Beware of Consequential and Liquidated Damages

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Consequential damages and liquidated damages generate more conflict than almost any other issue in contract law. For starters, they are unpleasant subjects: they concern the cost of a broken agreement. It is common for parties not to want to address the unpleasant subjects during the honeymoon phase of a commercial relationship, and thus, parties often gloss over them. However, this often leads to an even more unpleasant surprise when the contract is breached, and the consequential or liquidated damages clause determines the remedy. Sometimes the remedy seems completely disproportionate to the harm caused by the breach. In more cases, the remedy was misunderstood by one of the parties at the beginning of the contract, yet is being imposed against it. In short, consequential and liquidated damages pose a risk. Similar to all contractual risks, contractors must understand it, must negotiate their best position (if the contract is negotiable), and must mitigate the risk with sound business management practices.

 

I. Background On Contract Damages

The purpose is to put the injured party in as good a position, as it would have been in, had the contract been properly performed by awarding it all costs that naturally and probably result from the breach. Michigan common law divides these costs into two categories: direct damages, which “naturally and ordinarily follow the breach” and consequential damages, which “ensue, not necessarily or ordinarily, but because of special circumstances.” Both direct and consequential damages are necessary to fully compensate it because the innocent party entered the contract with the intention of receiving the full benefit of its bargain,

This sounds simple enough, but the costs associated with the full benefit of the bargain are frequently difficult to foresee when the contract is first formed. The cost of the “full benefit” may also be too large, or more than one party wants to bear. To avoid uncertainty, and to respect the parties’ freedom to fashion their own business affairs, Michigan law allows parties to agree upon the consequence of a broken promise and determine the damages for a breached contract within the contract itself.

Thus, when the law holds the breaching party responsible for its failure to perform a contract by imposing a judgment for damages, the law will impose whatever costs are necessary to provide the innocent party with its side of the deal – whether that bargain is for liquidated damages, limited damages, or the “natural and ordinary” damages and “special circumstances” damages that flow from the breach.

 

II. What Are Consequential Damages?

Since the mid-1800s, courts in most states have used the concept of foreseeability to define the two types of damages and to limit what a party could claim as the benefit of its bargain. Direct damages have been defined as those that “flow according to common understanding as the natural and probable consequences of the… breach of contract itself.” These losses are considered the natural results of the breach because they accord “with the common experience of ordinary persons.” In other words, direct damages are what the parties would expect to result from a given breach.

On the other hand, consequential damages have been defined as “those that do not arise naturally or ordinarily from a breach of contract, but which arise because of the intervention of special circumstances.” They usually result from an event acting in conjunction with the breach. Consequential damages are still proximately caused by the breach, but, under general rules of contract law, are only recoverable if the special circumstances or the other event was foreseeable by the party in breach when it made the contract. In other words, consequential damages are a distant, yet foreseeable, cost of a broken contract.

Michigan uses these definitions and basic rules of recovery. In practice, however, unless the damages suffered by a party were unforeseen by the breaching party due to an unknown circumstance, were too speculative to be stated with certainty, or were excluded by the parties’ agreement, courts rarely label damages as direct or consequential in their written opinions. Most of the time, injured parties simply get awarded sums to cover their losses. However, the few cases in which courts have classified different costs resulting from breached construction and government-supply contracts provide useful guidelines to contractors seeking to manage project risk.

 

A. Delay and Its Resulting Damages

When a project is delayed, extended general conditions are commonly regarded as direct damages. For example, in Synsil Products Inc v Wayne Brothers, the parties’ contract contained a mutual waiver of consequential damages. The owner that delayed the project sought to dismiss the contractor’s claim for extended general conditions, arguing that such costs were barred by the waiver. The court disagreed and permitted the claim to go forward.

Similarly, an owner who had waived consequential damages was awarded extended financing costs but denied compensation for a higher interest rate in Roanoke Hospital Association v Doyle & Russell, Incorporated. The court explained that extended interest payments were direct damages, but the higher interest rates were consequential damages, and therefore subject to the waiver:

Ordinarily, delay in completion requires an extension of the term of construction financing. The interest costs incurred and the interest revenue lost during such an extended term are predictable results of delay and are, therefore, compensable direct damages. Increases in interest rates are not caused by delays in completion of construction contracts. Rather they are caused by variable pressures and counter-pressures affecting supply and demand in the money market. For that reason, increases in interest rates are ‘special circumstances.’

Material escalation costs are properly considered consequential damages. In Gardner Displays Company v United States, a military contractor, supplying latex maps, saw the price of latex soar during a period of government-caused delays. The parties’ contract did not contain a waiver of consequential damages, and the contractor sued to recover the increased cost. The court acknowledged that the contractor’s damages could be said to have been caused by the Korean War, which triggered the latex price inflation, instead of by the government’s delay. But the court concluded the cause of the material cost increases is not as important as their foreseeability. Because the parties foresaw material price increases, the soaring cost of latex was recoverable as consequential damages.

Finally, most courts agree that an owner’s lost profits resulting from a delay in the completion of its project are consequential damages. Because the owner’s ability to operate its completed project at a profit depends on other events in addition to its construction, such as its marketing plan, lost profits are properly considered a special circumstance of the owner. In fact, a judgment for $14.5 million against the contractor in Perini Corporation v Greate Bay Hotel & Casino, Inc. to compensate the owner for lost profits on a project that completed three months behind schedule is often said to have been the motivation behind writing a mutual waiver of consequential damages into the American Institute of Architect’s A201 general conditions, the most commonly used form in the construction industry.

 

B. Waivers of Consequential Damages

Today, most owner-issued construction contracts require the contractor to waive its consequential damages. However, the cases above illustrate the wide variety of costs that can be considered “consequential damages.” There is no set definition of them in any state’s case law. As one court wrote, “the precise demarcation between direct and consequential damages is a question of fact.” Because of this, stronger waiver clauses will include examples of the costs that are being released. For example, the Michigan Department of Transportation’s (“MDOT”) standard specification lists the contractor’s consequential damages among the unrecoverable costs in the event of a delay claim. MDOT’s waiver includes examples of the costs barred by the clause:

  • Unrecoverable Costs. The Contractor is not entitled to compensation for costs not specifically allowed or provided for in this subsection including, but not limited to, the following:
  • Consequential damages, including loss of bonding capacity, loss of bidding opportunities, insolvency, and the effects of force account work on other projects, or business interruption.

Contractors seeking to limit their exposure to subcontractors’ claims should include similar language in their subcontract forms.

Today most credit applications issued by material suppliers also include a waiver of consequential damages. However, these typically do not define the prohibited costs. This unfortunate trend has resulted in a tremendous volume of litigation over the scope of such waivers, with each case being decided on its unique facts. Parties buying and selling goods who agree to waive consequential damages would be wise to include examples of the costs that are subject to the waiver. More importantly, the parties should become aware of and understand the risks that they may be exposed to in the event the goods fail to meet contract requirements.

Finally, prime and subcontractors seeking to limit their exposure to an owner’s delay costs by negotiating a waiver of consequential damages should identify the costs that are being released. The waiver in the AIA A201 general conditions provides a good model, as it lists the owner’s loss of use and lost rent as damages that are subject to the waiver.

 

III. What Are Liquidated Damages?

Many construction contracts fix a specific amount of damages an owner may recover in the event the contractor fails to complete the project by the scheduled date. Such a provision is generally referred to as a liquidated damages clause because the clause liquidates, or makes certain, the damages the owner will recover for the delay. For example, the contract would stipulate an amount that the contractor would owe for each calendar day past the agreed upon completion date for which work remains incomplete. Parties might consider liquidated damages when the harm is difficult to estimate at the time of contracting.

Michigan law enforces these clauses. However, the liquidated figure must be a reasonable estimate of the actual damages the owner would sustain for the delay. Liquidated damages that exceed this estimate or that over-compensate the owner will be regarded as a penalty and will not be enforced. Contractors reviewing – or contesting – liquidated damages provisions should therefore examine the actual costs incurred by the owner before acquiescing to the assessment of them, as this inquiry may support an objection to the reasonableness of the amount. Similarly, the owner should be able to show how it derived the number at the time of contracting.

 

A. Public Works Projects

Of course, if liquidated damages must approximate the actual damages sustained by the owner for delay, one might ask how liquidated damages can be enforced on a public works project in those particular situations where the owner incurs no readily identifiable cost for a delay.

The Michigan Supreme Court addressed this back in 1901 in what has become one of the nation’s leading cases on the subject. In Whiting v Village of New Baltimore, the contractor failed to construct an electric railway through the village, which assessed liquidated damages. Even though the village incurred no monetary damages as a result of the contractor’s failure, the Court upheld the clause because of the inconvenience suffered by the public. The Court wrote:

It may be conceded that the city, in its corporate capacity, suffered no damages by failure to build the road; but the contract was made by the corporate officers for and in the interests of the inhabitants.

As a result of this case, a public owner need not incur a monetary loss before it can obtain an award of liquidated damages. Modern courts have used the Whiting case to conclude the governmental body is a trustee for it citizens. Liquidated damages provisions are the “only method by which the city can obtain anything like and adequate compensation for the loss and damage sustained by the public.” Indeed, part of MDOT’s liquidated damages provision almost repeats this verbatim, as it says a component of a project’s liquidated damages provision represents “the inconvenience to the public, maintenance of detours, and other items that have caused an expenditure of public funds due to the Contractor’s failure to open to traffic or complete the work within the contract time.”

 

CONCLUSION

Whether consequential damages and liquidated damages are good or bad depends on a party’s perspective. The law is, after all, a two-edged sword. Thus, when entering into a contract it is important to understand the project risks, to negotiate the best deal possible, and to manage the risks actively, acknowledging that the law will impose whatever costs are necessary to provide the innocent party with the full benefit of its bargain – whether that bargain is for liquidated damages, limited damages, or the direct and consequential damages that flow from a breach.

 

*This blog article is for informational purposes only.  It does not create an attorney-client relationship and is not intended to be regarded as legal advice.   

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