"What Performance Did the Parties Bargain For?"
January 2005
The California Supreme Court just issued its
opinion in a case of both interest and consternation to the surety industry
and the construction industry, alike. In Lewis Jorge
Construction Management, Inc. v Pomona Unified School District, Docket
No. S112624, the court ruled that a contractor cannot recover lost profits suffered
on unidentified future construction contracts as a result of impairment to its
bonding capacity, which, in turn, resulted from a project owner's wrongful default
termination of the contractor.
by Marilyn
Klinger
Sedgwick,
Detert, Moran & Arnold LLP
The facts of the case are standard. Lewis Jorge was a public works contractor
with a $10 million dollar per project bonding limit and an aggregate limit of
$30 million. It entered into a $6 million contract with the Pomona Unified School
District. Once the project became 6 months behind schedule, the District terminated
Lewis Jorge and demanded that the contractor's surety complete the project.
The surety responded affirmatively and arranged for a completion contractor
to complete the project.
Although not set forth in the opinion, that surety appears to have ceased
issuing surety bonds for Lewis Jorge. The court did note that, by mid-1997,
"the only sureties willing to provide Lewis Jorge with bonding imposed a limit
of $5 million per project, with an aggregate limit of $15 million…." In 1998,
Lewis Jorge ceased operations.
Lewis Jorge successfully sued the District for breach of contract, among
other theories, based on its assertion that the default termination was improper.
During trial, Lewis Jorge presented evidence of its lost profits from the District's
breach of contract, based on its profitability for the 4 years prior. Its lost
profits experts provided testimony that Lewis Jorge's gross revenues would have
been $95 million, that its average profit was 6 percent, such that its lost
profit was $4.5 million, reduced to present value of $3,148,107. The jury awarded
Lewis Jorge $362,671 on the contract breach and $3,148,197 for lost profits
resulting from "the loss or reduction of its bonding capacity."
Legal Analysis
In issuing its ruling, the court first noted the overall rule regarding contract
damages—such damages seek to approximate the agreed-upon performance and, therefore,
cannot exceed what the injured party would have received if the parties had
properly performed the contract. In that way, the parties are able to estimate,
in advance, the financial risk of the transaction.
Then the court considered whether lost profit damages arising from a diminution
or elimination of bonding capacity were recoverable under either of two types
of contract damages: (1) general (direct) damages or (2) special (consequential)
damages.
General (Direct) Damages
The court explained that general damages are those that flow directly and
necessarily from the breach of contract, that is, in the ordinary course would
likely result from the breach. Thus, general damages are those that were within
the contemplation of the parties because their occurrence was predictable. Put
another way, general damages provide the nonbreaching party with the benefit
of its bargain.
The lower court allowed the lost profit damages as general damages finding
that impaired bonding capacity for public works contractors has long been recognized
as a direct consequence of a public owner's breach of its contract. Therefore,
the District should have known that such would reduce Lewis Jorge's ability
to obtain bonds and, correspondingly, its ability to win construction contracts.
However, the court noted that, for general damages, the trial court should have
evaluated what performance the parties bargained for, noting that general damages
are based on the value of the performance itself, not the value of the consequence
of lack of performance. Thus, unearned profits directly flowing from the breached
contract are allowed general damages. Unearned profits flowing from the inability
to perform a collateral, derivative, or related contract to the one breached
have also been allowed.
As to damages in the form of lost profits on future unidentified construction
projects, the court noted that no court in California or outside of California,
for that matter, has allowed such damages against a breaching construction owner
except for one 30-year-old Montana action that has not been followed, even in
Montana.
The court distinguished Arntz Contracting Co. v St.
Paul Fire & Marine Ins. Co., 47 Cal App 4th 464, 489 (1996), which allowed
Arntz to recover lost future profits on unidentified construction contracts
against Arntz's former surety. It noted that, in that case, the contractor's
recovery of lost profits on future contracts was not based on the fact that
its bonding capacity was impaired but from the surety's reneging on its commitment
of future bonding. As the court stated with respect to Arntz:
- Because the contract was one for future bonding, it was entirely within
the contemplation of the surety that its breach of the contract—resulting
in the contractor's loss of actual bonding—would preclude the contractor
from bidding on and being awarded major projects.
In concluding that Lewis Jorge was not entitled to its lost future profits,
it concluded that Lewis Jorge was only entitled to full performance on the breached
contract, which included profit on that contract limited by the contract price
and the cost of performance. As the court put it, "What performance did the
parties bargain for?" "[W]e cannot say that the parties' bargain included Lewis
Jorge's potential profits on future construction projects it had not bid on
and been awarded."
Special (Consequential) Damages
The court noted that special or consequential damages do not arise directly
and inevitably from a breach of the contract. Rather, they are secondary and
derivative losses arising from the circumstances that are particular to the
contract or the parties. Accordingly, special damages can only be recovered
if the breaching party knew or should have known of those circumstances. Because
the breaching party knew or should have known of those circumstances, the resulting
damages meet the test of foreseeability—they were not unanticipated damages
or those beyond the expectation of the parties.
The court noted that Lewis Jorge did not establish that, when the contract
was formed, the District contemplated that a breach would lead to the impairment
of Lewis Jorge's bonding capacity and, thus, its ability to obtain future contracts.
The court noted that even Lewis Jorge's bonding agent believed the surety's
cutback was only temporary. The court noted that the trial evidence indicated
that the breach could or could not have impaired Lewis Jorge's bonding capacity.
The District testified that it did not know Lewis Jorge's financial status or
the criteria that its surety used to determine bonding credit. Accordingly,
an impairment in its bonding capacity or the profits that Lewis Jorge might
lose on potential future projects were not foreseen or reasonably foreseeable.
As an aside, the court acknowledged that there are a few courts that have
accepted the concept that a party may recover lost profits on unrelated future
contracts but, typically, in those cases, the courts did not actually award
those damages because they found them to be too speculative, conjectural, and
remote or because their occurrence was uncertain.
Conclusion
In conclusion, the court stated:
It is indisputable that the District's termination of the … contract was
the first event in a series of misfortunes that culminated in Lewis Jorge's
closing down its construction business. Such disastrous consequences, however,
are not the natural and necessary result of the breach of every construction
contract involving bonding. Therefore, lost profits are not general damages
here. Nor were they actually foreseen or foreseeable as reasonably probable
to result from the District's breach. Thus, they are not special damages in
this case.
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