Negotiating Dispute Clauses That Affect Damage Recovery in Arbitration

Author: Charles M. Sink

July 01, 2002

The Construction Lawyer, Volume 22, Number 3, Summer 2002
by Charles M. Sink

The standard arbitration clause found in a construction contract normally does not specifically address or limit damages that the arbitrators may award. A typical clause might state as follows:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration administered by the American Arbitration Association in accordance with its Construction Industry Rules. Judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof.

In larger complex projects, where there is significant risk and a potential for disputes involving substantial damages, the parties may want to negotiate contract clauses specifying or limiting the award of damages in the event of a dispute. Where an arbitration clause is included in the contract, there is a perception that arbitrators sometimes ignore or read these provisions out of the contract when determining their damage award. Further complicating the matter, courts are unlikely to overturn the arbitrators' award for simple errors of law.

A solution to this problem is to include, in the arbitration clause itself, provisions specifying and limiting the damages that can be awarded by the arbitrators. The arbitrators are more likely to follow such instructions, and the courts are more likely to conclude that the arbitrators have exceeded their authority if they ignore these provisions. This article will discuss such clauses and provide practical advice for drafting and negotiating the provisions.

Consequential Damages
The construction lawyer may wish to limit an award of consequential losses, particularly if the client is providing design services, labor, material, or equipment. Such a limitation would be consistent with a recent trend that includes the controversial mutual waiver of consequential damages in the 1997 edition of the A 201 General Conditions promulgated by the American Institute of Architects and supported by the Associated General Contractors¹. The basic language for such a waiver might state: "The arbitrators shall have no authority to directly or indirectly award any form of consequential damages, as such damages have been waived by the parties to this contract."

Project owners may want to expand the clause by adding the following language defining consequential damages:

Such prohibited damages include, but are not limited to, lost profits; home office overhead, or any form of overhead not directly incurred at the project site; wage or salary increases; ripple or delay damages; loss of productivity; increased cost of funds for the project; extended capital costs; lost opportunity to work on other projects; inflation costs of labor, material, or equipment; non-availability of labor, material, or equipment due to delays; increased cost of bonding due to delay; or any other indirect loss arising from the conduct of the parties to this contract.

Similarly, the contractor or design professional might attempt to negotiate the following supplemental language:

Such prohibited damages include, but are not limited to, lost rent or revenue; rental payments for temporary offices; increased costs of administration or supervision; costs or delays suffered by others unable to commence work or provide services as previously scheduled, for which a party to this contract may be liable; increased costs of borrowing funds devoted to the project; delays in selling all or part of the project upon completion; termination of agreements to lease or buy all or part of the project, whether or not suffered before completion of services or work; forfeited bonds, deposits, or other monetary costs or penalties due to delay of the project; increased taxes (federal, state, local, or international) due to delay or recharacterization of the project; lost tax credits or deductions due to delay; impairment of security; or any other indirect loss arising from the conduct of the parties to this contract.

The rationale for including such a detailed list of excluded damages is that many arbitrators may consciously or unconsciously resist the notion that their powers are circumscribed. There is nothing like a compendium of prohibited damages in the arbitration clause to ensure that the negotiated limitations are understood and respected. Also, there is no universal definition of consequential damages. Therefore, it behooves the drafter to limit potential ambiguity, especially as to the scope of waived damages.

Conversely, a party who is much more confident in its own ability to perform the contract than in the ability of the other side may wish to affirm that "the arbitrators are authorized to award any and all forms of indirect or consequential damages."

Proof of Home Office Overhead Damages
Construction lawyers are familiar with the problems of relying on certain controversial forms of proving delay costs and consequential damages. One particularly notorious battlefield is the allocation of home office overhead, particularly the use of the so-called Eichleay formula and its many variations. Anticipating disputes in this area, a contractor's lawyer drafting dispute provisions should be willing to delineate the forms of overhead computation to be considered by an arbitration panel. Likewise, the lawyer for an owner doubtless would prefer to specify exactly which overhead costs are recoverable and may wish to foreclose consideration of certain damage formulations.

Because there are so many possible formulations and limitations on overhead calculations, it is beyond the scope of this article to provide more than a few basic options. Counsel wishing to expressly limit or to permit recovery of certain overhead costs should consult with their favorite forensic accountant or perhaps their client's accounting department. One simple approach is:

Compensable home office overhead and general and administrative expenses, apart from job site supervision, shall be awarded solely on the basis of applying the rate of ___% to any award of direct costs for increased labor, materials, or equipment. The arbitrators shall have no authority to award any other amount for home office overhead or G&A costs.

This sample sacrifices accuracy and flexibility in achieving greater ease and certainty in determining the allowable and allocable home office overhead. Allocable home office overhead seldom is a mathematical function of the dollar value of work. Nevertheless, in the long run such percentage formulae are simple to apply and may tend to even out certain inequities in change order pricing. Use of a percentage markup on direct costs is common in the industry.

Another approach might be to specify a daily home office rate, possibly combined with a daily site overhead rate. A clause incorporating such a formula might be:

The arbitrators shall award damages for increased home office overhead [and site overhead?] solely on the basis of $__________ per calendar day of compensable delay. The arbitrators shall have no authority to award any other amount for home office [or site] overhead costs associated with delay [or a percentage markup or other allocation of home office [or site] overhead when there is no delay.]

This fixed estimated cost per day of delay parallels liquidated damage calculations, and it may be unenforceable unless it is a good-faith approximation of anticipated real costs.

A more "pro-contractor" clause might provide: "Recoverable damages include increased home office overhead as measured by the Eichleay formula, or any other basis of calculation accepted in published federal or state decisions."

While this language may seem to open the proverbial floodgates to damage recovery, it does not foreclose any party from disputing which approach is the better measure of increased costs in each particular case, and it does not require the arbitrators to favor one approach over another. It instead provides flexibility to select any recognized formulation and to overcome the somewhat shopworn debate over whether Eichleay and other computations are authorized in a particular jurisdiction. Consistent with arbitration's emphasis on innovation and reaching a fair (rather than technical) result, empowering the arbitrators to weigh alternative analytical tools appears to make sense.

Profit
Defense-minded counsel sometimes display an aversion to allowing any profit return to contractors or other claimants who perform changed work or suffer from compensable delays. They may promote language like the following:

The arbitrators shall not award any profit computed on any damages, beyond claims for extra work or unpaid work under the contract provisions. No profit shall be awarded on any claims of disruption, interference, or delay, whether or not part of claimed extra work.

The following alternative may be acceptable because it is similar to many standard clauses governing compensation for extra work:

The arbitrators shall award profit [and overhead for both job site and home office?] by applying the rate of ___% to the direct costs of extra work compensated under the contract, but shall make no other award for any form of profit [or overhead].

Interest
Surprisingly often, little attention is paid to specifying if and when interest is due, the method of computing interest, and the restrictions on interest that may be appropriate under an arbitration clause. This is peculiar given the long delays often encountered on construction projects.

In choosing among the many alternative approaches to awarding interest, counsel may wish to consider at least some of the following: "No pre-award interest may be provided by the arbitrators, absent an express finding that the party against whom an award is made acted in bad faith." This somewhat unusual approach may be challenged as a de facto "no damage for delay" clause, but it perhaps may have a greater chance of enforcement. It of course would need to be coordinated with any statutory or contractual duty to pay interest on late progress payments, and it might be attacked as encouraging delay by a party wishing to take advantage of the time value of money.

A less extreme clause might provide: "Interest at ___% simple annual rate shall be added to any award of sums for which only liability, but not amount, was disputed." This offers less incentive for unwarranted delay, but it still provides an incentive for late payment when a payment amount is in dispute.

Of course, the simplest (and most generous) approach is to allow interest both on "liquidated" and "unliquidated" claims, along the following lines: "Simple annual interest at the rate of ___% shall be added to each element of awarded damage from the date of the [claim; performance of the work in question; invoice, architect's decision, etc.]."

Specifying the point in time when pre-award interest begins to accrue can be very helpful in clarifying the powers of the arbitrator. By injecting both certainty and an incentive for prompt payment, it is likely to promote prompt settlement of disputes when they arise. For example, it seems appropriate to measure interest from the date of an unpaid invoice if its amount is later awarded. On the other hand, some other items of damage may not be quantified until a claim (or even a verified claim) is presented. Measuring interest from the date a claim is rejected by an owner (or architect) provides some certainty, but it also could reward delay in claim processing. One possible solution is to provide that interest accrues on change orders, invoices, and midproject claims from the time(s) they are presented in writing, but that unliquidated indirect damages or consequential losses will accrue interest only from the date of award. It might not hurt to specify further that, if the amount of a claim item is increased at any time, interest shall be awardable only from the date the new sum is claimed (providing an incentive to prevent "damage creep").

As discussed below, settlement may be encouraged by conditioning an award of fees and costs on achieving a result better than the opposing party's previous recorded position(s). To ensure that the final award is compared on an "apples to apples" basis with previous offers, the following language may be considered:

Allowable interest shall [or shall not] be added to the principal award amount before comparing with another party's prior settlement offers for purposes of determining a possible award of attorneys' fees and costs, and/or the expenses of arbitration.

Clarity in this area can help guide the arbitrators in their award and may eliminate a possible source of misunderstanding or misevaluation in settlement talks.

Interim Relief
A general provision for interim relief or partial awards may be helpful in clarifying arbitrator authority and the available recourse to interim judicial relief. One clause that might promote ultimate recovery of damage awards could be:

At the request of either party, the arbitrators shall take such interim measures or shall make such provisional orders as they deem necessary concerning the subject of the dispute. Any provisional remedy (including injunction or specific performance) that would be available from a court of law or equity shall be available from the arbitrators pending completion of the arbitration. Such measures, orders, or relief may include, but are not limited to, steps to preserve assets, set aside funds, provide security, maintain or protect material or equipment on or off the site, turn over or conserve plans, manuals, CAD files, spare parts or other things necessary for the completion of the project or its reasonable operation, or to avoid unreasonable damage or delay to the work. The benefited party of such provisional remedy or injunctive relief shall be entitled to enforce such remedy immediately in a court of competent jurisdiction, although a final arbitration award has not yet been rendered.

Such clauses might be used to prevent economic waste or protect the purpose of the construction agreement.

In some circumstances, it also may be appropriate to authorize collateral: "The arbitrators may require parties to deposit reasonable security for the expected costs of such pre-award interim remedies as any party may seek from another party."

While the use of interim relief should not be treated as incompatible with intent to arbitrate, this doubt may be addressed with specific contract language.

A request for interim measures, relief, or orders by a party to a court of competent jurisdiction shall not be deemed incompatible with the agreement to arbitrate, nor shall it be deemed a waiver of any right to enforce such an agreement. This clause applies to the filing of any stop payment notice, mechanic's lien, payment bond claim, bankruptcy claim, temporary restraining order, preliminary or final injunction, and any other similar form of relief.

To clarify the scope of interim remedies, counsel may wish to consider language as follows:

Any such measure, relief, or order shall be without prejudice to the final determination of the controversy by the arbitrators. At the request of either party, the arbitrators shall state whether the award encompasses the claims or rights subject to such interim measures, relief, or orders.

Counterclaims and Offsets
Often the parties may prefer an award that either segregates claims from counterclaims or requires only a net award. Neither approach is "correct," but each version serves a purpose. For instance, a design professional may reasonably anticipate a counterclaim for unpaid fees if it has to defend a claim for malpractice. Such a designer would normally want to segregate its fee recovery from an offsetting malpractice award, so that the architect's errors and omissions carrier could pay the full malpractice damages without any offset for professional fees.

When an owner claims both insured and uninsured losses under a builder's commercial general liability policy, the contractor may prefer a lump-sum award that allocates no money to uninsured losses and provides no basis for a claim by the carrier against the insured. In many jurisdictions, the contractor's carrier will bear the burden of allocating any award (and often the defense costs), so that the insured benefits from an undifferentiated result.

Alternatively, however, the parties can segregate damages as follows: "The arbitrators shall award any amount allowed as an offset or as a counterclaim by a separate portion of the award, including a separate calculation of allocable interest, if any." This clause may be highly important not only for the amount of interest that may accrue, but also in determining which party may have prevailed on a particular offset or counterclaim. For example, if the amount awarded on a segregated counterclaim exceeds an earlier settlement offer, it could trigger a right to recover some part of the counterclaimant's fees and costs. Such a possibility obviously depends on how the "prevailing party" fees and costs clause is constructed.

Punitive Damages
Particularly in states where courts regularly have authority to award punitive damages in construction lawsuits, it seems prudent to specify by contract whether the arbitrators have or do not have authority to make such awards. It also may be helpful to define when arbitrators can consider such an award and whether such damages are to be separately stated. For example, the following provision could be included: "Punitive damages shall be awarded only in the case of [intentional misconduct, actual not constructive fraud, or intent to harm the person or property of the other party]."

There are many possibilities, but resorting to generalized concepts of "oppression" or "malice" may provide little guidance to arbitrators, especially if they are not lawyers. If the parties desire a remedy of punitive damages, the following approach may help clarify its applicability:

The arbitrators shall consider the gravity of the conduct in question, the amount of actual damages suffered by the aggrieved party, and the amount that may be necessary for the offending party to be punished. The assets of any parent or affiliated company shall [or shall not] be taken into account.

It also may be appropriate to specify meaningful guidelines to establish how the offending party's assets may be relevant. Counsel also may wish to place a ceiling on punitive damages, as either an absolute dollar amount or a percentage of some objectively ascertainable number:

Any award of punitive damages shall not exceed $_________ [or 1% of the party's net worth, ___% of the contract's final amount, or ___% of actual damages]. However, such damages need not be determined strictly as a percentage of assets, the contract value, or actual damages.

Additional requirements may be needed to satisfy applicable standards of due process. Project owners whose contracts raise the specter of liability for punitive damages also may anticipate that some reputable contractors will be unwilling to enter a contract that poses that risk.

Arbitration Fees and Costs
The arbitrators' fees, the costs of conducting the arbitration, and any administrative expenses usually should be addressed in some manner. Most agreements leave the ultimate disposition to the arbitrators. A typical provision allocates such expenses initially to each party in equal shares, giving the arbitration panel discretion to reallocate the costs as it sees fit.

All fees and expenses of the arbitrators, all administrative fees assessed by any arbitration service, the expenses for the hearing facilities, court reporters, and any other costs of conducting the arbitration shall be borne equally by the parties. Each arbitrator shall be compensated at a daily or hourly rate determined at the time of appointment for all time spent in the matter and shall be reimbursed for any travel expenses incurred. The cost of any expert engaged by the arbitrators shall be a cost of conducting the arbitration, upon prior approval by the parties.

Some form of reallocation may be appropriate, depending on the party's expectations: "The arbitrators shall have the authority to award the preceding costs and fees against the losing party or to divide those costs and fees in any proportion they may deem just."

Some parties, however, may prefer giving less flexibility to the arbitrators: "The arbitrators shall include in the award a recovery of the preceding costs and fees paid (or that otherwise would be paid) by the prevailing party."

The opposite extreme might be phrased as follows: "The arbitrators shall have no authority to award any of the preceding fees and costs, and the burden of such expenses shall remain equally with each party, regardless of result." This latter approach may be criticized, however, as tending to protect culpable parties against the consequences of their contract breaches.

Attorneys' Fees and Costs The recoverability of attorneys' fees in arbitration already has been addressed in depth in a recent issue of this journal.² As a result, this article will comment only briefly on this issue. In the absence of a clause requiring a fee award to the prevailing party, the so-called American Rule generally requires each party to bear its own attorneys' fees and costs. However, some arbitrators have been known or suspected to consider legal costs in their undisclosed calculations of lump-sum awards. The best way to avoid uncertainty in this area is to instruct arbitrators on the awardability of fees and costs. An example of such a clause is "The arbitrators shall have no authority to award any attorneys' fees and costs, or expert witness fees and costs."

The opposite extreme would provide:

In the event any dispute between the parties should result in arbitration (whether based on contract, tort, or other cause of action), the arbitrators shall award reasonable attorneys' fees and costs and reasonable expert witness fees and costs to the prevailing party.

A middle ground might be:

In the event of any arbitration relating to ____________, under this contract, the prevailing party shall be entitled to costs and attorneys' fees relating to that subject matter. In all other issues, each side shall bear its own costs and attorneys' fees. Each party acknowledges that it has been represented by counsel in the negotiation and execution of this contract.

In some states, such as California, it is possible to limit attorneys' fees to certain aspects of a contract, provided that each party has been represented by counsel and the contract so reflects.³ For instance, a contractor or design professional may wish to allow attorneys' fees only in proceedings to collect unpaid invoices. Conversely, an owner might limit such awards to actions for liquidated damages. The possibilities for abusing superior bargaining power are numerous. If a party attempts to impose a completely one-sided attorneys' fee clause, however, it may discover that applicable statutes or case law can interpret such clauses as applying reciprocally between the parties.

Drafters also may wish to provide a prevailing party's right to attorneys' fees shall extend to include reasonable fees incurred to collect on a judgment. For example:

Any attorneys' fees and other costs incurred in enforcing a judgment obtained pursuant to an arbitration award shall be recoverable separately from and in addition to any other amount included in such judgment, and such attorneys' fees obligation is intended to be severable from the other provisions of the contract and to survive and not be merged in any such judgment.

The point of this language is to address cases that have held that a prevailing party cannot recover its attorneys' fees for collection efforts once a judgment is entered because the prior contractual rights are merged into the judgment.⁴

A surprising number of contracts make no attempt to define "prevailing party," which can lead to needless arguments when there are counterclaims or when a claimant prevails only on some issues. It is usually better to define the term than to trust the arbitrators' subjective opinions. One possibility might be "prevailing party means the party that obtains a net recovery compared with the other party."

If this seems unduly to disregard the party prevailing on discrete issues or claims, an alternative definition might leave greater discretion with the arbitrators:

The prevailing party shall be determined by the arbitrators based upon an assessment of which party's arguments or positions taken in the proceeding could fairly be said to have prevailed over the other party's arguments or positions on major disputed issues in the arbitration.

Alternatively, a prevailing party clause can be tied to recorded settlement positions, which may be revealed after the arbitrators' preliminary award and before they reach the attorneys' fees and costs element of recovery. Such a provision could state: "Prevailing party means that party, if any, that achieved a better result than its last recorded settlement position before (award, the commencement of the hearing, or some other specified period)."

This provision means that a judgment debtor still may qualify as a prevailing party if it has bettered its last offer. Certainly if a party believes that it might be subjected to an inflated claim or may be dealing with a potentially unreasonable opponent, something similar to the following language should be included in the contract:

In determining if either party is the prevailing party, the arbitrators shall compare the award amount, with interest (if any is awarded) and any fees or costs of arbitration awarded, with the last settlement position of the respective parties. Offers or demands prior to the last settlement position shall not be considered.

The extra drafting required to include such terms should help produce a more predictable award, and one that (at least in this instance) plainly encourages reasonable settlement positions.

Sponsored claims on behalf of lower-tier contractors can raise thorny questions as to who deserves interest or may be a prevailing party. Both the owner and the general contractor may have their own separate reasons to favor separate treatment of such pass-through claims, such as: "The arbitrators may consider any subcontractor's claims separately from those of the general contractor for purposes of establishing a prevailing party."

Another approach to defining the prevailing party is to raise the bar so high that attorneys' fees are awarded less frequently: "Prevailing party means a party that has achieved a result (including any award of interest and arbitrator or administrative fees and costs) that is better than the last written settlement position of the other side." It is often relatively easy to "sell" such a clause at the time of initial contract negotiations, when each party expects itself to be reasonable in any future offer of settlement.

Explicit Limitation of Damages
A somewhat drastic and relatively rare provision is the "baseball rule," which is intended to reward the party who enters the arbitration hearing with the more reasonable position, at least as measured in relation to the arbitrators' conclusion.

On a date specified by the arbitrators, each party shall submit to the arbitrators and to each other its proposed valuation of all the claims before the arbitrators, as an aggregate amount. The parties shall include any specifics or breakdown of the amounts included within their respective figures, as they may desire. The arbitrators shall be limited to awarding only one or the other of the two proposed aggregate figures, being the amount closest to the arbitrators' own valuation of the aggregate of all submitted claims.

The drafter should clarify whether the amounts proposed by each party should include any claims for interest, attorneys' fees and costs, and the costs of arbitration. Whether to include these components may be left to the arbitrators, but careful thought should be given to providing for them in some manner in the arbitration agreement. The risk of losing under the "baseball rule" for the basic damages, compounded by liability for interest, attorneys' fees and costs, and arbitration expenses, would encourage the parties to bargain more vigorously before the award was received.

Because the "baseball rule" probably is best suited for money damages, the drafter may wish to provide that a court of competent jurisdiction shall be authorized to provide for additional temporary or permanent non-monetary relief.

Liquidated Damages
Because arbitrators usually are not strictly bound to follow substantive law, parties may fairly be concerned about the enforceability of any liquidated damages clause. Counsel is therefore well advised to research applicable statutory and judicial limitations on such language in each jurisdiction.

Liquidated damage clauses in any case should be drafted so as to preserve any important independent contract rights, such as rights to enforce a general indemnity clause. For example, a beleaguered contractor may argue that the owner's liquidated damages clause supersedes any obligation to defend the owner against third-party claims for damages. A starting point that addresses these issues might be the following:

Owner and contractor agree that owner will suffer economic damage in the event that substantial completion is not achieved by the contract completion date because owner is likely to incur additional expenses arranging for substitute occupancy and will incur additional costs for continued administration of the project. Owner has provided contractor with a schedule forecasting additional expense of $_________ per day of delay in substantial completion, and contractor agrees that this is a reasonable estimate of such costs. Owner and contractor further agree that such amount shall be treated as liquidated damages pursuant to [in California, Civil Code Section 1671 and Public Contract Code Section 10226] and that contractor shall accordingly pay owner the sum of $_________ per day for each day of unexcused delay in the substantial completion date, whether owner's actual damages are more or less than the liquidated sum. Such liquidated damages shall be owner's sole remedy for delay in achieving substantial completion, but are not in lieu of contractor's indemnity obligations set forth separately in the contract, nor shall these liquidated damages preclude the owner from recovering its actual damages for any damages claimed by third parties, even if arising out of the contractor's delay in achieving substantial completion.

In some jurisdictions, it is necessary to recite that damages covered by the liquidated damages clause would be difficult to establish at the time of default.

Endnotes

---

¹See J. William Ernstrom and Michael F. Dehmler, Mutual Waiver of Consequential Damages: The Contractor's Perspective, THE CONSTR. LAW., Jan. 1998, at 4; Lynn R. Axelroth, Mutual Waiver of Consequential Damages: The Owner's Perspective, THE CONSTR. LAW, Jan. 1998, at 11.
²See S. H. Sklar, An Arbitrator's Award of Attorneys' Fees: Just and Equitable Relief or Discretion Run Rampant? THE CONSTR. LAW, April 1996, at 24.
³CAL. CIV. CODE § 1717(a).5
⁴See, e.g., Chelios v. Kaye, 219 Cal. App. 3d 75 (1990).

Copyright © 2002, American Bar Association. Reproduced by permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.