Construction contracts often contain multiple provisions intended to allocate or limit risk, but those provisions can conflict if not reviewed carefully. Property owners, developers and contractors should review liquidated damages, consequential-damages waivers, liability caps and indemnity obligations carefully to ensure the agreement does not unintentionally restrict available remedies, create uninsured exposure or shift more risk than intended.
What Type of Damages Are at Stake?
The failure to perform under a construction contract can give rise to actual damages and consequential damages:
- Actual damages are foreseeable at the time the contract was entered into and result directly from a wrongdoing (such as negligence or breach of contract). An example is an owner having to pay holdover rent on its existing site because of construction delay at its new facility.
- Consequential damages do not result directly from a wrongdoing, but result from special circumstances of the injured party. Consequential damages are recoverable only if the party committing the wrongdoing had reason to know of those special circumstances at the time the contract was entered into. An example is an owner losing a contract to manufacture goods because delay in the construction of its new facility resulted in insufficient manufacturing capacity to meet the contract’s requirements.
Damages in the context of a construction project can result from different causes, including delay in completion, construction defects, negligence that results in personal injury or property damage, release of hazardous materials, and intellectual property infringement. Although insurance can be a source for covering some of these damages, in the absence of insurance coverage contract provisions affecting damages become more critical, so it is important for the parties to engage insurance counsel to understand the coverage of available insurance.
Risk Limitation vs. Risk Allocation Provisions: Why They Matter
A contractor typically reviews contracts with a focus on limiting its liability to losses covered by insurance, and, to the extent that is not possible, limiting its exposure through provisions that limit damages and/or waive liability. On the other hand, an owner customarily focuses on ensuring that its potential damages, to the extent caused by the contractor, are covered by the contractor whether or not through insurance.
Their differing focus results in negotiation of the provisions that affect damages, the four most common of which are:
- liquidated damages for delay in substantial completion;
- the mutual waiver of consequential damages;
- limitation on liability for direct damages; and
- “hold harmless” or indemnity provisions, such as a contractor’s hold harmless of owner for certain types of claims arising from the work.
Liquidated Damages
“Liquidated damages,” or an agreed-upon dollar amount for each day of delay in completion, is a commonly negotiated term in construction contracts. Contractors may view liquidated damages as a means of limiting a contractor’s potential liability for damages that an owner may suffer because of a delay in substantial completion. From an owner’s perspective, liquidated damages eliminate the burden of quantifying, proving or fighting over losses (such as lost profit) resulting from delay.
It is important for an owner to understand that the liquidated damages amount caps the owner’s recovery for delay, even if the resulting damages from delay are more. Owners should try to quantify damages that may be caused by delay in order to understand the reasonableness of any proposed liquidated damages amount. Both parties should be aware that liquidated damages may not be enforceable if they amount to a penalty rather than having a reasonable relationship to the range of actual damages that could have been anticipated at the time the contract was entered into. A contractor will want to ensure that the liquidated damages are the owner’s only remedy for delay.
Mutual Waiver of Consequential Damages
It is common for construction contracts to include a mutual waiver of consequential damages. Most of the preprinted forms used in the industry (AIA, ACG, Consensus Docs) include them. The waiver limits exposure on both sides to speculative or large indirect losses that could far exceed the contract sum. It is not uncommon to negotiate carve-outs from the waiver of consequential damages. If liquidated damages for delay are included in the contract, they must be carved out from the waiver. Other carve-outs may include:
- indemnity obligations for third-party claims;
- damages caused by intentional misconduct or fraud; and
- damages to the extent covered by insurance.
Limitation on Liability for Direct Damages
It also is common for construction contracts to include provisions limiting a party’s liability for direct damages under certain circumstances. One such provision involves limiting an owner’s liability for terminating the contract for convenience. It is becoming increasingly common in construction contracts for projects involving high complexity, high risk, or significantly high contract prices to include a general limitation on the contractor’s liability for direct damages. Such a limitation often takes the form of a stipulated sum or a percentage of the contract sum or the contractor’s fee.
Including such a limitation on liability and negotiating the carve-outs to it represents the delicate balance between the contractor’s desire to quantify and limit their risk exposure and the owner’s need for adequate protection against potential losses. An owner will want to consider including a clarification that the limitation on liability is not intended to relieve an insurer of its obligation to provide coverage. Regardless of this clarification, it is important for owners to consult with their insurance counsel to understand if a general limitation on the contractor’s liability will impact the owner’s insurance protection (e.g., precluding coverage for losses in excess of the limitation on liability).
Again, it is not uncommon to negotiate carve-outs from a contractor’s general limitation of liability. Similar to the carve-outs from the waiver of consequential damages, if liquidated damages for delay are included in the contract, they must be carved out from the general limitation of liability. Other carve-outs may include:
- indemnity obligations for third-party claims;
- warranty work;
- damages caused by willful misconduct, fraud or statutory violations;
- damages for defective or non-conforming work, and for completion if the contract is terminated for contractor’s breach;
- damages to the extent covered by insurance; and
- damages caused by the release of hazardous materials or intellectual property infringement.
Contractors should be aware that a limitation of liability may not be enforceable to the extent it is against public policy, such as a limitation of liability for their own willful misconduct.
“Hold Harmless” or Indemnity Provisions
The fourth and final provision affecting damages under construction contracts is the “hold harmless” provision. The most common hold harmless provision in a construction contract is the contractor’s hold harmless of owner for certain types of claims arising from the work. Most of the preprinted construction contract forms limit this hold harmless provision to claims arising from bodily injury or property damage caused by contractor’s willful misconduct or negligence. A contractor will want to limit the scope of the hold harmless so that it aligns with the contractor’s liability insurance coverage. The owner will want to expand the scope of the hold harmless so that it aligns with the damages caused by contractor’s willful misconduct or negligence, regardless of whether or not it aligns with contractor’s liability coverage.
Once again, negotiating the scope of the hold harmless represents the delicate balance between the contractor’s desire to quantify and limit their risk exposure and the owner’s need for adequate protection against potential losses. In any indemnity, it is important for the parties to focus on whether it includes the duty to defend. If included, the parties may consider additional language to address who selects counsel and who has settlement authority.
What Should Owners and Contractors Do Now?
The effectiveness of risk limitation and risk allocation provisions depends not only on how each clause is drafted, but also on how those provisions work together as a whole. Property owners, developers and contractors should resist the temptation to gloss over these terms, as they can significantly undermine preferred allocation of risk.
As a practical next step, businesses and individuals regularly involved in construction projects should review their existing contract forms and upcoming project agreements to confirm that these provisions are consistent, align with their risk-management objectives, and do not create unintended coverage gaps or limitations on available remedies. Taking a comprehensive approach during contract negotiations can help avoid costly disputes and unexpected liability after a project encounters delays, defects or other challenges.
If you have questions about your current construction contracts, please contact Lisa Stalteri or Jay Ross, or your regular Lathrop GPM attorney.