Is there a better alternative to liquidated damages on construction projects?
Liquidated damages have long been used in the construction industry to compensate principals for late completion of building work.
However, on projects where timeframes are tight and disputed extension of time claims are likely, liquidated damages can be difficult and time consuming to enforce. In these circumstances, an incentive scheme may offer a better alternative.
DELAY LIQUIDATED DAMAGES
In most cases, delay liquidated damages (Delay LDs) offer benefits to both parties. Principals avoid the difficulty (and expense) of proving actual damages and contractors have certainty as to their potential exposure in the event of late completion of a project.
Provided the Delay LDs are a genuine pre-estimate of the loss likely to be incurred by the principal due to delayed completion, they will generally be enforced by the courts.
However, Delay LDs also have some inherent drawbacks:
- contractors tend to factor the risk of incurring Delay LDs into their price;
- contractors rarely accept uncapped liability for liquidated damages; and
- disputes can arise over the contractor’s entitlement to an extension of time (EOT), which at the very least is an administrative headache, and potentially may relieve the contractor of liability to pay liquidated damages.
INCENTIVE SCHEME OPTIONS
Bonus or incentive schemes can avoid these problems by focusing the contractor on achieving early or on time completion, rather than on the preparation of EOT claims and the management of disputes.
Under an incentive scheme, if completion is achieved on or before a specified date, the contractor will be entitled to an incentive payment.
There are many ways to structure an incentive scheme, including:
- A ‘hard date’ for completion whereby the contractor is entitled to the incentive payment if completion is achieved on or before a specified date, but if the date is not achieved, the contractor receives no incentive payment at all.
- A progressive reduction in the incentive payable if completion occurs after the specified completion date (either a decrease by a particular amount each day or a stepped reduction upon specific future dates).
- A milestone system whereby the contractor is offered an incentive payment for each portion of the works that is completed on time (useful if the works are to be completed in distinct stages). In this situation, the incentive could be structured so that if one incentive milestone is not achieved on time, the contractor can still “earn” that incentive payment by rolling the payment over into a later incentive payment linked to achievement of a subsequent milestone payment.
Click here to view visual representations of these possible incentive structures.
ISSUES TO CONSIDER
An issue to consider in structuring an incentive scheme is whether (and in what circumstances) the date for completion and payment of incentive can be extended?
Again, there are a number of options:
- The contractor might not be entitled to an EOT in any circumstance. The rationale for such an approach is a mutual sharing of risk and desire to avoid time and resources being consumed in preparing and responding to EOT claims. Contractors may be more comfortable with such an arrangement where there is limited scope for the principal to cause delay and/or the majority of delay risks are known and capable of being managed/mitigated by the contractor.
- The contractor is entitled to an EOT for a range of specified events (similar to a traditional contract) including principal caused delays and ‘neutral’ causes of delay (such as latent conditions, directions by statutory authorities, inclement weather etc).
- An intermediate position might be that the contractor is only entitled to an EOT for principal caused delays or delays due to force majeure.
IS AN INCENTIVE SCHEME RIGHT FOR YOUR PROJECT?
As yet, there is limited empirical data to show whether completion incentives promote on-time completion better than Delay LDs or result in fewer disputes.
Certainly, incentive schemes should not be seen as the panacea for all of the “ills” associated with a traditional Delay LDs regime. For example:
- Any mechanism to extend the completion (incentive) date may still result in the parties becoming distracted by disputes over EOTs to that date.
- Where the contractor does not achieve completion on time and is not entitled to receive an incentive payment, in the absence of Delay LDs, will there be sufficient incentive for the contractor to complete the works in a timely manner (other than minimising the contractor’s own costs if completion is not achieved on time)?
What is appropriate as an incentive scheme will depend on the nature of the particular project. For a project where on-time completion is critical (e.g. a venue required for a major sporting event) the principal may require a hard date for completion, without any right for the contractor to claim an extension to the completion date. The trade off might be that the contractor receives a larger incentive than would otherwise be the case.
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