Beware the Bulletproof Construction Contract

Publication

Construction is an inherently risky undertaking. Larger commercial and industrial projects involve multiple parties (architects, engineers, contractors, subcontractors, suppliers, governmental authorities, insurers, and lenders, among others), complex global supply chains and installation techniques, and significant sums of money. And then there are the realities of operating in the field: unforeseen or concealed conditions, environmental hazards, health and safety concerns, and force majeure events.

Understandably, project owners will want to minimize their risks – and the primary way to do so is through the construction contract itself.

However, some owners mistake the construction contract for a cure-all remedy for any potential issue, which leads to one-sided contracts that shift all conceivable risk to the contractor. Owners might also prepare one-sided contracts to overcompensate for problems that arose on prior projects or because they are in the “purchasing agent” mindset, introducing terms common in other commercial transactions or corporate procurement policies that are not applicable or appropriate for construction. Finally, some owners impose construction contracts with unfair and oppressive terms simply because they have the leverage to do so.

Such “bulletproof” construction contracts can backfire in several ways that owners need to keep in mind:

• Economic Impact

Owners might limit their pool of responsive proposals if they go out to market with an onerous construction contract in their request for proposals. This scenario is likely in many markets right now, where the demand for contractors is exceeding capacity.

Owners should also be aware that sophisticated contractors price for contract risk just as much as they price the project itself. If a construction contract imposes unreasonable or immeasurable risks, the contractor will likely add a cushion in its pricing or inflate its schedule.

• Papering the Project

To minimize contractor claims, some owners impose unduly short notice periods for contractors to submit claims for issues such as concealed or unforeseen conditions, owner-caused delays, and force majeure. Unfortunately this can result in a contractor submitting excessive or premature claims to preserve its rights.

Excessive claims are a significant administrative burden for an owner to manage during the course of a construction project. They will also slow down both the contractor and the architectural and engineering teams (who may be entitled to additional costs for evaluating excessive claims) and stifle productive communication and collaboration between the parties.

• Claims for Additional Cost and Time

Some owners think they have won the battle once a contractor has signed their one-sided contract and agreed to an aggressive schedule and contract price. Unfortunately, the reality is that contractors often accept an owner’s contract terms just to win the job with the knowledge and expectation that they will recover their costs once the project is underway. On the other hand, less sophisticated contractors may not have the resources to seek legal counsel, or may otherwise fail to understand and price the risks they are taking.

In either instance, this will result in differing expectations and an endless war between the owner and contractor regarding claims for cost and time increases throughout the project.

• Enforceability

 A construction contract must be enforceable both legally and in the field as a practical matter.

Issues of legal enforceability often come up when owners borrow concepts from other types of commercial contracts or try to conform their construction contracts to corporate procurement policies. For example, some owners require contractors to indemnify them for their own negligence or impose lengthy payment terms (e.g., net-60 or net-90). However, owners need to be aware of applicable state laws because such contract terms may be void or unenforceable under anti-indemnity statutes or prompt payment acts. Inexperienced owners may not be aware of these types of state laws because they are often specifically applicable to construction projects.

Issues of practical enforceability often arise when construction contracts prescribe strict procedures or approval requirements. When a problem arises during construction, the owner’s on-site personnel or project manager might be unaware of the contract requirements or might decide the contract requirements are too harsh or unworkable. At this point there may be two separate contracts – the executed contract with the strict requirements and the “contract” being used in the field that arises out of the owner’s personnel’s course of dealing. This is a dangerous situation for the owner, as the contractor may later argue that the owner abandoned the executed contract. 

One example of this is when owners require a change in the work. Most construction contracts require any extra or changed work to be documented as change orders in writing in advance. However, a contractor might have to proceed with extra or changed work when issues arise suddenly in the field and there is pressure to keep a project moving forward. In some cases, courts have found that even if the parties fail to follow their own contractual procedures for making changes, they can still bind themselves to change orders through words or conduct. 

All of the owner’s contract drafting is useless if the owner does not scrupulously follow its terms – which can add undue burdens and costs to the owner’s team.

Creating a Balanced Contracting Approach 

Of course, there will be valid circumstances for owners to impose more onerous contract terms or shift additional risk to their contractors. For example, the owner might be subject to strict requirements from a party providing project financing, or the owner is willing to pay more for a contractor to shoulder certain project-specific risks. But owners should be purposeful in imposing such obligations, while remaining mindful of practicality. Onerous contracts for the sake of being onerous can be a recipe for disappointment. We have seen construction contracts that require contractors to continue performing even if the owner fails to pay for properly performed work or if the owner enters into bankruptcy. Putting aside the potential unenforceability of such terms, no contractor will continue performing work if it is not paid or if the project owner is bankrupt, no matter what the contractor agreed to in the contract. Owners should ask themselves if they want the right to sue the contractor when the contractor walks off the job, or if they want to finish the project on fair terms? 

A more balanced contracting approach will result in more realistic expectations of what a contractor can deliver and greater collaboration between the parties when project issues inevitably arise. 

Conclusion

To avoid some of the pitfalls outlined above, owners should seek the advice of experienced construction counsel, who have added knowledge of the construction process and project administration, when drafting their construction contracts. Forms prepared by the American Institute of Architects (AIA) or other industry groups can also provide a starting point or useful suggestions on appropriate terms. Ultimately, a construction contract should not be viewed by owners as an insurance policy against all conceivable project risks. Instead, a construction contract should be the basis for aligning the parties’ interests and incentives to complete a project on time, on budget, and free from defects.

Raj Patel is a real estate partner in the firm’s Chicago office, focusing his practice on construction and infrastructure projects.