LEED And Penalty Clauses

The growing trend of green building and Leadership in Energy and Environmental Design (“LEED”) certification shows no signs of slowing down. LEED is a voluntary green building rating program that was originally developed and administered by the United States Green Building Council and more recently has been adapted for use in our country by the Canada Green Building Council.

There are currently over 400 buildings across Canada that have received LEED certification. In June 2007, for example, the Ontario Liberal Government announced that it is making LEED certification the minimum design standard for new government-owned construction and major renovation projects. In British Columbia, Vancouver has adopted a policy of having its large municipal buildings designed to LEED gold equivalency since 2004.

As the number of LEED projects increases, claims and disputes over whether a project has achieved LEED certification will inevitably follow. Consequences for the failure of a completed project to meet a specified LEED standard will also be an issue. The parties involved (owners, contractors and professional designers) must evaluate and manage the special risks related to green building during the formation and administration of their contracts.

How does LEED work?

LEED is a rating system in which points are earned for building attributes considered environmentally beneficial. The rating system addresses six major areas: sustainable sites, water efficiency, energy and atmosphere, materials and resources, indoor air quality and innovation and design process.

Certification of the building is based on the total point score achieved following an independent review and audit. Buildings are rated as one of four levels: certified, silver, gold or platinum.

Although there are substantial opportunities and benefits associated with green building, there are also increased expectations. Building owners could suffer financial loss (diminished building value) if the stated LEED certification level is not achieved. Accordingly, owners are contractually requiring that their buildings be designed to a specific LEED standard and are specifying financial “penalties” if the building fails to meet that standard.

Penalty clauses vs. liquidated damages

The enforceability of financial “penalties” in a construction contract that requires a certain level of LEED certification will depend on whether the provision can be characterized as a penalty or as a requirement for payment of liquidated damages. A penalty can be defined as a requirement for a fixed sum to be paid upon a default or breach of a specified clause(s) where the amount does not bear a direct relationship to the actual loss suffered. Often the penalty will be an amount well beyond the damages actually incurred.

On the other hand, liquidated damages are a genuine pre-estimate of damages that a party is likely to suffer if a breach occurs –in this case, a building’s failure to achieve LEED certification. In other words, the parties agree at the outset that the amount stipulated (or a specific mechanism or formula to determine that amount) will represent the likely damages that the owner will suffer if the building fails to meet that LEED standard. The “liquidated damages” amount is often expressly stated to not be a penalty.

The general rule is that provisions for liquidated damages are enforceable while penalty clauses are not (S. M. Waddams, The Law of Damages, CLB 2007). That is, the courts will not enforce a penalty even if the parties have clearly intended at the outset of their relationship that they wanted the penalty clause to be enforceable.

But the use of the words “liquidated damages” or “penalty” in the contract does not determine whether it is in fact one or the other. In other words, the courts may still find a clause to be a penalty notwithstanding that the parties have called it “liquidated damages.” The key is to attempt to estimate what actual loss would be caused by the breach by the offending party to ensure that amount will be considered fair and reasonable.

A court may determine that a clause providing for payment upon a breach or default should be categorized as a penalty clause:

• if the required payment amount is excessive and unconscionable compared to the greatest loss that could conceivably have been incurred as a result of the breach;

• if the breach consists only of a failure to pay a sum of money, and that sum is an amount greater than the sum which ought to have been paid;

• if a lump sum is payable by way of compensation on the occurrence of one or more of several events irrespective of their nature or magnitude; and

• even though a precise estimation of an amount is possible.

Whether a provision provides for penalty or liquidated damages is likely to be decided by a court upon the terms and inherent circumstances of each particular contract, judged at the time of the making of the contract and not at the time of the breach.

Green building is undoubtedly here to stay. However, the requirements for LEED certification are rigorous and if a building fails to meet the standard stated in the contract the failure could give rise to disputes and possible claims against the professional designer.

One possible solution is careful contract language that clearly identifies and allocates that risk. A well-drafted liquidated damages clause adds certainty to a design agreement and it will ensure that both parties clearly understand their obligations.

Owen D. Pawson is a partner with with Miller Thomson LLP in Vancouver.