A Twist on Damages: The Owner’s Right to Choose Either Liquidated Damages or Actual Damages

September 12, 2017

Liquidated damages clauses have been a mainstay in construction agreements for decades. The idea behind them is that a pre-agreement about the charge per day of late project delivery is valid so long as the amount is a fair pre-estimate of the likely costs. If the liquidated damage amount is excessive, it may be considered a penalty and not enforced. Courts regularly find that liquidated damages clauses are not penalties so long as (1) the parties intended to liquidate the damages, (2) the amount of liquidated damages is reasonable, and (3) ascertaining actual damages is difficult. Contractors often dislike even the thought of liquidated damages, but many contractors smartly prefer liquidated damages to unquantifiable or unknown actual damages.

States across the country are split on how they view alternative damages clauses—that is, clauses that allow a non-breaching party to choose either liquidated damages or actual damages.  Just this week, the Colorado Supreme Court weighed in and held alternative damages clauses are valid and enforceable.

A recent decision of the Colorado Supreme Court, Ravenstar v. One Ski Hill Place LLC, Case No. 16SC224, 2017 CO 83 (Colo. Sept. 11, 2017), gives guidance for how Colorado courts will apply such alternative damages clauses to construction agreements. In Ravenstar, five different purchasers (the “Purchasers”) entered into five different, but identical, contracts for the purchase of yet-to-be-built condominium units from a developer (the “Seller”). Each contract required a Purchaser to pay a deposit. Each contract also contained an alternative damages clause in the event that a Purchaser breached the contract. Under the alternative damages clause, the Seller had the right to either retain the deposit as liquidated damages or terminate the contract and recover its actual damages. The five Purchasers failed to obtain financing and defaulted under their respective contracts. The Seller opted to retain the full amount of the deposits as liquidated damages. Both the trial court and the appellate court held the alternative damages clause was valid and enforceable, permitting the Seller to retain the liquidated damages. The Purchasers appealed.

The Colorado Supreme Court agreed the alternative damages clauses were enforceable. It reasoned that contracts between competent parties, voluntarily and fairly made, should be enforced according to their terms, which includes the benefits, risk, liabilities, and consequences. While the law requires that parties intend to liquidate their damages, they do not need to agree that liquidated damages be the sole and exclusive remedy. According to the Court, parties can freely agree that one party can choose between liquidated damages and actual damages, and courts should hold the parties to their bargains. The Court also noted that in some settings, it might be logical for a non-breaching party to choose to recover a lesser liquidated damages amount rather than higher actual damages, if that option entails greater certainty of outcome or a more efficient and less costly litigation process. The Court was not persuaded that the alternative damages clauses are penalties merely because non-breaching parties will choose the remedy that provides them the largest payday. The Court did make one caveat, though: an alternative damages clause must be exclusive. That is, a non-breaching party must choose one remedy; it cannot have both.

Ravenstar addresses an everyday risk-allocation issue for the parties involved with a construction project. From an owner’s standpoint, the case potentially greenlights clauses that give the owner an advantageous choice of damages that may change with market conditions over the course of a project. In a simple example, a prime contract for an apartment construction project requiring two years to perform might have liquidated damages based on a projection of current market rates. If the market surges during construction and the contractor does not timely obtain completion, the owner may opt for actual damages if they are greater than the liquidated damages amount estimated two years earlier. Conversely, if the market dips, the owner may elect liquidated damages if that yields a higher damage amount that its actual damages.

A prudent contractor must be aware that its risks for late completion increase if an owner includes an alternative damages clause and should either price the risk accordingly or insist on the more traditional liquidated damages clause.

Subcontractors and suppliers must also be conscious of their risks for late completion when entering into lower-tier subcontract agreements. Any subcontractor or supplier that signs a subcontract or purchase order without taking the time to obtain, review, and understand the upstream agreements incorporated into its subcontract or purchase order may be doing so at its own peril.

If you have any questions or need assistance, please contact one of Woods & Aitken LLP’s Construction Attorneys. For additional construction news, tips, and updates, we encourage you to view our Construction E-Brief archives.