Construction agreements can be lengthy. They often include terms covering everything from logistics for working on the project site to complicated provisions regarding intellectual property. Many provisions in a construction agreement deal with risk and who is going to pay for damage claims if or when they occur.

However, not all risk-shifting provisions are equally important. While provisions that impose obligations on the contractor to maintain confidentiality, indemnify for personal injury or property damage, or correct defective work can expose a contractor to substantial damage claims and are thus important, contractors can significantly control the amount of damages the owner can claim by including a well-drafted waiver of “consequential damages” provision in the agreement.

Because the waiver of consequential damages can significantly control the amount of damages for which a contractor is assuming risk and greatly limit the owner’s ability to recoup many damages, it is arguably the most important provision in a construction contract. Therefore, it is essential for contractors and owners to carefully consider the waiver of consequential damages before entering into any construction agreement.

What is a consequential damage?

Generally, when the contactor has breached the construction agreement, the owner will have direct losses (e.g., cost to fix the work) and will have other indirect or consequential losses (e.g., lost revenue incurred during project down time). Whether or not a loss is consequential or direct is determined by state law, and unfortunately, there is no uniform approach among the state cases and statutes. What is a consequential loss to one judge may be a direct loss to another judge evaluating similar facts.

Because state laws and courts are inconsistent in defining which damages are consequential, parties should consider specifically defining them in the consequential damages waiver. For example, the AIA A201 includes rental expenses, losses of use, income, profit, financing, business and reputation, and loss of management or employee productivity in its definition of an owner’s consequential losses. The ConsensusDocs 200 includes similar language.

Historical inclusion of waiver of consequential damages

The types of damages described as “consequential” in many standard agreements such as the AIA and ConsensusDocs (and as defined by courts and state statutes) can be significant. Depending on the type of project, an owner can sustain millions in loss of use damages and lost profits if the contractor is late in delivering performance. Because consequential losses can be so substantial, neither the contractor nor owner wants to absorb the risks associated with those losses.

For the last 20 years, the most widely used construction general conditions (the AIA A201) have included a broad waiver of consequential damages where the owner waives its right to claim lost profits or loss of use damages caused by the contractor’s failure to perform. Contractors argue the AIA document’s approach is equitable because contractors’ fees are not sufficient enough to allow them to assume the risk of millions in lost owner profits if an unexpected event were to occur and the owner was damaged by delayed or defective contractor work. On the other hand, owners argue against this provision, noting that if a contractor fails to honor the agreement, the contractor should be responsible for all losses, including direct and consequential damages.

Modern treatment – Proposed owner carve-outs

Recently, many owners and their counsel have started proposing carve-outs to the waiver of consequential damages during contract negotiation. Owners say they will agree to the waiver of consequential damages, but not in connection with claims asserted against the contractor based on the contractor’s promises to indemnify in the agreement, the contractor’s gross negligence or willful misconduct, the contractor’s failure to pay taxes or liens, or the contractor’s breaches of the provisions relating to intellectual property and confidentiality. Some owners even try to limit the waiver of consequential damages so it does not apply to claims arising from breaches of warranty.

Contractors evaluating these suggested carve-outs must carefully consider the risk that each will create. In the indemnity provision(s) in a construction agreement, contractors often agree to pay for any losses resulting from their negligence (not necessarily those incurred by third parties and not necessarily only those losses like insured property damage or personal injury losses). A contractor is negligent if it fails to perform its work as well as other similarly situated contractors. If a contractor assumes the risk of any consequential losses (lost profits) arising from any failure of the contractor to perform its work as well as other similar contractors, it is exposing itself to substantial damage claims.

Again, many owners try to limit the consequential damages waiver so it does not apply to claims arising from gross negligence. The contractor may believe it is fair to agree to unlimited liability for consequential losses for gross negligence claims, but what if the applicable law doesn’t recognize varying degrees of negligence or separate claims for gross negligence from ordinary negligence claims (as in Missouri)? By agreeing to limit the waiver of consequential damages so it doesn’t apply to gross negligence claims, is a contractor living in a state that doesn’t recognize gross negligence claims agreeing to pay consequential damages for any ordinary negligence claim?

Agreeing to pay consequential damages for a narrow group of claims like those arising out of failure to satisfy liens or pay taxes (and arguably even claims arising from breach of confidentiality or intellectual property agreements) is tolerable because a contractor has more control over whether those claims occur (and the consequential damages flowing from those clams would presumably be less). Contractor delays and mistakes, however, including those leading to accidents or defective work, are more difficult to control. Contractor negligence and defective work (breaches of warranty) can shut down a project and cause significant delays as well as consequential damages. Therefore, a contractor needs to be wary when agreeing to pay consequential damages resulting from gross or ordinary negligence, fault short of willful misconduct, or breaches of its warranty obligations.

Solutions and proposed compromises

Because many contractors will not accept broad carve-outs to the waiver of consequential damages, owners, contractors and their counsel have started looking for ways to compromise. In some recent contracts, owners have required contractors to be responsible for consequential damages for any indemnity claim, but have agreed the owner can only recover consequential damages when seeking reimbursement via the indemnity provision for a non-affiliated third party’s consequential damages. While agreeing to be responsible for a third party’s consequential damages can still expose contractors to significant damage claims, this compromise does limit the contractor’s exposure to possible substantial lost profit claims by the owner.

In other recent contracts, some owners have agreed to broadly waive consequential damages, but not for claims covered by insurance. Contractors can significantly control their risk, of course, by agreeing to limit recoverable consequential damages to those that are otherwise covered by insurance.

Detailed compromises vis-à-vis the waiver of consequential damages are likely to be commonplace in future construction agreements. Contractors and owners’ counsel are becoming increasingly wary of the risks assumed and transferred in the waiver of consequential damages, and have recognized its importance. Indeed, many counselors believe it is the most important provision, requiring a great deal of attention from all parties.