This is Part II of the fourth post in our “Top 10 Construction Contract Provisions” series. Part II 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. Read Part I here.
Categorization of Damages: Direct, Incidental, and Consequential
As contracting parties have historically sought to deviate from the general rule in allocating risk, contract law has developed rough categories of damages to determine what damages will be recovered in a given contractual situation. The primary categories are labeled “direct” (sometimes called “general”), “incidental,” and “consequential” damages (with incidental and consequential sometimes labeled collectively as “special” damages).
“Direct” damages are generally costs that arise naturally and necessarily from a breach. In construction, direct damages typically refer to an owner’s cost to complete the project through a replacement contractor, less any unpaid balance on the original contract. If the owner is the breaching party, the contractor’s direct damages are linked to the increase in its costs to perform the contract.
In our example, the developer’s direct damages would include his payments to the replacement contractor, less the balance remaining on the original contractor’s price. Although that amount could be substantial, it is also relatively simple to document.
“Incidental” damages are expenses incurred by the non-breaching party to complete the contract that would not have been required if the other party had performed. The Uniform Commercial Code provides an illustrative definition in the context of a sale of goods: “Incidental damages resulting from the seller’s breach include expenses reasonably incurred in inspection, receipt, transportation and care and custody of goods rightfully rejected, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expense incident to the delay or other breach.” RCW 62A.2-715(1). In the construction industry, incidental damages could include inspection and re-procurement expenses.
“Consequential” damages are losses that are reasonably foreseeable, but linked to the non-breaching party’s particular needs and circumstances rather than the contract itself.[i] Consequential damages are highly dependent on the specific circumstances surrounding the contract. They can take innumerable forms and implicate staggering amounts of money. Typical examples of consequential damages include lost profits, third-party claims, loss of use, loss of reputation, lost opportunities, and interest. Because they depend on circumstances outside the direct subject matter of the contract, consequential damages can be a wild card when disputes arise.
The majority of the developer’s losses in the hypothetical example in Part I are consequential damages. His lost lease profits are consequential because they were reasonably foreseeable by the contractor, but flow not from the contract itself (i.e. completing the work), but the developer’s specific circumstances. The same is true of the tenant’s lawsuit for breach of lease, the developer’s extra loan payments, his lost opportunity in the second project, the decrease in property value, and the foreclosure.
Contractual Waiver of Consequential Damages
There are several ways to contractually address the “parade of horribles” presented by the example in Part I. Our earlier article on Liquidated Damages discusses one way to quantify and allocate some of this risk. A broader blanket of protection can be provided by an express mutual waiver of consequential damages, which sets limits of each party’s recoverable damages to direct and incidental damages (in most cases, costs to complete), and requires any other risks to be shifted by express agreement.
There are innumerable variants, but one example of a waiver of consequential damages is as follows:
MUTUAL WAIVER OF CONSEQUENTIAL DAMAGES
The Parties agree to waive all claims against each other for any consequential damages that may arise out of or relate to this Agreement. This waiver includes but is not limited to loss of use of the Project, loss of income or profit (except Contractor’s reasonably anticipated profit on the Project), loss of financing, loss of reputation, loss of business or opportunities, loss of bonding capacity, or insolvency. The provisions of this section shall also apply to the termination of this Agreement and shall survive such termination. [Notwithstanding the foregoing, the Parties specifically exclude the following from this waiver: _____________.]
This is a variant based loosely on the ConsensusDocs 200 form. AIA A201 includes a similar clause.
In the example in Part I, a clause such as this would limit the contractor’s liability to the developer’s cost to complete the project. That amount could be substantial, but limited and presumably well documented. The developer would bear the various consequential risks-not an unfair result in the situation where the developer created much of the risk by “betting the farm” on the contractor’s performance.
This is not to say the upstream contracting party, the developer in our example, should always bear the risk of consequential damages if the downstream contractor fails to perform. Rather, the mutual waiver of consequential damages encourages the parties to negotiate and expressly allocate such risks at the time of contracting rather than allow these items to exacerbate and inflate disputes that may arise after contracting.
For example, if the developer and contractor agreed that the contractor would bear the risk of losing the committed tenants due to delay or other construction deficiencies, they could either assign a reasonable estimate to that potential loss and include it as elements of liquidated damages, or simply exclude lease-related profits from consequential damages waiver. The resulting contract would expressly reflect the parties’ negotiated risk allocation and avoid protracted disputes about topics such as the project’s fair market value at various points in time, the certainty of the projected lease revenues, etc. A mutual waiver of consequential damages would also allow the parties to price appropriately based on their respective risk allocation. For the right price, the contractor would presumably be willing to bear more of the risk. In any event, the mutual waiver of consequential damages promotes clarity of purpose, increases predictability, and reduces the likelihood of extensive and costly litigation/arbitration.
[i] See, e.g., RCW 62A.2-715(2). The term also generally includes damages resulting from a breach of warranty. Id. Warranty provisions will be covered later in our “Top 10” series.