The Estimation of Construction Contract Liquidated Damages

There are few businesses for which the saying "time is money" is more appropriate than the construction industry. Timing is typically highly sensitive in the context of construction contracting. 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.

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." Many contracts simply establish the number of days of performance instead of a specific date of completion in order to accommodate the uncertainty of when a project may be authorized to proceed.

In certain construction contracts, the owner may not only set a completion date but also require the completion of portions of the work by interim dates. These interim dates, commonly referred to as "milestones" require the contractor to schedule and perform the work in a manner that meets the milestones for specified portions of the work. In addition to the contract completion date, a liquidated damage provision may also apply to milestone dates. Under these circumstances, the liquidated damage assessment in failing to meet multiple milestone dates would then be cumulative.

Contract milestone or completion dates can be changed just as any other contract requirement. These changes can be agreed upon between the owner and contractor, usually resulting in a "change order" to the contract. Contract changes can also be constructively imposed on the contractor by the owner. A constructive change is one in which the owner's acts or omissions change the conditions under which the contractor agreed to perform the work such that the contractor is entitled to an equitable adjustment in contract price or time of performance. It is not surprising that owners and contractors have differing opinions as to whether a contract has been constructively changed and if so what, if anything, is a fair and equitable adjustment for the change.

In sum, the contract milestone and completion dates are the original milestone and completion dates set forth in the contract, as adjusted by change orders and constructive changes. This can be expressed as:

COMPLETION DATE = ORIGINAL CHANGE ORDER ADDITIONAL DAYS OF COMPLETION + TIME EXTENSIONS + EXTENSION FOR DATE CONSTRUCTIVE CHANGES

Completion of Performance:

Having established the contract milestone and completion dates, the owner and contractor must then determine what constitutes "completion." For most commercial transactions, completion is easily measured and achieved at some definable moment. For instance, the purchase of some fungible commodity requires the perfect and complete tender of that commodity before payment is due. Upon delivery, performance is then complete. In construction practice, the point at which a project becomes "complete" is rarely so definable and, again, subject to disagreement between owner and contractor.

Under traditional principles of contract law, the obligation to pay for performance arises only when that performance is perfectly complete in every aspect. Perfection is not a practicable measurement of performance in construction practice (or for that matter, in engineering or architectural services) and to relieve the owner from the obligation to pay for any performance less than perfect is neither fair nor equitable. Consequently, construction law has adopted the concept of "substantial completion."

Substantial completion is achieved when the owner has beneficial use of the project. In other words, the contractor has substantially completed at that point in time when the owner can take advantage of the project for purpose intended by the owner. For example, a building may be substantially complete when it is occupied, a treatment plant when it is started up, or a road or bridge when it is open for traffic. In each of these examples, the work may not be 100 percent complete but the project's purpose has been achieved.

Again, owners and contractors frequently have different opinions as to when a project has been substantially complete. Owners tend to hold off substantial completion as long as possible to delay the release of retainage and commencement of the project warranty period that commonly occur at substantial completion. Contractors seek substantial completion as soon as possible for the opposite reason. Additionally, contractors seek to free up bonding capacity for new projects which occurs as older projects reach substantial completion and related bond obligations expire.

Substantial completion does not relieve the contractor of completing the project in its entirety, nor does it obligate the owner to pay the entire contract price. Substantial completion, however, does entitle the contractor to be paid the contract balance minus the value of the work which remains to be completed, usually referred to as "punchlist." Most contracts also require the release of "retainage" upon substantial completion. Retainage is a percentage, usually in the order of 5 to 10 percent of the value of the work already completed, withheld by the owner as a further incentive for the contractor to reach substantial completion. Hence, in theory:

FINAL COMPLETION = SUBSTANTIAL COMPLETION + PUNCHLIST COMPLETION

Massachusetts Law on Substantial Completion

In Massachusetts, there are certain statutes that further define substantial completion. For example:

"Substantial completion, for the purposes of this section, shall mean either that the work required by the contract has been completed except for work having a contract price of less than one per cent of the then adjusted total contract price, or substantially all of the work has been completed and opened to public use except for minor incomplete or unsatisfactory work items that do not materially impair the usefulness of the work required by the contract." Mass. Gen. Law Chapter 30, Section 39G

"After the receipt of a periodic estimate requesting final payment and within sixty-five days after (a) the contractor fully completes the work or substantially completes the work so that the value of the work remaining to be done is, in the estimate of the awarding authority, less than one per cent of the original contract price, or (b) the contractor substantially completes the work and the awarding authority takes possession for occupancy, whichever occurs first, the awarding authority shall pay the contractor the entire balance due on the contract less (1) a retention based on its estimate of the fair value of its claims against the contractor and of the cost of completing the incomplete and unsatisfactory items of work..."

"A certificate of the architect to the effect that the contractor has fully or substantially completed the work shall... be conclusive..."

Mass. General Law Chapter 30, Section 39K

Section 39G applies to public work projects, such as highways, bridges, sewers and water main. Section 39K applies to public building projects such as the construction, renovation or repair of any public building. Whether public work or public building project, the statutory definitions of substantial completion incorporate the concept of beneficial use of the project. Under Section 39G, beneficial use is measured by whether the project has been opened for public use except for minor items that "do not materially impair the usefulness" of the project. Under Section 39K, beneficial use is articulated to occur when the owner takes over or possesses the project "for occupancy."

When a project can be beneficially used by the owner is a subjective determination subject to disagreement. Massachusetts statutory law, however, also incorporates an objective standard of measuring substantial completion. For public works projects, substantial completion occurs no later than when the project is 99% complete based on the original contract price. For public building projects, substantial completion occurs no later than when the project is 99% complete based on the adjusted contract price. In practice, the measurement of completion is made as the contractor submits and the owner accepts periodic payment requisitions that document a project's progress.

Massachusetts law also recognizes that most projects are monitored by architects or engineers who are called upon and given the authority by contract to determine project completion as part of the pay requisition review process. Deference is given to an architect's or engineer's decision in this regard, and such decision is conclusive unless arbitrary, or otherwise made in bad faith.

Conceptually, when the project reaches substantial completion, the owner has enough of what the owner bargained for to obligate the owner to make payments to the contractor. If substantial completion as it relates to milestone portions of the work falls on or before the contract milestone dates as adjusted by contract changes, the milestone work has been completed on time. Similarly, if the substantial completion date of the entire project falls on or before the contract completion date as adjusted by contract changes, the project has been completed on time.

What happens if the contractor fails to meet a project milestone or contract completion date? Failure to meet a time of performance provision of a contract is a breach of that contract, entitling the owner to its contract based remedy which in the presence of a liquidated damages clause is the application of liquidated damages.

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."

The key then to liquidated damages is the value assigned to the per diem cost "X."

The Law of Liquidated Damages

It is no surprise that the imposition of liquidated damages fosters disputes between owners and contractors. Disputes, in turn, create litigation which in turn cause courts to write decisions regarding the enforceability of liquidated damages. These decisions then become law that owners and engineers need to bear in mind when drafting liquidated damages provisions.

The basic legal principle of liquidated damages is:

"Damages for breach by either party may be liquidated in the agreement but only at an amount that is reasonable in the light of the anticipated or actual loss caused by the breach and the difficulties of proof of loss. A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.

Comment a:...(T)he parties to a contract are not free to provide a penalty for its breach. The central objective behind the system of contract remedies is compensatory, not punitive. Punishment of a promissor for having broken his promise has no justification on either economic or other grounds and a term providing such penalty is unenforceable on grounds of public policy. ..."

Hence, despite what many owners and engineers may believe, a liquidated damages provision may not punish a contractor for late completion. The purpose of the provision must be compensatory only. The per diem liquidated damage may not be set at whatever level the owner or engineer believes is necessary to coerce the contractor to complete on time. Instead, the owner and engineer must set the liquidated damage at an estimate of what it costs the owner if the contractor is late in completion. Contract remedies, like liquidated damages, may not punish and Massachusetts courts will not enforce a liquidated damage provision that acts as a penalty.

It is the compensatory nature of a liquidated damages clause that causes its application to substantial completion versus final completion. Since liquidated damages are an estimate of the cost to the owner of a project which cannot be used as the owner intended when the owner intended and the owner is able to beneficially use the project at substantial completion, substantial completion ordinarily cuts off the owners rights to continued assessment of liquidated damages against the contractor.

How does an owner or engineer know whether a contract-defined per diem liquidated damage is a penalty? Massachusetts case decisions establish a number of guidelines to address this question.

To be enforceable, a liquidated damages provision must satisfy:

"...the well established principle that the amount of liquidated damages specified in a contract must reasonably relate to the anticipated or actual loss caused by the breach".

Hence, the liquidated damage amount cannot be arbitrary and must relate to the consequences of late completion. Furthermore:

"[W]here the actual damages are easily ascertainable and the stipulated sum is unreasonably and grossly disproportionate to the real damages from a breach, or is unconscionably excessive, the court will award the aggrieved party no more than his actual damages."

Hence, if what the owner actually incurs for late completion is much less than what is charged against the contractor as liquidated damages, the liquidated damage provision will not be upheld. Massachusetts law thus allows an after-the-fact comparison between what it actually costs the owner for late completion against what the owner has charged the contractor under the liquidated damages provision.

What if the damages are not easily "ascertainable?" The additional cost of engineering as well as the impact on other contractors can usually be determined when a contractor is late. Engineers invoice the owner for extended professional services and other on site contractors make claims for delay costs. These costs are quantifiable. Inconvenience to the public, lost opportunity, or an owner's ongoing administrative costs all caused by late completion, however, may be difficult if not impossible to quantify within a reasonable degree of accuracy. Nevertheless, these are real costs to the owner. Under these circumstances, Massachusetts law considers how the liquidated damage provision was determined at the time the contract was prepared. This prospective analysis has been articulated as:

"Where actual damages are difficult to ascertain and where the sum agreed upon by the parties at the time of execution of the contract represents a reasonable estimate of the actual damages, such a contract will be enforced."

What if it is simply uncertain whether the original estimate at the time of execution of the contract was reasonable or not? Massachusetts law then defers to enforcing the liquidated damages as a contract term to which the parties agreed. For example:

"We recognize that a liquidated damage provision is appropriate where the harm is incapable or very difficult of accurate estimation."

"When losses are difficult to quantify, considerable deference is due the parties reasonable agreement as to liquidated damages."

The bottom line appears to be if the court can figure out how much an owner has been damaged and that actual damage is so much less than the liquidated damages charged to the contractor to appear unfair then the liquidated damage provision will not be enforced. If the court, however, cannot determine what an owner's actual damages are due to late completion, then the liquidated damages will be upheld so long as the estimate of damages at the time of contract preparation was not unreasonable.

How does all this translate into everyday practice? First and foremost, engineers and owners must make a good faith estimate of cost to the owner of late completion at the time the construction contract is prepared.

Secondly, engineers and owners must document how that estimate was made. If challenged, the owner must bear the burden of demonstrating that the liquidated damages provision was based on a reasonable forecast of actual damages. As owners rely on engineers, the engineer would be asked to identify the impacts of late completion and how each impact was estimated. As a practical matter, documents showing how the liquidated damages amount was determined are essential. The absence of any documentation on this calculation may indicate the specified liquidated damage amount was arbitrarily determined.

Project Examples

How the liquidated damages provisions were determined for two of Boston's major projects, the Boston Harbor Project at Deer Island of the Massachusetts Water Resources Authority (MWRA) and Central Artery/Tunnel Project of the Massachusetts Highway Department (MHD), make for an interesting comparison of approaches and degrees of complexity in estimating liquidated damages.

Boston Harbor Clean Up Project:

The Boston Harbor Project is a billion dollar plus construction effort to construct wastewater treatment facilities that will ultimately clean up the Boston Harbor. This project is court ordered and must meet certain court established deadlines for completion. Like any large project, the Boston Harbor Project has numerous construction contractors simultaneously working on the same site. In order to coordinate and complete this complex project on time, each contractor must meet milestone and completion dates set in their respective contracts. The MWRA has liquidated the damages associated with missing these dates.

The MWRA, through its construction manager ICF Kaiser Engineers, established liquidated damage provisions in the various Boston Harbor Project construction contracts through straightforward proportioning calculations. These proportioning calculations involved assigning the engineer's estimate of cost to each construction contract, and then determining the percentage that each contract represented against the entire Boston Harbor Project cost estimate. This percentage would then be applied against what the MWRA estimated would be its "extended cost" during the life of the entire project. These extended costs included the costs of construction management, design services, in-house project management costs, utilities, power, water and the wide variety of support contractors on the site during the construction period. Hence, each contract was assigned its proportionate share of MWRA's extended costs based solely on each contract's cost estimate.

In order to determine a per diem liquidated damage amount, MWRA then divided each contract's proportionate share of the extended costs by an estimate of how long each contract would take to perform. The resulting per diem cost estimate was then used to establish the per diem liquidated damage cost for both contract milestone and completion date breaches.

The MWRA's formulation is elegant in its simplicity:

CONTRACT COST X TOTAL EXTENDED COST
TOTAL PROJECT COST X CONTRACT DURATION = LIQUIDATED DAMAGES

Its application is shown on Attachment A. Whether such straight forward formulation meets the legal standard for an enforceable liquidated damage provision is another question.

A few observations are in order. The MWRA formula inherently assumes that the cost incurred by the MWRA because of late completion is:

1. A Linear Function of Contract Cost. It is not unreasonable to assume, as a general proposition, that the greater the contract cost, the more resources MWRA must expend in support of that contract. However, construction contracts are not created equal and MWRA's support cost can and will not be expended in a linear fashion. For example, MWRA estimated that there is approximately 19" of support cost for each $1 of construction. On a practical basis, one would expect MWRA to expend more in support costs on complicated and intensively inspected work than on more common and traditional construction. The MWRA formula does not provide for such adjustment.
2. An Inverse Function of Contract Time. As with cost, it is not unreasonable to assume that the proportionate extended costs will be expended within the contract duration. Again, however, construction contracts are not created equal. Longer duration contracts may require the expenditure of more extended costs per day than shorter duration contracts of equal cost simply because of the nature of the work. The MWRA formula does not consider the nature and timing of support cost expenditure during and after the contract duration.
3. The Extended Costs are Uniform. The MWRA will incur certain fixed costs independent of project progress. The MWRA will also incur certain variable costs that ebb and flow with job site activity. By uniformly applying these costs across the project, the resulting liquidated damage provision does not reflect the significance of when a contract is performed. For instance, certain contracts may be performed during a critical period of project performance and late completion could have a drastic effect on extended costs. Other contracts may not be critical and late completion may be of no consequence to overall job progress. The uniform application of extended costs does not allow for this distinction as there is no consideration given logic of the project schedules. In other words, it is more important when a contractor is late than how much the contract was estimated to cost and how long it was expected to take to complete.
4. Milestone Application. The MWRA formulation fails to take into consideration milestone delays. If the resulting liquidated damages are applied against each milestone, late completion could conceivably result in multiple liquidated damages being charged. For instance, a three milestone project schedule, all three of which are missed, could cause liquidated damages to be assessed at three times the calculated rate. No matter how reasonable the original estimate of an owner's actual damages, it is unreasonable to charge three times that estimate and assert that such charges are "liquidated."

Whether the inherent assumptions of MWRA's proportionate methodology are so limiting for a court to find the resulting liquidated damages a penalty and, therefore, unenforceable will be determined when or if a contractor challenges this formulation.

The consequence of the above assumptions is that expensive contracts that must be performed in short periods of time have disproportionately higher liquidated damage rates than less expensive contracts that can be performed over longer periods of time, regardless of the nature of or when that work is performed against the entire project schedule. Furthermore, the MWRA's formulation allows a liquidated damage rate to be determined without considering the logic in the construction schedule or the effect of intermediate milestones. The methodology is straight forward without consideration of the circumstances of each contract or the impacts of late completion of each contract.

The Central Artery Project takes an alternate case-by-case approach in liquidated damage determination.

Central Artery/Third Harbor Tunnel Project:

The Central Artery/Third Harbor Tunnel Project is the largest project in New England. Like the Boston Harbor Project, the Central Artery Project will have numerous contractors working within interdependent schedules. Similarly, the Central Artery Project has an extensive and expensive management and support services burden for the project construction.

Unlike the Boston Harbor Project, however, the Central Artery Project determines liquidated damages on a case-by-case basis. The Mass Highway Department examined the scope of each individual contract, determined where that contract fit in the procurement and scheduling of the entire project and estimated specifically how much support services such as resident engineers, office engineers, field inspectors, and secretaries would be needed if the project were to go beyond its contract completion dates. The MHD also considered costs associated with permits, fees, licenses, right-of-way, pest control and most importantly evaluates the impact late completion of milestone or final project completion dates would have on other contractors.

The MHD considers the probability that the delay in one contract would have on an interfacing contract. This impact is then classified as of no consequence, relating to non critical activities or causing a critical impact to other contractors. In the event there is an impact on other contractors, the MHD then estimates the anticipated cost that a delayed contractor may assert based on historical data of "general conditions" costs.

The MHD then discounts impact cost based on the probability of impact as measured by available float time between the projects. Finally, the MHD considers project postponement and financing costs by application of cost escalation factors.

Although one may disagree with the various rates, probability factors and historical data on which the MHD relies, the systematic analysis of impacts on a contract by contract basis is rational, considers scheduling logic and requires the exercise of engineering judgment.

CONCLUSION

The engineer must make a reasonable estimate of the owner's damages in the event of late completion of a milestone or contract completion date in order to apply that estimate as a contract liquidated damage. The more difficult it is to estimate an owner's damages, the more likely a court will defer to the liquidated damage provision as agreed to by the owner and contractor. There are a number of ways to estimate liquidated damages.

The MWRA utilized a proportionate application of its extended costs across all contracts regardless of the interdependence between contractor performance, schedule logic and nature of contract work. The MHD estimated liquidated damages on a case by case basis using historical data adjusted for probability of impact as well as individual estimates of management and other costs. The MHD's method is more sophisticated and requires the exercise of engineering judgment. The MWRA's method reflects an across the board application which, in the author's view, is less reasonable and more likely to be successfully challenged.

ATTACHMENT A