Can Construction Contracts Shift the Risks?
Today we’re going to take a few minutes to discuss the allocation of risks in construction contracts, and how risk allocation should always be factored into pricing in the construction contract. I’m Jeffrey C. Regan, managing partner of Regan Atwood in Jacksonville, Fla.
Greater Risk, Greater Reward
The adage that with greater risk comes greater reward is also true in all areas of contracting, and in particular, construction contracting. Theoretically, the more risk a contractor takes in entering into a construction contract, the higher that contractor’s price should be. From an owner’s perspective, the lower the risk that the owner takes, the more money the owner should expect to receive the building that it’s contracted for.
How Are Risks Allocated?
So, how are risks allocated in construction contracts? One of the things that we see in our practice over and over again is that the contractors and the owners will often focus on the technical specifications and requirements that are in the plans and specifications that are being provided for the construction project. And based on the plans and the specifications, the contract pricing is then determined. Only after the price is determined do the parties oftentimes then put together the formal contract.
Well, in that formal contract and the general conditions, and often supplementary conditions that become a part of the contract are numerous risk-shifting provisions that should have been considered and discussed upfront because they can affect the construction contract price greatly.
Let me give some examples as to how this can be understood. Oftentimes a contractor may come in and set us price. He’s going to do a civil construction job, and gets the terms and conditions of the contract and an owner may say, “This is our standard contract we always use and we’re going to use it on this subdivision improvement project that we want you to do,” and you look in the general conditions and it has a provision in it that says the contractor shall not be entitled to damages for encountering differing site conditions at the work project.
Site Conditions Can Vary
Well, all kinds of differing site conditions could exist. In a civil project, earth is moved. Earth is imported. Sometimes earth is exported, and once you dig into it, you lay underground pipes, you put in your drains, all of your underground utilities, you put in the roadways, you finally then pave them, you may encounter unsuitable conditions such as muck, clays, soils that just won’t support the utilities or the work that is about to be performed. If a contractor has agreed unwittingly in the general conditions or supplementary conditions of its contract that there will be no damages for differing site conditions, then the contractor will be stuck with the extra cost that will incur.
If you’re a subcontractor, you may have what’s called a paid-if-paid clause in your subcontract that the general contractor gives you, and what that means is that if the general contractor for any reason at all is not paid by the owner, then the general contractor can say to the subcontractor, “I know you did the work, but I don’t have to pay you anything,” even though the reason for nonpayment may not have been your fault. That would be another example of how risks can be allocated in a construction contract.
Limitations on Indemnity
Another common practice that you’ll see in a construction contract will be an indemnification clause. Now in Florida, we have statutory limitations as to what extent a party can indemnify someone else for their own negligence or malfeasance in performing work under a construction project.
That would be a seminar all unto itself, but those provisions are enforceable under certain circumstances. If you have agreed in a construction contract that if something happens and goes wrong and injures somebody, or should it damage property in the area of the construction that you are going to indemnify the person who suffered that loss, not just for your contribution to that accident or that event, but the party you’ve contracted with to their contribution to it as well.
Know What is Required of You
Well, that’s taking on an enormous risk. It’s the contractor or in this case the subcontractor basically providing an insurance policy to the party with whom they contracted. You should know that that’s what’s being requested or required of you before you determine your contract price.
How do you deal with those situations? Well, the example I just gave you is you could refuse to enter in the contract, or you could do something different. You could call your insurance broker and say, “How much is it going to cost me to get a policy to ensure this provision in my contract?” Then you know what the cost of it is to you, and then you can factor that additional insurance cost into your contract.
How Do Flow Down Provisions Affect Risk?
Flow down provisions, and how do those affect the risk on a contract? A general contractor, any of those of you who work with contractors or are contractors know, generally subcontract the majority of the work under the contract they have with an owner or developer.
Well, what oftentimes happens is there are differences in some of the fine print terms in the boilerplate if you will in the subcontract that are different from what would be in the general contract. I’ve seen a number of contractors find out that their obligations to the owner with respect to quality of performance, with respect to warranty obligations and things of that nature, turn out to be greater than the requirements that were set forth for the subcontractor performing that particular scope of work on the project.
So a flow-down provision is one that makes sure that in the subcontract, the subcontractor agrees to be bound to the contractor to the full extent that the contractor is bound to the owner under the owner-contractor contract. That’s another area where great risks could be shifted from one party to the other, and if you’re not familiar with the risk-shifting in your contract before you agree to your pricing, you may found that you have underpriced your construction agreement.
In Construction, Time is Money
There are any number of different areas in construction contracts that come up where we see these risk-shifting provisions. Another one would be no damages for delay cause. Again, the adage that time is money certainly couldn’t be truer than in the construction industry.
The more time it takes to complete a project, the more labor, general conditions, materials even can be incurred and the cost goes up. Likewise from an owner, the more time it takes to get a project done, the owner is delayed from using the project to make a profit if there’s going to be a manufacturing operation there or if it’s an office building, losing rent to potential tenants out there.
So if there’s a no damage for delay clause in the contract from a contractor’s perspective, you would want to know that if there’s a delay that’s not your fault, that it’s the cause of the owner or a design error that has to be corrected and construction or something of that nature, you would know that you’re not going to be entitled to additional compensation even though it’s costing you money to be hanging around for a longer period of time.
How Does Pricing Shift Risks?
There’s, as I said, any number of different areas in the construction contracting process where risks are constantly being shifted from one party to another. Another example would be pricing. What if in the marketplace, suddenly there is a shortage in certain types of supplies or materials such as lumber or drywall or copper electrical wiring, anything of that nature and there’s suddenly a price jump, but you’ve got a contract that’s a fix on contract and so you’re stuck with now high prices and losing money because your materials have gone up?
You may consider negotiating a material escalation clause into the contract so that if pricing out in the marketplace increases by a certain percentage, you’ll be entitled to seek a change order in order to modify your contract price.
At Regan Atwood, we review these issues every day with our clients and the devil is in the details. It’s very important to understand and read carefully all provisions of the contract, be able to pick out those areas that are shifting risk from one party to the other and to make sure the client understands that the agreement is seeking to have them assume more risk so that in that way, in fairness to all the parties, the contract pricing can then be appropriately adjusted before the contract is entered into.