This is a good article that effects the entire surety bonds business (whether it be construction bonds, bid bonds, or performance bonds). These contracts are used all the time and having consequential damages provisions can be difficult to work through. Take a look and see if this can help our your business.
Consequential Damages in Construction – The Silent Killer
One of the biggest risks contractors and subcontractors face on construction projects is liability for consequential damages, although many of them may not even know about that risk, much less understand it. Consequential damages are damages which flow indirectly from a breach of contract and are typically related to delays in performance and delays in completion of a project. The best way to think of such damages is in connection with an income-producing project such as a hotel, convention center, manufacturing facility, etc., from which an owner will derive revenue. If the project is not completed on time, the owner will lose the benefit of that revenue and the contractor and responsible subcontractors can face liability for that loss of revenue, i.e., consequential damages. Such damages can be huge. In fact, it can represent a bet-the-company risk.
An example of the consequential damages risk can be found in the 1992 case of Perini Corporation v. Greate Bay Hotel & Casino which arose from Perini’s reconstruction of the façade of an Atlantic City casino. Perini was late in completing the project and while Perini’s initial fee on the project was only about $600,000, it was hit with an adverse award of $14.5 million in consequential damages arising from the casino’s lost revenues due to the late completion. From this case came a shift in the 1997 revisions to the AIA contract documents, in particular, the A201 General Conditions. Beginning in 1997, A201 included a mutual waiver of consequential damages provisions which today (2017 version) reads as follows:
Waiver of Claims for Consequential Damages
.1 damages incurred by the Owner for rental expenses, for losses of use, income, profit, financing, business and reputation, and for loss of management or employee productivity or of the services of such persons; and
.2 damages incurred by the Contractor for principal office expenses including the compensation of personnel stationed there, for losses of financing, business and reputation, and for loss of profit, except anticipated profit arising directly from the Work.
Every contractor and subcontractor should consider and evaluate the risk of consequential damages on each project. This is one of the most heavily negotiated issues I deal with in my contract review practice. Here is a favorite clause of mine which excludes such damages:
Notwithstanding anything herein to the contrary, Client shall have no liability whatsoever for consequential, indirect, delay, special, incidental or liquidated damages whether arising in contract, tort, indemnity, warranty, strict liability or otherwise.
There are several nuanced modifications that can be made to this language such as agreeing to liability for such damages “only to the extent covered by insurance.” This change broadens liability for consequential damages but perhaps not the risk as any claim would be covered by insurance. Another modification would be to carve out from the waiver third party claims for indemnity or contribution. Again, this broadens consequential damages liability and perhaps the risk since such third party claims might not be covered by insurance.
Often times it is difficult to negotiate away entirely the risk of consequential damages (or liquidated damages – see below), but in contract negotiations owners, contractors and subcontractors must consider the level of risk one party assumes when it bears 100% of the risk of consequential damages. As a compromise, parties will often agree to cap consequential damages either at a specific dollar amount or a specific percentage based upon the contract value. That cap can be anything the parties negotiate but in my experience it ranges anywhere from 5% to 15% of the contract value. For example, a 10% consequential damage liability cap on a $30 million contract would be $3 million. On a cost-plus project the cap might be based on the contractor’s fee or some multiple of that fee. The idea in setting a cap is basically to limit the liability to the contractor’s fee or profit as opposed to the contractor having to come out of pocket to fund liability for consequential damages.
But what about liquidated damages?
Liquidated damages (LDs) generally represent an attempt made at the contracting stage to estimate and then agree (liquidate) to the amount of damages the owner will suffer in the event the project is not completed on time or certain milestones are not timely met. LDs can be low or they can be high. I have worked on DOT projects where the LD amount was $50 per day and I have worked on sports venue projects where the LD amount was in the millions of dollars per event if events did not occur on time. However, LDs cannot be so severe as to constitute a penalty because a penalty would be unenforceable. They must bear some reasonable relation to the damages the owner would suffer from late completion. LDs are usually set on a per day basis and generally replace consequential damages. While a contractor might have an aversion to LDs, at least it is a known amount in the event of a delay as opposed to an unknown and unlimited consequential damages amount, such as in the Perini case. In other words, “the devil you know is better than the devil you don’t know.”
While LDs may be known (liquidated), they can still add up such that, again, contractors and subcontractors should attempt to negotiate a cap on LDs. Some contractors are proud to say they negotiated LDs out of a particular contract. However, that contractor does not understand that by removing LDs, a known amount of damages for delay, it, perhaps unwittingly, threw itself into the unknown world of consequential damages. I am not saying one is better than the other but I am saying contractors and subcontractors should understand each and the risks associated with each one.
The presence of LDs in a contract typically means consequential damages for delayed completion are generally not recoverable since they both generally represent duration-related damages. Still, it is appropriate to seek a waiver of consequential damages even if LDs are present. Why? LDs typically end at substantial completion but the risk of consequential damages may exist post-completion due to warranty issues, i.e., the manufacturing plant has to shut down post-completion due to a problem with the HVAC system which was covered by the contractor’s warranty. The result is consequential damages in the form of lost revenue. To protect against this sort of post-completion consequential damages risk, and other risks, be sure to include waiver of consequential damages language even if the contract has an LD provision.
How do you evaluate those risks?
The risk of consequential damages and LDs generally relates to the failure to complete a project or achieve a milestone on time. When my clients are deciding how to manage this damages risk, I advise them to look at the complexity of the project, the quality of the design documents, the schedule and their contractual right to obtain time extensions. These and other factors can help you evaluate how much consequential or liquidated damages risk to take, if any. As noted at the beginning, many contractors and subcontractors enter into contracts every day without even knowing the risks they face with respect to such damages. However, the risk is there and can be a silent killer. You should know, understand and evaluate this risk on every project.