Clifford Chance

The common law is well-known for its difficult relationship with liquidated damages ('LDs'), with its complicated set of rules which may be beloved by construction lawyers, but considered arcane by any other standards. In spite of this, parties to construction contracts have a deep and understandable attachment to LDs.

Caps on a contractor's liability are typically among the most hotly contested provisions in any construction contract. That heat is often generated by a flawed rationale which relies on the sometimes nebulous concept of 'market practice' to justify an insistence on a specific level of cap, rather than on weighing the value of the proposed cap, on a project specific basis, against (i) the 'value' of the worst case downside scenarios (e.g. do you need a 100% cap if a full rejection and contract price repayment remedy is neither required nor available?), (ii) the contractor's financial covenant - a 100% cap can be illusory on a very large project, and (iii) the various heads of loss and damage which are expressly carved out of the cap.

Cap carve-outs are arguably just as important a part of the overall package as the level of the underlying cap. Getting them right is likely to help developers, lenders and contractors alike reach swifter agreement on a balanced overall capping regime which protects all of their respective legitimate interests. Here are some potential carve-outs which merit consideration:

1. Liabilities to Third Parties

Employers and their projects are always exposed to potential liabilities to third parties, even where those liabilities are caused by the contractor. These might include (a) liability for death, injury or property damage to third parties arising in connection with the work, and/or (b) statutory fines and penalties, e.g. for environmental or H&S-related offences. These employer liabilities are usually backed-down to the contractor via indemnities.

To the extent that (a) the employer has no or little ability to control its level of exposure to such claims, and/or (b) injured third parties are equally entitled at law to seek to recover their losses from the contractor instead of/as well as from the employer, it is difficult to see objective justification for capping the contractor's exposure for the same liability where a third party routes its claim through the employer, but leaving it uncapped if the third party chooses to claim directly against the contractor.

Contractual liabilities to third parties (e.g. delay damages to a future occupier and/or a power purchaser) merit different treatment from these liabilities at law and it is less easy to justify carving them out of a well-sized overall cap.

2. The cost of carrying out the works

Contractors are typically obliged to carry out rework to rectify defective workmanship or design prior to completion / taking over (even if, dependent on the pricing structure, they sometimes get paid for doing do). This carve out seeks to prevent any potential arguments that pre-completion rework is a 'liability' which counts towards any overall liability cap.

3. Insurance recoveries

Construction/Erection All Risks insurance should cover reinstatement costs in full (subject to an excess or deductible) in the event of damage to the works during construction and is taken out for the benefit of all parties rather than to cover liabilities per se. To the extent CAR monies are available to the contractor (or would be but for the contractor's failure to insure, or its vitiation of the relevant policy), carving out insurance recoveries closes the door on arguments that the Contractor's obligation to reinstate is a 'liability' which is subject to the cap.

4. IP (intellectual property) infringement

The consequences of a project infringing third party IP can include damages, additional licensing fees, the costs of procuring alternative non-infringing parts, and/or even the cost of having to redesign and re-procure the project. The more proprietary the technology or the design, the greater the potential impact on a project of an infringement claim and it is common to see liability for third party IP infringement carved out of any overall cap as a result. In certain sectors where there is a lot of emerging technology, separate and higher capping arrangements are sometimes applied to IP-related liabilities.

5. Repayment of any advance payment

Is the advance payment part of the contract price or is it structured as a loan, with amortised repayments over the construction period? If the latter, there is objective justification for carving them out of an overall cap which is less than 100%.

6. Fraud, corrupt acts, wilful breach/misconduct

In most jurisdictions it is not possible to limit liability for fraud and in some jurisdictions it is not possible to exclude liability for gross negligence either. These are nonetheless relatively common express carve-outs, which of course add nothing if they cannot be limited as a matter of law in any event. Despite occasional conceptual arguments about the potential distinction between wilful breach and wilful misconduct, it is rare for contractors to object to these carve-outs (although there may be a requirement for the wilful act to be directed from a senior level of management). 

7. Liquidated Damages (LD)

The higher the overall cap, the more likely it will be acceptable for LD liability, which itself is usually sub-capped, to sit within the overall cap. The lower the overall cap, the greater the potential need to carve LDs out in order to ensure that the cap is available to cover downside scenarios.

8. Enforcement costs

Caps are not typically designed to cover the potentially significant costs of employers having to enforce their contractual remedies or, indeed, pursue claims on behalf of the contractor under other project agreements. Where a high cap is agreed however, it may be unnecessarily idealistic to insist on this carve-out.

A couple of final points – carve-outs are often agreed in terms of an overall cap 'not applying to them', but parties should also be clear whether the intention for each carve-out is that it 'accrues towards' the cap (i.e. the cap is only disapplied to the extent that liability in excess of it falls within one of the carve-outs) or whether carve-outs sit completely outside the capping regime. The latter is usually intended, but then not properly reflected in drafting.

On those project finance deals where lenders (re)finance pre-construction development costs as well as capex, even a 100% cap may not be sufficient to repay lenders in a total project failure scenario. In some markets, we have seen contractors agree to cap uplifts to enhance lender protections.

The vast majority of the carve-outs discussed above are also candidates for carving-out of any exclusion or waiver in respect of 'consequential or indirect' loss (a murky and sensitive topic which will need to be the subject of a separate post).