The Contractor’s Approach to Risk Allocation III:

Consequential Damages Clauses

          This article continues the series of discussions about risk allocation and the manner in which contractors can use various contract clauses to more equitably assign risks inherent in the industry to parties best suited to accept risk.  In the last two columns, I’ve addressed delay damages and indemnity clauses.  In this column, I will discuss the consequential damages clause.  This clause often appears as a waiver of consequential damages, thereby preventing the recovery of certain types of damages in the event of a claim.

Consequential Damages:

A discussion about the types of consequential damages clauses must start with consequential damages themselves.  In order to fully understand and assess the amount of risk one is shifting, accepting, or eliminating, one must have a basic understanding of the scope and type of damages affected by this clause.

Consequential damages are damages, losses, or injuries that do not flow directly and immediately from the act of the other party on the project, but rather as a consequence or result of the act. For example, an owner change that affects the scope may lead to delays that increase costs.  These delay costs are direct damages attributable to the owner’s change of scope and are attributable to and directly connected to the project. Consequential damages differ from direct damages in that the same event may cause the damages, but the consequential damages occur away from the project.

Typically, the following types of damages are considered direct damages under Texas law: a) time and materials to perform extra work; b) extended general field conditions; c) costs for subcontractor performance of changed work; d) extended rental fees for equipment; e) labor costs associated with acceleration or devotion of additional crews to a project.  This list is not exhaustive, but it provides examples of certain types of direct damages.

Consequential damages, on the other hand, can be any of the following: a) lost profits; b) lost bonding capacity; c) extended home office overhead; d) inefficiency costs and lost productivity costs on other projects; e) increased bond and or insurance premiums; and f) interest on credit extensions.  Again, this list is not exhaustive, but it provides examples of consequential damages a contractor might incur as a result of events on a project.

The Consequential Damages Clause:

In many contracts, the waiver of consequential damages is mutual.  The language often used is similar to the following: “The Owner and Contractor waive claims against each other for consequential damages arising out of or in connection to the Work.”  Many contracts utilized by public owners, especially local governmental entities, contain a similar waiver of consequential damages.  However, it is not uncommon to see contracts that do not waive consequential damages, nor is it uncommon to find provisions that contain unilateral waivers.  Texas law does not require waivers of damages, whether consequential or otherwise, be mutual in order to be enforced.  Texas is a freedom of contract state, meaning that parties are free to negotiate any terms they see fit.

In the case of a mutual waiver of consequential damages, the parties to a contract may be under the impression that the risk of consequential damages has been eliminated entirely.  However, the parties must analyze potential costs of eliminating both the ability to be charged for consequential damages incurred by the opposing party as well as the ability to recover consequential damages caused by the opposing party.  Certainly, a mutual waiver clause eliminates the risk that a contractor will have to pay the owner’s consequential damages, but it does not eliminate the risk posed to the contractor for collateral business damages from potential issues that have consequences beyond the project.

From a contractor’s perspective, the risk and type of consequential damages potentially available to both parties must be evaluated in determining whether the elimination of this risk is truly equitable.  A public owner building a new park and associated infrastructure may have virtually no exposure to consequential damages in the event of delay.  However, a contractor on that project may have a significant risk of consequential damages should a delay occur.  In this case, the mutual waiver is not as even as it seems on its face.

On the other hand, a public owner constructing a revenue-producing project or one that has a heavy debt burden attached, may have significant consequential damages associated with it.  The mutual waiver here may, indeed, be more equitable for a contractor who is potentially at-risk for significant consequential damages on the same project.

Generally, waiving consequential damages may result in higher costs for a project.  Contractors who see a waiver provision during the pre-bid contract examination might have a knee-jerk reaction and increase margins to protect against the waiver provision.  Likewise, subcontractors who are required to incorporate these provisions through a flow-down provision, might raise their prices.  In this case, the elimination of risk may actually do harm to a project that might otherwise have been delivered with better value for the owner.

Using the examples from above, in the situation where the Owner has a low risk of consequential damages while the contractor has a high risk, a contractor that is negotiating a contract that does not address consequential damages may want to accept the contract as is.  On the other hand, where the owner has a higher risk that equals or exceeds the contractor’s risk, suggesting a mutual waiver would make the most sense.

With respect to unilateral waivers of consequential damages, contractors should follow the same analysis to determine whether they are being asked to accept an inequitable allocation of risk.  Conventional wisdom would dictate that a unilateral waiver is inequitable.  If, however, both parties have low-risk or low-exposure to consequential damages on a particular project, then agreeing to a unilateral waiver may not be as inequitable as it seems on its face.  Especially if the contractor is able to negotiate for something in return that might actually tilt the scales of equity back into its favor.

In almost every contract negotiation, contractors should look at how each contract deals with consequential damages and evaluate the equities accordingly.

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