How to prevent price increases from hurting you.

We have recently witnessed price increases of historical proportions for a number of building materials--steel, concrete and copper to name just a few. Some have resulted from international events as China's explosive growth impacted the world supply of concrete. Others, such as the price increase for fiberglass pipe insulation, were caused by the catastrophic fire at the John Manville plant in Defiance, Ohio, which has been producing 40% of the national market for such insulation. Extraordinary increases in the price of steel have also recently caused hardships.

What is a contractor or subcontractor to do with a fixed price contract when "as bid" pricing assumptions are decimated by extraordinary commodity price fluctuations? Is there a legal means for obtaining contractual relief? The answer will vary greatly between the public and private sectors of the industry. In this article, private sector considerations will be addressed.

The basic premise of private contracts is, of course, that "a deal's, a deal." Barring a mutually agreed upon change order, a party will be held to the terms of a fixed price contract. What is significant, however, is that unlike the public sector, such "change orders" are not illegal per se. Even though no additional benefit is being provided in exchange for the price increase, a private owner can agree to it if he believes that it is in his best interest to do so.

However, besides an agreed upon change order, there are a number of legal theories that may also be available to a "performing party" suffering extraordinary commodity price increases on private projects.

Courts in New York will excuse contractual performance only where such performance has become "objectively impossible," not merely difficult. There is an extremely high standard of proof that must be overcome to establish impossibility of performance. For example, New York courts have not excused performance where blizzards, the inability to obtain federal funding or the closing of a business due to substantial financial losses have prevented parties from fulfilling their contractual obligations.

On the other hand, New York courts have excused performance upon the destruction of a factory or where government closure of one of two waste disposal facilities resulted in a 666% price increase.

The second prong of the impossibility of performance test is "foreseeability." Again, an occurrence must be objectively unforeseeable, not merely unanticipated. Courts have found that delays caused by a snowstorm, although unanticipated, were foreseeable where delivery was scheduled in the middle of winter. Similarly, a court has found that the hotel's financial difficulty and closing was foreseeable and that relief from contractual obligations because of such an occurrence should have been provided for in the contract.

Force majeure clauses enable a party to contractually avoid liability due to an irresistible, natural or unavoidable force. Upon such an occurrence, the parties are excused from performance under the contract.

However, New York Courts take a strict view of force majeure clauses as well.

Close inspection of the contract is required to ensure the clause includes failure to perform as a result of the specific type of problem encountered, such as a loss of supply or a fire casualty. Only if the clause specifically includes the event can application of the clause be relied upon. Without the incorporation of the specific cause within a force majeure clause, it is an open question as to whether a catch-all force majeure provision would cover a given situation.

Furthermore, drastic commodity price increases, by themselves, are not a cognizable "cause." The better argument would be that the problematic extraordinary price increases are a direct result of a recognized force majeure causation.

Another possible avenue of relief might be found in the Uniform Commercial Code ("U.C.C."), which governs the sale of goods and provides remedies to problems that arise in such transactions. New York has adopted the U.C.C.; accordingly, it would govern any situation involving "impossibility of performance" under a contract to buy or sell goods. Construction contracts involve the sale of services and goods.

With regard to the "impossibility defense," the U.C.C. holds non-performing parties to a more lenient standard than does general commercial law. In contrast to the common law, which requires "objective impossibility," the U.C.C. allows excuse from contractual obligations when performance becomes "commercially impractical" or extremely and unreasonably difficult to perform due to an unforeseen event. Courts have noted that U.C.C. [section] 2-615 may be invoked as a defense when a severe shortage of raw materials due to an unforeseen contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply or the like, either causes a marked increase in cost or altogether prevents the seller from securing supplies necessary to his performance. Thus, U.C.C. [section] 2-615 excuses performance where a rise in cost is due to some unforeseen contingency which alters the essential nature of the performance.

Although the U.C.C. standard is clearly more lenient, its application is also more limited. The U.C.C. does not apply to contracts for labor or services, only the sale of goods. In the context of a contract to provide both goods and services, such as a construction contract, courts use a balancing test to determine whether the focus of the contract is the sale of goods or the provision of services. If the sale of goods predominates over the element of labor or service, the U.C.C. will apply, otherwise the general commercial law will control the dispute. Courts have generally held that standard form construction contracts fall under the scope of the common law, not the U.C.C. However, given this balancing test, each contract must be examined individually. A general contractor may not be able to avail itself of the U.C.C, but a material supplier might. A subcontractor will fall somewhere between the two.

Thus, it is clear that a cost increase alone will not excuse contract performance. However, when combined with an unforeseen contingency and an extraordinary commodity price increase, performance may be excused under either the common law or, possibly, under U.C.C. standards. Does an unanticipated circumstance make the performance of the original contractual promise vitally different from what should reasonably have been within the contemplation of both parties? If so, the risk should not fairly be borne solely by the performing party and there is a growing legal trend that performance should be excused if contingencies create a substantially unjust situation totally outside contemplation of the parties.

In addition to the legal defenses to the performance of a contract, the relative bargaining position of the parties may be determinative. A sense of urgency in private sector construction is always an issue, with construction loans and debt service looming as a backdrop to any negotiations. If "time is money," it may simply pay for the owned developer to adjust a contractor's price to keep a job running smoothly, rather than allow the unavailability of a commodity and resulting price increases to destroy a project's schedule. Clearly, commodities such as concrete and steel, which are invariably on the "critical path" of a project's schedule, have the potential to have this effect. As stated earlier, there is no legal impediment to the parties mutually agreeing to a price increase in the private sector.

These legal arguments--whether meritorious in any particular instance or not - are always available for negotiating purposes in the private sector. As mentioned, that is not always the case regarding public works contracts.

We will be discussing legal issues related to coping with extraordinary commodity price increases in the public sector in Part II of this two-part series.

Henry L. Goldberg

Goldberg and Connolly