It’s important to understand the provisions of your construction contract, especially the ones that concern monetary damages. Two of the more negotiated damage provisions are consequential and liquidated damages. Although related, these terms are commonly misunderstood. That’s alarming because either could make or break your business! Let’s take a deeper look.
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Damages When the Contract is Breached
Fundamental contract law states that when there is a material breach of a contract, the non-breaching party is entitled to compensation for losses that result from the breach. Compensation comes in the form of damages, of which there are two main categories: direct and consequential.
Direct, or general, damages are those that cover losses directly resulting from the breach. Direct damages will typically include any costs associated with the actual completion or correction of the work. Mainly, labor and materials costs. These are relatively easy to prove; the damages awarded should place the claimant in the same position they would have been, had the contract been appropriately executed.
But what about consequential damages?
Let’s Talk Breach
What are Consequential Damages?
Consequential damages arise when a party to a contract fails to hold up their duties under their contract, and the other party is damaged as a result. Consequential damages extend beyond the direct damage caused, though. Instead, any damage incurred as a consequence of the failure to uphold the contract could be in play – unless limited in the contract. Unless reigned in, consequential damages could extend far beyond the terms of the contract.
When actual, consequential damages are in play, damages could quickly spiral out of control. Frequently, though, potential liability for consequential damages will be curbed via a liquidated damages clause in the contract. Let’s take a deeper look at each.
Actual Consequential Damages
Consequential (indirect) damages are those that do not flow directly from the breach but instead are a secondary or indirect consequence of the breach. These occur when a party breaches a contract and is liable for all foreseeable losses incurred by the other party. To recover consequential damages, the claimant must prove they were (1) proximately caused by the breach and (2) were reasonably foreseeable at the time the parties entered into the contract.
Determining foreseeability is one challenge, yet the more difficult hurdle is proving the amount. Courts will not award damages unless the amount is proven within reasonable certainty. For owners, damages could include loss of use of the building, lost profits or increase in financing costs.
On the other hand, consequential damages for contractors could consist of lost opportunities, lost profits, or damages to their business reputation. Not only does the claimant need to plead these damages specifically, but they’ll also need to provide enough evidence to support their claim. This is a highly factual and time-consuming process. Given the inherent difficulty in quantifying actual consequential damages, many parties opt to waive these in favor of liquidated damages, which provide the benefit of certainty.
A liquidated damages clause operates in a much different manner. Liquidated damages clauses provide a pre-determined amount of money that may be recoverable if a party breaches the contract. Liquidated damages clauses will typically be tied to specific types of breaches, such as failure to complete work on time. These breaches are usually spelled out very clearly in the contract to avoid any disputes. In the situation described above, they’re typically set at a value or percentage per day after the completion date.
Consequential and liquidated damages should be mutually exclusive. Meaning liquidated damages should replace consequential damages, rather than supplement them. Additionally, liquidated damages should generally be preferred because the contractor can, at the very least, be aware of the extent of their exposure to damages.
Consequential Damages Could be Substantial – Consider a Waiver
Many construction contracts will include a waiver of consequential damages. These will typically be waived in favor of liquidated damages for the benefit of the owner, and exclude any lost profits in favor of the contractor. However, having a mutual waiver of consequential damages benefits the contractor much more than it does the owner. It puts the contractor in the best position to control and manage risk to avoid liability. This is especially true if the improvement is a commercial building.
Think about it! A completed commercial building can generate higher revenues and profit margins than a contractor on any given project. The owner’s inability to use the structure can result in massive financial losses. So, comparatively speaking, the contractor would be on the hook for much more lost profits money than the owner would be for the contractor’s lost profits.
Establishing consequential damages is a delicate balancing act, and it’s one point that should be negotiated heavily before accepting the contract. Contractors view consequential damages waivers as leveling the risk between owner and contractor so that a contractor’s potential exposure is proportionate to its compensation under contract. Meanwhile, some owners believe contractors should be responsible for any possible damages caused by a failure to manage risk. So what gives?
Things to Keep in Mind When Negotiating the Contract
First, it’s important to inform the owner that any consequential damages resulting from completion delays can be addressed through liquidated damages. In many cases, having a set amount that will be due upon injury (via a liquidated clause) will be preferable! But, because consequential damages could benefit owners, and because the owner’s upside outweighs their risk, many owners will be reluctant to waive consequential damages.
Regardless, both parties to a given contract should seek to provide concrete definitions of what damages will be included and which will be waived if any. Specificity is key! Try to exclude at least any damages that would otherwise be covered by any applicable insurance policy. Another useful option is to set a cap on how much consequential damages can be awarded. Otherwise, these could be limitless based on the size and complexity of the project. And lastly, if the owner won’t budge on consequential or liquidated damages, maybe negotiate incentives into the agreement to make it worth your while.