June 18, 2014

A Risky Business


Construction is a risky business. Things happen and things change during the time it takes to plan and build a project. Over time, even the most well planned undertaking can go awry. We know it is inevitable. We just don't know when — or how. Project owners and construction contractors deal with this uncertainty through contracts that distribute the various risks among the parties. Construction contracts, anticipating the unexpected, typically contain provisions that adjust the relationships, responsibilities, and rights of the parties when the inevitable occurs.

A good contract relationship directs risks responsibly — that is, to the party or parties best able to 1) reduce exposure by carefully managing the activity and 2) absorb the cost of management or loss. The first factor turns on the authority and qualifications, while the second turns on the price and value received and financial ability to respond. Because of varying levels of sophistication, or due to a lack of bargaining leverage, small, unqualified contractors or subcontractors may accept contract responsibility for project risks beyond their management or financial ability. This situation results in an increased exposure to the project and uncertainty as to who will bear the losses when something goes wrong.

The following article discusses my thoughts on the three risks that owners and contractors must consider before they start any project.

Where's the Money?

Construction is expensive. Materials, equipment, tools, trades, labor, and energy pour into a project for months or years. While the work goes on, the property sits — not idle, but out of service — while the owner waits for the benefit he or she will eventually realize. Even the money costs money, as interest accrues on accumulating construction costs until the work is done. Money buys the materials, leases the equipment, and feeds the workers. Owners and builders alike have to face the risk of the money running out before the work does. When the money runs out or runs short, the work slows, the quality control fails, and eventually progress stops.

Contract payment provisions protect both the owner and the contractor. Progress payment provisions regulate the flow of money, allowing the contractor relief from the burden of construction financing while protecting the owner from depleting his or her reserve before the work is done. Contractor performance and payment bonds, personal guaranties, withholding rights, and even retainage accounts secure the contractor's promise to complete the project for the contract price and provide an alternate fund if the contractor fails. Lien release requirements offer some assurance that the work is being paid for from the progress payments.

Contractors, subcontractors, and certain suppliers may exercise lien rights, a statutory security interest against the improved property, if the money runs out. Subcontractors usually understand that the money to pay for their work is coming from the owner, and they expect to wait for their payment until the contractor receives payment from the owner. Some subcontracts restrict the subcontractor's right to payment to those funds received, regardless of the subcontractor's responsibility for the nonpayment. Finally, the right to suspend work if payment is past due allows the contractor to avoid becoming an unwilling construction lender when the owner's resources fail.

Be Careful What You Ask For

The construction contract determines what gets built. Owners and contractors face the risk that the contract scope of work cannot be completed as anticipated or that the completed work will be inadequate or unsuitable. Traditionally, the project owner provides the design for a project, prepared by design professionals to meet the owner's needs and requirements. The builder receives instructions on how to accomplish the design in the form of project drawings and specification. The owner carries the risk that the requirements may not be met so long as the builder follows the instructions. On design-build projects, the owner provides criteria (requirements) the project must satisfy, and the builder creates the design and the construction documents. Now, the builder risks failure of the owner's requirements so long as they are correctly stated in the contract. By ceding design control to the builder, the owner allows flexibility in developing more easily constructed designs that reduce cost and risk for both parties.

Contract scope-of-work provisions describe the work to be completed. Loosely drafted provisions place on the contractor the risk of underestimating its responsibilities. Scope that is too tightly defined increases the owner's risk that some essential work elements have been left out. Contractors must carefully coordinate subcontractor work. Overlapping duties result in unnecessarily high costs; omitted work results in increased project costs. Though the additional costs may reflect additional value, they can also threaten project solvency. When undertaking work, the contractor and its subcontractors take the risk that they cannot complete it as promised or that they will have to complete it at their own expense.

Owners and contractors must be concerned that the scope will probably change before the project is complete. Changes include the discovery of unanticipated concealed conditions underground or in existing structures; unanticipated external circumstances such as shortages, blockages, or natural phenomena; and changes in the design or performance requirements that require the contractors to perform changed work. Contract provisions for change notices, change directives, change orders, and change order pricing distribute these risks and responsibilities so that the work impacted by such scope changes can be completed without disrupting overall progress.

One of the most problematic risks in construction is the risk of encountering concealed obstructions to the work while the work is under way. The risk of encountering unanticipated conditions can be reduced or eliminated through exhaustive exploration. The cost of discovering an obstacle early may exceed the cost of removing the obstacle if it is encountered during the work. If the owner decides to carry the risk of such encounters, it can manage the risk by maintaining contingency resources to cover the work if it becomes necessary. If the owner passes the risk to the builder, a smart builder should create its own contingency charged to the contract as a cost to be paid whether it is used or not.

When The Clock Runs Out (Timing is Everything)

Construction contracts usually contain many provisions for time. In addition to a time in which to complete the work, they include time for technical submittals and time for submittal review; time for payment applications and time for payments; time for notices and time for making claims. If the contract provides, as most construction contracts do, thattime is of the essence, each of these provisions is an enforceable contract promise, and anyunexcused failure to meet a deadline is a breach of the contract. The burden of acting in time falls on the party responsible for the act, the party who takes the risk that the clock may run out.

When a project is completed late, it will probably cost the owner money, at least for extended financing costs and possibly for delayed or lost opportunities. It also costs the contractors whose extended presence at the project increase the overall field operations and facilities costs such as field offices and supervisory personnel. The contractor committed to the project also carries ongoing overhead expense, such as home office costs and general capitalization expense. The cost and risk of proving delay damages can be daunting, and the causes of delay are often subtle and arguable. Owners moderate the risk by providing for liquidated damages, damages in an amount agreed to in lieu of proving actual damages, for late completion. Contractors can participate in the moderation if the liquidated amount relieves the contractor from the risk of being liable for the more arguable consequential business losses.

Owners protect themselves from contractor delay claims, and similarly contractors from subcontractors, through delay damage provisions distributed throughout the agreements. "No damages for delay" clauses are unenforceable in Oregon public contracts, but are enforceable in private contracts and against subcontractors on public contracts if they are properly drafted. Most construction contracts attempt to control the risk of such claims by providing short notice and claim requirements that may be written to cut off any claim if they are missed. Like any risk shifting provisions, they operate in concert with other provisions and all must be reviewed together before one can determine whether the risks under the contract are worth the contract price.

For more information on this topic, please contact marketing@jordanramis.com or call (888) 598-7070.


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