Contract formation is usually a time of optimism. Whether the fledgling project involves parties who have enjoyed a fruitful relationship and past successes or one in which the parties are relative strangers, hoping for the best, contractors and design professionals sometimes view contracts as little more than a formal step necessary to secure the job.
With visions of a future ribbon-cutting ceremony celebrating a profitable project that finished ahead of schedule and under budget (where the happy owner shouts “let’s build five more together!”), contract review may be focused on establishing “When can we start?”, “What are the change provisions?” and “When and how do we get paid?” Understanding, let alone negotiating, contractual terms that allocate risk between the parties often takes a back seat or is overlooked altogether.
Three important types of risk allocation provisions that should be considered and evaluated at the contract formation stage are:
- waiver of consequential damages provisions;
- limitation of liability provisions; and
- indemnification provisions.
In the unenviable event of a dispute, such contractual terms move from the background spaces they occupied during happier times to the forefront, as they function to define the metes and bounds of each party’s liability and/or exposure. Of course, when considering the applicability and utility of these risk allocation mechanisms, it is critical to recognize jurisdictional nuances. What is enforceable in one state may not be enforceable in another. There may be specific language, or even a specific font size, that must be used to give a clause its desired effect. Accordingly, it is important to understand the law that will govern the contract when drafting, negotiating and interpreting these risk allocation provisions.
Waiver of Consequential Damages
Consider a situation in which an owner claims that a contractor breached its contract by defectively constructing the owner’s factory. The owner may claim that the contractor is responsible for the costs of repairing the defective construction, as those costs flow directly from the alleged breach. Now consider that the owner also claims that due to the construction defects, its factory could not operate for six months and seeks its lost profits for that period. The owner’s lost profits are consequential damages, in that that they do not arise directly from the breach, but rather from the consequences or results of the breach.
In addition to lost profits, other types of consequential damages include lost revenue, lost productivity, loss of financing and increased costs of operation. Consequential damages are often unpredictable (particular to the claimant’s business or industry) and may subject the party that is allegedly in breach to large exposure – far more than might have been foreseen at the time of contracting. Waivers of consequential damages serve to control the risk of such exposure by precluding them as an item of damages.
When negotiating a waiver of consequential damages provision in a construction contract, keep in mind the following:
- if consequential damages are not waived, a party can be sued for them;
- the provision should be conspicuous, clear and unambiguous;
- the terms and damages waived under the provision should be as well-defined as possible (some jurisdictions have defined what constitute consequential damages), but the provision should typically include a “catch-all” phrase; and
- beware of one-sided waivers. If the other contracting party includes or opposes a one-sided waiver, propose a mutual waiver.
Limitation of Liability
A limitation of liability provision caps the maximum amount of damages for which a party can be liable for any type of dispute, under any theory of recovery (tort, contract, statutory). Unlike a waiver of consequential damages, a limitation of liability provision is not limited as to the “type” of damages to be capped. The cap can be a fixed amount or a variable amount. For example, many such provisions include a cap using the compensation received by the party as the primary factor for determining the cap. Similar to a waiver of consequential damages provision, the purpose of a limitation of liability provision is to control a party’s exposure and “runaway” damages. However, it is important to recognize that the contractual limitation of liability only caps liability to another contracting party; it does not apply to other potential claimants or limit their damages.
Consider the following when negotiating a limitation of liability provision:
- the limitation of liability provision should be conspicuous, clear and unambiguous: if possible, have the other party initial the provision;
- if the provision is included on the form contract, leave the monetary cap blank as indicia of negotiation; and
- another way to control risk is to include a contractual limitation on the time within which a claim under the contract must be brought, in effect, shortening the “statute of limitations.”
Indemnification
The most common contractual method of allocating risk is to include an indemnification or “hold harmless” provision. The purpose of an indemnification provision is to shift the risk of loss from one party to another. These provisions typically include language that requires one party (the “indemnitor”) to pay for the damages incurred by another party (the “indemnitee”) arising from a negligent act or omission (the “duty to indemnify”). Often, such provisions also require the indemnitor to defend the indemnitee (pay for attorneys’ fees and other legal costs) from claims made against the indemnitee (the “duty to defend”). Some courts may refuse to find that a duty to defend is created by an indemnification provision, particularly where the provision does not expressly include the “defend” language.
Indemnification provisions can be placed into two general categories:
- fair and equitable; and
- onerous.
Fair and equitable indemnity provisions generally provide for mutual indemnity. In other words, the parties are responsible for their own negligence. If a claim arises, and it is determined that one party is 40 percent at fault and the other party is 60 percent at fault, each party will pay its respective percentage to satisfy the claim. In contrast, onerous indemnification provisions provide for unilateral indemnity for the negligence of the party to be indemnified, even if the claim arises from the negligence of that party. Under an onerous scheme, if a claim arises, and it is determined that the indemnitor is 10 percent at fault, and the indemnitee is 90 percent at fault, the indemnitor will be required to pay 100 percent of the claim despite its minimal relative fault. Thus, in order to fully appreciate risk and exposure, it is important to fully understand the indemnification obligations at play in the contract. Which party has an indemnification obligation and under what circumstances? Do the obligations include only a duty to indemnify or is there also a duty to defend?
Enforcement of the more onerous types of indemnification provisions can prove challenging, if not impossible. In many states, in order to have an enforceable agreement to indemnify for an indemnitee’s own negligence, the contract must contain a specific, clear and unequivocal provision protecting the indemnitee from liability caused by its own negligence. Generic language, like that which purports to require indemnification for “any and all liability” may not be enough. Further, in a growing trend, several jurisdictions have enacted “anti-indemnity” statutes, which prohibit, as a matter of public policy, contract clauses that attempt to provide indemnification for an indemnitee’s own negligence in certain types of contracts – especially contracts for construction and design, where negligent performance could have public safety implications.
When negotiating an indemnification provision:
- be mindful of indemnity clause enforcement issues and specific anti-indemnity statutes under the law that govern the contract;
- attempt mutuality – the parties are responsible only for their own negligence;
- avoid the obligation to defend, if possible;
- remember that the indemnification provision is only as enforceable/valuable as the assets and/or insurance of the indemnitor;
- if the contract includes a limitation of liability, tie indemnification obligations to the liability cap;
- tie indemnification obligations to “proven” or “adjudicated” acts of negligence (this defers the contractor’s indemnification obligation);
- limit who the construction company is required to indemnify and whose negligence it will indemnify against; and
- avoid agreeing to indemnify for the negligence of the party to be indemnified.
