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November 26, 2004

NJPA Real Estate Journal: Owners should seek a limitation of liability for consequential damages

Whether liability for consequential damages should be waived or otherwise limited by an owner under a construction contract should be carefully considered during the negotiation process. The American Institute of Architects (AIA) documents clearly reflect the construction industry's efforts to minimize or eliminate a contractor's exposure to such damages, which may not ultimately be in the best interests of an owner. For example, Article 4.3.10 of AlA Document A201-1997 provides for the owner and contractor's mutual waiver of claims against one another for consequential damages arising out of the construction contract. This mutual waiver includes (i) "damages incurred by the Owner for rental expenses, for losses of use, income, profit, financing, business and reputation, and for loss of management or employee productivity or of the services of such persons" and (ii) "damages incurred by the Contractor for principal office expenses including the compensation of personnel stationed there, for losses of financing, business and reputation, and for loss of profit except anticipated profit arising directly from the Work" (AIA Document A201-1997, Article 4.3.10). While on its face, a mutual waiver may seem fair, in reality, the contractor will benefit more from such a provision than the owner.

From a contractor's perspective, protection against claims by an owner for consequential damages is paramount, since the very nature of this type of damage makes it virtually impossible to quantify in advance, and, therefore, difficult to adequately insure. Additionally, the "trade-off' by the contractor for gaining this protection (i.e., the contractor's waiver of claims for consequential damages against the owner) should have little if any impact on the contractor, since it is unlikely that a contractor will incur substantial consequential dam ages in the event of an owner's default. From the owner's perspective, however, preservation of the owner's rights to make claims against a contractor for consequential damages may be more justifiable, because potential liability for the owner's consequential damages (which would be substantial) may incentivize the contractor to exercise a greater degree of care.

Resolution of these potentially competing interests may require that each party to the construction contract accept some of the risk of liability for consequential damages. For example, the owner and contractor may agree in advance to a monetary limitation on recoveries for consequential damages by capping the total liability of each party at the agreed upon amount. This option may appeal to a contractor because it eliminates the guesswork in determining the contractor's potential exposure for this type of loss for insurance purposes. Alternatively, the owner and contractor could agree to mutually assume some of the risk of liability for consequential damages by carving out exceptions to the standard mutual waiver provision in the AIA documents to permit claims for consequential damages by a party that arise for instance out of the other party's gross negligence or willful misconduct. Additionally, an owner may be more comfortable accepting a mutual waiver of consequential damages provision, if the parties have provided for other types of remedies in the construction contract which address the owner's particular needs in connection with a project, such as a liquidated damage provision designed to compensate the owner for its losses if the contractor fails to complete the project on time.

While it may be difficult in an arms length transaction to convince a contractor to deviate from industry practice by accepting responsibility for consequential damages, an owner should not simply acquiesce, but should seek to protect its interests whenever necessary.

Reprinted from NJPA Real Estate Journal. 781-871-5298. 800-584-1062 . 781-871-5299 (fax) .