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Fundamentals of Construction Contracts

Posted by Nicole Liotine | May 18, 2017 | 0 Comments

Every business needs to create certainty about how it will obtain inputs and how it will produce outputs for clients. Lack of certainty about either of these things creates a risk to the business. In the world of construction, small project deals are often forged by word and sealed by a handshake, with written contracts relegated to the world of large project bids. However, writing down the details goes a long way to ensuring that a true meeting of the minds has occurred, and that both parties expect the same things from the deal.
In the construction industry, written contracts are useful both from a practical and a strategic standpoint. This month's newsletter will introduce some of the practical benefits of written contracts and then provide an overview of some key provisions found in construction contracts. Understanding these provisions will help you manage business risk by scrutinizing terms and knowing when to seek legal counsel for assistance in negotiating and drafting terms that fairly allocate risk among the parties.

The contract negotiation process brings three important benefits. First, well-written contracts give both parties useful guideposts to help navigate crucial aspects of the project. These matters include the time and manner of payment, project milestones, and risk allocation for various foreseen and unforeseen issues. Without a clear written agreement before the project begins, each side will be left scrambling-and often disagreeing-about how to address problems as they arise or even how to fairly manage seemingly simple matters like payment.

Second, written agreements signal when a deal has not or cannot be reached. When a true meeting of the minds occurs, both parties will tend to agree on the fundamentals and put them in writing easily. If one party and the other quickly reach agreement on fundamental terms before tackling peripheral or more granular details, rest assured that you and your counterparty are on the same page. On the other hand, when that portion of the negotiation fails, it becomes obvious that there is no deal.

Third, creating a written contract will give you key insights into the mindset and the integrity of the other party. The contracting process offers a sneak peek at whether the counterparty intends to keep its word. The manner in which the other party deals with contracts often reveals their general approach to handling business affairs. A company that agrees to pay within 30 days after the job ends but then rejects firm language requiring payment in 30 days or requiring an interest penalty if payment is made later than 30 days is probably not committed to paying on time.

A construction company that utilizes written contracts will realize further benefits. Well-drafted contracts determine survival and profitability in the construction industry. The specific provisions agreed to will ultimately impact the bottom line. Contracts lay the foundation for healthy working relationships and mutually profitable work by setting forth key terms, the scope of work to be performed, the price, terms and conditions of payment, and the allocation of risk, allowing both parties to create certainty for their business, avoiding costs that threaten the business.

ESSENTIAL MATTERS

It is important to ensure you understand the whole contract before you sign and accept. As a starting point, here are some significant matters addressed in most construction contracts. These provisions comprise the core of the agreement.

Scope of work: This part of the contract establishes the duty owed by the party delivering or performing the work to the party paying and/or receiving the work. This is the heart of any construction contract. Without a scope of work, a contractor's duty and liability cannot be determined. Similarly, when scopes of work are brief or vague, uncertainty arises about when a contractor has fulfilled its performance obligations. A detailed and thorough scope of work is essential to avoid disputes.

Price and method of payment: This establishes when and how the contractor will be paid for work. Typically it includes a schedule for specific tasks or portions of work. As those work items progress, the contractor will attest that a percentage of the work has been completed and then is entitled to specified payment.

Project changes and change order requests: This part of the contract sets forth the allowed method for submitting, evaluating, and approving any changes to the work plans or specifications of the project after the project has begun. In the case of fixed-price contracts, this language must be structured carefully to ensure the contractor has sufficient discretion to block superfluous or non-critical changes.

Delays: Frequently, construction contracts segregate delays into two categories and address each separately. For delays arising from reasons within the contractor's control (or assumed to be within that locus of control), the contract might allow a certain number of days before imposing penalties. For delays arising outside the contractor's sphere of control, the contract will seek to explicitly disclaim any liability or penalty to the contractor, announcing that the contractor will not owe any damages. A contractor may also want to impose penalties and automatic damages payable to reimburse its costs resulting from project delays for reasons outside its control. A contractor's resources are scarce and valuable; any idle resources might otherwise have been used to make money from another project.

Suspension and termination: The circumstances by which the contract may be suspended or cancelled if the either party fails to perform as agreed is another essential contract term. This section gives both sides enforceable rights to end the contract for failure of the other to uphold its end of the bargain. Typically, only substantial or material breaches that go to the heart of the contract will trigger a suspension or termination right. However, contracts drafted by the owner are likely to contain language that allows the owner to invoke suspension or termination for a multitude of reasons including seemingly trivial matters tangential to the broader purpose of the contract, while substantially limiting the contractor's right to suspend or terminate the project.

Disputes: This section should not be overlooked because it addresses how the parties must proceed in the event a dispute arises about what the contract says or how the parties have performed. Some construction contracts contain mandatory arbitration clauses that compel the parties to resolve their dispute before an arbiter rather than a judge in a state or federal court. In California, arbitration clauses are generally enforceable, so contractors should carefully consider whether they want to surrender their right to pursue contract claims in court.

PROTECT YOUR BUSINESS

Any construction contract that is well conceived and well drafted will be lengthy and a bit complex. Length and complexity are necessary consequences that arise from the search for clarity and fair risk allocation. Receiving assistance from qualified legal counsel to negotiate a construction contract is a great way to ensure that your deal is clear, fair, and arranged the way you want it to be. Experienced counsel may also have valuable wisdom about how to structure terms to maximize the value to your business.

Rodney R. Moy at HMS Law Group has worked extensively with owners and contractors of every tier negotiating both simple and complex construction contracts.

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