Dealing With Damages In Construction Contracts
01 March 2007
When owners, developers, contractors, construction managers, design professionals, consultants or subcontractors negotiate a contract, they frequently confront several provisions related to damages. In many cases, the contracting parties wish to establish, at the outset how much, and under what circumstances, compensation must be paid if the contract is breached.
Sarah B Biser and Robert A Rubin, Seyfarth Shaw LLP
There are, however, different types of damages, and it is critical for the parties to understand exactly which types of damage the contractual provisions cover. Thus, for example, when a contract provides for liquidated damages, the provision typically applies only to direct damages resulting from delay. The contractor, however, may still be liable for other types of non-delay related direct damages as well as for non-delay related consequential damages, over and above the liquidated damages.
Similarly, the contract may provide for a waiver of consequential damages, following the AIA model as discussed below. The waiver of consequential damages does not preclude an award of liquidated damages, or of non-delay related direct damages, unless provided for under the contract.
It is therefore essential for parties to construction contracts to understand the different types of damages that such contract terms cover.
Direct damages are those immediately connected with the work. When a contractor fails to perform, the owner’s cost of completing the contract are direct damages. For example, in a case involving a claim by an owner for faulty construction of a roof, direct damages will include the labour and materials to repair or replace the roof. When a contractor is liable for delay, direct delay damages recoverable by the owner can include all direct costs incurred as a result of the contractor’s delay, such as penalties on existing lease, existing rental payments, cost of construction financing, cost of warehouse equipment and materials that cannot be installed on schedule, payments for mortgage and taxes on unoccupied building, etc. Direct damages related to delay may be very different than those direct damages related to faulty or negligent work.
Consequential Damages are costs that are one step removed from direct costs. Depending upon the facts of a particular case, consequential damages may include lost profits, loss of bonding capacity, loss of business reputation, loss of use, dimunition in value, lost rental income or unabsorbed or underabsorbed home-office overhead resulting from delay. To determine which consequential damages are recoverable, the courts apply a test of foreseeability. Those consequential damages that the party breaching the contract knew or reasonably should have foreseen would result from a breach (at the time of contract formation) are recoverable; those the party did not know and should not reasonably have foreseen are not recoverable. Damages that are not reasonably foreseeable are often referred to as remote damages.
In one of the more startling decisions involving consequential damages in the past twenty years, Perini Corp v Greate Bay Hotel & Casino Inc, 610 A. 2d 364, 129 N.J. 479 (1992), the New Jersey Supreme Court upheld an arbitration panel’s award of $14,500,000 in lost profits against Perini Corporation, the construction manager, when completion of construction work on the owner’s casino was delayed. These lost-profit damages far exceeded the $600,000 fee – plus reimbursable expenses – that the construction manager received for the project.
Following the Perini decision, the AIA adopted the well-known “mutual waiver of consequential damages” provision in A 201-1997. The language set forth in article 4.3.10 provides:
“Regarding claims for consequential damages: the contractor and owner waive claims against each other for consequential damages arising out of or relating to this contract. This mutual waiver includes:
- 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
- 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. This mutual waiver is applicable, without limitation, to all consequential damages due to either party’s termination. Nothing contained in this section 4.3.10 shall be deemed to preclude an award of liquidated direct damages, when applicable, in accordance with the requirements of the contract documents.”
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By agreeing to AIA A 201 -1997, Section 4.3.10, waiver of consequential damages,
- the contractor waives the right to recover: so-called Eichely Formula damages (unabsorbed or underabsorbed homeoffice overhead resulting from delay;) lost profits on other projects, loss of bonding capacity, loss of business reputation;
- the owner waives the right to recover: Lost profits, loss of use, diminution in value, lost rental income.
However, a waiver of consequential damages does not preclude recovery for direct damages and should not be considered in lieu thereof. To avoid any argument that the delineation of specific consequential damages may limit the universe of otherwise recoverable consequential damages, a careful draftsperson will make it clear that a delineation of specific damages is not meant to limit the broad effect of the waiver. Others argue that certain damages, while ‘consequential’ in one situation are ‘direct’ in another.
Punitive damages, when awarded, are intended to punish the defendant for wanton, malicious or egregious conduct, extreme bad faith or fraud. Punitive damages are generally not awarded in contract cases no matter how egregious the breach (see Corbin on Contracts section 59). However, punitive damages can be assessed against an insurer or surety if its refusal to pay on a policy is found to be have no basis in law or in fact (eg, if its refusal is totally unbelievable, the surety or insurer has engaged in a frivolous or an unfounded refusal to pay).
Provisions to Limit Damages:
The parties can maximise recovery for damages (or minimise exposure to damages) in several ways. Parties to the contract can include a waiver of consequential damages and a liquidated damages provision. Keep in mind, however, that there may be direct damages that are not included within the purview of a liquidated damage provision and, of course, fall outside the waiver of consequential damages. These direct damages could include, for example, costs to repair or replace negligently constructed work, expert costs to investigate existence of (or lack thereof) design errors, and demolition or other removal costs.
Consequential Damages:
The most effective way to limit liability for consequential damages is to insert a clause barring their recovery. Limitation of liability provisions are likely to be enforced, if not deemed by a court to be unconscionable. Such clauses should be drafted in the positive rather than the negative. For example, “in the event the roof leaks, we will pay for all labour and materials necessary to repair the roof, but in no event will we be responsible for damage to personal property, office furnishing, loss of rentals or other consequential damages.” The AIA waiver of consequential damages (section 4.3.10 of the AIA A 201 – 1997) discussed above is another such example.
By setting forth specifically the consequential damages that are waived, many uncertainties regarding the awarding of damages upon breach of contract are eliminated. Waivers of consequential damages give the owner and contractor the benefit of knowing that, in the event of breach, they will be responsible only for the more easily quantifiable direct damages caused by that breach. A broadly written consequential damages waiver can include loss of goodwill to a company, resulting in loss of other business contacts or clients, loss of other business opportunities, or any other consequential damages that may arise based upon the facts at issue.
Liquidated Damages Provisions:
When damages are not predetermined/ assessed in advance, the parties must look to a court or other tribunal to determine the amount of damages recoverable upon breach of the contract. It is quite common for an owner and contractor to agree to a liquidated damages clause in which the parties stipulate, at execution of the contract, the amount of damages recoverable for certain breaches – usually related to delay or performance criteria for specified plant equipment. For example, the AIA A 101 – 1997 at Section 3.3, provides a reference for a per diem liquidated damages provision as follows:
“(Insert provisions, if any, for liquidated damages relating to failure to complete on time or for bonus payments for early completion of the work.)”
Another liquidated damages clause may provide that
“If the Subcontractor fails to complete the work within the time specified in the subcontract as the Substantial Completion Date or any extensions thereto, the subcontractor shall pay to the Contractor as liquidated damages, the sum of $___________ per day for each calendar day of delay, not to exceed $_______ ______. Both parties agree that such amount is not intended to be a penalty regarding Subcontractor’s failure to complete the work as specified hereunder.”
These clauses are generally upheld notwithstanding that the stipulated sum may be less than the actual damages allegedly sustained by the injured party. A liquidated damage provision will not be upheld unless the amount so-fixed is a reasonable forecast of just compensation for the harm caused by the breach, and the harm caused by the breach is one that is not amenable to or incapable of accurate estimation. If the sum quantified and agreed upon by the owner and contractor at execution of the contract far exceeds the actual loss, such liquidated damage clause may be regarded as a penalty and may not be upheld. Then, the owner is relegated to proving the actual damages. Further, if no evidence shows that the amount of agreed upon delay damages bears any relation to the harm that was anticipated or that occurred, the clause may be deemed a penalty, particularly if it deviates from any customary per diem charge (see Corbin on Contracts section 58.21).
The chart below illustrates the different types of damages.
| Event Triggering Recovery of Damages | Direct Damages | Consequential Damages | Remote Damages |
|---|---|---|---|
| Contractor constructs office building for owner and causes two-year delay in substantial completion and occupancy of building. Owner sues: | 1) penalties on existing lease and existing rental payments 2) cost of construction financing 3) cost to warehouse equipment and materials that cannot be installed on schedule, or financing costs for warehouse 4) payments for mortgage and taxes on unoccupied building 5) costs of telephones, cable and other utilities 6) costs to heat or air condition unoccupied building | 1) loss of rental income of office space | 1) hospitalisation of owner for nervous breakdown suffered over construction problems with office building and dealing with lawyers handling possible law suit against contractor |
| Owner delays performance of contractor’s contract to build and install all millwork for office building. Contractor sues: | 1) lost profits 2) escalation costs of labor and materials 3) costs to warehouse equipment and materials, or financing costs for warehouse 4) reduced labour efficiency 5) extended utilisation of equipment 6) extended home office overhead expenses | 1) Salaries of estimators kept on payroll who could not estimate other work because contractor’s bonding capacity at maximum | 1) loss of bonding capacity 2) lost profits on jobs that contractor could not bid upon because he was still working on this job for an extended and unplanned period of time 3) emotional distress suffered by contractor’s wife, children and parents because of worry and aggravation created by owner caused delay |
| Performance bond surety unreasonably fails to pay owner completion costs after contractor defaults on strip mall construction project. Owner sues: | 1) excess cost to complete the work | 1) extended financing costs 2) loss of rentals 3) liquidated damages paid to a tenant per special terms of lease |