Critical Risk Mitigation Provisions for Design Contracts — Part 1: Waiver of Consequential Damages

An essential element of architect and engineer contracts with their clients is the treatment of risk sharing between the parties. Design professionals who are typically simply providing services for a fee, and who are not investors who will share in the profits of a successful project, can ill-afford to expose themselves to unlimited liability for negligent errors and omissions in the performance of their services. Architects and engineers would argue that it is fundamentally unfair to expose them to unlimited downside risk when they do not directly participate in the upside profit potential of the projects they design. Owners and developers would counter that this is why design professionals carry professional liability insurance. But even simple design errors can lead to liability that is many times greater than the amount of such insurance. For example, one simple design error on a multi-family project can be repeated by the total number of units in the project.

Such unlimited risk can be mitigated by contract. Two of the most important contractual risk mitigation tools are: (1) waivers of consequential damages and (2) limitation of liability (“LOFL”) provisions. In this first installment of this two-part series, we examine waiver of consequential damages provisions and the role they play in allocating risk in design contracts. Part 2 will address limitation of liability provisions and the key considerations in negotiating and drafting those clauses.

Waivers of Consequential Damages

Two types of damages may typically be asserted in litigation arising out of the negligent design or construction of a project. The first is direct damages, which flow directly from the breach of contract. Direct damages, in design or construction matters, typically include the costs incurred to correct the design or construction issue existing at the project and may also include additional costs incurred to complete the project.

The second is consequential damages, which arise from indirect losses flowing from the design error or errors involved. Consequential damages include items such as lost profits, loss of use, business interruption, and additional financing costs. Consequential damages are typically difficult to quantify and may also be difficult to anticipate at the outset of the project. It is not uncommon for consequential damages to exceed the overall value of the design contract or even the direct damages arising out of the claimed design defect. Consequential damages are typically recoverable unless their recovery is limited or excluded by contract.

Negotiating a waiver of consequential damages allows the parties to allocate risk in the event of a breach of contract. It is important to note that an owner’s insurance policy may not typically cover consequential damages. If a project owner is concerned about specific losses, the owner could obtain certain insurance, such as business interruption coverage. A discussion about which side will bear the risk allows each side to ensure adequate insurance is obtained, or that the contract price is adequately negotiated commensurate with the risk involved for the project.

Waiver provisions have become more common in construction contracts. Notably, the AIA form contract contains a mutual waiver provision. There is nothing atypical about requesting that a provision be included to allow the contracting parties to allocate risk under the contract, similar to indemnity provisions and limitation of liability provisions. A useful approach may be to suggest a mutual waiver of consequential damages, as such a provision is more likely to be accepted. If the other contracting party has already proposed a unilateral provision, meaning a provision that only extends the waiver to one party, a mutual provision extending the waiver to both contracting parties can be proposed.

In drafting a consequential damages provision, it is recommended that the term “consequential damages” contain sufficient specificity with respect to the damages included (i.e., lost profits, loss of use, etc.) to avoid any argument that the provision is ambiguous. Not only is a dispute over whether a provision or term is ambiguous potentially costly (i.e., with respect to attorney’s fees spent arguing the issue before the judge or arbitrator), it could lead to an interpretation of the provision that was not intended.

Care should also be taken to ensure that other provisions in the contract do not conflict with the waiver provision. For example, an indemnity clause could be broadly drafted to include the type of consequential damages that may also be intended to be subject to the waiver.

In Part 2 of this series, we will examine limitation of liability provisions, including common drafting approaches, enforceability considerations, and the practical balance between reasonable risk allocation and maintaining adequate remedies for project owners.