Consequential Damages In Construction Contracts and Architects Agreements Part 1 - What Are Consequential Damages?

Posted on May 27, 2009 by Joshua Glazov
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big-money-bag.jpgWhy Talk About Consequential Damages?

Why talk about consequential damages? Because they're a big money and a chronic problem. They're an issue that affects the negotiation of every prime contract, subcontract, and architects agreement. And they're often a contentious issue in settlement negotiations, mediation, arbitration, and litigation. So this will be the first installment in a series on consequential damages.

Topics in this series will include:
  • Identifying consequential damages - what makes then different from direct damages

  • How consequential and direct damages are treated differently

  • Why consequential and direct damages are treated differently

  • Practical considerations to better your odds of getting consequential damages and lowering the odds you'll have to pay them
The toughest question: what are consequential damages? Put another way, what makes some damages consequential, and others not?

Two Types of Damages?

When it comes to breach of a contract, damages fall into one of two categories:
  • Direct damages (a/k/a general damages)

  • Consequential damages (a/k/a special damages)
How do you tell which category damages qualify for? It's tough. Many decisions written by many judges have tried to answer that question. The earliest, and most often cited, is the 1854 English case of Hadley v. Baxendale.

  1. Did you click the link to the Hadley case?

  2. Did you read it?

  3. Are you now more confident in your knowledge of how to identify consequential damages?

  4. Or are you at least as confounded as before you clicked that link and started reading?
If you answered yes to questions 1, 2, and 4, help is on the way.
Consequential damages confounded me until I stumbled across the Virginia Supreme Court's decision in Roanoke Hospital Association v. Doyle & Russell, Inc. This case does the best job I've seen at explaining how to categorize damages as either (a) direct or (b) consequential

Identifying Direct Damages

The judges in the Roanoke Hospital decision case said that direct damages are:
Damages that arise "naturally" or "ordinarily" from a breach of contract; they are damages which, in the ordinary course of human experience, can be expected to result from a breach.
Said another way, direct damages are the kinds of damages that ordinary people would expect one side (the "victim") to suffer if the other side (the "breacher") breaches the contract. Because every ordinary person should know that the victim will suffer these kinds pf damages, judges presume that ordinary people know that, regardless of whether they actually know it. Enough abstraction! Let's focus on the practical.

The Roanoke Hospital decision offers a decent example. In that decision the contractor finished a hospital late causing the owner all sorts of problems with their construction lender and their permanent lender. The owner claimed three types of interest rate related damages:
  • Extended interest on the owner's construction loan. Because the contractor completed the project late, the owner was late paying-off the construction loan. And because the owner was late paying off the construction loan, the construction lender charged the owner additional interest for each extra day the construction loan wasn't paid-off.

  • Higher interest on the owner's construction loan. Interest rates went higher between the scheduled completion date and the actual completion date. The owner's construction lender passed these increases on to the owner via the loan's adjustable interest rate.

  • Extra interest on the owner's permanent loan. The owner had a permanent loan commitment at a lower interest rate. But to get that loan at that rate, the project had to be completed by a deadline. The contractor didn't complete the project by the deadline, so the owner had to get a different permanent loan at a higher interest rate.
Much of the Roanoke Hospital decision focuses whether the owner's interest cost damages should be categorized as direct or consequential. The judges decided that extended interest costs on the construction loan are direct damages. They said:
We agree with the owner that the extended interest costs are direct damages. Customarily, construction contracts, particularly large contracts, require third-party financing. Ordinarily, delay in completion requires an extension of the term of construction financing. The interest costs incurred and the interest revenue lost during such an extended term are predictable results of the delay and are, therefore, direct damages
Because the judges thought that extended interest costs on the construction loan were predictable to an ordinary person, they decided those damages were direct. I devised a rule of thumb to help me identify direct damages: the Chinese Sign Test. The ordinary (non-Mandarin speaking) person doesn't need any special knowledge to know to do when they drive-up to this sign.....

Stop_Sign_China_2.jpgLikewise, they also don't need any special knowledge to predict direct damages that someone will suffer either.

Identifying Consequential Damages

The judges in the Roanoke Hospital decision said that consequential damages are:
Damages that arise from the intervention of "special circumstances" not ordinarily predictable.
Said another way, consequential damages are the kind of damages that the reasonable, ordinary, and prudent person wouldn't predict unless someone tells them that those damages are possible.

In the Roanoke Hospital decision, the judges decided:
  • Higher interest costs on the construction loan were consequential damages. They said:
    We agree with the contractor that the damages resulting from increased interest rates are consequential damages. Increases in interest rates are not caused by delays in completion of construction contracts. Rather, they are caused by variable pressures and counter-pressures affecting supply and demand in the money market. Although interest rates on short-term borrowings are characteristically more volatile than those on long-term borrowings, both are usually unpredictable. For that reason, increases in interest rates are "special circumstances", and damages resulting from those increases are consequential damages.

  • Extra interest costs on the permanent loan are consequential damages. The judges explained this using the same reasoning as they did above in deciding that higher construction loan interest costs were consequential damages.
The Roanoke Hospitaldecision is just one practical example. The judges' conclusion that frequent interest rate changes are unpredictable, making the second two types of damages consequential instead of direct, is questionable now. But this decision gives you a good idea of how judges focus on predictability when deciding whether damages should be considered direct or consequential. The second part of the Chinese sign test identifies consequential damages. Our ordinary, non-Mandarin speaking, person needs special knowledge to understand this sign......

Chinese Sign Best.jpg

Likewise, they'll need special knowledge to predict consequential damages too.

Ask Yourself A Final Question

When you're trying to decide whether damages are direct or consequential, ask yourself:
Are the damages more like the first Chinese sign or the second?
If you answer the first, then they're probably direct. If you answer the second, they're probably consequential. Would an ordinary person, in the position of the breacher at the time the entered into the contract, without any special or unusual knowledge (say from the victim themself about what's at stake), expect those damages to occur? If you answer yes, they're probably consequential damages.

In The Next Post

Now that you're better prepared to tell the difference between direct and consequential damages, in the next post we'll talk about why that difference is important.
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