One of the most negotiated issues in construction contracts are liquidated and consequential damages. What I have found interesting over the last several months, is that contractors, surety brokers and even surety underwriters really do not know the difference between liquidated and consequential damages. And when you throw in the term direct damages, the conversation gets even more complicated.
There are really two types of damages for a breach of a construction contract. This is true whether there is a dispute between an owner and a general contractor or a dispute between a general contractor and a subcontractor. For the purposes of this article, I will use an owner and contractor. Direct damages are the most understandable. Direct damages are those that flow naturally and necessarily from the breach and compensate for loss that is presumed to have been foreseen or contemplated by the parties because of the breach. Examples of direct damages include unpaid contract amounts due the contractor, costs incurred by an owner to repair defective work or complete the work of the contractor, and reduced project value due to nonconforming work. The contractor who does not finish its work gets a credit for the balance remaining under the contract but is liable to the owner for any costs over and above the contract price. The next set of damages is consequential damages, which are recoverable in New York State unless the contract precludes the award of consequential damages.
Consequential damages are those damages that do not necessarily, but do directly, naturally, and proximately result from the injury for which compensation is sought. In other words, they are the result of special circumstances not usually predictable. Not only must the damages be directly traceable to the breach of contract and result from it, but the damages must also be “foreseeable.” Common examples of consequential damages are lost profits, lost bonding capacity, financing costs, reduced value or lost sales of real estate, and extended general conditions/overhead costs. There are two ways in which an owner may recover consequential damages. They are by recovering the provable, actual consequential damages, or through a liquidated damages clause in the contract. Thus, liquidated damages are a type of consequential damage.
Liquidated damages clauses are used because it may be very hard to quantify actual consequential damages. These clauses set a specific dollar value typically per day for each day after the contractual substantial completion date until the contractor substantially completes its work. Utilizing a liquidated damages clause saves much time and money proving the damages. Liquidated damages may not be used as a “penalty.” Liquidated damages are enforceable if they reflect a reasonable measure of anticipated damages and the calculation of damages are difficult to otherwise calculate. If the damages provided in the liquidated damages provision are not a reasonable estimate or the calculation of damages would not be particularly burdensome, courts may not enforce such provision. In addition, an owner may not recover liquidated damages if the contractor dies not substantially completing its work. In that case, even though the owner may not recover liquidated damages, it will be allowed to prove its actual consequential damages.
As set forth above, many contracts will contain clauses which preclude the award of consequential damages. In other instances, contracts will state that the parties waive consequential damages except for any liquidated damages that may be inserted in the contract (for the benefit of the owner) and except for lost profits on the contract (for the benefit of the contractor.) It is extremely important to know if and to what extent a party may be liable for consequential damages (whether actual or liquidated) when the contract is reviewed.
There are many instances when an owner will not remove liquidated or actual consequential damages from the contract. If that is the case, the contractor should try to insert a bonus clause for early completion. But more importantly, the contractor should limit the amount of any consequential damages for which it may be liable. Many bonding companies will not underwrite a performance or payment bond if there is no cap on consequential damages. This is critical because a contractor may enter into a $1 million contract and end up facing a consequential damage claim for millions of dollars. A good cap is the amount of profit the contractor anticipated making from the contract or a percentage of the contract price.
In all, it is imperative that owners and contractors alike understand consequential damages and understand the ramifications of consequential damages clauses. The days of just signing the contract without review are over. The consequences could put a company out of business.
Andrew Richards, Esq., is a co-managing partner at Kaufman Dolowich & Voluck, Woodbury, N.Y.