Nate Budde | Construction Executive
Anyone who has worked in the construction industry is familiar with the financial risks involved. With thin margins, cash flow issues and the litany of potential claims and damages that can arise, contractors need to be able to manage that risk properly.
There is the right way of going about it, and there’s a wrong way. Unfortunately, the wrong way (which involves using leverage and shifting risk to other parties) is the more prevalent approach. There are different contractual tactics employed by owners and general contractors alike to shift financial risk to other parties.
WHY IS CONSTRUCTION SO FINANCIALLY RISKY?
There are a few different reasons there is so much risk involved. First and foremost, the construction payment chain itself is inherently risky. Owners and lenders release project funds and trust that the money will reach everyone on the job. But that can’t happen unless each link in the payment chain passes payment to the next. That’s a lot of trust for an industry that’s not particularly known for it.
Another reason is how construction projects begin. Upfront payment is rare in this industry. This leads to floating the initial costs, extending credit and potentially borrowing money to do so. And those who typically bear this burden, lower-tier subs and suppliers, are the least equipped for that level of risk.
Lastly, given the number of different contractors, subcontractors, suppliers, vendors, laborers and equipment lessors that may be present on a given project, there’s a lot can go wrong. Liability and risk are everywhere. It takes collaboration to carry out a project, but when it comes to payment, a lot of that collaborative spirit goes out the window. This has caused the industry to move towards a protectionist mindset, each party resorting to the “looking out for themselves and only themselves” mentality.
One way this manifests itself is through contract terms. Parties will play a game of contractual tug-of-war on how to allocate, spread and shift risk and liability to other parties.
CONTRACTUAL LANGUAGE TERMS THAT CAN SHIFT RISK
There is a fundamental legal principle in the U.S. known as the freedom of contract. This refers to the fact that, by and large, courts won’t interfere with an agreement between two parties as long as the goal of the agreement is legal.
There are laws and statutes that help protect rights, but sometimes there are ways around them – giving deference to the freedom of contract. Prompt payment statutes may include the phrase “unless otherwise agreed by the parties.” This means parties can agree through their contract to have requirements and penalties different than what the law states. But, unless the contract creates new rules, the law will fill in the blanks as default terms.
Some construction contracts look more like a dictionary, exceeding 100 or more pages. It is a lot to expect from contractors and suppliers – that they’ll not only read the entire contract, but understand it as well. There are a number of landmines and red-flags that need to be identified in order to ensure that the terms are fair and reasonable. Here are a few of the most common ways that risk and liability can be shifted one way to the other within a construction contract.
NO LIEN CLAUSES
It’s pretty common for owners, developers or contractors to include a waiver of the ability to file a mechanics lien into their contract, referred to as “no-lien clauses.” These essentially act as lien waivers before any work is commenced or payments become due.
Many states prohibit waiving lien rights before any work is performed and other states require that the waiver be done via separate document to ensure that contractors are fully aware of what exactly they are waiving. However, there are a small number of states that have no specific law against no-lien clauses. An even fewer amount of states specifically allow it.
SUBORDINATION OF MECHANICS LIEN RIGHTS
A lien subordination clause can be just as dangerous as a no-lien clause. Although mechanics lien rights may be intact, a properly filed claim may ultimately be worthless. Mechanics liens give claimants an interest in the property and a right to proceeds if the property is foreclosed. However, there are only so many pieces of the pie to go around. And when a project goes south, anyone with an interest in the property will come clamoring for a piece. The ones who get fed are the ones that have priority.
Priority is who gets the first crack at the foreclosure funds. This can include other lien claimants, pre-existing construction loans or mortgages. The amount of risk associated with these types of clauses depends on the priority assigned to mechanics liens where the project is located. For those states where mechanics liens are inferior to most other security interests, this won’t be a huge level of concern.
However, in the other states where priority is afforded to mechanics liens, having this clause in the construction contract can result in other security interests leap-frogging the contractor’s spot in line when it’s time to get paid.
PAY-IF/WHEN-PAID CLAUSES
Contingent payment clauses are easier to identify since they directly relate to how and when payment will be made. There are two prevalent types: pay-when-paid and pay-if-paid clauses.
A pay-when-paid clause will set a reasonable time for a contractor to pay subs or suppliers from when they receive payment. As for a pay-if-paid clauses, these are much more dangerous. These clauses will result in the contractor not being obligated to pay until they receive payment from the higher-tier. There are a number of states that have prohibited the use of pay-if-paid clauses. But there are also a fair amount of states that consider these clauses enforceable.
In states where pay-if-paid clauses are enforceable, they are strictly regulated. The language must clearly establish that payment from the higher tier party is a condition precedent to payment, which means if they don’t get paid, lower tiers don’t get paid. Fortunately for subcontractors and suppliers, many states have taken the bite out of these types of clauses, by relegating them to nothing more than a timing mechanism for payment.
INDEMNITY CLAUSES
Instead of shifting some risk, an indemnification clause will flat-out transfer certain risks to another party. These will typically include such language like “[Party] agrees to indemnify and hold harmless any and all claims, damages, and expenses caused by or arising out of the acts, errors, omissions, or negligence arising out of the party’s performance”
This typically applies to personal injury or property damage issues that occur on the project due to defective work, inadequate materials or negligence. For example, if someone is injured on the owner’s property, the owner will likely be sued by the injured party. This clause will allow the property owner to seek reimbursement from the general contractor for any costs associated with the injury. If included in the contract, be sure the types of damages are narrow, and specifically list out the types of damages that may fall under this clause.
NO DAMAGES FOR DELAY
Delays on a construction project can cause a financial domino effect on a number of different parties. Typically, if a contractor’s performance is delayed by the actions of another, they will be entitled to monetary compensation for damages caused by the delay and an extension of time for performance. However, that’s not the case if there’s an enforceable no damages for delay clause.
These types of clauses will limit the compensation to strictly time extensions, and usually only if timely notice was given. This protects the owner, while leaving the subcontractors to pay out of pocket for any losses incurred by the delay. Depending on the extent of the delay, this can add up quickly.
MUTUAL WAIVER OF CONSEQUENTIAL DAMAGES
A construction project is an amalgamation of a lot of different contractors, subcontractors, material suppliers and laborers. When another party on the job breaches their contract, it ultimately affects others. That’s where consequential damages come into play.
Direct damages are those that were the direct result of a breach of contract. These are relatively easy to track and quantify. Consequential damages, also referred to as special damages, are damages that are indirectly caused by the breach. For owners, these are typically lost profits or loss of use of the completed project. On the other hand, common consequential can include claims for lost profits, increased bonding costs, or even damage to their business reputation.
Having a mutual waiver of consequential damages clause will typically benefit the contractor. Think about lost profits. From the owner’s position, the loss of use of a commercial building can cost a lot. On the other hand, contractor margins are thin, and lost profits won’t amount to much. This is one way to push financial risk back to the owner.
PUTTING A CAP ON LIQUIDATED DAMAGES
Some types of damages are incredibly difficult to prove, which can make it tough and expensive to recover damages. That’s why liquidated damages clauses are so prevalent in the construction industry. A liquidated damage is a predetermined amount of damages that will be awarded for certain contractual breaches or consequential damages.
These clauses can be helpful in many ways, the most prevalent being predictability. However, if the cap is set too low, contractors can find themselves with little to no recourse if the damages incurred surpass this amount. There are many states that govern these types of clauses by stating they must be reasonable at the time of contracting. Worse yet, if a contractor thinks the cap is unreasonable, they may find that challenging these terms in court can be expensive and time consuming.
SHORT CLAIM NOTICE DEADLINES
This is one of the more subtle ways to shift risk. These can be buried deep within the claims section of a construction contract. A contract can seem to be fair and reasonable on its face. But it might require unreasonably short deadlines for claim notices. Given the amount of paperwork and other notices that swirl around the construction industry, this one can get lost in the weeds quickly.
Just about every type of claim covered under a contract will require some sort of notice, such as delay claims, lost productivity, differing site conditions and more. The problem is, some contracts attempt to make the notice procedures so short or extensive, that there is no practical way a contractor can comply. Once the notice deadline has passed, the claim will likely be off the table. Courts and arbitrators will typically enforce the notice requirements strictly, regardless of who is right or the amount in controversy.
HOW TO PROPERLY MANAGE THESE RISK-SHIFTING TACTICS
The first step, and most obvious step, is to read the entire contract. If there is any language or provisions that aren’t understood, reach out to the contracting party for clarification. Keep those channels of communication open, so there are no surprises later on.
If still unsure, reach out to an attorney to help review the contract and assist with the negotiation process. Also, understand applicable state laws. Regulations can drastically change across state lines, so know rights before signing anything.
Lastly, lead by example. Be a champion of open communication and transparency. Instead of playing it close to the chest, lay cards on the table and try to find the best solution for all parties involved. A construction project is a naturally collaborative effort, so why can’t construction payment be also? Employing divisive and protectionist tactics only leads to more problems than it presumably solves.