The following content is sponsored by Old Republic Surety.
There is a saying in the construction surety world — “Contract is king.” If your contract and bonds end up in a litigation setting, then courts tend to hold the surety to the contract over the bond forms. Performance and payment bonds, by their nature, carry out the terms of a contract and therefore are inherently attached to it. This important connection has made underwriting the contracts that are being bonded a large part of the surety bond underwriting process. Most brokers have created a bond-request form, which requests a high-level outline of standard terms within the construction contract, generally including damages, payment terms, and warranty period. The next few articles will outline why surety professionals zone in on these specific terms and how contractors can use them to mitigate their risk.
Why the “Damages for Delay” Section Is Important
Understanding how the contract defines and, most importantly, sets damages for delay is essential to the risk analysis of a contract. Damages for delay can be defined in three ways: liquidated, actual, or consequential. Liquidated and actual have their benefits and drawbacks and should be used strategically while consequential should be avoided. No matter what damage clause is being used, a contractor should ensure there is a clause limiting its liability.
Liquidated damages are defined prior to the execution of the contract and set according to a time frame. The majority of the liquidated damages are set per day; however, you may find that when an owner has high costs associated with missing deadlines, damages are defined by minute or hour. It is imperative that contractors understand what the cost will be to them should they miss this deadline and why the cost was set.
Liquidated damages should be in lieu of any other damages; however, not all states or case law clearly define this. In order for a contractor to protect itself, it should always define that the liquidated damages are a sole remedy to the owner for delay. More than that, a contractor must be familiar with the state-specific construction laws that impact contracts in the locations it works.
A very important portion of the contract language is distinguishing liquidated damages from a penalty. Liquidated damages avoid the difficulty of determining the actual damage caused by delay on the back end by defining a fair estimation of what these damages are before any delay occurs. Liquidated damages, in theory, should not be excessive, used to motivate completion, or used to penalize a contractor that misses a deadline.
If damages are not a reasonable estimate of the loss to the owner for delay of completion and if there is no justification for the amount, then damages could be unenforceable. Even so, proving that a set damage that was agreed upon at the beginning of a contract amount was made arbitrarily is a large and difficult task with an uncertain outcome. Contractors should be comfortable with the time frame and amount of the obligation at the time they sign the contract and should not hope to escape it on the back end through costly litigation.
Advantages of setting liquidated damages include helping a contractor by better defining the risk on a tightly scheduled project and allowing them to more accurately account for that risk when preparing their estimates for that project, and also avoiding the costly legal fees that can occur to settle the actual damage amount (mediation, arbitration, and litigation). On the other side, setting the amount prior to damage occurring could result in a contractor paying more than the actual damages that occurred.
Here's a quick list:
- Liquidated damages should be:
- Set prior to beginning work
- In lieu of determining actual damages
- The sole remedy of the owner or GC
- A reasonable estimation of actual damage caused to contract
- Liquidated damages are not:
- To penalize the contractor
- Excessive in order to coerce the contractor into a performance schedule
- In addition to other actual or consequential damages
If damages are not set in the contract, then the contractor would be liable for actual damages. This means the owner or obligee will pass to the contractor (and hence the surety) the costs that are a direct result of failure to complete the work according to the agreed upon schedule. Generally, these costs will be direct labor and material costs.
Actual damages work best for a contract where damages for delay are easily determined. In these instances, undefined damages can sometimes work in the contractor’s favor because the obligee must prove the damages. Drawbacks to actual damages may include costly litigation in a claims situation to define what damages are, as well as the difficulty in building costs associated with scheduling risks into a contractor’s estimate, since the amount is unknown.
Consequential damages are damages that occur indirectly because of breach of a contract (or multiple contracts) usually related to performance or project completion delays. If left in a contract (or, perhaps, even if a contract remains silent), consequential damages may open contractors up to crippling liability. Examples of these damages are lost anticipated profits, cost to repair defective goods, loss of goodwill, loss of reputation, loss of future sales or rents due to the delay, added interest paid on construction loans, etc.
One of the most famous examples which outlines the magnitude of losses caused by a contractor entering into a contract with consequential damages occurred in 1992 when the appellate court upheld Perini Building’s responsibility to pay Greate Bay Hotel & Casino $14.5 million in damages due to lost revenue. This award is even more jarring when considering that the amount of the construction contract in dispute was a construction management contract in the amount of a $600,000 fee plus actual expenses and a 4% additional markup for costs over $20 million. The total renovations that Perini was overseeing equaled $24 million.
Identifying and understanding terms is the first step. However, knowing them is not enough; contractors need to be empowered to negotiate alterations, additions, or deletions to terms where needed. The following are how the standard forms of widely used construction contracts handle consequential damages:
- AIA A201, General Conditions of the Contract for Construction, Section 15.1.7 provides a mutual waiver of consequential damages.
- ConsensusDocs 500, Standard Agreement and General Conditions Between Owner and Construction Manager (CM At-Risk), 2017and revised December 2021 provides a limited mutual waiver of consequential damages.
- EJCDC C-700, Standard General Conditions of the Construction Contract, 2018 remains silent on consequential damages but can be coupled with the EJCDC C-520, Agreement Between Owner and Contractor for Construction Contract, 2018, which clearly carves out all other damages from the liability of the contractor if liquidated damages are set.
Other Clauses to Consider
The better defined the contract is regarding the construction schedule and when/how a contractor is granted a time extension, the better a contractor can identify and take action to mitigate its risk.
A time extension is generally granted for:
- Delay caused by owner, architects, or separate contractors. It is important to look for the inclusion of “sole responsibility” within this condition. Should the owner, architect, or other contractor be required to be solely responsible, it can be much more difficult to obtain additional time.
- Changes ordered in work. During the change order process, it is important that the contractor understand the steps that must take place for a change order to be considered valid. This includes the person with authority to enter the owner into the change order.
- Acts of God. Fire, weather, and labor disputes are generally considered acceptable delays.
- COVID-19 does not always factor into this because it is no longer considered an unknown event.
- Projects may already build in weather days to the schedule. In order to be granted additional time, the adverse weather days must equal more than was built into the schedule.
Additionally, there are often defined time frames and methods for requesting time extensions. Contractors should be aware of these prior to the beginning of the project and make sure that they follow these steps so as not to lose their rights to the extension. If the methods are too strict, then negotiating adequate time to request for extensions is necessary.
Limitation of Liability Clause
When damages for delay are severe, a limitation of liability clause, which caps the total liability for damages the contractor may face, can help make them more palatable. The limitation should be clearly defined and generally based on a percentage of the total contract amount.
Damages Clauses Included in Subcontracts
Subcontractors generally have little control over the contract schedule and often are subject to downstream delays. GCs rarely set liquidated damages in their subcontracts; most often GCs have clauses allowing them to pass down damages to the subcontractor. How the damage is assessed is in the details of the subcontract and can be a large risk factor.
When looking through the subcontract, the subcontractor should ask itself the following:
- Are consequential damages waived in the subcontract and in the prime contract?
- Is the subcontractor limited to the amount of liquidated damages assessed against the GC, or is it actual damages?
- How are the portions passed to the subcontractor determined?
- Do losses need to be a direct result of the subcontractor’s work or can they be discretionary? For example, if a subcontractor’s truck is parked in the wrong spot and blocks the entrance for another subcontractor, is the subcontractor liable?
- Do damages have to be in proportion to the extent that the subcontractor is involved, or can they assess any amount of their damages based on any fault?
It is always important to review the prime contract if you are a subcontractor. The ability for your GC to fulfill the terms of the prime will directly affect your own success on the project. This is even more important when a subcontract passes terms of the prime contract downstream, making the terms a direct risk to the subcontractor.