Sixth in a series of articles addressing key provisions in construction contracts
One may wonder why parties in construction contracts would agree in advance to waive their rights to consequential damages. Such waivers are fairly commonplace in today’s competitive construction market and often stand to benefit both parties.
What are Consequential Damages?
A basic principle of contract law is that when there’s a material breach by one party, the other party is entitled to be compensated for losses resulting from the breach. There are different categories of damages, including “general” (aka “direct”) and “consequential” (aka “indirect” or “special”).
While interpretations of consequential damages vary widely among courts, contracts, and circumstances, they’re typically described as damages that do not flow directly from a breach of contract, but rather are a secondary or indirect consequence and loss.
Although there is not a bright line test applicable to all construction contracts and circumstances, one way to differentiate and categorize damages is to view general/direct damages as the actual costs of completing and correcting construction (e.g., labor and materials), and consequential/indirect damages as all other losses.
Examples of consequential damages include:
- To an owner – loss of use of a completed project, lost profits, and increased financing costs;
- To a contractor – lost opportunities and profit, loss of bonding or increased bonding costs, and damages to reputation.
Why Waive Consequential Damages in a Construction Contract?
A mutual waiver of consequential damages may appear to have more direct value and benefit to a contractor than to an owner, primarily because a completed building is often used for business purposes and contributes to the generation of business profit. The inability to use a building because of delayed completion, or because some or all of a building is out of service while defects discovered after construction are corrected, can result in losses to the owner. Depending upon the type and size of the business, the lost profits could be substantial — and far exceed the fee earned by a contractor on the project. Because the risk of being “on the hook” for what could be tremendous lost business profits, there are contractors that will decline a project if the owner refuses to waive its rights to recover consequential damages. Such a decision is both motivated and justified by legitimate financial and market realities.
The profit margins of contractors are relatively low, and competitive margins may not include amounts that would otherwise be necessary to manage and accept the risk of liability for an owner’s lost profits. Owners benefit from price competition, and the margins on all projects are not increased to cover the contractor for assuming the risks of an owner’s lost profit.
Negotiating Mutual Waiver of Consequential Damages Provisions
Owners should not jump to a conclusion that requirement of a waiver by a contractor is a negative reflection of the contractor’s quality or financial condition. Mutual waivers of consequential damage provisions have been included in standardized contracts in for more than 20 years (See § 15.1.7 of AIA A201 – 2017, and ConsensusDocs 200 § 6.6.).
If the parties are not comfortable with a standard mutual waiver, what are their options contractually, so that each can accept a mutual waiver? Some options and considerations include:
- Provide that the waiver does not apply to consequential damages that would be paid by insurance applicable to the project.
- Set a maximum limit on consequential damages that may be recovered from the contractor, by agreeing to a cap on recovery of consequential damages, such as:
- a specific dollar amount
- a percentage of the contract sum
- an amount based upon the contract fee (equal to, portion of, or multiple of)
- Define a particular type of loss that the parties recognize in advance will not be waived, and perhaps set a maximum limit on such loss.
- Recognize that consequential damages that flow from a delay in completion of construction may be may be addressed through liquidated damages terms agreed to by the parties.
While mutually waiving consequential damages may seem counterintuitive at first, the waiver allows construction contractors to protect themselves from exposure to potentially huge and unpriced lost profit risks and for owners to reap the benefits of competitively priced contracts.