Limitations of Liability Provisions in Construction Contracts: A Means to Manage Risk and Limit Financial Exposure

Specific construction risks can be limited through an LOL clause—that’s limitation of liability.

Taking a cue from architects and engineers, construction contractors have started inserting limitation of liability clauses in their construction contracts to manage risk and limit financial exposure. This article will address the specific risks that can be limited through an LOL, tips for negotiating the LOL terms with reluctant owners to cover those specific risks, how to limit unintended consequences of an LOL (such as relieving an insurer of its obligations to cover certain losses), and approaches to setting the amount of the liability cap in the LOL.

Addressing Particular Risks

An LOL can address a wide range of risks, including:

Damages for delay
Liability for non-conforming or defective work
Liability for third-party bodily injury or property damage
Liability excluded by a general liability policy (e.g., pollution and cyber liability)
Liability related to intellectual property

Delay Damages

A mutual waiver of consequential damages is standard in construction contracts. This clause limits the contractor’s liability for, and the owner’s ability to recover for, owner’s lost rents, profits, etc. The risk of damages for delay is more frequently addressed through liquidated damages associated with late delivery. By establishing a liquidated amount, both owners and contractors can quantify and manage their risk. Any LOL clause in a contract that includes liquidated damages should expressly exclude liquidated damages from the LOL.

Damages for Non-Conforming or Defective Work

When defective or non-conforming work is discovered before acceptance, the owner can reject the work and, ultimately, terminate a contractor who does not correct the work. In that case, the LOL can be used to limit recovery against the contractor for costs of correction or even the cost to complete the work under the contract. Contractors should be prepared for owners to exclude liability for defective or non-conforming work or contractual liability for termination from an LOL.

After acceptance, the warranty is the primary method for addressing defective or non-conforming work. If an LOL is applied on top of a warranty, the contractor shields itself from liability beyond the LOL no matter how much damage defective work causes or how much it costs to correct.

Liability for Third-Party Bodily Injury/Property Damage

The standard approach in construction contracts is to place primary risk of liability for third-party property damage and bodily injury on contractors because they are in the best position to manage site safety and possess specific expertise required to mitigate these physical risks. Contractors are also in the best position to insure these risks. Including these risks within an LOL may protect a contractor from liability to the owner for the uninsured losses, but it will not protect the contractor from liability to third parties. It may also have the unintended consequence of relieving an insurer of its obligation to cover the owner for otherwise covered losses.

Because the contractor typically indemnifies (and agrees to defend) the owner for third-party bodily injury and property damage, and the contractor insures this obligation with its general liability policies, the indemnification obligation for third-party bodily injury and property damage is typically carved out of an LOL. A clause clarifying that the LOL is not intended to relieve the insurer of its obligations to provide coverage is also typical.

Liability Excluded From General Liability Policy

Some third-party liability is not covered by a standard general liability policy. Primary examples of this are the standard exclusions for pollution and cyber liability. A standard general liability policy excludes liability for “pollution,” which is defined broadly to include “smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste.” These are common risks from a contractor’s operations. Similarly, standard general liability policies exclude damages “arising out of the loss of, loss of use of, damage to, corruption of, inability to manipulate electronic data.”

As the proliferation of AI continues, and the construction industry embraces new technologies, the risk of bodily injury and property damage as a result of cyber attacks on operational technologies is increasing. For example, there was a notorious incident in 2008 in Lodz, Poland, in which a teenager hacked into the tram system and caused four trams to derail. As vehicle systems incorporate technology connected to the internet, they become vulnerable to cyber attacks that may result in injuries to third parties.

Attention should be given to such risks, and they should be consciously addressed through the contract. If an LOL is included, the best practice is for the contractor to insure those risks, indemnify the owner for those risks, and to carve out the indemnification from the LOL.

Intellectual Property Liability

It is common for suppliers of products to indemnify buyers against liability for third-party claims that the products infringe on intellectual property rights, such as patents, copyrights or trademarks. Such indemnifications are also common in construction contracts. When negotiating an LOL, care must be taken to apportion the risk of IP claims through negotiated carve-outs to the LOL clause.

Settling the Value of the Limitation

In many cases from other industries, particularly professional service contracts, the initial proposal for an LOL clause limits damages to the amount of fees paid under the contract. This is frequently rejected. Negotiations may result in some language tied to “available insurance” or “the limits of available insurance.” Many of these negotiated clauses are inherently ambiguous because they could be interpreted in multiple ways (e.g., to apply only to amounts actually paid by an insurer versus to apply to amounts that should be covered under a standard general liability policy).

Using insurance policies as a measure of the LOL creates a risk of disappointing the expectations of the parties because many variables could impact whether insurance actually covers the losses. For example, insurance policies may not pay claims because the limits have been exhausted in the payment of other claims unrelated to the contract or because the insurance policies are written on a non-standard form including unexpected exclusions impacting the amounts payable (e.g., exclusion for work at heights).

Given all of the variables that might come into play in securing insurance coverage, establishing a particular dollar amount as the LOL creates the most certainty for both parties. The limits of insurance required by the contract, however, can provide a useful measure to establish the value of the LOL.

When proposing an LOL, the contractor should focus on the particular risks it wants to limit and make certain that the LOL is drafted in such a way that it does not have unintended consequences with respect to insurance coverages and other obligations. Careful drafting of an LOL can limit a contractor’s exposure to many risks. While a sophisticated owner will not accept a blanket LOL with a small cap, a contractor can limit some financial exposure through a well-crafted LOL.

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