Are You Really Protected from Consequential Damages Exposure?

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.

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.