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Top ten most important clauses of construction contract: how to reduce the likelihood of disputes during and after the project.

CONSTRUCTION projects are extremely complex undertakings and are usually governed by highly detailed contracts. While any one of hundreds of clauses in a large contract can be crucial, certain issues are important on almost every job.

This paper addresses what the authors consider to be the ten most important clauses in a typical construction contract. We believe that focusing on these clauses prior to commencing a construction project will reduce the likelihood of disputes during and after the work. For each clause, we spell out the issue and its importance to the project, then set out the most common approaches used by owners, contactors, and designers. We often make reference to the standard form contracts promulgated by the American Institute of Architects ("AIA"), since those are a comprehensive and widely-used standard in the building industry. (1)

I. Payment

One of the most sensitive areas for all parties involved in a construction project is the payment process. While all parties bear a significant risk in this area, it is important to understand each parties' unique concerns. Owners, as well as their lenders, are concerned about overpaying the general contractor before the work is completed and failing to hold back adequate retainage as security. On the other hand, general contractors and subcontractors are concerned about prompt payment. Any delay in the cash flow can essentially force the general contractors or subcontractors to finance the project, which may ultimately result in the contractors' insolvency.

Neither the owners, nor the contractors, of course, desire this result. Accordingly, the terms of payment clauses should be designed to balance the parties' concerns.

A. What Documents Must be Submitted for Payment?

The AIA form contracts require progress payments for projects of any considerable size. (2) The contractor initiates the process by submitting an "Application for Payment" to the architect on a monthly basis. (3) The Application must be itemized and "shall be notarized, if required, and supported by such data substantiating the Contractor's right to payment as the Owner or Architect may require. ..."(4) Typically, owners will require supporting back-up documents such as lien waivers, certified payrolls (for public sector work), schedule updates, and test results on work performed to date. Lien waivers are of particular importance as they protect the owner and lender, if applicable. Indeed, if a lender is involved, it will most likely require lien waivers before any distribution is made under a construction loan. Because lien laws can differ between states, owners and lenders should examine the lien laws of the state in which the project is located before specifying the requirements.

Before the contractor submits the first Application for Payment, however, the contractor must submit a "Schedule of Values," subject to the architect's approval. (6) The Schedule allocates portions of the contract price to designated portions of the work. After receiving the Applications for Payment, the architect will use this Schedule to scrutinize the Applications, which is then used as a check and balance system to prevent front-end loading by the contractor. An owner, in essence, does not want to overpay for work completed. Otherwise, the contractor would have little incentive to complete the project. It is crucial, therefore, to have a balanced schedule of values to keep cash flow fairly distributed through the end of the project.

B. How Quickly Will the Contractor Get Paid?

The parties are left to set their own deadlines for the payment process. Section 5.1.3 of A101 states that an owner will make payment "not later than the--day of the month." Such payment is conditioned on the architect receiving the Application for Payment "not later than the--day of the month." Alternatively, if the contractor submits a late Application, the owner will pay the contractor "not later than--days after the Architect receives the Application ..." (7)

Parties should always specify the deadlines in the payment process by filling in the blanks. If they do not, disputes are certain to ensue as to the payment schedule. The parties may be left with the uncertain reasonableness standard. With respect to the AIA form contracts, Section 9.3.1 of A201 creates a residual standard in the event A101 payment deadlines are left blank. Nevertheless, the parties should always specify the deadlines for the payment process. One must keep in mind, however, that the deadlines should differ depending on the owner's financing source. If the money is in the owner's hands, then the payment process can be faster. On the other hand, if the owner must draw from a construction loan, the owner will need additional time.

C. Retainage

Under most contracts, the owner retains a specified percentage from progress payments until the end of the project which protects the owner in the event of a contractor breach or subcontractor liens. In addition, retainage provides an excellent incentive for the contractor to finish the project.

The typical retainage amount ranges from five to ten percent. Because contractors or subcontractors do not typically obtain the retainage until the end of the project, this process essentially forces them to finance part of the project. Several states have sought to limit such inequities by imposing limitations on the amount of retainage, both on public and private projects. Some contracts reduce or eliminate retainage as a certain portion of the work is completed. For example, if fifty percent of the work has been completed to the owner's satisfaction, the retainage can be reduced or eliminated completely. The goal is ultimately to balance the interests of the contractors and owners. Other contracts exempt certain parts of the billing from retainage, such as a construction manager's fee or general conditions billings.

D. What Third-Party Roles May Impact The Payment Process?

To further complicate the payment process, one must address third-party roles, specifically, the roles of architects and lenders. The architect's role may have a significant impact on the payment process. The architect must have time to scrutinize an Application for Payment before it can be paid. The Architect must, within seven days "after receipt of the contractor's Application for Payment, either issue to the Owner a Certificate of Payment ..." or give notice of the reasons why certification is being withheld. (8) Thus, before considering any payment deadlines, the parties should consult with the architects, or others responsible for the review process, to ensure that they have adequate time to perform their duties. Architects are not always responsible for the review process; at times, owners may decide to remove the architect from the process to save costs or use a different advisor. The AIA form contracts emphasize the architect's role.

The lender's role will also likely impact the payment process. Most lenders require that contractors and subcontractors provide lien waivers before any amounts are released for progress payments. Lenders may also independently verify the work on the project to ensure that the amount of the progress payment is proper. In light of these examples, owners should consult with their lenders to determine what particular requirements they may have with respect to the payment process.

E. What Right To Interest On Late Payment?

Section 7.2 of A101 provides parties with the option of determining the interest rate amount for late payments. A fair method is to use an interest rate that the owner is being charged on the construction loan for the project. By doing so, the owner would be discouraged from using the contractor as a financing source. An interest rate that is very high may at a glance seem favorable to the contractor. Nevertheless, state usury laws and truth-in-lending acts may impact the validity of such rates. The parties, therefore, should always consider these factors before determining the interest rate.

If the parties leave the rate blank, Section 7.2 provides for a default rate. That rate is the legal rate prevailing at the place where the project is located. Typically, this rate in most states is the same as the rate for unpaid court judgments, which can range from five to ten percent.

F. What Provisions For Billing Disputed Work?

It should come as no surprise that contractors and owners often disagree over certain work. For instance, additional work may be needed, but the parties cannot agree as to the price for a change order. To avoid delaying the project, the owner and architect may issue a construction change directive ("CCD") that orders the contractor to carry out the work, with the amount to be determined at a later time by a specific formula. Section 9.3.1.1 of A201 allows the contractor to bill for this work up to the amount agreed by the owner which treats both parties fairly. (9)

II. Pay-When-Paid Clauses

Most of the clauses discussed so far involve the relationship between the owner and general contractor. Equally as important is the relationship between the general contractors and subcontractors. This section examines an often-litigated issue concerning whether the general contractor's obligation to pay the sub-contractor is conditioned on payment from the owner.

As a threshold matter, one must consider the parties' view points. General contractors agree that subcontractors should be paid if nonpayment by the owner is the general contractor's fault. Subcontractors agree that they should not be paid if payment by the owner is delayed due to the subcontractor's failure to perform work or process the required paperwork.

The dispute arises in circumstances under which the nonpayment by the owner is unexcused or another subcontractor has breached. General contractors believe that they should not have to pay until they are paid and that any loss should be shared equally. Subcontractors, in response, note that the general contractors are in the best position to evaluate the owner's financial position. Indeed, subcontractors explain that most form contracts, including the A201, give general contractors the right to request financial information from the owner. (10) Accordingly, subcontractors believe that they are not on equal footing with the general contactors.

Payment clauses that seek to allocate these risks technically fall into either one of the following categories: (1) pay-when-paid or (2) paid-if-paid. Pay-when-paid clauses allow reasonable delay before the general contractor must pay the subcontractor. On the other hand, under pay-if-paid clauses, the general contractor's obligation does not arise until the owner has paid the general contractor. That is, payment from the owner is a condition precedent. Courts will not view a clause as creating the latter category, unless it explicitly states that payment is a condition precedent. (11)

While the general contractor and subcontractor may vigorously debate which clause to use, the AIA has chosen a middle ground, thereby keeping out of the dispute while protecting the owner's interest:

The Contractor shall promptly pay each Subcontractor, upon receipt of payment from the Owner, out of the amount paid to the Contractor on account of such Subcontractor's portion of the Work, the amount to which said Subcontractor is entitled, reflecting percentages actually retained from payments to the Contractor on account of such Subcontractor's portion of the Work. The Contractor shall, by appropriate agreement with each Subcontractor, require each Subcontractor to make payments to Sub-subcontractors in a similar manner. (12)

This clause is deliberately vague and states only what the prime contractor shall do if it is paid. The clause does not, however, state that the prime contractor must pay subcontractors only if it is paid. This language may be interpreted as not being specific enough to create a payment condition. (13)

Some states have enacted prompt payment statutes for both public and private projects. Such statues specify that, after receiving payment, the contractor must pay the subcontractor in a specified time.

III. Project Delivery Systems and Contractor's Design Responsibilities

In their simplest form, construction projects are designed by an architect or engineer, then built by a contractor who simply follows the plans and specifications. This is an over-simplification, however, since almost every project involves details of construction that are not spelled out in the plans. Most contractors are skilled enough to know how the details should be completed and how to supply the best solution to small problems in the field. The situation is complicated further with respect to certain types of work that are routinely designed by subcontractors specialized in that field. Sprinkler systems and stairwells are two areas in particular that are usually designed by specialty subcontractors rather than the owner's architect.

This dichotomy between design and construction has several important legal implications. First, the contractor is generally responsible for following the plans and specifications. The contractor is liable to correct any "non-conforming" work and for any harm caused to the owner and others due to work that does not conform to the plans and specifications.

Second and conversely, the contractor is generally not liable for problems caused by the design. Thus, if the owner finds that the design does not serve the owner's purposes, the contractor will bear no liability for that. Similarly, if the design is found to be defective (e.g., because it cannot be built, or is contrary to building codes), the contractor not only bears no responsibility, but will also be entitled to extra compensation for any losses it incurs because of the design problem.

Some owners seek to shift this allocation of responsibility back to the contractor by imposing a duty on the contractor to review the design and discover any design errors before starting work. Contractors resist this shift, arguing that architects have more time and skill in preparing design and it is unfair to shift that burden to a contractor who has limited time to review and understand the design.

A. Construction Management and Design/Build Projects

In recent years, owners have employed new methods of contracting for design and construction, in part to deal with the tension between the two processes. These are considered alternative "project delivery systems" in that they are alternatives to the traditional approach of (1) design, (2) bid, and (3) build.

One such alternative approach is "construction management," by which owners retain a contractor in a management capacity to review the plans and specifications as the design process is underway, thus providing the construction manager the luxury of more time to review the design, while providing input at an earlier stage when changes can be made more easily.

Another quite different approach is one that combines design and construction responsibilities in a single party. This project delivery system is entitled design/build. It enables the owner to have a single point of responsibility, and thereby avoid the possibility of contractor claims of design defects. At the same time, it entails some surrender of control, since the owner will not have the same checks and balances between an unaffiliated architect and builder.

B. Shop Drawing Review

On major projects, contractors are required to provide drawings showing how they plan to supply the details of the design that are not specified in the contract drawings. These details are shown on "shop drawings," prepared by each subcontractor, showing how that subcontractor will handle its part of the work. Usually the shop drawings are submitted through the general contractor to the owner and architect for review to assure that they are consistent with the overall design.

Major disputes can arise from the shop drawing process. Architects try to avoid legal responsibility for the sufficiency of the detail in the shop drawings by reviewing them only for general conformity with the project design, while disclaiming any assurance that they are proper. Subcontractors and contractors, meanwhile, argue that review and acceptance of a shop drawing gives the drawing the same legal effect as the contract drawings, such that they can be relied on by the contractor and may be the basis of a legal claim if they prove to be incorrect or defective.

Disputes also arise from the speed of shop drawing review. Time is important and costly on a construction project. Subcontractors cannot start their work until their shop drawings have been approved. If the architect (or others in the submittal chain) takes too long to review them or requires unnecessary revisions, the subcontractor may be delayed and may thereby cause delays to the overall job. Some contracts set turn-around times for shop drawing review, though these time periods are difficult to apply since some drawings are easier to review than others, and the architect's ability to review and return them will depend on how many drawings are being submitted at one time.

IV. Differing Site Conditions

Contractors are forced to make assumptions about the difficulty of the project when they price the work. One of the hardest areas of costs to estimate in advance is that which is not visible. It is not uncommon for a contractor to encounter a physical condition, usually subsurface, that was not anticipated by the parties at the time of contracting. Underground rock, water, or objects, such as unused tanks or buried structures, add to the cost of completing the construction project. These cost increases are often significant, and as a result, unanticipated physical site conditions, or "differing site conditions," provide the grounds for many construction claims. Depending on the contract and the facts, the results can go both ways. In some cases, the owner is ordered to pay the contractor for any cost increases caused by the differing site condition. In other cases, the contractor is forced to bear the increased costs on its own. It is imperative, therefore, for both owners and contractors to undertake certain precautions and employ certain strategies to minimize the risk that a differing site condition will be encountered during the course of a project.

A. Types of Differing Site Conditions

Two major types of differing site conditions exist: Type 1 Claims and Type H Claims.

1. Type I Claims

A Type I differing site condition exists when subsurface or latent (non-obvious) physical conditions at the site differ materially from those indicated in the contract. Common examples of a Type I differing site conditions include the presence of underground rock where the contract indicates otherwise. Other examples include the presence of abandoned utility lines or situations where contract documents incorrectly identify the type rock thus leading to increased drilling costs.

In order for a contractor to recover the increased costs associated with the unanticipated site condition from the owner, the contractor must be able to prove several things. First, the contractor must show that the contract indicates the subsurface conditions that form the basis of the contractor's claim. Second, the contractor must demonstrate that it relied on such indications and that the contractor's interpretation of the contract and such indications is reasonable. Third, the conditions encountered by the contractor must be "materially" or "substantially" different from those conditions indicated in the contract and that such conditions were "reasonably unforeseeable." Finally, the contractor must show that the damages claimed are directly attributable to the unforeseen conditions.

2. Type II Claims

Even where a contract fails to indicate subsurface or latent conditions, a contractor may nevertheless be entitled to an equitable adjustment for encountering a differing site condition. Under a Type II claim, a contractor may obtain an adjustment if it encounters conditions that differ from those usually found on similar projects. Unlike a Type I claim, however, a Type II claim is not concerned with representations made in the contract. Indeed, in order for the contractor to recover, the contract must be silent on the subsurface or latent conditions that form the basis of the contractor's claims.

The absence of contract language makes the contractor's burden of proof significantly more difficult than that of a Type I claim. Recovery on a Type II claim requires both a subjective and objective inquiry. The contractor must first establish what type of conditions would normally be encountered on a similar project. The contractor must then show what conditions were actually encountered and prove that such conditions differed "materially" or "substantially" from the physical conditions that would ordinarily be encountered at a similar project. Finally, the contractor must show that the conditions caused an increase in the cost of performance.

B. Standard Contract Clauses

Generally, there is no implied right to additional compensation for encountering a change or unforeseen condition as part of the contract unless an actual contract clause so indicates. In the absence of such a clause, the contractor will have a much more difficult time proving its claim. Failure to include a clause in the contract will also alter the degree of the parties' responsibility, as well as the method and manner of enforcement. For these reasons, construction contracts typically include clauses governing differing site conditions. It is incumbent upon the contracting parties to carefully review the relevant contract clauses to determine which party, owner, or contractor bears the risk for the differing site condition.

Most changed condition clauses used today shift the risk to the owner. In the private sector, for example, AIA Document A201 is commonly used to define the parties' responsibilities with respect to differing site conditions. Section 4.3.4 of A201 defines the types of differing site conditions (Type I and Type II), while [section] 4.3.6 provides the remedy for the contractor who encounters such a condition. Specifically, Section 4.3.6 permits a contractor who encounters a Type I or Type II concealed condition to obtain an equitable adjustment to the contract price in an amount equal to the cost of performance.

In addition to Form A201, state and federal jobs routinely include differing site condition clauses in their contract documents. Like the AIA Document A201, the standard federal contract clause defines the types of differing site conditions (Type I and Type II) and similarly provides for an equitable adjustment to the contract price in an amount equal to the cost of performance. Unlike the A201, the standard federal contract clause requires the contractor to notify the contracting officer, who will in turn investigate the encountered condition and determine whether the condition differs "materially" and whether the condition actually caused the contractor to incur additional costs.

C. Exculpatory Clauses

In addition to standard contract clauses governing differing site conditions, a typical contract may also include clauses that absolve a party from liability for a changed condition. In the interest of brevity, we will only touch on the most common of these clauses.

1. Pre-Bid Inspection

Most contracts today include a clause requiring the contractor to examine the site before bidding the project. This type of clause is typically included in the contract to shift some of the risk back from the owner to the contractor. A pre-bid inspection clause usually requires that any condition that should be seen by the contractor during such a pre-bid inspection will be deemed disclosed to that contractor. It is important for the contractor to be aware of such a clause and to take care in inspecting the project site.

2. Duty to Discover Obvious Errors

It is also common for a contract to include a clause requiring the contractor to examine the contract documents and to discover any patent (obvious) errors. Such a clause may also require the contractor to discover conflicting provisions or ambiguities and notify the owner so that the owner can clarify such ambiguities by addendum before bids are opened. Like the pre-bid inspection clause, a "duty to discover patent errors" clause shifts some of the risk from the owner to the contractor. In reality, such clauses are most effective when the contractor's bid documents show that the contractor was actually aware of the error.

3. No Damages For Delay

It is worth addressing the impact of a "no damages for delay" clause on a contractor's right to an equitable adjustment for encountering a differing site condition. The presence of a "no damages for delay" clause can have a substantial effect on a Type I or Type II differing site condition claim if the only impact of the changed condition was that the contractor's work was delayed. In such a case, the contractor may only be entitled to additional time to complete the work, but the contract will not allow for an equitable adjustment.

D. Owner and Contractor Strategies

The key to understanding the impact of differing site condition clauses is to understand risks imposed on the parties by such clauses. Even if the risk seems to weigh heavily on one party, that party can undertake certain strategies to minimize the risk. For owners, it is important to disclose everything and give the contractor access to all prior drawings. Owners should also use standard contract clauses, as any ambiguities will be construed against the drafter. Owners should pay attention to bidders' questions and disclose any information in the owner's possession. Finally, owners should respond promptly to any notice by the contractor of a differing site condition.

Contractors should similarly undertake strategies to minimize the risks that they will be forced to bear with respect to the costs of encountering a changed site condition. Contractors should ask for, and pay careful attention to, existing drawings. Contractors should also always attend the site inspection and ask questions at the pre-bid meetings. It is also important for the contractor to keep careful cost records, and, where possible, keep joint cost records with the owner. Finally, contractors should give prompt notice of any differing site condition encountered on the project.

V. Dispute Clauses

Procedures to resolve claims and disputes are necessary components to all construction contracts. Diverse parties, shifting relationships, and high levels of risk inevitably result in disputes. Thus, it is imperative to create an appropriate roadmap by which the parties can resolve their differences. This process must be able to work both during construction and after substantial completion.

A. Threshold Question: What Type of Dispute Procedure is Best for the Project?

Most form construction contracts employ a process by which claims and disputes are first heard and decided by the design professional. (14) If necessary, they proceed next to mediation and conclude in arbitration. (15) In most cases, this three-tiered approach is the best process, but that is not always so. Thus, the most fundamental (but oft overlooked) question is what type of dispute resolution process is best for the project.

To answer this question, one should consider a number of factors: project size, project complexity, number of parties to the project, complexity of contractual relationships, risk distribution, owner status, and length of construction. After balancing such factors, it may be clear that the three-tiered approach is inefficient or that litigating disputes in court may be more appropriate than arbitration. For years, many assumed that arbitration was faster and cheaper than litigation, but it is not always the case. Arbitration may ensure, however, that disputes that are technical in nature are heard by those trained in such technicalities.

Unless parties agree contractually or unless it is allowed under the governing arbitration rules, joinder of parties or multi-party arbitration is precluded in many jurisdictions. (16) Yet those jurisdictions will often allow consolidated litigation. Thus, if the nature of the project will likely involve disputes between more than one party, it is important to consider whether parties would prefer dispute process that allows joinder or consolidation of claims.

Discovery in arbitration is limited. Many jurisdictions prohibit discovery in arbitration from a non-party. (17) Many practitioners fail to realize that if their client is not a party to arbitration, they are not required to produce documents or deponents for discovery. The subpoena power of practitioners or panels is usually limited to requiring the production of documents or witnesses to a hearing. If it is highly probable that the resolution of a dispute will depend upon obtaining discovery from parties with whom one is not in privity, practitioners may prefer to consider a forum with liberal discovery rules.

B. Standard Clauses

Most form contracts use the standard three-tiered dispute resolution process, as embodied in the 1997 edition of most AIA documents. This elemental structure has proven effective over decades, and it is wise to use when drafting a non-form contract and prudent to maintain when using a form contract. On smaller jobs, all tiers may not be necessary, as the multiple layers would not be efficient. On large jobs, one should reflect more on the overall dispute procedure process as suggested above in subsection A.

The effectiveness of this three-tiered system, or any process, depends upon the provisions supporting it. Necessary provisions include the following six elements:

1. Parties must put all claims in writing, and claims should be addressed to a previously designated individual. (18) Written claims create a record. They also add gravitas to the situation, requiring parties to focus immediate attention on the problem. They force the claimant to perform some cursory due diligence prior to making a claim, and they are an effective way to communicate issues.

2. Parties must make claims within a finite time from discovery. (19) The industry standard requires that claims are made within twenty-one days. A finite time period has many benefits including that it brings to light claims or potential claims so they may be addressed before further consequential harm is realized It also forces parties who wish to mitigate damages to begin sooner rather than later.

3. Parties must continue performing other obligations, notwithstanding claims. (20) Design professionals must continue to administer the contract; contractors must continue to prosecute the work; and owners must continue to pay undisputed amounts.

4. Parties must commence mediation within a finite period of time from when the claim is submitted to the design professional or when the design professional renders a decision. (21)

5. Parties must file arbitration demands within a finite period of time from the same benchmark. (22)

6. Parties must designate an applicable set of rules (or jurisdiction) as well as the location for both mediation and arbitration. (23)

C. Customized Clauses

Though most form contracts create an adequate structure to resolve claims, they often lack a number of important details which results in unnecessary and wasteful disagreements over procedure at a time when energies should be focused on discussing merits. Practitioners should agree on such details during the contract drafting stage.

Most of these omissions pertain to the arbitration provisions. For instance, unless the contract states otherwise, the right to arbitrate a dispute exists only between the parties to that contract. Construction projects, however, involve multiple parties, and often the culpable party does not have a contract with the injured. For parties that will likely find themselves between the guilty and the injured, such as a contractor or owner, it is important that contracts contain provisions allowing for consolidation or joinder of parties.

Contracts should designate the arbitration panel. Large contracts often identify a panel comprised of an odd-number of arbitrators; three arbitrators are often recommended. The American Arbitration Association will attempt to provide neutral panels consisting of a design professional, a contractor, and an attorney. Alternatively, each party may select an arbitrator, and then those two arbitrators select the third. Owners often prefer the second method of choosing arbitrators, especially if they find lists proposed by dispute associations lacking owner-friendly representatives.

In arbitration, parties are not necessarily entitled to discovery. In large cases, arbitration rules may provide that the panel can order discovery from the parties, but that is not always the case, especially when a small amount is in dispute. Even in large cases, arbitrators will likely limit the scope of discovery compared to that which would normally be available in court. Thus, it is important to include discovery rights in one's contract, which should consist of a finite number of depositions and the right to inspect or audit the opposing party's documents.

VI. Liquidated Damages

One of the most important elements of a construction project is time. An owner makes a large capital investment in a project and requires a return on that investment promptly for the project to meet its intended purpose. Owners also rely on the expected completion date of project, including plans for moving people and operations into a building and undertaking contractual obligations that require occupancy. Therefore, owners suffer significant loss when a project comes in late, but these losses can be hard to calculate. If the owner is in the public or non-profit sector, major disputes may arise regarding the value of the space to the owner or the nature of the loss suffered by late occupancy.

To deal with these problems, owners frequently use liquidated damages clauses in construction contracts. These clauses almost always work by assigning a daily charge for substantial completion later than the scheduled date. Daily rates can be as low as a few hundred dollars or in the tens of thousands of dollars, depending on the size of the project and its time sensitivity.

A. Enforceability of liquidated damages

The standard rule of law is that the courts will enforce liquidated damages as long as they do not constitute a "penalty." The courts will generally find that to be the case only when an owner is not suffering any damages at all from the passage of time. Nonetheless, when liquidated damages are grossly disproportionate to the owner's actual damages, courts or arbitrators may intervene and refuse to enforce them.

Owners can avoid the risk of unenforceable liquidated damages by taking several precautionary measures. First, owners should avoid the use of the word "penalty" in referring to these damages. Second, if the damages figure seems high, owners should include in the contract language an explanation of the importance of prompt completion and the serious nature of the harm to the owner from late completion. For example, a school board can include language reciting that liquidated damages are high to reflect the immense disruption to the educational program that would result from interference with school operations.

Third, owners can bolster the enforceability of liquidated damages by offering early completion bonuses. Contrary to popular belief, liquidated damages need not be "mutual" so as to be enforceable. Nonetheless, an owner who agrees to pay extra for early completion will have an easier time defending reduced payment for late completion.

B. Elements of Liquidated Damages

In the for-profit sector it is not difficult to decide on liquidated damages figures. The sum should be a combination of the lost profits from late completion and administrative expenses from continued oversight of the project, coupled with the cost of disruption to move-in plans.

In the public and non-profit sector, the equation is not so simple. One approach is to take the daily interest cost of the capital cost of the project as of the completion. Another approach would include evaluating the cost based upon the value that the project is intended to ultimately provide its users. Some public owners have relatively sophisticated means of calculating the value of the project. For example, some highway authorities calculate the value of motorists' time that is taken due to delayed traffic that is a result of incomplete highway projects as the basis for liquidated damages.

C. Stepped Damages and Milestone Deadlines

Another approach is to have "stepped" liquidated damages, by which the daily rate rises after a certain point. Part of the theory of this approach is that a major delay (e.g., many weeks or months) is much more harmful than a modest delay in occupancy. This approach also allows an owner to avoid appearing punitive, by assigning a low liquidated damages figure to limited delays, while protecting the owner from large losses from a project that completely loses its way.

Liquidated damages can be employed during a project as well as at the end. When an owner desires to maintain close tabs on the progress of a job, the owner can establish deadlines for completion of stages of the work. If these are important, the owner can assign liquidated damages to these as well as to the end date. This approach is used by owners who fear that their contractor has limited management skills and may lose track of the job. Liquidated damages at milestones during the job assure that the contractor will not lose sight of the job's overall schedule.

VII. Delay and Extensions of Time

Every construction project has a schedule that determines, in advance, the sequence of work. For the owner, a schedule provides the answer to the owner's number one concern: "When will it be finished?" For the general contractor or construction manager, a schedule is a crucial tool in managing a particular project.

Unfortunately, it is a rare occurrence for a construction project to progress to completion without some disruption to the original schedule. In most cases, these disruptions cause delays, which in turn cost the owner or contractor, or both, time and money. The contract documents dictate which party is responsible for the delay and whether the contractor is entitled to an extension of time or for reimbursement of costs incurred as a result of the delay. If the delay is caused by the owner, the contractor will often be entitled to recover the costs incurred as a result of the delay. Some contracts, however, contain exculpatory clauses that restrict a contractor's right to recover compensatory damages. An example of an exculpatory clause is a "no damages for delay" clause. While beneficial to owners, "no damages for delay" clauses severely restrict contractors' rights to recover damages where there is a delay caused by the owner.

A. Types of Delays

For those involved in the construction business, various types of delays often pervade progress; however, there are ways to contract around these delays by including various remedies under standard contract documents for each type of delay.

1. Inexcusable Delays

Generally, inexcusable delays are those delays caused by, or within the control of, the contractor or its subcontractors. Examples of inexcusable delays include equipment problems, slow work, poor management, or poor coordination. In such cases, the contractor bears all of the responsibility and will not be entitled to any additional time or money.

2. Excusable Delays

Excusable delays, on the other hand, are typically those delays that are outside the control of either party. Causes of excusable delays include unusually severe weather, labor disputes (such as union strikes), or national shortage of materials. In situations involving excusable delays, the owner is required to give the contractor additional time to finish the project. The contractor is not, however, entitled to compensation from the owner for costs incurred as a result of the delay.

In some cases, the owner may nevertheless require the contractor to finish by the originally-scheduled completion date. When this happens, the owner has "accelerated" the work and must pay the contractor for costs incurred as a result of such acceleration. Often, these costs are substantial because acceleration requires over-time and double shifts. An owner should evaluate the situation carefully and should never accelerate for the purpose of mitigating delay damages. It is almost always cheaper to pay delay damages than to pay for the costs of acceleration.

3. Compensable Delays

Compensable delays are those delays for which the owner bears responsibility and must give the contractor additional time and compensation. Examples of compensable delays include design changes or errors that slow down the progress of the work, interference with site access not anticipated by the contractor, failure by the owner to secure necessary permits, or decision making by the owner that results in work delays.

4. Concurrent Delays

Occasionally, two different types of delays will overlap on a particular project. Such occurrences are commonly referred to as "concurrent delays." In order to determine whether two delays are concurrent, the parties must independently identify and evaluate each delay. If each delay would cause the project to be delayed for a similar period of time, the delays are considered concurrent.

It is not always easy to apportion responsibility in situations involving concurrent delays. One well-established rule, however, is where a compensable delay is concurrent with an inexcusable delay, the period of delay is reclassified as an excusable delay. Thus, the contractor will get additional time to complete the project, but will not be compensated for costs incurred as a result of such delays. Other combinations are debatable. For example, what remedy, if any, is available where a compensable delay runs concurrently with an excusable delay? How about where an inexcusable delay runs concurrently with an excusable delay? Such questions require lengthy discussion, which we will leave for another day.

VIII. Indemnification and Insurance

An important function of the contract drafting process is identifying risks and negotiating their allocation among the parties. The party most apt to handle the risk should assume it, provided that the party is adequately compensated; however, the party with the greatest bargaining power will often insist on shifting risk to the other party to a contract. These risks are especially great in construction where smooth progress can so easily be disrupted at great expense to the parties, and where the consequences of lapses in safety can be so great.

At the first level is allocating the risk for project completion, which may be accomplished through various provisions, usually placing the contractor at risk to complete the job. The owner, however, bears the risk of contractor insolvency. The owner may require bonding the project, but because it is the owner's risk, the cost of bonding can be passed back to the owner. Similarly, the contractor must consider risks implicated by owner insolvency. The AIA A201 addresses such risks, though not in their entirety, by allowing the contractor to request in writing evidence of financial arrangements made to fulfill the owner's obligations to the contractor as a precondition to commencement or continuation of the work. (24)

At the next level are the risks inherent with construction activities, owning property, or providing a professional service. Where these risks should lie are self evident. Though standard contract provisions place most building risks on the contractor, they do not completely protect the owner or design professional against third-party injury claims. Because safety is best controlled by the contractor, other contractual tools, such as indemnification and insurance, are necessary.

There are two types of indemnification clauses. The first provides indemnity for all work-related incidents regardless of guilt. The second provides indemnity for work-related incidents arising from an indemnitor's wrongful conduct. It is important to note with respect to the former indemnity clause that many courts and state statutes prevent indemnification of a person whose own negligent acts caused the injury. (25)

Insurance fills gaps left by indemnity. Moreover, it provides incentive to the indemnitor to assume indemnity obligations since it can insure them and pass the cost back to the indemnitee, usually the owner.

When drafting contract provisions that require a party to obtain insurance, it is important to (1) require inclusion in that policy as an additional insured; (26) (2) require that the policy continues without interruption until completion; and (3) require notice of cancellation of any policies. The policies typical to a construction project are commercial general liability, project management liability, property, loss of use, off-site storage, boiler and machinery, and professional liability.

IX. Notice-of-Claim Requirements

Most construction contracts require parties who are asserting a claim to provide prompt notice to the other party. Such notices most commonly apply when a contractor encounters a field condition that will delay the work or cause cost overruns. The typical clause requires notice of a claim within a certain number of days of the time the claimant learns of the facts leading to the claim and in any event prior to the date on which the claimant begins to expend extra funds for which it will seek compensation.

While the specific timing and method of notice vary, there are several consistent principles underlying notice requirements. First, notice of a claim gives the recipient an opportunity to gather information relating to the claim before it is lost. For example, upon receiving notice of a claim for additional costs due to subsurface conditions, the owner will want to measure, photograph, or sample the buried structure or rock that the contractor claims will lead to additional costs, lf the owner is not given notice, the contractor may remove the rock or structure before the owner has the chance to preserve the evidence that will govern the contractor's entitlement to a claim.

Second, notice may enable the parties to reach agreement regarding the amount of loss. When both parties investigate a claim simultaneously, they share the benefits and burdens of finding a solution which tends to minimize the chances of any future dispute regarding proper remediation methods.

Third, notice requirements may help assess whether a claim is genuine. In some situations, owners believe that once a contractor completes a project and discovers that the project lost money, the contractor will begin asserting claims in an attempt to recoup the loss. Requiring prompt notice at the time of the event in question helps avoid after-thoughts.

Fourth, owners have to manage the budget of a construction project and make decisions based on information regarding the prospective costs of the job. If the owner does not learn until late in the job that there will be cost overruns, the owner has less ability to arrange additional financing or change parts of the project so as to save the money needed to cover the claim.

There are, however, limitations on the enforceability of clauses requiring notice of claims. The best advice for all parties is to strictly follow the contractual notice requirements, even if notice of a claim is also provided in another manner (often less formal). Doing so is likely to eliminate the need to litigate any notice issues. However, failure to comply strictly with contractual notice requirements may not be fatal to a claim. In some instances, a court or arbitrator will not enforce technical requirements of a notice clause where the purpose of the clause has been met, such as where minutes of job meetings confirm actual discussion and consideration of a potential claim.

In contrast, merely showing that the owner had knowledge of the field condition at issue may not prove compliance with a notice clause. For example, knowing that the contractor has encountered rock that is slowing its progress is not the same as knowing that the contractor considers that to be the owner's problem and financial responsibility. The distinction is important because, if the contractor plans to effectively spend the owner's money, the owner is entitled to give direction on whether and how to proceed. The owner might, for example, decide on a design change to minimize the problem.

X. Termination Clauses

Perhaps the worst thing that can happen on a construction project is contract termination. Everyone loses money in that situation, and some parties will lose a significant amount of money. Litigation very frequently follows terminations. Terminations arise in three situations: terminations for convenience by the owner; terminations for cause by the owner; and terminations for cause by the contractor.

A. Termination for Convenience

Termination for Convenience clauses allow an owner to cancel a project after the construction contract has been executed. This situation usually only happens when financing fails or a permit necessary for the project cannot be obtained. Changes in the law or technology may also make a project obsolete or the planned approach illegal.

This clause provides that the owner pays the contractor its actual costs up to the point of notice of termination. Typically the contractor also receives demobilization costs. If any overhead costs have not yet been recovered through billings for work performed, the contractor may seek to be compensated.

B. Owner's Termination for Cause

The worst case scenario for an owner is a contractor that has stopped performing. When all else fails, the owner's remedy is termination of the contract.

Form A201 contains the basic clause concerning owner termination. It provides that the owner may terminate the contract if the contractor: 1) persistently fails or refuses to supply enough properly-skilled workers and/or materials; 2) fails to pay subcontractors; 3) persistently disregards applicable laws, ordinances or rules; or 4) is otherwise guilty of a substantial breach of the contract (the "catch-all"). Once the architect certifies any of the above causes, the owner may, without prejudice to other rights and remedies, terminate the contractor after providing seven days' written notice to the contractor and its surety, if applicable. If the cost to complete the work exceeds the unpaid balance of the contract sum, which is almost always the case, the contractor is responsible for the amounts over and above the contract sum.

As with notice provisions, strictly following the termination procedures is imperative, particularly since litigation so often follows from a termination for cause. In addition, proper termination may have an effect on any rights to recovery under performance bonds. Often performance bonds are given by the contractor at the inception of a project in order to guarantee that the project will be completed if the contractor is unable to do so. Obligations under performance bonds typically are not triggered unless a claimant first follows all proper procedures to terminate the contract. Often performance bonds require that the surety be notified of an intention to terminate and any subsequent termination of a contract. Failure to follow those clauses may impair a claimant's right to future performance to complete the original contract.

C. Termination For Cause by Contractor

Contractors seldom wish to terminate contracts. However, in some instances, job conditions may become so unbearable that a contractor decides to take such drastic action. Some contracts contain a clause which provides that a contractor may terminate if the owner fails to make payment for thirty days or the architect fails to recommend payment for thirty days, through no fault of the contractor. The contractor is required to provide seven days' written notice to the owner and architect. Thereafter, the contractor is entitled to be paid for all work performed together with proven loss with respect to materials and equipment and even reasonable overhead and profit.

Because termination is a drastic remedy, contractors should carefully consider whether termination will serve to limit their liability as opposed to increasing it. Contractors should also be mindful of any obligations that they might owe the surety as a result of cancellation, as sureties' rights to indemnification in these situations are generally quite broad.

(1) AIA Forms A101 and A201 are referenced frequently throughout this article. Form A101 refers to the 1997 "Standard Form of Agreement between Owner and Contractor" ("A101") and Form A201 refers to the 1997 "General Conditions of the Contract for Construction" ("A201").

(2) A 101, Article 5.

(3) A101 [section] 5.1.2; A201 [section] 9.3.1.

(4) A201 [section] 9.3.1.

(6) A201 [section] 9.2.1.

(7) A101 [section] 5.1.3.

(8) A201 [section] 9.4.1.

(9) A201 [section] [section] 9.3.1.1 and 7.3.8.

(10) A201 [section] 2.2.1.

(11) See Thomas J. Dyer Co. v. Bishop Int'l Eng'g Co., 303 F. 2d 655 (6th Cir. 1962).

(12) A201 [paragraph] 9.6.2.

(13) Framingham Heavy Equipment Co., Inc. v. John T. Callahan & Sons, Inc., 6l Mass. App. Ct. 171 (Mass. App. Ct. 2004).

(14) A201 [section] 4.4.

(15) A201 [section] [section] 4.5 & 4.6.

(16) See, e.g., Thomas J. Stipanowich, Arbitration and the Multiparty Dispute: The Search for Workable Solutions, 72 IOWA L. REV. 473, 509 (1987).

(17) See, e.g., Jerold S. Solvovy and Robert L. Byman, Arbitration Discovery, THE NAT'L LAW JOURNAL, at 24 (Sept. 8, 2003).

(18) A201 [paragraph] 4.3.1.

(19) A201 [paragraph] 4.3.2.

(20) A201 [paragraph] 4.3.3.

(21) A201 [paragraph] 4.5.1.

(22) m201 [paragraph] 4.6.1.

(23) A201 [paragraph] [paragraph] 4.5.2 & 4.6.2.

(24) A201 [section]2.2.1.

(25) A201 [section] 3.18.1.

(26) The most common document requested to ensure that a party has been included as an additional insured is a certificate of insurance. Certificates of insurance, however, are not policies: they are only informational documents. Without amendment to an insured's policy, an "additional insured" is not covered. See Vinco, Inc. v. Royal Ins. Co. of America, No. 01-7411, 2002 WL 337988, at *1 (2d Cir. Mar. 4, 2002).

IADC member Timothy S. Fisher is the managing partner of the Connecticut offices of McCarter & English, LLP, where he chairs the firm's Construction Practice Group. Mr. Fisher's twenty-five years of work in the construction industry have equipped him with in-depth familiarity with the issues facing owners, contractors, and others involved in bringing construction projects to successful conclusion. Mr. Fisher received his B.A. from Yale University in 1975 and his J.D. from Columbia University in 1978.

Francis A. Kirk is counsel at McCarter & English, LLP, where his practice focuses on construction disputes and related business litigation matters. He has litigated various construction and contract disputes since 1992 when he received a J.D. from Rutgers University School of Law. Mr. Kirk received his A.B. from Brown University in 1989.

James F. DeDonato, Salvatore N. Fornaciari, and Jason C. Welch are associates at McCarter & English, LLP in Hartford, CT. Mr. DeDonato received his B.A. from Providence College in 1997 and his J.D. from Catholic University of America in 2000. Mr. Fornaciari received his B.A. from Central Connecticut State University, magna cum laude in 1996 and his J.D. from Quinnipiac College School of Law, magna cum laude in 2000. Mr. Welch received his A.B. from Hamilton College in 1994 and his J.D. from Quinnipiac University School of Law in 2001.
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Author:Fisher, Timothy S.; Kirk, Francis; DeDonato, James; Fornaciari, Salvatore; Welch, Jason
Publication:Defense Counsel Journal
Date:Jul 1, 2005
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