LAW: THE CONTRACTOR'S SIDE: Discussing a penalty

Clause holds up in South Carolina case

Article January 06, 2012
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Most contractors with whom I work understand that liquidated-damage clauses in construction contracts are a part of the business and that such clauses are enforceable unless they amount to a penalty.
The rules courts use to determine whether a particular liquidated-damages amount is a penalty are pretty uniform across the country.  
A recent case in South Carolina involved a challenge by a terminated subcontractor’s surety to a subcontract provision that entitled the prime contractor to 15% administrative costs on top of direct costs incurred remedying a subcontractor default. The prime contractor in that case was appealing a trial court’s ruling that sided with the surety and held that the clause constituted an unenforceable penalty.
In Erie Ins. Co. v. The Winter Constr. Co., 713 S.E.2d 318 (S.C. App. 2011), an electrical subcontractor entered into a subcontract for a little over $4.5 million on a high school construction project. After approximately 14 months on the project, the subcontractor defaulted and the prime contractor called on the subcontractor’s surety to finance payments to a replacement subcontractor, which the prime hired after receiving bids from several electrical contractors.
At the end of the project, the surety, which had satisfied all of its financial obligations to the replacement subcontractor, requested from the prime the unpaid balance on the original electrical subcontract. The prime agreed the surety was entitled to the difference between the agreed-upon subcontract sum and the amount paid to the original subcontractor prior to its default, but the prime withheld from its payment to the surety an amount equal to 15% of the replacement subcontractor costs to compensate itself for the administrative burden of dealing with the default. In support of its claim, the prime the following provision:

If Subcontractor fails to cure an event of default within seventy-two (72) hours after receipt of written notice of default . . . [Prime] may, without prejudice to any of its rights or remedies, terminate the employment of Subcontractor and . . . shall be entitled to charge all reasonable costs incurred in this regard (including attorney[’s] fees) plus an allowance for administrative burden equal to fifteen percent (15%) to the account of Subcontractor.

The trial court sided with the surety and ruled that this provision was unenforceable because it amounted to a penalty.
The South Carolina Court of Appeals held that the administrative burden contract provision at issue is clear. Recognizing the law of both South Carolina and most other states, the court indicated that the touchstone question is “whether the amount is reasonably intended by the parties as the predetermined measure of compensation for actual damages that might be sustained by reason of [the subcontractor’s] nonperformance.” If it is, the clause does not result in an impermissible penalty and is thus enforceable.  
The surety argued that 15% amounts to a penalty because the prime’s actual costs of administering the default was only $84,066, or less than one-fourth of the $350,000 sought by the prime. The court responded that the disparity between these amounts is not enough to prove the liquidated-damage amount is a penalty. In ruling for the prime, the court recognized that it was virtually impossible for the parties to predict when they signed the subcontract what the prime’s actual costs of tending to a default might be, and it noted that an earlier default by the subcontractor would be more costly than a default occurring later in the project. The court thus held that a “sliding scale” approach based upon a percentage of the direct costs incurred to finish the subcontractor’s work was a reasonable approach. Thus, in South Carolina, a clause of this nature, which is based upon a reasonable mark-up percentage, is enforceable. R&B

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