The Contractor’s Approach to Risk Allocation:
Liquidated Damages and No Damages for Delay
In my last column, I introduced the idea of addressing risk allocation in a series of columns to appear on a monthly basis. The goal of this series is to educate contractors, subcontractors, and owners about the effects of contractual risk allocation, the consequences of such, and current trends in the industry in this vital area of business management and project performance.
In the construction industry, the trend in recent years has been to draft provisions that not only shift the risk to the party with less leverage and negotiating strength, but to also draft more onerous provisions that shift greater quantities of risk within a particular provision.
For example, most sophisticated contracts currently in use contain clauses that address contract time, scheduling, and delay. I have previously written about the Port of Houston Authority v. Zachary case. That case deals with a very onerous and harshly interpreted no damages for delay clause. This clause shifted all risk for delay to the contractor. In the past, language commonly found in contracts would only allocate certain aspects of the risk of delay amongst the parties. The Zachry case reflects a modern trend to relieve one party of the risk while saddling the other with all of it.
A further discussion of no damages for delay is an appropriate foundation for this series of articles because of that clause’s place among the most highly used for risk shifting. However, because I have addressed this clause previously, it will be more instructive to also look at liquidated damages clauses because those also deal with contract time and delay.
For owners, many projects are time sensitive. For contractors, time and efficient progress through the planned schedule on all jobs is essential for realizing profits and minimizing losses. Unfortunately, many contracts fail to recognize the joint interest that both parties have in seeing a project complete on time. Owners realize there is significant risk in delay and often attempt to shift this risk to the contractor using a liquidated damages clause and/or a no damages for delay clause.
In general, and under Texas law, liquidated damages clauses are not inherently unfair. They are entirely appropriate when the Owner has the potential to suffer damages for delayed completion but those damages are inherently difficult to ascertain at the time the project begins. However, liquidated damages can be set very high and potentially inflated so that a contractor is forced to accept more risk.
Additionally, liquidated damages clauses can be manipulated to shift more risk to the contractor than might be readily apparent. While enforceability might be subject to challenge, some contracts contain the following language or something similar: “In addition the liquidated damages provided for herein, the owner may also recover from contractor damages for loss of use, lost revenue, and any other damages as a result of a contractor default.”
Texas courts have ruled that liquidated damages serve an exclusive remedy for delay if so elected for enforcement by an owner. Regardless, it is not too difficult to foresee a situation at project close-out where an owner, armed with such a clause, will seek to withhold additional damages from a contractor. Because this clause is arguably unenforceable, it can be put aside with only the mention given it above. As long as contractors and owners recognize the weakness of this clause and do not allow or attempt to use it offensively, to the detriment of the contractor and potentially to the detriment of the project, its adverse effects can be neutralized.
A more severe injustice occurs when a liquidated damages clause is combined with a no damages for delay clause. In this situation, the owner places the financial risk of delayed performance on the contractor while, at the same time, absolving itself of potential liability for delay costs incurred by the contractor, even if caused by its own actions.
The use of an example is illustrative to demonstrate how accepting both clauses can harm a contractor. Assume a contractor is building a structure and, through a series of events, the critical path is delayed by 10 days due to delivery issues of sole-sourced materials specified in the bid package and contract documents but procured by the contractor. Let’s further assume that the critical path is delayed by an additional 5 days due to the design professional’s inspections. Neither of these events is the fault of the contractor. Both might be compensable delays on another project without the risk-shifting no damages for delay clause. However, in this situation, the contractor has to absorb the costs for this delay event and is also liable for 15 days of liquidated damages to the owner. The joint force and effect of these two clauses inequitably shifts too much risk to the contractor.
A solution to this situation that would likely benefit both the owner and contractor would be the elimination of one of the clauses. An alternative would be a modification of the no damages for delay clause to allow for delay damages in the event a delay is caused by the owner, directly or indirectly. By sharing this risk, at least in part, the parties can best absorb the costs and preserve the ultimate success of the project and each parties’ long-term outlook towards the work.
Ultimately, too harsh a shift of risk to the contractor leads to potentially detrimental effects for the owner as well. The enforcement of these provisions can place a contractor is a severe economic position. Such financial strain can have ripple effects on the project so that the owner, while protecting itself from direct damages, may end up with a project with a shortened life-span, greater operational costs, and potentially valueless warranties.
Thoughtful consideration of these risk shifting clauses, both dealing with time, can aid in a project’s success. Ultimately, recognition of a more equitable position will stabilize costs and facilitate higher quality construction services and projects.
This article initially appeared in the April 2014 issue of Texas Contractor Magazine.