Understanding Construction Contracts
A construction contract is an agreement between an owner and a contractor for the payment and performance of construction projects. Construction contracts define parameters for costs, scope of work, timelines, and other aspects of a construction project. Both the owner who hires and other stakeholders who benefit from the project depend on construction contracts to meet expectations for pricing, schedule, and performance.
There are many parties to a construction contract, including owners , contractors, subcontractors, and suppliers. Depending on the size of the project, there may be many tiers of these parties.
Construction contracts are typically organized in phases so that contracts are designed to win and complete a specific phase of the project. Mostly the construction contracts will begin with an agreement for the full scope of the project, followed by a series of sub-contracts or other contracts that complete specific aspects of the overall project.
Essential Elements of a Construction Contract
Every construction contract should at a minimum include the following information:
- Scope of Work: The contract should clearly define the work agreed upon, and all materials that will be used; this is the art work description.
- Schedule: The contract should include at least a complete project duration with specific milestones identified. In some cases it makes sense to include minimum break points at which an owner will make progress payments.
- Payment Terms: the contract should spell out a payment schedule and the method for determining the price of changes and disputes regarding costs.
- Dispute Resolution: the contract should outline how the parties will resolve disputes; litigation, arbitration, mediation and other processes are common methods of dispute resolution.
- Warranty Provisions: the contract should state the length of time each party warrants their work; the time period often ranges from 1 – 2 years.
- Other Legal Provisions: the contract should include any additional responsibilities that the parties agree to, such as relevant state law, applicable fees, mechanics lien provisions, insurance and indemnity requirements.
How to Spot Potential Risk Factors
Construction contracts are riddled with potential risk factors that can significantly impact the scope and cost of a project. Common risks include delays, cost overruns and unforeseen site conditions. These potential risks should not be treated as nuisances lurking in the contract as they may be defining features of the projects themselves.
Delays can be the most destructive and costly potential risk factor on a construction project. Failure to complete construction on time has serious consequences, including potential claims from clients and contractors further down the line. It is important to define what are acceptable delays. The relevant contract may provide specific exclusions from the obligation to complete construction by a specific date such as strikes, lockouts, fires, floods and credit unavailability.
Beyond defining acceptable delays events, it is important to understand the cause of the potential delay. Many construction projects include provisions dealing with compensation for specific delays. A construction contract may entitle the contractor to a fee on a percentage basis for delays caused by either it or the client.
Some potential delays are frequently addressed in construction contracts. For example, many construction projects contain a schedule that must be followed. A common risk involves a contractor’s inability to comply with the prescribed schedule. Many construction contracts include remedies for the scheduling of progress payments based on actual completion of different stages of work. Some payment schedules use "milestones" to release funds to the contractor as specific objectives are met. Delays to the contractor’s ability to meet these milestones will likely involve disputes relating to non-payment.
Construction contracts also address the potential for termination of a contract for convenience and for cause. The right to terminate a contract for convenience allows the principal to end the contract without specifying a reason. This is type of termination is often accompanied by damages to the terminated party. The right to terminate a contract for cause involves a sale of services from one party to another. For the developer or owner, this involves the right to end the contract for a specific reason (such as the failure to meet progress schedule or fee milestones). The general contractor often has similar rights. Many construction contracts receive recognition in light of the potentially disastrous repercussions of a poorly worded clause.
Legal Considerations and Compliance
Construction contracts are not just about the work to be performed, but also about the standards and laws that govern that work. Before signing a construction contract, ensure that all compliance and legal requirements have been met. This includes but is not limited to laws related to labor and industry, construction standards, environmental regulations, and building codes. Valid licenses and permits are essential. Violations can lead to fines, delays, or even termination of the contract. Substantive changes to the law may make the contract unenforceable after the fact. Not all construction contracts require the same set of compliance provisions. A government agency involved in construction may have a number of very specific requirements that a private entity will not. Compliance with laws at the state and federal level is also critical. Uniform laws between states can help create certainty, but variations exist. Federal laws may require additional provisions and are just as important as those at the state and local levels.
The Importance of Change Orders
Change Orders address modifications to the project that are either proposed by an owner or requested by the contractor. Either way, they are an essential part of construction projects and can be the source of dispute. Many times, a proposed change order does not address every aspect of the change. A good change order needs to address, at a minimum, the price, time, and scope of work. These are the critical pieces without which a construction contract will become unbalanced as the work proceeds. The owner, the contractor, and the subcontractors should all look into incorporating a change order into the contract.
Change orders are the most effective method to modify or supplement the contract—for price, time, and scope. They also provide a record of amendments to the contract. Nonetheless, many contracts do not contain sufficient information about how the owner and contractor should handle a proposed change. Incorporating a sample form change order to the contract helps the parties set a standard for review and approval of change orders. It becomes useful if there is, then, a significant modification and negotiation of the terms for the later proposed change order.
Contractors and subcontractors should be aware of different articles or sections in the contract that may require notice when a change occurs, or even a proposed change is pending. Not only is timing important, but the information that the owner or contractor requests may be different . The contractor or subcontractor needs to read the contract very closely for the intricacies of its notice provisions for change orders.
Ideally, change orders for a large project will occur after extensive negotiations, and will be executed as the work progresses and as progress payments are made. For a smaller project, additional negotiation may not be necessary for the parties to agree on the contract sum and the time. Overall, the general contractor and the owner do not have to re-sign the entire contract; the addendum changes or supplements only the cost and time.
When drafting a change order, it is best to clearly state the scope of work (this is often the hardest part), the new contract price, time remaining, and how the parties intend to resolve disputes from the prior contract (pick which lawyer will interpret the contract).
The change order may also define lower-tier procedures so that the same provisions can be passed down the chain. Likewise, it can list the flow-down of any agreements that involve the value of the contract. Many contractors, especially builders, incorporate the schedule. This is how the parties can minimize the risk of a dispute on a large construction project. It allows the contractor and owner to measure the impact and value of the change together and in open communication. It is a best practice to have all three elements documented.
Effective Dispute Resolution Provisions
Dispute resolution clauses are common in all types of construction contracts. Often the parties are required to undertake some pre-litigation steps. Consideration should be given to whether those steps are also required after litigation commences. For example, a common precondition for litigation or arbitration is that the parties must first conduct one or two good faith, at-the-table negotiations. In addition to those informal discussions, a "meet and confer" pre-litigation requirement can be a useful tool. It requires the parties to confer with each other, hopefully in person or at least via telephone, in advance of a scheduled court appearance (particularly beneficial prior to a summary judgment motion).
The development of state and federal mediation programs further encourage the inclusion of ADR provisions. By now, you have likely experienced various processes that require mediation prior to trial.
Other forms of dispute resolution include, but are not limited to binding arbitration, non-binding arbitration, and mini-trials. For binding arbitration, a number of factors should be considered. What are the qualifications of the arbitrator? In what capacity has he/she served? Are there areas of expertise? Have the parties experienced prior arbitration proceedings with that arbitrator and, if so, were they satisfied with the results? What are the costs associated with arbitration (including AAA or JAMS fees, arbitrator and attorney fees)? What is the scope of discovery? Is there a limitation on the number of depositions that can be taken? Is a jury permitted to hear the matter? Who will pay the arbitrator fees?
The goal of these dispute resolution clauses is to have the parties capture the process most suitable to resolve their disputes, including the most important procedural safeguards. These types of clauses also afford significant control and predictability over the litigation process.
The Value of Professional Review
Just as most experts would recommend that you have your plans and specifications reviewed by an engineer or architect before proceeding with a construction project, the same reasoning applies to having the actual construction contract reviewed by a legal professional before proceeding as well. A professional review can help ensure that all aspects of the contract are legally appropriate, protect your interests, and can possibly help avoid disputes over the meaning or application of certain provisions during performance.
For example, although it is common for construction contracts to contain a liquidated damages provision, the validity and enforceability of such a provision under Pennsylvania law are not as straightforward as many assume. Because of the possibility that particular language could result in a court finding a provision to be an unenforceable penalty, it is wise to have a liquidated damages provision reviewed by an attorney experienced in this area to assure that the language is appropriate. Such is the same for many other commonly seen areas of disputes or claims, including, for example, indemnification provisions, payment terms, and even some provisions related to termination of the contract.
Also, it may be that the contract is not appropriate for the situation or that stronger language could be used to protect your interests. In the same way that it is always more difficult to assert claims or counterclaims after a construction project is over, it is also true that it will never be easier to negotiate and have recorded appropriate contractual terms and provisions than while the parties are still actively negotiating the contract.
Final Contract Review Checklist
A thorough review of a construction contract is the final stop before the project begins. The terms and conditions of the contract can accompany the plans, specifications and other contract documents attached to it on the road from beginning to completion. In order to ensure a successful journey, here are key areas of a construction contract to scrutinize with a fine-tooth comb:
Description. A precise description of the project, including scope of work, responsibilities and requirements, is essential to avoid disputes over what is included. These can include clauses that, in their own words, limit or control rights or remedies. Be cautious about language that attempts to alter interpretation principles or presumptions under the law.
Time. Look carefully at provisions concerning performance time frames, the amount of time for certain actions to take place (such as changes to the design), scheduling, accelerations and delays. Be alert for entitlement to damages and other compensation for failure to meet these contractual deadlines.
Payment. Instead of simply referring to an attached proposal or offer, the contract should outline the payment process. It should clearly state whether a deposit is due before the work starts and how many subsequent draws will be required to complete payment . Also, how does the contract set out to determine when payments will be made? Are there specific triggers for payment? A schedule for completion of milestone payments should be monitored closely. Finally, are there provisions for late payment and interest penalties?
Permits. Make sure the contract specifies clearly which party is responsible for applying for, and obtaining, required permits for the work. Be sensitive to deadlines for all aspects of permitting.
Dispute resolution. The contract should require the parties to exhaust all administrative remedies through hands-on negotiations or other informal means before being allowed to file suit or initiate other formal dispute resolution processes. There should also be an informal discovery process, if applicable, that occurs before a lawsuit is filed. Finally, is there a stipulation about what happens to any performance or other bonding that has been posted while the dispute is being resolved?
This list is not complete, but covers many of the most significant issues that could impact a project. A careful review also should be done for any areas in which one party has more risk than the other and determine how this affects you.