Getting to Know Construction Contracts
Agreements to construct a building or development are common in the construction industry. Construction contracts are simply agreements by which one party, or ‘the contractor’, agrees to build or develop something, in exchange for a payment for doing so. Different forms of construction contract exist to suit different types of construction, and it is important for both parties to ensure that they enter into the correct form of construction contract for the particular project in question.
Without entering into some form of construction contract, a construction project is likely to descend into chaos. For example, without the contract, it would be difficult to ascertain the scope of work to be carried out, the timescales for completion, the quality of work to be achieved or the price of the work.
Construction contracts will be entered into between differing parties, obviously construction projects are usually between the person who wishes to build/develop something and the person who tends to the building work (i.e. the contractor). However, it is not always as simple as that, sometimes there may be multiple parties involved (for example the client may be an institution, developer or builder, and the contractor may be an employed contractor for the developer or builder, and such contractor may have also sub-contracted part of the work out to sub-contractors). Sometimes there are circumstances where contracts are entered into between parties who do not actually intend to engage in a construction project. In such situations, the parties are acting for a purpose which is entirely different from the purpose intended for the construction contract, and so they should beware before entering into such contracts.
In terms of the types of construction contracts available, construction contracts fall into a number of different categories. For example, some construction contracts are ‘formal commercial documents’, for example JCT standard form contracts . These types of documents will usually contain all of the terms expressly agreed between the parties. On the other hand, you will find that some construction contracts are based upon the conduct of the contracting parties (for example a contract may be formed based upon the conduct of the parties when it comes to paying for completed work). Here, it is less clear what the terms of contract are, but if it is clear that those terms exist and are discussed or agreed between the parties, then the construction contracts may stand.
The most common form of construction contract is for the contract to be based upon terms that have been discussed between the parties. For example, it may be clear between the parties what the payment for the work is to be, and so it does not necessarily have to be expressly set out in the contract; it can instead be implied. In practical terms, it is generally considered that it is best practice for a construction contract to be expressly documented, so ensuring that you have the signing of a written contract should be carried out. However, if the parties agree later on terms which amounts to a contract, then it will be valid even if it is not expressly documented.
At the other end of the spectrum, there will be contracts of guarantee (where one party agrees to pay costs incurred by another party if the other party fails to pay those costs), and construction contracts which are created based upon a course of dealing between the parties (i.e. here, the parties will continually enter into contracts over a period of time, which amount to the creation of a contract). There may also exist the situation where you have an agent acting on behalf of its principal, and so it is important to be aware of when a contract has come into existence, what its terms are, and whether it is fair and reasonable when you are acting as an agent.
Components of a Construction Contract
There are four main components to any construction contract: scope of work, project timetable, payment timetable and dispute resolution process.
Scope of Work
One of the most important aspects of a contract is the scope of work. The scope of work identifies exactly what is to be performed by the contractor, subcontractor, and others. A contract should be clear on what work is included and what is not included. If the scope is not clear, it would be reasonable to allow the contractor to perform what it believes is necessary to complete the work. Likewise, if the scope is not clear to the contractor, a court or jury should be allowed to determine whether the additional work is necessary to complete the project. The scope of work in this case should be clear and precise, to include all work to be performed as well as all items not included in the contract.
A contractor undertaking remodel or new construction projects or having existing service obligations should pay special attention to the scope of work in the contract. An unclear scope of work can result in costly delays and disputes that lead to litigation. If a contractor engages in a dispute over a scope of work, it should become familiar with the following Texas laws: (1) Chapter 53 of the Texas Property Code provides for the right to lien for unpaid labor and for providing labor or materials; and (2) Article 8 of the Texas Business & Commerce Code provides that a contractor has a duty to mitigate its damages through the strict performance of the contract.
Timetable
A contract should set a timetable for project completion. This timetable should be agreed upon and capable of being fulfilled by the contractor. For most residential construction projects, a written scope of work will provide ample information to determine the timetable for performance.
Payment
A construction contract should have a provision for payment. It should be very clear on what constitutes payment and the schedule for achieving such payments. Most of the major construction trades provide sample contracts which adhere to the recommended best practices for their trade.
Dispute Resolution
Any contract should have a dispute resolution process. This can be as simple as requiring arbitration in the event of a dispute over the contract. If a court or jury trial will be required, many contractors and general contractors include a provision that binds the customer to an arbitration process. This allows for the matter to be resolved without the delays and potential costs associated with court litigation.
Different Types of Construction Contracts
Types of construction contracts share an important element – how they generally divide the risk in the event the project does not go as planned. A developer’s negotiated terms with their contractor should take into account risk, budgeting, and the unpredictability of construction. Each type of contract has unique advantages and disadvantages. A brief primer is provided below on each of the four common types of construction contracts.
Lump sum contracts are the most transparent way to set price. In a lump sum contract, the price is predetermined. Any changes to the work scope or delay are added as change orders at an agreed-to price negotiated under the contract terms.
In addition to the simplicity and predictability from an accounting perspective, lump sum contracts provide the incentive for the contractor to conduct thorough fieldwork and meet schedule obligations. However, the developer must be careful when utilizing a lump sum contract with a contractor who is not a proven performer. If the developer fails to adequately assess the contractor’s ability to perform the work, the contractor may underprice its bid. The developer may be held accountable for the difference in the original lump sum and the actual higher price necessitated by the contractor’s mistakes.
Assuming the contractor bid the lump sum in good faith and no mistakes were made, however, this type of contract allows the developer to easily budget and forecast the costs of the work. It also allows the developer to shift to the contractor the financial risk of loss if the contractor fails to complete the project in a timely manner.
By contrast, in a cost plus contract, the actual cost to the contractor is paid by the developer plus a predetermined overhead and profit percentage. We can think of this type of contract as the "worst case scenario" contract. The contract protects the contractor against physical loss and eliminates the incentive for observance of any of the duties it assumed in the contract.
Under the cost-plus contract, the risk lies with the developer. The contractor is incentivized to provide fewer resources to the project to maximize its profit margin. And unlike the lump sum contract, the developer cannot pass responsibility onto the contractor for the agreed-to price in the fixed-priced contract. The lump sum contract provides for changes to the scope of the work by way of change order, but no money back guarantees.
Nonetheless, a cost-plus contract is appropriate in several specific scenarios. First, where the work scope is fluid, dynamic, and constantly evolving the developer can pay the contractor based on work completed. Second, where careful, accurate control of the work is absolutely essential, the developer can always ensure that the contractor is performing the work as required. Third, this type of contract works well where close monitoring of the schedule and cost is required to meet the party’s goals for the project.
Under a time and materials contract, the developer agrees to reimburse the contractor for its labor and materials that went into performing the work plus a predetermined profit margin. One positive aspect of a time and materials contract is that the contract will specify particular rates that will be charged for various services. This method of charging differs significantly from a lump sum contract.
Despite being more labor intensive in terms of paperwork and tracking, Time and Materials contracts can be beneficial in three circumstances. First, small projects or limited extra work, should be performed under a time and materials contract. Second, if active management by the developer is impossible (i.e. too much work is assigned to one manager) a time and materials contract allows the developer to limit any unprojected profit to a fixed percentage of either labor or material. Third, if the developer wishes to preserve its right to recover lost profits in the event it is injured, this may be the best choice of contract.
A unit price contract provides for compensation to the contractor based on a base unit price for a specific form of work. The unit price is set forth in the original contract and compensates the contractor at the bid unit price for labor and materials. Change orders will be issued for additions to the scope of work and will be give the developer the ability to reject changes it did not approve.
Unit price contracts are useful for work that can be measured by a standard unit. This may be a unit of time (actual hours), square footage, number, weight, or other appropriate unit that can be measured. This arrangement is often preferred when the actual price for the work is not known. This doesn’t mean this is a bad way to do business. However, it does mean that a developer may not want to use this type for a fixed scope project.
Common Mistakes Made in Construction Contracts
One of the most frequent types of mistakes that we see in construction contracts is a lack of clarity in terms and scope. These are not something that can be determined as you go along. You need to use your common sense and build in extra time and budget for the unknowns.
Makes sure there is sufficient information in the specs to enable the bidder to price everything, not just parts. Do not expect a contractor to include in his bid some elements of design because he necessarily will not be privy to everything that you have in mind.
Also, when you stray from the plans in the middle of the process after bid, or award, you need to understand that there will be additional cost and time. Of course, if you proceed with payment without additional money in hand you may be straying into the world of the financial impossibility and ultimately litigation.
Payment schedules, properly drafted are critical to fast tracking a project. You must insist in full back up documentation to support every payment. I have seen too many times that contractors submit false backup, make commitments on that basis and then suddenly they disappear and you are left with a lesser contractor.
The timing and amount of liquidated damages continue to be a hot button in construction. Liquidated damage are meant to penalize the contractor and are generally enforceable, but you should make sure that the amount is reasonable given the situation. The courts may not sides with you if you price your liquidated damages without regard to common sense and damages.
In case of default, understand how much money is at stake if you default. We see too many bonds where there is more than one bond being required for the same project and parties. Especially if you are the developer and not the contractor, make sure that the bonds are worded to protect you and your lending partners on the project so that the contract obligations to the lender are protected. A wrong word there could wax over a $40 million dot.
Practical Ways to Approach Construction Contracts
Constructing a clear and effective written agreement, whether drafting a new contract or remodeling an outdated one, is an essential step in making your agreement successful. Too many disputes arise from contracts that contain ambiguities, omissions or errors, sometimes creating misunderstandings where none existed before. In order to avoid these types of disputes from emerging, a contract can be drafted to:
- Contain clear, unambiguous terms. This ensures that each party understands what they are agreeing to up front. If a particular term is not used commonly, it may be a good idea to define the term within the four corners of the agreement.
- Incorporate only contracts actually agreed upon by the parties. To the extent a particular provision – i.e., a warranty, limitation of liability, waiver of certain rights, etc. – found elsewhere (in any ‘form’ contract or otherwise) is optional, such that a party has a choice in deciding whether to include it or not, then such a provision should not be treated as an "industry standard." In other words, just because there are forms available to choose from does not mean that any particular provision is appropriate for inclusion in your contract.
- Include all enforceable and necessary terms and conditions. A written contract is not enforceable unless it contains essential terms which sufficiently describe the subject matter, i.e., the signatories, a scope of work, description of services, etc. In addition, a contract should contain specific terms that the parties have agreed to and which clearly define their rights and obligations under the contract . Otherwise, the parties may have difficulty enforcing their respective rights, and the ambiguity may likely give rise to unnecessary disputes.
- Be careful about the incorporation by reference of other documents. Generally, extra-contractual documents may not be enforceable if they are not included in the four corners of the contract. Thus, while it may be a good idea to include other documents by incorporation by reference (e.g., copies of the State Building Code), be sure to review them carefully and confirm that they do not contradict or otherwise interfere with your contract terms.
- Avoid using "Form" contracts provided by third parties. Standards practices, custom and usage may be the basis for many of the terms in a form contract. However, such terms may not reflect the specific objectives or the specific risks that the parties or the project may face. Concentrate on your objectives rather than the practices of others.
- Utilize "Standard" contract documents from reputable industry organizations. Resources such as the American Institute of Architects (AIA) and The Joint Contract Documents Committee (JCDC) (composed of the National Society of Professional Engineers (NSPE), the American Institute of Architects (AIA), the American Institute of Contractors (AIC), and The Associated General Contractors of America (AGC)) develop standardized contracts for use in the construction industries. These documents provide provisions that reflect best practices for all parties involved in a construction project.
Legal Factors for Construction Contracts
The enforceability of a construction contract will often depend not only upon the legal capacity of its parties, but also their legal rights and obligations under the applicable body of law. The parties will therefore need to familiarize themselves with the statutory requirements for a binding contract, whether it is between them and a private party or with a public entity. This sub-section also looks at the general legal obligations that each party to a contract has not only to the other contracting party, but also to third parties such as laborers and suppliers, the regulatory status of the parties and relevant insurance requirements.
The statutory requirements that must be met for a contract to be binding will depend upon how the parties are characterized under the law. For example, specialized statutory requirements may apply to agreements between a public body such as the state government, and a private contracting party. Other statutory requirements are contingent upon the type of work being performed for the public entity, such as whether the project is to be a "public work" or "maintenance work" as defined elsewhere in the Construction Contracts or general state laws. There are also more strict requirements for contract relationships between a foreign party and a resident of the state, or between residents of a foreign country and of this state. Parties should therefore consider not only the manner in which they are characterized under the law (e.g. domestic vs. foreign), but also whether the subject matter of the agreement is subject to any unique statutory requirements for such contracts, such as those that apply in the construction industry or with regards to preparing agreements with public entities. Parties that do not make these considerations or attempt to circumvent any applicable statutory requirements may find themselves facing a range of potential consequences under the Construction Contracts or other statutory or regulatory code.
An additional legal consideration is each party’s responsibilities to third parties, such as Subcontractors and Suppliers. General Contractors are obligated under the Common Law and the Construction Contracts to pay their Subcontractors for all work performed on a project, and Subcontractors have further obligations to pay their underlying Subs instead of pushing the burden of payment for their work to either the original Contractor or the project owner. Consequently, the parties to a contract should be mindful of their obligations to third parties such as Subcontractors and Suppliers, and to familiarize themselves with the range of remedies available for the protection of such third parties (such as the ability for a Subcontractor to place a lien on the property of the General Contractor under certain circumstances to secure payment for work performed once all contractual remedies have been exhausted). Other legal obligations that parties to a Construction Contract should consider are those concerning labor laws, including the prohibition against child and forced labor. Depending upon the specific terms of the agreement, the parties may also have obligations that extend to future use of the project. Parties should consult with experienced legal counsel to ensure that they are prepared to meet both their existing and future legal obligations under their proposed agreements.
Resolving Disputes in Construction Contracts
Due to the complexity of construction projects, and the various stakeholders involved, disputes are not unusual. Addressing these disputes can be uneven in a construction contract. Some contracts contain detailed procedures for the resolution of disputes, while others contain limited or no procedures. This article briefly reviews common dispute resolution mechanisms. It then discusses how these are commonly addressed in construction contracts, and some strategies for preventing and resolving disputes efficiently.
Common Dispute Resolution Mechanisms A construction contract may provide for a variety of ways to resolve a dispute. Commonly, the contract will first require the parties to engage in some form of alternative dispute resolution. A simple tiered mechanism may provide for negotiation between the parties. More involved processes include mediation and arbitration. Litigation—where the parties submit their dispute to a court—is typically (but not always) the final resort. For public sector work, where a public agency is involved, litigation is often the only avenue. For many private sector projects, the parties can contractually agree to (or not agree to) any dispute resolution forum—so the degree to which arbitration, mediation, or a tiered approach is needed may depend on their relative bargaining power.
Alternative Dispute Resolution: Mediation, Arbitration, and Litigation Mediation is a non-binding process where a third-party acts as a facilitator. Mediators are not typically subject area experts (e.g., a construction professional). Instead, they are trained in conflict resolution. The parties may present facts, evidence, and their version of events to the mediator. The mediator can then propose a solution that, they predict, both parties will find workable. However, the mediator should not impose a solution. Because a mediator cannot bind either party, the process continues until the matter is resolved, or a party terminates the process. Mediation is often the preferred early dispute resolution mechanism as it tends to be relatively cheap and fast—if it works. If not, the parties may engage in a more formal arbitration process or resort to court. Arbitration is a private and often more formal process. In arbitration, parties can contract around the rules that govern the arbitration . The arbitrator usually has subject area expertise relevant to the dispute. An arbitrator need not be a member of the bar, unlike a judge. During arbitration, parties present evidence, submit written materials, and make oral arguments. The arbitrator then makes the final, binding award. The arbitration award is subject to very limited review, meaning the scope of appeal is much smaller than in litigation. Because arbitrators are not bound by precedents, their awards may be inconsistent. Like with mediation, the process may move quickly. Costs associated with arbitration may be less than litigation, although not as less than mediation. Similar to arbitration, litigation is a relatively formal process. Unlike arbitration, the parties are bound by procedural rules of court. Parties are also bound by the law as it exists at the time the complaint is filed. In litigation, parties pose questions to witnesses under oath, and the judge or jury considers evidence and issues their respective verdicts. Unlike an arbitrator, judges are bound by precedent and can only issue rulings to the extent of applicable law. The exception to the limitations of appeal, in arbitration, is that a court can review an arbitration award to determine if it was procured by fraud, partiality, or if the arbitrator exceeded their powers under the contract. In litigation, a decision can be appealed by either party or both parties. Litigated cases tend to be longer and more expensive than arbitration.
Prevention and Alternative Dispute Resolution of Construction Disputes As discussed above, a well-crafted construction contract may provide for tiered dispute resolution mechanisms—meaning that parties may try a less formal approach before resorting to litigation. However, it is important to understand that most construction contracts do allow for litigation to eventually occur. The following are additional best practices to help prevent or manage construction disputes: Litigation and all of the legal processes that surround it are often the last thing parties in a construction project want to engage in. Tiered-dispute resolution mechanisms, when implemented correctly, can help narrow the field of disputes that render a project ineffective and unenjoyable for the parties involved.