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Essential risk shifting provisions in construction documents

Shifting or limiting certain risks in construction contracts is nothing new. Owners and contractors have sought to incorporate contract protections that best suit their respective interests. Risk shifting is even more important today because project funding is often limited and owners seek to stretch dollars by imposing additional risks on design professionals and contractors. Parties should consider incorporating certain key provisions into their construction or design related contracts to reduce their potential risk exposures. Such provisions include (1) indemnity obligations, (2) limitations of liability, and (3) waivers of consequential damages. While there is a well-recognized list of other issues that should be addressed in such contracts, these three provisions are addressed below. These provisions are of even greater importance for the engineering, procurement, construction (EPC) or design-build contractors since they assume risks of design, construction, and often construction management.

Indemnity

Indemnity provisions can be total or partial in their application. The provisions require parties to make good the losses or damages of others. Such provisions can effectively reduce or shift a party's construction risks and legal exposure depending upon whether the provisions are total or partial. Although some states disfavor indemnity provisions, the "anti-indemnity" limitations are typically applicable to sole negligence, active negligence, willful misconduct, and fraud and deceit. Indemnity provisions should state conspicuously the indemnification scope, such as stating whether the indemnity is for "claims" or "losses." Even when unclear or ambiguous, courts will construe and enforce indemnity provisions like any other contract provision, typically against the drafter. In some cases, courts have found that indemnity provisions imply a duty to defend immediately upon demand whether or not the indemnitor was negligent. In others, anti-indemnity statutes have voided contractually mandated "additional insured" status. (See ACCL Journal, Vol. 8, No. 2, for a recent comprehensive anti-indemnity statutes overview.) Indemnity provisions coupled with express defense obligations are often construed as separate obligations, but the defense obligation may be subject to the same limitations as indemnity.

When utilizing indemnity provisions to allocate risk, owners, developers, design professionals, construction managers, contractors, and subcontractors should consider the potential consequences and purpose of the indemnity obligation. Successful enforcement of indemnity provisions against owners, design professionals, and contractors on small and large construction disputes has significantly affected dispute outcomes - in some cases, resulting in a multi-million dollar award in damages, fees, and costs. Thus, the importance of express contractual indemnity provisions, although often overlooked, should not be underestimated.

Limitation of Liability

Limitation of liability (LOL) provisions should be distinguished from exculpation clauses. "Exculpation" clauses relieve or exempt entirely the indemnitee from any responsibility (including willful misconduct) that many jurisdictions (including California, Civ. Code § 1668) deem unenforceable as being against public policy. LOLs, however, that do not attempt to provide a complete bar to liability are enforceable as "negotiated" risk limitation provisions. (See, e.g., Markborough Cal., Inc. v. Superior Court (1991) 227 Cal.App.3d 705.)

LOLs may limit monetary damages, the duty / standard of care, or may be tied to liquidated damages for schedule delays or performance guaranties. Monetary limits may be tied to amounts not exceeding contract fees, available insurance, or some other pre-set monetary limit. Duty or standard of care LOLs typically require a showing greater than ordinary negligence or a failure to meet the standard of care such as gross negligence. LOLs that exempt a party's fraud, willful injury, or gross negligence are not enforceable in many jurisdictions. Another consideration is the "flow-down" LOL for subcontractors, subconsultants, or suppliers. The LOL cap on a primary contract liability may be significantly larger than the LOL cap on the next-tiered agreement, leaving the prime contracting party potentially liable for the sub-tiered party's errors exceeding that LOL cap.

LOLs should be consistent with the potential risk: the greater the risk, the greater the LOL protection necessary to avoid the "bet the company" liability exposure.

Consequential Damages Waiver

Consequential damages are indirect damages that do not flow directly from, but are a consequence of, a party's breach. To recover consequential damages, the damages must be reasonably foreseeable at the time of contracting, and typically include lost property value or rent, lost revenues and anticipated profits from future operations, interest, and may include finance charges, depreciation, lost bonding capacity and additional energy costs, among others. Failing to include a consequential damages waiver could potentially expose a party to significant risk. In many cases, the exposure can be significantly greater than the fees earned or the direct damages incurred, and may also result in "bet the company" litigation.

Consequential damages waivers can greatly limit a party's liability. Parties should consider their bargaining power and position and tolerance of risk when considering whether to include such a provision. Because there is an inherent risk of breach by any party to a contract, consequential damages can flow both ways. Therefore, the inclusion and scope of a consequential damages waiver provision should be considered on a project-specific basis. As a general rule, however, for contractors or designers, consequential damages risks often significantly outweigh the benefits of any individual contract, particularly when the delay or non-performance may involve liability in the hundreds of millions of dollars.

When adding a consequential damages waiver provision, incorporate a broad consequential damages definition; do not leave the definition to the court or trier-of-fact. Parties should also consider the interplay of consequential damages waivers with indemnity provisions and other limitations of liability that could create ambiguities resulting in one provision circumventing another. To coordinate the risk limiting provisions, best practice suggests including a provision that expressly provides that all limits of liability, indemnities, waivers of consequential damages, and other risk limiting provisions constitute the parties' negotiated liabilities limitations, whether for contract, tort, or other claims.

H James Wulfsberg, Stephen L Cali, and David J Hyndman are part of the new Construction Law practice group at Burke, Williams & Sorensen, LLP, and are located in Oakland, California. They can be reached at 510-273-8780.