This is Part I of the fourth post in our “Top 10 Construction Contract Provisions” series. As a powerful mechanism to control contract risk, increase predictability, and reduce the cost and complexity of potential disputes, we frequently recommend that our clients’ contracts include a mutual waiver of consequential damages. Part I explains the significance of such a clause and the risk a contractor assumes without it.
A mutual waiver of consequential damage precludes recovery of foreseeable losses incurred not in completing the contract after one party breaches, but as a result of the particular needs and circumstances of the non-breaching party. Examples of consequential damages include most losses of profits, business, use, financing, reputation, and bonding capacity.
A general waiver of these types of damages encourages the parties to identify and negotiate an appropriate allocation of specific risk elements by either expressly excluding them from the waiver or including them as an element of liquidated damages. A contract without such a waiver leaves the parties to dispute what elements of damages are permitted and excluded based on other clauses (e.g. liquidated damages or warranty provision) and fosters conflict about potentially astronomical damages that one or both parties may have never envisioned at the time of contracting.
The Importance of Consequential Damages: An Example
A local developer asks if your construction company would be interested in his latest and greatest project. The developer has lined up bank financing and obtained several key lease commitments for the finished project. He has even signed one major lease, fixing a firm move-in date. He has a buyer committed to purchase the project after completion. He plans to use the proceeds for a second investment opportunity and has all the necessary contracts in place, pending receipt of the sale proceeds from this first project.
Excited about the project (and the price the developer offered), you sign the developer’s construction contract.
Midway through the project, things begin to fall apart. Key subcontractors are failing to perform. Your project manager has taken another job and her replacement is not working out. The schedule is lagging. You have missed your anticipated margins on a couple other major projects and cash is tight. Every change order becomes a battle. The owner is threatening to terminate.
The original substantial completion date arrives and the project clearly has months of work remaining to be performed. Finally, the developer terminates your contract and hires a replacement contractor to complete the job. The new contractor ultimately finishes the project a year after your original contractual completion date.
Meanwhile, unwilling to wait to move into their new spaces and leery of the distressed project, the tenants have withdrawn their commitments and the major tenant sues the developer for breach of contract. The prospective buyer terminates his purchase agreement due to the delay. The market has declined in the months since the original completion date and there is no new buyer in sight. With no revenue from this project, the developer is making ongoing loan payments out of his rapidly declining cash reserves. The developer’s second investment opportunity collapses as the parties terminate their contracts due to the developer’s lack of funding. His cash reserves finally run out, his bank forecloses, and he faces a significant deficiency judgment.
Ultimately, the developer sues you for damages based on a breach of contract claim. “What’s my total exposure here?” you ask yourself. The answer, of course, depends on your contract and on how each element of the developer’s damages is categorized (whether as “direct,” “incidental,” or “consequential”).
Contact Damages 101: The Benefit of the Bargain
A basic premise of contract law is that a contracting party is legally entitled to receive the benefit of his/her bargain. If the other party breaches the contract, a court will award damages in an amount sufficient to place the non-breaching party in the same position as if the other had fully performed. The damages recoverable under this rule are limited only to what was reasonably foreseeable at the time of contracting and what the non-breaching party can prove with reasonable certainty.
Under this general legal rule, the developer in our example would be entitled to recover all of his damages, as the discussions between the parties made it reasonably foreseeable to the contractor that the developer would suffer devastating harm if the construction contract was not timely and adequately performed. Here, the foreseeable and recoverable damages could include the developer’s increased cost to complete the project using the replacement contractor, as well as lost lease profits, damages to the major tenant for breach of lease, extended financing costs, lost investment opportunity in the second project, and the diminution in the property’s value between the actual and contractual completion dates, potentially including the foreclosure deficiency.
This type of result is not merely hypothetical. As discussed in an earlier post on the Ahlers & Cressman Construction Law blog, in the highly-publicized case of Perini Corp. v. Greate Bay Hotel and Casino, 129 N.J. 479, 610 A.2d 364 (1992), the construction manager of the New Jersey Sands Hotel and Casino renovation project was required to pay over $14,500,000 in lost profits damages because the facility was not open by the summer gambling season, despite the fact that the construction manager’s fee was only $600,000. This result was a driving force behind groups including the AGC suggesting that a mutual waiver of consequential damages be included in industry contract documents such as the AIA A201 and ConsensusDocs.
Part II of this post will discuss the various categories of damages flowing from a breach of contract and conclude with examples of how parties can limit these damages to reflect their agreed allocation of risk.
 We must assume the developer can prove each element of damages with reasonable certainty. The process and burden of proving damages opens a whole new array of issues outside the scope of this article.