News & Insights

Energy Law Exchange

August 1, 2011

Best Practices: Avoiding Unenforceable Liquidated Damage Provisions

Delay liquidated damages and performance liquidated damages are two of the most commonly negotiated commercial terms in construction contracts in the energy industry. As a consequence, parties can sometimes lose sight of a key factor of such negotiations: the legal enforceability of the provision.

This article outlines several tips parties should consider when negotiating and drafting liquidated damage provisions to increase the probability that a court or arbitral panel would find the provision enforceable. In addition, several negotiation and drafting tips are included to blunt the potential impact in the event a provision is deemed unenforceable.

General Principles of Enforceability

A general principle behind the enforceability of liquidated damage provisions in most jurisdictions is that the effect of the provision should not be a penalty. An enforceable liquidated damage provision should approximate, in good faith at the time of the signing of the contract, the actual damages a party is likely to incur in the event of a breach.

However, nuances in the enforceability of liquidated damage provisions exist across jurisdictions. For example, contractual provisions allowing a non-breaching party to elect, as its remedy, either a liquidated damages amount or actual damages are void in the State of New York. By further example, under United Arab Emirates law, either party to a contract may apply to a court for an adjustment to the liquidated damages amount so that the liquidated damages equal the actual loss. Accordingly, consideration must be given to the governing law when crafting these provisions.

Record Negotiation Considerations

The enforceability of a liquidated damage provision is often determined in light of the parties' expectations and good faith attempt to forecast actual damages at the time of contract formation. Evidence of such expectations and good faith attempts often takes the form of witness testimony. Since such evidence may become necessary years after the liquidated damage provision was negotiated, parties should consider documenting any and all issues, assumptions, and calculations regarding forecasted damages that were considered at the time of negotiation and drafting of the provision.

The key is usually to demonstrate that the stipulated amount was not arbitrarily selected and that there was a rational basis for believing that the amount would be a fair approximation of actual damages. Preparing the detailed documentation described above may increase the likelihood that a court or arbitral panel will enforce the provision. Nevertheless, use of such documentation as evidence does not come without risk, and parties should also be wary of providing a court or arbitral panel with evidence that could show that the parties ignored factors that significantly affected actual damages.

Contractual Language

The term penalty should be avoided when describing or referring to the liquidated damage provision. In fact, any suggestion that the provision is primarily intended to penalize a party to induce timely performance, as opposed to approximating actual damages, should be avoided. Instead, parties should consider including language stating that the actual damages resulting from the breach are difficult to ascertain, that the liquidated damages are intended to constitute an estimate of damages, that the parties agree the liquidated damages are reasonable in light of the anticipated harm caused by the related breach, and that the liquidated damages do not constitute a penalty. Such language would likely bolster enforceability of the provision in many jurisdictions.

Tiered or Differentiated Stipulated Amounts

All damages are not alike, so the stipulated amounts for liquidated damages should be differentiated based on the different kinds of contract breaches (e.g., delayed completion versus failure to meet performance thresholds). In addition, parties should consider specifying tiered stipulated amounts. Such tiering can be useful, for example, where an owner anticipates a phased commencement of beneficial use of a project. It also serves as evidence that the parties carefully considered different factors in drafting the provision. A tiered approach might also be useful where the estimated damages are very high, and the contractor is unlikely to agree to a stipulated amount commensurate with the estimated damages from the onset of the delay.

Provide Incentives for Performance

The parties should consider providing positive incentives to induce timely performance rather than merely stipulating damages for untimely performance (i.e., award a bonus for each day that project completion is early) if the project would indeed benefit from early completion. Such bonus provisions, however, can lead to a peculiar circumstance where project completion is late (based on the original completion date), but the contractor is nevertheless claiming entitlement to an early completion bonus (based on a completion date adjustment due to force majeure or other factors). To avoid this situation, consider negotiating fixed early completion dates that are not subject to adjustment for the purposes of awarding a bonus.

Other Unenforceability Considerations

Construction contracts often include waivers of consequential damages, which can eviscerate the lion's share of an actual delay damages claim. Such waivers should typically include exceptions to allow recovery of all actual delay damages (including consequential damages) in the event that the liquidated damage provision is determined to be unenforceable. Not only does this achieve the purpose of allowing the owner to recover actual damages it might otherwise not recover due to such waiver, this type of provision also tends to persuade contractors not to challenge the enforceability of the liquidated damage provision.

In some jurisdictions, termination of a contract prior to the required completion date may void a liquidated damage provision and require the owner to look to the contractor solely for actual delay damages. However, the parties can often contract around this issue by specifying that if project completion is not achieved prior to termination, liquidated damages shall be based on the date that a substitute contractor achieves project completion.