Delay Risks and Management Tools – A Framework for Drafting and Negotiating Liquidated Damages Clauses
Jeffrey R. Appelbaum
I. Introduction[1]
The role of a transactional construction lawyer, especially when representing the project owner, is to assist in creating a project framework that maximizes opportunities for success. This is not usually achieved by creating onerous or draconian contract provisions that unreasonably shift risk, thereby creating the need for other project stakeholders to respond in a counterproductive fashion. Rather, the goal is to develop an overall project approach whereby project assets and opportunities are maximized, and project risks are assessed and controlled as efficiently as possible.
On sophisticated projects, it is useful for the owner to create a project risk management matrix to catalogue and quantify the anticipated risks of construction and develop a comprehensive strategy to either abate risk (i.e., minimize the risk with corrective systems and processes), allocate risk (i.e., establish a fair sharing of risks and rewards among the owner, design professional and contractor), or transfer risk (i.e., place risk with the entity most capable of absorbing the risk).[2] While this process will address several types of potential risk, a critical concern on most commercial and institutional construction projects, and the focus of this paper, is the risk of delay.
The failure to achieve substantial completion by a required date can result in extraordinary financial loss and inconvenience to the owner and other stakeholders. For example, most professional sports facilities are scheduled to be substantially complete at least one month before a major “opening day” event.[3] Missing that date is unthinkable – the result is millions of dollars of lost revenue and extraordinary expense incurred in canceling, delaying or moving the opening day event to an alternate facility, not to mention embarrassment to the sports team and/or the facility operator.
Well-managed projects employ a wide range of tools to deal with the issue of project delay. Some of those tools are designed to avoid delay in the first place (which is normally the highest priority).[4] Even with the best project protocols in place, however, delays do occur and the employment of a prompt mitigation strategy to address resulting damages is often critical to project success. While it is important for the owner to establish appropriate methods for dealing with delays outside of the contractor’s[5] control, one of the chief concerns of the owner from a contractual perspective is to properly address delays, and resulting damages, that are within the contractor’s responsibility. This may be best achieved through implementation of an effective liquidated damages provision in the owner/contractor agreement.
This paper provides a suggested framework for crafting liquidated damage provisions that effectively allocate risk for contractor-caused delays, incentivize timely completion, and maximize opportunities for overall project success. To fully understand the role, and limitations, of liquidated damage provisions within a comprehensive risk mitigation scheme, it is helpful to first categorize the different types of delay and resulting damages that typically occur on a construction project, as discussed in Section II below. One can then proceed to consider remedies for delays that are within the scope of the owner’s responsibility, as discussed in Section III.A, and those that are the primary responsibility of the contractor, as discussed in Section III.B. Focusing on contractor-caused delays, the discussion then concentrates upon the art of negotiating and crafting effective liquidated damage provisions that appropriately manage the risk of loss to the owner.
II. Background: Delay Types, Causes and Consequences
Delays on construction projects happen for a variety of reasons. Some delays are caused by the parties involved in the design and construction process (i.e. the owner, contractors, or design professionals), while other delays are caused by outside forces. A party’s responsibility for delay is primarily based on that party’s ability to manage and control the specific delay event, since some parties are in a better position to control certain types of delays than others.
Delays can be generally categorized into three groups based on these principles:
· Compensable Delays: Delays that are within the control or responsibility of the owner are referred to as compensable delays. Examples of compensable delay “triggers” include owner-initiated changes, design errors or omissions,[6] and differing subsurface conditions. The owner is typically in the best position to manage and mitigate these types of risks, and the contractor is normally entitled to both an extension of time and financial compensation for compensable delays.[7]
· Excusable Delays: Delays that are not within the control or responsibility of either the contractor or owner are referred to as excusable delays. Examples of excusable delay “triggers” include unusual weather, industry-wide strikes, and events of force majeure. Since neither party is in a position to control these risks, the parties share in the costs associated with resulting delay. The traditional view is that the contractor is entitled to an extension of time but not compensation for excusable delay. However, sometimes the timely completion of the project is more important to the owner and an extension of time is not possible. If the owner is unable or unwilling to grant an extension of time for an excusable delay, then the contractor is forced to accelerate, and the cost of acceleration becomes compensable.
· Non-Excusable Delays: Delays that are within the control or responsibility of the contractor are referred to as non-excusable delays. Examples of this type of delay include delays resulting from defective work or improper sequencing or management of subcontractors. Since the contractor is in the best position to avoid or mitigate these types of risks (and is normally legally responsible to do so through express contractual provisions), the contractor is entitled to neither a time extension nor money on these occasions. To the contrary, if a non-excusable delay occurs, the contractor may have responsibility to compensate the owner for the damages that ensue.
Each type of delay can cause damages to the owner. However, as between the contractor and the owner, the primary issue is the damage resulting from non-excusable delays, which are exclusively the contractor’s responsibility. The types of delay damages the owner can recover from the contractor for non-excusable delay generally fall into two categories:
- Direct Damages: Direct damages are those that follow naturally and necessarily from the contractor’s breach,[8] and are reasonably foreseeable at the time of contracting. Examples of direct damages to an owner arising out of a contractor-caused delay can include the cost of temporary facilities, replacement contractors, or the cost of extended project administration, such as additional compensation paid to owner’s representatives or other consultants.
- Consequential Damages: Consequential damages are more attenuated. They are damages that flow from the consequences of the contractor’s actions, not from the contractor’s conduct itself.[9] Examples of consequential damages that an owner might incur include lost profits and rents, lost business opportunities, and adverse effects to reputation.[10]
The classification of damages as direct or consequential has significant implications. Direct damages usually require only proof of costs because causation is obvious or presumed. In order to recover consequential damages, however, an owner must specifically prove causation (i.e., that the damages resulted from the consequences of the contractor’s actions, and not from other intervening causes, like economic downturn or slow business) and foreseeability (i.e., that the consequences that caused the damage were contemplated by the parties at the time of contract).[11] In addition, some courts require only proof of direct damages based on a “reasonable estimate,” whereas consequential damages must be proved with “reasonable certainty.”[12]
In practice, it may be difficult to determine whether a certain type of damage will be viewed as direct or consequential by a court. Courts can reach different determinations even in the same opinion. For example, in Roanoke Hospital Ass’n v. Doyle & Russell, Inc.,[13] the court held that additional interest cost resulting from extension of the term of construction financing due to a contractor delay was a “direct” damage, but added interest cost due to a change in interest rates during the delay period was a “consequential” damage. According to the court, additional interest from extension of the loan term was a “predictable result” of the delay, whereas additional interest due to changes in interest rates during a delay period are caused by market factors and not the delay itself.
III. Delay Remedies and Risk Management Tools
Each type of delay can cause significant issues for the owner. Depending on the nature and cause of delay, the primary tools for addressing resulting loss (from the owner’s perspective) are insurance, contingency funds, and contractual risk allocation provisions, such as liquidated damages clauses (which are the focus of this paper).
A. Owner’s Risk or Risk Neutral Events – Insurance and Indemnity
Some risks for which the owner maintains primary responsibility and result in “excusable delay” are best covered through insurance. This is particularly true when the loss due to delay results from a “fortuitous event” (which may be insurable) as opposed to the purposeful act of the owner (which may not be insurable). An effective builder’s risk insurance policy will not only cover replacement cost that may result from a builder’s risk event (fire, flood, named storm, earthquake, etc.), but can also be crafted to cover the associated costs of resulting delays.[14]
For example, if a wind storm knocks down a masonry wall during construction, the builder’s risk policy will normally cover the direct replacement cost of the wall (i.e., labor and materials). It may be necessary for the masonry contractor to rebuild the wall on an overtime or second shift basis at substantial additional cost in order to maintain the project schedule. This cost should be covered by the builder’s risk policy if the owner has purchased “Expediting Expense” coverage. Expediting Expense coverage, however, is normally limited to the work of the directly affected contractor (in this example, the mason), and only applies for the time frame during which the work is replaced. If the project is still behind schedule after replacement of the masonry wall, and the impacted downstream subcontractors (such as the electrical or mechanical subcontractor) must proceed on an accelerated basis to complete the project on time, such acceleration expenses may also be covered if the builder’s risk policy includes an additional coverage typically known as “Contractors Extra Expense.” In the worst case scenario, the builder’s risk event is so severe that no amount of overtime or additional workforce can preserve the completion date, and the project completion is delayed, resulting in a large financial loss to the owner. This financial consequence can be addressed through the procurement of “Delay in Completion” coverage under the builder’s risk policy as well.
Other risks are that are initially the responsibility of the owner, as opposed to the contractor, may be assignable to other project participants, such as the architect, and the owner may recoup resulting delay costs from the other responsible parties.[15] For example, a common cause of compensable delay is design errors or omissions. For projects that employ a typical design-bid-build or construction management project delivery system, the architect or engineer is retained directly by the owner. The architect/engineer prepares plans and specifications which the owner, in turn, supplies to the contractor with an implied warranty as to their adequacy.[16] This allows the contractor to submit its best price in reliance upon the adequacy of the drawings, with the understanding that it will be paid for additional work that may be required as a result of errors or omissions in the plans and specifications, including any cost associated with delays resulting from such errors or omissions.
Although the owner is responsible to the contractor for errors or omissions in the drawings (as well as resulting costs and delay damages), it does not necessarily follow that the architect/engineer who prepared the drawings is, in turn, responsible to the owner. This is because the design professional does not warrant the adequacy of its work product to the owner, but only agrees to perform in accordance with the applicable "standard of care."[17] Thus, a "gap" arises between the owner's obligation to the contractor and the architect/engineer's obligation to the owner.
The resulting difference in responsibility, sometimes referred to as the Spearin Gap, is a frequent source of disputes. To the extent that errors or omissions are due to the design professional’s failure to meet the applicable “standard of care,” the resulting costs associated with project delay or acceleration may be recoverable from the design professional and should be covered by that professional’s professional liability insurance policy, or a separate professional liability insurance policy put in place by the owner.[18] To the extent the errors or omissions do not rise to the level of “professional negligence” (and thereby fall within the Spearin Gap), or are otherwise not subject to reimbursement by the design professional or professional liability insurance, then the risk resides with the owner, and it is incumbent upon a responsible owner to maintain an adequate financial contingency to deal with such issues.[19]
B. Contractor’s Risk – Consequential Damages and Liquidated Damages
A primary concern for the owner of a complex construction project is addressing the cost and other impacts of delayed completion caused by factors within the control or responsibility of the contractor. As described above, such delays are typically referred to as “non-excusable.” In the event of a non-excusable delay, significant issues arise as to the nature and extent of the financial responsibility that the contractor should bear to the owner, and how and when the resulting delay damages should be calculated and assessed. The most significant resulting costs are normally within the realm of “consequential damages,” which can be extraordinary in amount and difficult to predict with accuracy.
The contractor must take primary financial responsibility for such delays and resulting damages, as there is no insurance or other risk transfer vehicle available for the owner to address this peril, and it would be cost prohibitive for the owner to maintain a financial contingency capable of addressing such risk. On the other hand, the contractor will seek to limit its exposure, particularly to consequential damages, to avoid a disproportionate blow.