Are You Really Protected from Consequential Damages Exposure?
November 2005
One of the liabilities that contractors fear
most is an owner's claim for consequential damages. These damages can be substantial,
and may include not only costs like lost profits and revenue, but also costs
incurred by the owner to third parties as a result of the deficiencies of the
contractor.
by Michael
Loulakis
Wickwire Gavin,
P.C.
Most contracts contain provisions whereby both parties mutually agree to
waive consequential damages, since the commercial benefits of a deal do not
justify the risk of having a problem with performance. However, this is not
always the case, as is demonstrated by a recent Fifth Circuit Court of Appeals
decision, Action Industries, Inc. v. U.S. Fid. & Guar.
Co., 358 F.3d 337 (5th Cir. 2004).
Action Industries involved an appeal from
a district court’s order enforcing an arbitration award against a design-builder
of a conveyor system that failed to achieve contractually agreed on production
rates. The Fifth Circuit concluded that the arbitrators did not abuse their
power by awarding consequential damages to the owner, since the warranty clause
did not expressly waive consequential damages caused by defective design.
Action Industries, Inc., and Engineered Handling Systems, Inc. (EHS), entered
a contract whereby EHS was to design, build, and install a conveyor system for
Action’s furniture manufacturing and distribution facility in Mississippi. This
contract specified that the conveyor would accommodate a production rate of
11 units per minute. The finished conveyor ultimately only achieved 47 percent
of this specified rate, causing Action to incur substantial labor and maintenance
costs.
Action filed an arbitration demand alleging that EHS was liable for negligent
design and for breaches of express and implied warranties. When the arbitration
panel awarded Action over $1 million, Action quickly filed a lawsuit in Mississippi
state court to confirm the arbitration award. A few days later, EHS sued Action
in a Tennessee state court to vacate the arbitration award. Both lawsuits were
eventually removed to federal court. The Mississippi federal court confirmed
the arbitration award and EHS appealed to the Fifth Circuit Court of Appeals,
arguing, among other things, that the arbitrators exceeded their authority by
awarding consequential damages, since the warranty clause in the contract waived
consequential damages.
The Fifth Circuit rejected this argument, concluding that EHS was reading
the limitation of consequential damages far too narrowly:
- The warranty provision merely provided that "in no event shall [EHS]
be liable for any compensatory or consequential damage in connection with
the installation, use or failure of the equipment." The consequential damages
award did not derive from the installation, use or failure of the conveyor,
but rather from its defective design. The warranty clause is notably silent
whether such damages are prohibited.
The Fifth Circuit agreed with the district court that the conveyor’s failure
to accommodate the required production rate could be attributed to faulty design,
and that the arbitrators had the ability to award damages on this basis. The
court also noted that, at most, "the warranty provision creates an ambiguity
as to whether the panel may award consequential damages for design defects."
EHS drafted the contract, and ambiguous contract language is to be construed
against the party who drafted the language.
- If EHS had actually intended to prohibit all consequential damages,
it should have simply drafted a blanket prohibition of such damages. Instead,
EHS drafted a warranty provision which prohibited only certain types of
consequential damages.
As a result, the award against EHS was confirmed.
Action Industries contains a classic performance
specification: produce X number of widgets in Y number of hours. The failure
of EHS (the design-builder) to meet this production left it exposed to a breach
of contract claim in the arbitration. While this type of exposure is inherent
in a design-build relationship, liability for consequential damages is not.
EHS did a poor job of negotiating the warranty clause, and never should have
allowed the consequential damages waiver to be as muddled as it was. It would
not have been difficult to express clearly that there was a full waiver of consequential
damages for anything arising out of or related to the contract.
Readers should note that Action Industries gives us a somewhat unique opportunity to evaluate how arbitrators think. Action
presented two alternative claims to the panel, one of which sought the cost
of a properly designed conveyor (approximately $5.5 million), with the other
seeking a refund of the purchase price paid to EHS for the improperly designed
conveyor (approximately $1.3 million). The award in favor of Action was based
precisely on the second theory, after giving EHS credit for some extra work.
EHS actually dodged the bullet, since the arbitration panel could have justified
an award for the properly designed conveyor, as well as other costs claimed
by Action for maintaining and operating the defective conveyor (which were almost
$3 million). As a side note, ask yourself why the refund of money was considered
a consequential damage—it certainly seemed like a direct cost for a design-build
"wrap" that went bad.
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