It is almost impossible to plan for every eventuality that may occur during the course of a construction project. Projects often run over budget or programme, delays and disruptions occur, and/or political or labour issues transpire. Sometimes these events are brought about due to the fault of a particular party, but other times it is not possible to determine fault. The reality is, no company has unlimited resources (or unlimited insurance cover for that matter) to account for all eventualities in a project.
Commercially, the most effective way to manage risk and to limit a party's total exposure in respect of these unknowns, for both the Employer or the Contractor, is to place a limit on liability for certain types of losses that may result from these unknowns.
How is this done? Through the identification of the various types of losses that can occur in a construction project, as well as how best to limit liability in respect of those damages.
The basic principle of placing a limit on liability is a simple one: To allocate risk in a reasonable proportion to the benefits to be derived from the project so as to avoid unlimited and unproportioned financial exposure to the parties when something goes wrong.
So… what are losses requiring limitation?
Various types of incidents carry various risks of loss. Broadly, loss can be split into two camps: direct or indirect/indirect.
> Direct Loss is that which immediately flows as a natural consequence of a loss causing event. It is a primary loss which the parties are usually able to mitigating against because they are reasonably expected and contemplated in the minds of the parties. Such losses are recoverable because the link between the loss causing event, the defaulting party, and the loss itself, are usually quite clear.
What is the general rule to limitation of direct loss? No limitation is necessary because these types of losses are reasonably contemplated, and can be guarded against.
Examples of theses losses include:
- loss of profit, production, business
- the costs incurred to complete a project following a Contractor's default or wrongful abandonment from site
- the costs necessary to repair defective work
- costs bringing a project up to the contract specifications
> Indirect Loss (also known as consequential loss) is usually not recoverable because they are not reasonably contemplated by the parties. In the case where the party in default might have expected the relevant breach/loss causing event to produce a loss, taking into account its actual knowledge of special circumstances of the other party, these losses would be recoverable.
What is the general rule to limitation of indirect loss? Limit it! You don't know what might happen.
Examples of theses losses include:
- costs associated with the replacement of a Contractor on the project
- damage to either of the parties' brand
- higher debt costs because of either of the parties having to exceed their respective debt thresholds
- where the defaulting party is aware of special circumstances of the other party at the time of a breach
But why is loss of profit both a direct and an indirect loss?
Let's look at some examples.
- The Completion of construction of apartment blocks is delayed due to a Contractor error. The Employer is not able to rent out the units as anticipated, thereby resulting in a loss of rental income, and loss of profit.
- There is a delay in Completion of a factory resulting in the inability of the factory owner to conclude certain lucrative deals with regard to the items it intends to produce in its factory, this loss of business opportunity is also a loss of potential profit. This is not immediately determinable as being a direct loss, but rather, indirect to the Contractor's delay.
Number 1) is clearly direct loss. The link is clear and the consequence of a failure to fulfil its obligations in terms of the contract are reasonably anticipated by the Contractor. These losses would be recoverable in the normal course of the operation of the contract. Number 2), however, is not. The Contractor could not reasonably have anticipated or been expected to contemplate the business that the factory owner would purport to conclude during construction. This is clearly indirect loss. It would not be recoverable, unless the Contractor had knowledge of the Employer's special circumstances - i.e. that it wanted to conclude business during the construction phase which would be hindered by any delay in Completion.
So why is loss of profit direct and indirect? The answer is, well… it depends on the context.
So what's the big deal - I've got insurance?
Direct losses are the types of losses that are usually covered by insurance policies because they are foreseeable or, at least, reasonably foreseeable. They are also fairly easily quantified because the loss is, as its name suggests, direct and therefore relatively uncomplicated. Indirect loss, on the other hand, is a different beast. Its central characteristic is that it is intangible loss that is not easily quantifiable. Because of this, insurance cover for this type of loss is not often obtainable, and if it is, it is extremely expensive.
An inclusive approach to limitations clauses
Misunderstanding the difference between direct and indirect losses, particularly in the case of loss of profit claims, can lead to limitation of liability clauses that do not achieve their intended purpose. Typically, one of the parties wants to exclude liability for all loss of profit but the contract describes loss of profit as a species of indirect loss. What, then, happens to claims for direct loss of profit? It would, in that situation, still be recoverable. Courts have considered the interpretation of limitation clauses at length. It is best then, to avoid any potential for misunderstanding by adopting these four Rules:
Rule #1: Be CLEAR about what losses the parties what to limit.
Rule #2: Avoid the use of "OTHER" and "INCLUDING" - these have the effect of limiting the loss they refer to.
Rule #3: Use "INDIRECT" v "CONSEQUENTIAL". It is usually more widely understood commercially.
Rule #4: Make sure to guard against AMBIGUITY with the rest of the contract.
So why not avoid the uncertainty of indirect losses (and loss of profit, whether direct or indirect), by simply placing an overall cap on liability in respect of those types of loss? The answer is there is no reason why not.
Not only would this be a get of jail free card (through avoiding liability for potentially contemplated intangible losses in light of knowledge of special circumstances), but it is also a death nail to potentially exorbitant claims for losses by creating certainty as to which losses are recoverable from the other party, and which are not.