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March 1, 2010

Power Owners in Strong Position to Collect Liquidated Damages

By Judah Lifschitz, Esq. and James McMichael, Esq.

The Enforceability of Liquidated Damages Clauses

American jurisdictions disagree on the issue of how the reasonableness, and thus the enforceability, of a liquidated damages clause should be determined. Should the liquidated damages clause be viewed solely as of the time of contracting, or with the benefit of hindsight? The better established, more “orthodox” view, is that the reasonableness of a liquidated damages clause should be determined solely as of the time the contract was entered into, without the benefit of hindsight.

This view, sometimes referred to as the “prospective” approach, requires only that the amount of liquidated damages specified in the contract be a reasonable forecast or estimate of the damages expected, or likely to flow from a breach of the contract, as of the date the contract is entered into. In other words, the proper determinant is whether the amount of liquidated damages specified is reasonable compared to the anticipated damages, rather than the actual damages.

This approach is not universal. In a number of jurisdictions, the actual loss sustained by the owner is relevant. Arbitration panels use a retrospective analysis, in addition to the prospective one, to determine the reasonableness of the liquidated damages.

So American jurisdictions today use two models to determine the reasonableness and enforceability of a liquidated damages clause. In each, the clause is enforceable if the stipulated amount is found to constitute reasonable compensation to the owner for inexcusable delay and is unenforceable if the amount is found to constitute a penalty against or goad to performance of the EPC contractor. The two approaches differ as to whether the actual damages suffered should have any bearing on the “compensation” versus “penalty” determination.