Mitigating Contract Risk: Damages

One of the most critical aspects to pay attention to in a construction contract is the issue of damages. While there are various types of damages that can impact a contractor, we will focus on the three most encountered in the industry, how to mitigate the risks associated with them, and potential ways to get your surety company comfortable with them.

Contractual damages refer to the financial compensation one party may owe the other in the event of a contract breach. The goal of these damages is to return the injured party to the position they were in before the breach occurred. Understanding the different types of damages is essential for managing the risks they present.

Types of Contractual Damages

Actual (Compensatory) Damages:

• General or Direct Damages: These compensate for direct losses resulting from a breach. For instance, if a contractor fails to complete work on time, these damages may cover the extra cost of hiring another contractor to finish the job.

• Special or Consequential Damages: These are for losses that are a consequence of the breach but are not directly caused by it. Examples of consequential damages include lost profits, loss of use, increased operating costs, damage to reputation, loss of future business, and additional financing costs.

  • Consequential Damages are viewed, by surety companies, as one of the riskier types of damages that contractors come across as they are difficult to measure and can be sizeable dependent upon each individual situation.

  • When consequential damages are present in your contract, there are 3 potential ways to help get your surety comfortable:

    • The best and most favorable option for your company is to fully negotiate these types of damages out of your contract.

    • The next best option would be to put a cap on the damages, so any potential loss if measurable.  A known risk is much better than an unknown risk.

    • If the owner is not agreeable to either of the above, modifying the contract to exclude these damages from the bond would be a last resort.

Liquidated Damages:

• Liquidated damages are pre-determined amounts stated in the contract to be paid if a breach occurs. The amount is meant to cover the expected harm caused by the breach and is commonly used in construction contracts to ensure timely project completion.

• Liquidated damages must be reasonable and enforceable if they represent a genuine pre-estimate of loss.

  • When liquidated damages are large in nature, your surety company will likely recommend that you try to negotiate a cap on the total LD’s to be paid out.

Punitive (Exemplary) Damages:

• These damages are designed to punish the breaching party and discourage future misconduct. While punitive damages are rarely awarded in contractual cases, they can be substantial when they do arise in construction-related cases.

  • Not commonly outlined in construction contracts.

Mitigating the risk of paying contractual damages involves both careful contract drafting and proactive risk management. Here are some strategies to help reduce the likelihood of encountering these damages:

1. Clear and Detailed Contracts:

   • Ensure the contract outlines expectations, deadlines, and responsibilities clearly for all parties involved. Specific terms (such as deliverables, timelines, and payment schedules) help reduce the chances of a breach.

   • Include liquidated damages clauses that clearly define the financial consequences of a breach. This can prevent disputes over damages if a breach occurs. Liquidated damages are seen as lower-risk by sureties since they are predefined. If the liquidated damages are excessive, as stated above, negotiate a cap on the total damages payable in case of delay.

   • Clearly define terms like “delay,” “force majeure,” or “breach,” and ensure both parties understand what constitutes a breach and what exceptions apply.

2. Risk Allocation:

   • Consider including provisions that allow for adjustments to the contract price or deadlines if unforeseen circumstances (such as material shortages or natural disasters) affect performance.

3. Performance Bonds, Subcontractor Default Insurance, and Insurance:

   • Performance bonds or subcontractor default insurance can help mitigate the risk of non-performance. These tools can provide compensation to complete work if a subcontractor fails to perform.

   • Ensure that all contractors, suppliers, and other key parties have adequate insurance coverage. Specify coverage limits and requirements for subcontractors and vendors and verify that the necessary insurance is in place with certificates of insurance.

4. Dispute Resolution Clauses:

   • Include dispute resolution clauses that encourage mediation or arbitration over litigation. This can help resolve issues faster and more affordably, reducing the potential for costly damages.

   • Be aware of the jurisdiction listed in the contract, as it determines which legal system will resolve the dispute. Some jurisdictions may be more favorable to plaintiffs or defendants, which can influence the damages awarded.

   • Consider an escalation clause that establishes a step-by-step process for resolving conflicts, starting with negotiation, moving to mediation, and then arbitration if needed.

5. Force Majeure Clauses:

   • A force majeure clause protects the parties from liability for non-performance due to extraordinary events outside their control (such as natural disasters or pandemics).

   • Ensure the clause is comprehensive and includes a wide range of potential events that could cause delays or prevent performance.

   • If possible, negotiate weather days into the contract to cover delays not included under the force majeure clause.

6. Regular Communication and Monitoring:

   • Regular monitoring of performance is essential for identifying potential issues early. Keeping stakeholders updated on timelines, risks, and unforeseen problems can help reduce the risk of a breach.

   • If there’s a possibility of delays (such as with materials or labor), address the concern early to avoid it escalating into a breach.

7. Termination Clauses:

   • Clearly define what circumstances allow for contract termination and outline the procedures for doing so. This can help manage damages by addressing performance issues before they become full-blown breaches.

8. Subcontractor and Vendor Management:

   • Ensure that subcontractors and third-party vendors are held accountable through contracts that require timely delivery and quality work. If a subcontractor fails to meet obligations, the primary contractor may be liable.

   • Prequalify subcontractors to ensure they are financially stable and capable of completing the work. This can be done through internal risk management or by using third-party prequalification services.

Contractual damages can pose a significant financial risk if not managed properly. By taking a proactive approach to contract drafting, risk allocation, securing appropriate insurance, and implementing effective dispute resolution processes, companies can reduce the likelihood of suffering financial losses from a breach and ease any concerns their surety may have. Maintaining open communication with all parties involved is also crucial to avoid misunderstandings that could lead to costly legal disputes. Your surety agent can serve as a valuable resource in reviewing contracts and helping you minimize risk exposure.