accurately followed. The contractor will follow the concept that, any delay is a major delay, the owner must be aware of this and defend against this concept.

b.) The owner must understand and covey to their team, that any failure within the contract documents to provide every dimension and detail necessary to properly, and in a timely fashion, construct the project, will be amplified by the contractor. It does not matter if the color of the walls is the only answer pending, the contractor will claim a delay that this decision has not been made.

c.) As previously noted, every RFI, Change Order, or other type of consequence that provides an opportunity to identify failure on the architect or owner’s part, will be documented and exploited by the contractor. The owner cannot be shy! This is a matter of financial success, if you decided to include the liquidated damage clause, you must be ready to defend it.

d.) Any owner ordered material, equipment or subcontractor requirement, which is identified as the owner’s responsibility will be scrutinized by the contractor for failures. Any delay, no matter how small, or currently non consequential must be either eliminated or clearly documented and defined. Although it is repetitious, the continued management and documentation of every element of delay, indecision, incorrect data or simply stupid misdirection must be documented with a defensive position, by you, the owner.

e.) The owner must understand that every subcontractor will probably be included under the liquidated damage clause umbrella. This will cause all parties involved on the project to have the same management direction regarding delays and cost issues. It is imperative that every conversation, meeting, correspondence, or email be structured in a manner that continually provides you, the owner, a defense for any type of delays or additional costs incurred on the project.

The owner must understand that, if the contractor is experienced and capable, they will use a contract with liquidated damages, in a fashion that will ultimately make them money, if the owner is not as professional and savvy in their management and supervision style and methodology. If you as the owner felt it necessary to incorporate a liquidated damage clause, the contractor will use this as a stimulus for an aggressive and relentless assault on the accuracy of the architect’s documents, the owner’s financial capabilities, as well as the developer’s ability to achieve the proper permits and approvals.
It is up to the owner to defend, every allegation as they occur.
I personally enjoy being involved with a contract that has liquidated damages included. What this immediately indicates to me is the following;
1.) The owner, architect and developer, even if identified differently, are NOT team players. The owner must understand this concept and accept the reality of the total environment that they have set up.

2.) The contractor and subcontractors obligated by a contract with liquidated damages, are not going to be team players and you as the owner must be very aware of this attitude.

3.) The liquidated damage clause in the contract can be used as a stimulus to the contractor , that you, as the owner, are not trusted, and certainly not of the opinion that you feel the contractors are trying their best.

4.) The liquidated damage clause can be used as an incentive for bonuses and appreciation by the contractor when dealing with their employees. This is a very disconcerting awareness by the owner. This means that the project manager as well as the superintendent on the project, are looking to find reasons to manipulate the activities on the project to eliminate any possibility of their employer incurring any liquidated damages. Unfortunately this is usually not achieved by getting the job completed on schedule and on budget, it usually means finding alternate defensive positions to be used against you, as the owner.

5.) The contractor will insist that the liquidated damage clause be used by their own personnel to instill a sense of teamwork focused on a common theme, take advantage of the clause and push back! A competent and experienced contractor is not intimidated nor scared of a liquidated damage clause, they will simply use it as an excuse to push back even harder.

6.) The contractor will use the liquidated damage clause, as a reason to charge for everything! It is amazing how much is actually given away to an owner, architect or developer, if there is no liquidated damage clause. Each subcontractor will attempt to be the best friend of the owner, architect or developer. This attitude will stop immediately, when it is clear that there is a liquidated damage clause in existence. This clause will be used as a reason and incentive for the subs to never give it away! You as the owner must be aware of this!

7.) The contractor will probably use the attitude, that if you can give it away, your price was too high to start with! If there is a liquidated damages clause in the contract, every price, every estimate, every change order is accurate and without any slush fund, additional money, or padding, or whatever other financial description, that you want to use. Again, this is the overall impression that will be used by the contractor, that you as the owner must understand.

Liquidated damages equals no holds barred management and supervision.

In summary, the inclusion of a liquidated damages clause within a construction contract is a clear and very obvious identification of where you, as the owner, stand in the opinion of the contractors on the project. It is a perfect indication of a financial exposure for the opposite side, and should be managed with this in mind. Do not allow the opposition to take advantage of that liquidated damage clause. If you as the owner insist on including the liquidated damage clause, then each designer, architect, engineer, consultant, financial advisor on your side, must be aware that they cannot provide any ability for the contractors to take advantage of the liquidated damage clause.

THEY MUST BE PERFECT!

The insistence on liquidated damages, has just changed the game from flag to tackle!

GOOD LUCK!