ELEVENTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE

ELEVENTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE LIQUIDATED DAMAGES REVISITED Responses Available to the Surety Robert A. Koenig SHUMAKER, LOOP & KENDRICK, LLP 1000 Jackson Avenue Toledo, OH 43624-1573

LIQUIDATED DAMAGES REVISITED Responses Available to the Surety INTRODUCTION Parties to a contract may agree in advance as to an amount of damages to be paid in the event that a breach of the contract occurs. The purpose of such a liquidated damage provision is to quantify a loss that is not easily susceptible to accurate computation at the time of contracting. Liquidated damage clauses by nature are uncertain and, in practice, may pay the non-breaching party more or less than their actual damages. Such liquidated damage clauses are commonly found in construction contracts. The typical construction contract may provide that for each day the contractor fails to complete the project beyond the agreed date, a per diem amount will be assessed as liquidated damages and withheld from the contract price. Liquidated damages accrue between the contract completion date and the date the project is substantially complete. Generally, courts will not enforce a liquidated damage clause unless two conditions are found. First, the amount of liquidated damages so fixed must be a reasonable forecast of compensation for the harm that is caused by the breach. 1 Second, the harm that flows from the breach must be difficult or incapable of calculation at the time the contract was entered into. 2 A liquidated damage provision is unenforceable as a penalty which is against public policy if the agreed amount is unreasonably large. 3 Performance bond sureties have been held liable for liquidated damage where the principal, without excuse, fails to complete the project on time. 4 The AIA Document A312 Performance Bond specifically states that: the Surety is obligated without duplication for: * * * Liquidated damages, or if no liquidated damages are specified in the Construction Contract, actual damages caused by delayed performance or nonperformance of the Contractor. 5 Similarly, where a performance bond surety has issued a bond on behalf of a subcontractor, the surety may indirectly be exposed to the liquidated damage provision contained in the prime contract between the owner and general contractor 6. Flow down clauses contained in subcontract agreements generally provide that a subcontractor agrees to pay liquidated damages to the prime contractor for any 1 Restatement of Law, Second, of Contracts, Section 356(17)(1981). 2 3 4 See e.g., A etna Cas ualty & sure ty Co. v. Butte-M ead Sanitary W ater Dist., 500 F. Supp. 193 (D.S.D. 1980); Southern Roofing & Petroleum Co. v. Aetna Ins. Co., 293 F. Supp. 725 (E.D. Tenn. 1968). 5 AIA Document A312 1984, Performance Bond, 6.3. 6 John H. Grego ry and Michael Jay R une, II, Liability Of the Performance Bond Surety, The Law of Performance Bonds, 136 (ABA 2000). 2

delays created by its failure to perform on time. 7 Sureties have been found liable for liquidated damage provisions in the amount specified only in the prime contract. 8 One of the most significant revisions made to the AIA Document A201 1997 General Conditions of Contract for Construction in 1997 focused on waiver of consequential damages arising from the contract. Revisions were made to the General Conditions document in an attempt to limit potentially enormous, unforeseen, and unpredictable consequential damages 9. The 1997 AIA Document A201 General Conditions document now provides that The Contractor and Owner waive all Claims against each other for consequential damages arising out of or relating this Contract. 10 Unfortunately, the revisions in the 1997 AIA Document A201, - General Conditions document further provide: Nothing contained in this Subparagraph 4.3.10 shall be deemed to preclude an award of liquidated direct damages, when applicable, in accordance with the requirements of the Contract Documents. 11 Therefore, Subparagraph 4.3.10 of the General Conditions document preserves the owner s ability to recover liquidated damages while attempting to limit the nature of those damages in such a manner as to preserve the intent of the mutual waiver of consequential damages. The 1997 General Conditions document does not define what constitutes direct liquidated damages. Some have suggested that the term direct was inserted into the description of acceptable liquidated damages to preclude the owner from using such exception to recover indirectly the consequential damages being waived in 4.3.10. 12 Direct damages are those that flow naturally and predictably from the breach of contract. 13 Therefore, direct damages are typically easily identified and quantified. By contrast, liquidated damages are enforceable only when the harm flowing from the breach defies 7 See e.g., AIA Docum ent A401 1997, Standard Form of Agreement Between Contractor and Subcontractor, Article 2, 2.1. 8 Industrial Indemnity Co. v. Wicker Construction Co., 680 P.2d 1100 (Alaska 1984) 9 J. W illiam Ernstrom and Michael F. Dehmler, Mutual Waiver of Consequential Damages: The Contractor s Prospective, The Construction Lawyer, 4, (ABA January 1998). 10 AIA Docum ent A401 1997, Standard Form of Agreement Between Contractor and Subcontractor, Article 4, 4.3.10. 11 AIA Docum ent A401 1997, Standard F orm of Agreeme nt Between Contractor and Subcontractor, Article 4, 4.3.10. 12 Lynn R. Axelroth, M utual W aiver of Consequential Damag es The O wner s P erspec tive, The Construction Lawyer, 15, (ABA January 1998). 13 3

accurate estimation. Thus, the 1997 revisions add a new and contradictory element to the liquidated damages analysis. Ultimately, the revisions made in 1997 to the General Conditions document intended to limit consequential damages provide no new protection against liquidated damages for the contractor, subcontractor or surety providing them performance bonds. Certainly adding direct to the description of acceptable liquidated damages is unlikely to provide any clarity but will certainly increase litigation over the meaning of this new term. TIME OF DECISION PRINCIPAL S DEFAULT The critical time for a surety to best avoid paying liquidated damages is upon default of its principal before a decision is made regarding completion of the project. By their nature, liquidated damages begin to accrue upon the original contract completion date and continue to be assessed until the project is substantially complete. Delay in completion of the project can be extremely costly to the principal and its surety. Imposition of liquidated damages can significantly diminish the contract balances available to the surety to offset costs of completing the project upon the principal s default. Therefore, a critical element of successful damage control can be achieved if the surety can avoid the imposition of liquidated damages. The issue of assessment of liquidated damages should be an important part of the negotiations with the obligee following the principal s default termination. After the surety completes its initial project review, negotiations with the obligee should commence to reach an agreement on the potential assessment of liquidated damages or extension of time to complete the project under the terms of the contract. At this juncture, the surety will be able to exercise maximum leverage in avoiding liquidated damages since the obligee s primary concern is in getting the project complete. In order to maximize leverage and successfully avoid liquidated damage assessments, the surety should have a professional basic understanding of the wide variety of defenses available to defeat imposition of liquidated damages. Generally, upon termination of the principal, the surety has the option under the performance bond of completing the project (with the principal itself), or completing the project through a tender and buyout. 14 The surety s decision will be driven by determining the most cost effective technique for satisfying the performance bond obligations and managing the risks associated with these options. During negotiations with the owner, assessment of liquidated damages and/or extension of time under the contract should be key elements considered by the surety in deciding which option to follow. Again, the owner will be motivated by its concern to complete the project and will be the most open to waiving liquidated damages or agreeing to an extension of time. Thus, the surety must be in a position to review the key documents and analyze all potential defenses to a liquidated damage provision under the contract. The surety can make a variety of compelling arguments to avoid imposition of liquidated damages. Initially, the surety should analyze the defenses that are available to the principal in defeating liquidated damages since they are equally available to the surety. Thereafter, the surety can focus its analysis on the obligee s equitable duty to mitigate its damages in response to the contractor s default. Thus, analysis of the defenses available 14 AIA doc ume nt A312-1984, P erform ance B ond, 4.1, 4.2, 4.3 and 4.4. 4

to a surety begins with review of the contract provision itself, the conduct of the principal and, ultimately ends with review of the obligee s own conduct in acquiescing in the principal s delay. A. Asserting the Principals Defenses 1. Liquidated Damage Provision As An Unenforceable Penalty Fundamental to the availability of liquidated damages under a construction contract is a determination that the provision is enforceable. It is well settled that a liquidated damages provision will be considered an unenforceable penalty if the specified sum is unreasonably large or not reasonably related to the probable damages following breach. 15 Courts have looked to determine whether the specified liquidated damages amount agreed to in advance are: (1) reasonable in light of the anticipated or actual loss caused by the breach; and (2) the harm resulting from the breach is difficult to estimate. 16 Liquidated damages provisions which are not a reasonable forecast of just compensation for damages caused by the breach of contract have been denied enforcement finding such provisions an exaction of punishment. 17 Investigation of the process used to establish the penal sum for a liquidated damage provision should be completed by a surety. Use of a standard liquidated damage amount will likely not satisfy the elements identified above. The liquidated damages provision must be a fair estimate of damages to be suffered rather than an added spur to performance. 18 Therefore, factual investigation of what reasonable damages will result from the breach is critical to arguing a liquidated damage provision is an unenforceable penalty. 2. Liquidated Damages Provision Unenforceable Where Contractor Completely Abandons In some jurisdictions, abandonment of the project by the contractor can be a decided advantage in defeating the liquidated damages clause in the contract. Some courts have rejected liquidated damage assessments where contractors have abandoned projects prior to the contract completion date. Rejecting liquidated damages, the courts have relied upon the lack of language in these provisions requiring application if abandonment occurs prior to the scheduled completion date. 19 The leading case in New York, City of Elmira v. Larry Walter, Inc., reviewed the liquidated damage clause language 15 Restatement of Law, Second, of Contracts, Section 356(17)(1981). 16 Ogden Development Corp. v. Federal Ins. Co., 508 F.2d 583, 586-87 (S.D. N.Y. 1974). 17 Priebe & Sons v. United States, 332 U.S. 407, 413 (1947). 18 332 U.S. at 413. 19 City of Elmira v. Larry Walter, Inc., 564 N.E.2d 655 (N.Y. App. 1990); Continental Realty Corp. v. Andrew J. Crevolin Co., 380 F. Supp. 246 (S.D. W. Va. 1994 ); Twin River Construction Co. v. Public Water Dist., 653 S.W. 2d 682 (Mo. Ct. App. 1983). 5

and concluded that it does not contain clear and unambiguous language as it should, indicating that it was also intended to apply to defendant s outright abandonment of the project, an entirely separate eventuality. 20 The New York court found the liquidated damage provision enforceable, but not available where the contractor completely renunciated the contract prior to the completion date of the contract. 21 A determination of whether or not liquidated damages will accrue after abandonment by the principal requires close examination of the individual contract provisions. 22 Thus, the language of the liquidated damages provision should be reviewed to determine whether abandonment will preclude assessment of liquidated damages in the local jurisdiction. 3. Substantial Completion Losses due to the assessment of liquidated damages can also be reduced if the project is substantially complete. As discussed above, liquidated damages ordinarily accrue between the contract completion date and the date the project is substantially complete. Generally, courts have found that liquidated damages provisions cease to accrue when the project is substantially complete. 23 Courts have been reluctant to impose liquidated damages assessments in projects where the owner is able to reopen the closed road, or take occupancy and use the project for its intended purpose. In Stone v. City of Arcola, an Illinois court concluded that liquidated damages assessments must cease upon substantial completion of the contract. 24 The Stone court initially reviewed the language agreed to by the parties in the contract related to both time for completion and liquidated damages assessments. The court of appeals concluded that: The trial court found substantial completion on October 10, 1983. Since the project was sufficiently complete at that time to be used for the purpose for which it was intended, then it would seem appropriate to construe the liquidated damages provisions to close at the time of substantial compliance, even though they may be minor repairs, adjustments, or finishing work remaining. After all, if the contractor can get paid at substantial compliance, that is the logical time to discontinue the applicability of the liquidated damages clause. 25 The Stone court found that assessment of liquidated damages would cease upon substantial completion of the work by the contractor. Therefore, the contractor was able to avoid imposition of liquidated damages based upon the fact witnesses and the weight of the evidence submitted to the trial court as to when the City could have 20 564 N.E.2d at 656. 21 22 United States v. American Surety Co., 322 U.S. 96 (1944). 23 Ston e v. City of Arcola, 536 N.E. 2d 1329 (Ill. App. Ct. 1989). 24 536 N.E. 2d at 1338. 25 6

undertaken operation of the plant. 26 In other cases, where the contractual language provides that liquidated damages will be assessed until the project is finally completed, the contractor may only be held liable for liquidated damages for the period between the contract completion date and the date the owner took possession. 27 Therefore, the surety should investigate the critical language included in the liquidated damages provision and investigate whether or not the project is substantially complete to determine whether such a defense exists. 4. Excusable Delays Many liquidated damages clauses expressly provide that assessments will not occur based upon excusable delays in the construction project. The surety will, therefore, want to investigate the factual cause that its principal failed to complete the project by the agreed contract date. Determining the factual basis for the delay may provide a surety with an additional defense to the imposition of liquidated damages. The liquidated damages clause in Stone v. City of Arcola, for example, expressly excluded from calculation delays arising from unforeseeable causes beyond the control and without the fault or negligence of the contractor including abnormal and unforeseeable weather. 28 Excusable delays may also include delays caused by waiting for formal change orders, labor disputes and unusual delays in delivery of materials, and any causes beyond the contractor s control. 29 Investigation of the factual basis for the project delay is critical and may result in limiting or eliminating payment of liquidated damages by the surety. 5. Obligee Caused Delays The contractor or surety may also avoid assessment of liquidated damages in whole or in part where the principal s failure to complete the project by the contract date can be attributed to the owner obligee. As a practical matter, delay in construction projects is often contributed to by both the owner and the contractors on a project. The surety should complete factual investigation of the cause for the project delay to determine whether the liquidated damages liability can be reduced or eliminated. An obligee cannot recover liquidated damages for delays resulting solely from its own conduct. 30 The surety should review the construction contract to determine whether or not there is an apportionment clause providing for apportionment of damages. Generally, if the contract fails to contain a clause providing for apportionment of damages and the owner is responsible for some amount of delay, courts will not apportion damages. Under those circumstances, liquidated damages should be denied even though the delay was largely 26 27 Dillon Construction, Inc. ENGBC A No. PCC-36, 81-2 BCA paragraph 15, 416, 76, 385 (1981). 28 536 N.E. 2d at 1337. 29 See e.g., General Casualty Co. v. United States, 127 F. Supp. 805, 815 (Cl. C t.), cert. denied, 349 U.S. 938 (1955). 30 United States v. United Eng g Contracting Co., 234 U.S. 236 (1914); Mid-State Hauling Co. v. Watson, 172 So. 2d 262 (Fla. Dist. Ct. App. 1965). 7

attributable to the contractor. 31 If, on the other hand, the construction contract does contain an apportionment clause, the court applying such a provision should reduce (apportion) the assessment of the liquidated damages. 32 Therefore, if investigation of the factual record reveals any delay caused by the obligee, the surety may be entitled to reduce or avoid imposition of liquidated damages. 33 B. Defenses Resulting From Obligee s Conduct Additional defenses may be available to a surety based upon the conduct of the obligee, if a contractor is permitted to work beyond the contract completion date. Once a contractor fails to complete a project and the contract completion date has elapsed, the owner is forced to decide whether to terminate the principal and hire a new contractor to complete the work, or to permit the original contractor to continue on with the project. Allowing the original contractor to complete the work may seem to the owner to be more cost effective and expeditious, but it also involves additional risks to the contractor itself. The law does not allow the obligee to allow a defaulted contractor to continue to work on a project while at the same time subjecting the principal and surety to liquidated damage assessments because completion of the project has slowed as a result of the owner s decision not to terminate the contractor. Failure of the obligee to terminate a defaulted contractor in a timely manner may provide additional defenses to the surety for liability for liquidated damage provisions. Courts have found that an obligee may waive or be estopped from its right to terminate the contractor based upon delay when such owner permits the defaulted contractor to work beyond the contract completion date. 34 Under this waiver doctrine, a surety may have the termination for default set aside or converted to a termination for convenience. In government contracts, this waiver, estoppel or election doctrine is commonly referred to as an application of the DeVito doctrine. In DeVito v. United States, the court found that where the obligee waived the contract completion date by allowing the contractor to continue beyond such date without establishing a new completion date, there can be no termination default based upon delay. 35 When the court applies the DeVito doctrine, converting the termination for default into the termination for convenience, the surety s liability for liquidated damages is not eliminated, but it is minimized. 36 Applying this doctrine, the general rule that liquidated damages accrue until substantial completion occurs is inapplicable and liability for liquidated damages should be limited. 37 31 Glassman Construction Co., Inc. v. Maryland City Plaza, Inc., 371 F.Supp. 1154 (D. Md. 1974). 32 Southwest Eng g Co. v. United States, 341 F.2d 990, 1100-1101 (8 th Cir. 1965). 33 See e.g. S.O.G.- San Ore-Gardener v. Mississippi Pacific R.R., 658 F.2d 562, 570 (8 th Cir. 1981). 34 Olson Plumbing & Heating Co. v. United States, 602 F.2d 950, 956 (Ct. Co. 1979). 35 413 F.2d 1147, 1153 (C t. Co. 1969). 36 Martin J. Simko Construction Co. v. United States, 11Cl.Ct. 257, 727 (1986), vacated and remanded on other grounds, 852 F.2d 540 (Fed. Cir. 1988). 37 8

The DeVito court concluded that by allowing the contractor to continue after the expiration of the contract completion date, the government induced the contractor to rely on its forbearance regarding enforcement of the completion date. As a result, the obligee is then estopped from enforcing the contract completion date. 38 The Court concluded that: [W]here the government elects to permit a delinquent contractor to continue performance past a due date, it surrenders its alternative and inconsistent right under the Default clause to terminate, assuming the contractor has not abandoned the performance and a reasonable time expired for a termination notice to be given. 39 Therefore, the DeVito doctrine provides an additional defense to a surety, where the government fails to mention or promptly access liquidated damages against a contractor who has worked past the completion date. Under such circumstances, where the government fails to establish a new completion date, it has waived the original contract completion date and termination for default should be deemed improper. 40 Additionally, the common law doctrine of mitigation can provide a further defense to a surety in order to avoid imposition of liquidated damages where the obligee fails to terminate a principal within a reasonable time after its default. 41 The doctrine of mitigation requires the obligee to act within a reasonable time period after default to mitigate its damages. 42 The doctrine provides that the contractor in breach should not be liable for damages which the obligee could have avoided with reasonable effort and without undue risk or expense. All that is required is that the government act reasonably and promptly given the circumstances. 43 Clearly, the government is not required to make extraordinary efforts to ferret out the single best situation which will absolutely minimize the breaching party s damages. 44 The case law, however, makes clear that the surety bears the burden of establishing a prima facie case for failure to mitigate in order to apply the doctrine of mitigation. Finally, in government contracts, the courts have found an equitable duty of the government to take into account the interest of the surety. This equitable duty owed to the surety arises where the government permits the delinquent contractor to continue after the completion date under the contract and fails to terminate within a reasonable time period. 45 The courts require that when government officials are making decisions concerning whether to proceed with a delinquent contractor, the obligee must balance its 38 at 1153. 39 at 1152. 40 ; See also International Fidelity Ins. Co. v. United States, 25 Cl. Ct. 469 (1992). 41 See, e.g., International Fidelity Ins. Co. v. United States, 25 Cl. Ct. 469 (1992). 42 43 Ketchikan Pulp Co. v. United States, 20 Cl. Ct. 164, 166 (1990). 44 at 166. 45 See, e.g., Ohio Casualty Insurance Co. v. United States, 12 Cl. Ct. 59 0 (1987). 9

own interest against the possible harm to the surety. 46 As a practical matter, if an obligee waits too long to terminate a principal, the surety may lose the opportunity to engage another contractor who could have completed the project months earlier for substantially less money. In the Ohio Casualty Insurance v. United States case, the court concluded that it would be manifestly unjust to require the surety to pay for the government s poor judgment in failing to terminate the original contractor. The court found that the surety was entitled to damages that were a direct result of the defendant s failure to terminate within a reasonable time. 47 This equitable duty to the surety can be argued to relieve the surety of liability for liquidated damage assessments that accumulate as a result of the obligee s failure to reasonable exercise its equitable duty to the surety in deciding whether to terminate the defaulted contractor. CONCLUSION Avoiding liquidated damages by a performance bond surety depends upon the language of the contract, the conduct of the principal, the reason for the project delay, and the response of the obligee once default was eminent. Liquidated damages may be reduced through negotiations for an extension of time to complete the project after the principal s default, but before the surety commits to any performance option. A thorough investigation of the underlying facts of the case, as well as an understanding of the law of liquidated damages is critical to the surety s successful avoidance or limitation of liquidated damages liability. 46 at 1319. 47 at 596. 10

ROBERT A. KOENIG Robert A. Koenig is a partner in the Toledo, Ohio office of the law firm of Shumaker, Loop & Kendrick, LLP, with offices in Tampa, Florida; Charlotte, North Carolina; Toledo Ohio, and Columbus, Ohio. He practices in the commercial litigation section of the firm, specializing in the areas of surety and fidelity law, construction litigation, and banking creditors rights litigation. He received his Bachelor of Arts in Political Science from Case Western Reserve University in 1980 and his juris doctorate from New York Law School in 1983. 11