Contractor’s Lost Profits Due to Impaired Surety Bonding Capacity
Denny Construction, Inc. v. City and County of Denver, Colorado, acting by and through its Board of Water Commissioners
This article presents a case analysis wherein a general contractor sued for breach of contract and litigated the owner for breach of co bid due to its impaired bonding capacity, which resulted from defendant’s declaration of default and claim against the contractor’s performance bond. This latter act had a negative impact on the general contractor since the surety company reduced or eliminated the general contractor’s bonding capacity until the litigation was resolved. Therefore, the general contractor was unable to bid on bonded work and suffered lost profits, among other elements of damages, as a result of this wrongful action. This article sets forth how lost profits was proven.
[su_pullquote align=”right”]Resources:
Foundations of Financial Forensics Workshop
Financial Litigation Specialty Webinars
Understanding Financial Litigation for CPAs/Financial Advisors
[/su_pullquote]
Contractors who perform work for municipal owners (local, state, or federal government entities) must provide a surety performance and payment bond for each project. These contractors are issued a bonding capacity by the surety company which represents the maximum amount of bonded construction work the contractor can have under contract at any one time. If their bonding capacity is impaired or reduced in any way, then this can be a catastrophic impact and added risk to the ongoing profitability and valuation of the contractor.
This article presents a case analysis wherein the contractor litigated the owner for breach of contract including the owner wrongfully filing a claim against the contractor’s surety performance bond. This had the negative impact of the surety company reducing or eliminating the contractors bonding capacity until the litigation was resolved. Therefore, the contractor was unable to bid on bonded work and suffered lost profits, among other elements of damages, as a result of this wrongful action.
I was engaged on behalf of the plaintiff as a construction forensic accounting damages expert on the Denny Construction, Inc., a Colorado corporation (Plaintiff or Denny) v. City and County of Denver, Colorado, acting through its Board of Water Commissioners, a municipal corporation of the State of Colorado, (Denver Water).
Denny prevailed at the District Court jury trial and was awarded lost profits and other damages. Denver Water appealed and the lost profits damages awarded at the jury trial was reversed by the Colorado Court of Appeals (Appeals Court – Case No. 05CA1535). The reversal was based on issues as a matter of law. Denny appealed the case to the Supreme Court of Colorado (Supreme Court – Case No. 07SC236) and the Supreme Court agreed with the jury at the District Court and reversed the Appeals Court ruling.
Background
As a result of a public bidding process in which Denny was the low bidder, Denver Water and Denny entered into a written contract whereby Denny agreed to build an office facility for $3.5 million. The contract required Denny to complete construction of the facility in approximately eleven months. However, due to a series of weather incidents and design changes, construction of the facility was delayed. Denny submitted several requests to extend the completion date for the project. Denver Water ultimately granted extensions for only three more months; however, Denver Water did not grant several of the other extensions requested by Denny.
Denver Water began occupying the facility two months after the revised completion date, a few days after a certificate of occupancy for the facility was issued. At that time, the project was largely, although not entirely, completed. The project remained uncompleted in the following spring, and Denver Water declared Denny in default. Denny’s surety company which issued the performance bond for the project, took over the project and completed the remainder of the construction. According to Denny, if all of its requests for extension of the completion date had been allowed, the contract date of completion would have been after the certificate of occupancy was issued, and therefore Denver Water would not have declared Denny in default.
Denver Water withheld retainage payment and other amounts for the cost to complete the remaining work. Denny alleged that this withholding rendered it unable to pay its subcontractors. Several subcontractors subsequently brought lawsuits against Denny seeking payment.
This case began when one of Denny’s subcontractors filed suit against Denny, Denver Water, and others, including the surety company, to obtain funds withheld by Denver Water for work allegedly performed by the subcontractor. Denny filed crossclaims against Denver Water for breach of contract and declaratory judgment.
Denny alleged, among other things, that Denver Water wrongfully withheld amounts payable under the contract, modified the scope of the work without following contractually required procedures, wrongfully asserted a claim against the performance bond, and failed to grant requested extensions of the completion date. Denny requested damages for payments due under the contract, loss of business reputation, diminution of its credit status, and costs relating to Denver Water’s claim against the surety company on the performance bond.
Denver Water filed crossclaims against Denny for, among other things, breach of contract for Denny’s failure to complete construction by the contractual completion date and its failure generally to perform all the work required by the contract. Denver Water sought damages, including liquidated damages as set forth in the contract.
Prior to trial, all subcontractor claims were settled except for Denny’s and Denver Water’s crossclaims against each other. A jury trial was held on the crossclaims for breach of contract. At trial, Denny asserted breaches of express provisions of the contract and the implied covenant of good faith and fair dealing.
As a result of the claims and litigation, the surety company dramatically reduced Denny’s surety bonding capacity to a point where Denny was unable to continue bidding and contracting on future municipal contract work until the litigation was resolved.
The jury found in favor of Denny on its claim and awarded it $1,063,000 in damages on its various claims, including $380,000 for lost profits through the date of trial attributable to contracts Denny could not bid on due to impairment of its bonding capacity; and $465,000 for such lost profits after the date of trial. The jury also found in Denny’s favor on Denver Water’s crossclaims.
The Denver Water appealed the District Court’s jury award and the Appeals Court reversed Denny’s jury award. The Appeals Court cited that Denny’s claim against the Water Board for lost profits based on projects it could not bid on due to its impaired bonding capacity:
- Was speculative and not reasonably foreseeable by Denver Water,
- Denny failed to identify any specific projects that it lost,
- There was no evidence that the parties contemplated a loss of bonding capacity when they entered into the contract,
- There was no evidence that Denver Water knew the extent of Denny’s bonding capacity,
- There was no evidence that Denver Water knew Denny’s overall financial condition, or
- There was no evidence that it knew what effect declaring Denny in default would have had on Denny’s bonding capacity and future business prospects.
Denny appealed to the Supreme Court who agreed with the District Court and jury award and reversed the Appeals Court opinion. In its reversal of the Appeals Court opinion, the Supreme Court opined that lost profits in a breach of contract action due to impaired bonding capacity are not speculative as a matter of law; instead, claims of lost profits due to impaired bonding capacity, like all claims for lost profits, must be established with reasonable certainty.
More specifically, the Supreme Court held that:
- Lost profits in a breach of contract action due to impaired bonding capacity are not speculative as a matter of law;
- Political subdivision was not exempt by immunity legislation from breach of contract claims;
- Damages against political subdivision in breach of contract action were not limited by immunity legislation to exclude lost profits; and
- Standard for determining whether lost profits were reasonably foreseeable was whether the Water Board knew, or should have known, such loss would probably occur.
Lost Profits Damages Analysis
The Supreme Court cited that I met the elements of the standard of reasonable certainty by testifying that the loss of bonding capacity was the cause for the significant drop in Denny’s profits. The Supreme Court further cited that I explained how I had analyzed data for years prior to the impairment of its bonding capacity, including:
- Market and industry conditions,
- Denny’s financial statements and bidding history,
- The number of public works contracts typically won by Denny, and
- The profits from those contracts.
I also opined that:
- Denny had sufficient work available to bid subsequent to the impairment of its bonding capacity, and
- It was likely Denny would have been awarded bonded work had it bid on the available projects.
Based on my analysis, I calculated that Denny had incurred pre-trial lost profits of $537,525 and that Denny would incur post-trial lost profits of an additional $1,025,204.
An entity suffers lost profits damages when revenues and gross profits are lower than they would have been but for the effects of a negative impact. In Denny’s case, it had been damaged from its loss of bonding capacity and inability to bid on and obtain viable public bondable construction work as it has in the past.
The methodology I employed to measure the amount of damages suffered by Denny due to its loss of bonding capacity can be summarized as follows:
- Analyzed the historical financial statements.
- Calculated the historical weighted average revenue and gross profit for a previous un-impacted period.
- Calculated projected revenue after the impact date assuming no impact occurred.
- Calculated the historical weighted average gross profit rate.
- Calculated the loss of revenue during the impact period by comparing the projected revenue to the revenue during the impact period.
- Applied the reasonable gross profit rate to the lost revenue. This results in the lost gross profits and damages amount.
- Calculated and applied a discount rate to the post-trial damages.
- Calculated damages on a pre-trial and post-trial basis.
In addition to the above financial calculations, the Denny estimating process was analyzed and estimating personnel interviewed. This effort was done to reasonably estimate how much work Denny lost and to provide reasonable certainty that Denny would have been awarded the work lost. Following is a summary of the Denny estimating process analysis:
- Projects available to bid.
- Projects awarded.
- Bonded jobs completed
- Total completed contracts.
- Calculation of a percentage of bonded jobs to total jobs completed.
The results from this bidding and estimating analysis were compared to the damages calculated from the financial analyses to provide corroborating evidence for the damages.
To estimate the loss of bonding capacity impact date and to calculate the lost profits, I formulated assumptions with respect to Denny’s loss of bonding capacity. These assumptions were based on Denny management representations and corroborated with documents reviewed. Specifically, these assumptions were:
- The loss of or impaired bonding capacity impact date was a specific date which coincided with the surety company’s dramatic reduction of Denny’s surety bonding capacity.
- Denny’s normal bonding capacity was in place prior to the impact date.
- The bonding capacity was severely reduced or completely eliminated.
- The loss or impairment of the bonding capacity was due to the performance and payment bond claims asserted by Denver Water against the surety company bond.
Except for the Denver Water project, there have been no other claims against any performance and payment bonds issued on other Denny bonded projects for the six prior years analyzed.
Conclusion
Contractors who perform work for municipal owners (local, state, or federal government entities) must provide a surety performance and payment bond for each project. These contractors manage their company to maintain their bonding capacity issued by the surety bonding company. This is a positive attribute to the contractor but could represent added risk to a lost profits or business valuation analysis if a claim is made against the surety bond.
The source of information for this article was from my work product on the referenced litigation and the Appeals Court and Supreme Court opinions.
Jack W. Harris, CPA, is a forensic accounting expert with a focus on construction contract damages, construction cost audits, commercial damages, cost analysis, lost profits, accounting and related areas. He has 40 years professional experience and has worked on numerous domestic and international projects. Mr. Harris serves as an independent expert and consultant and has also been admitted as a panelist for the American Arbitration Association for construction and accounting matters. Please visit his website at www.jackwharris.com.
Mr. Harris can be contacted at (303) 324-5812 or by e-mail to jack@jackwharris.com.
