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Here’s the situation: During construction, the rise in material costs have impacted your ability to complete the project as originally bid.

Who is responsible for the change in material costs? The contractor or the owner?

Material Prices Are Going Up, Up, Up

While the economy has struggled for two years, material costs have remained quite steady in recent times. In fact, Ken Simonson, chief economist for the Associated General Contractors of America, documents a 2.3% decrease in material costs in the first 9 months of 2009.

Simonson speculates, however, that this drop in prices in materials is bittersweet. Between the months of October and November 2009, material prices rose 0.6%, and Simonson writes that the construction industry should treat this rise as a “warning call.”

Simonson is not alone.

The San Francisco Business Times reports that "Material costs continue to squeeze contractors."   Likewise, New Jersey Biz writes that "Spiking materials costs may puncture project prices."

Prices Increases Creates Danger Zone for Contractors

The current economy presents a dangerous situation for contractors. On the one hand, material costs are on the rise. On the other hand, the lack of construction work makes the bidding process more competitive than ever.

So, how does a general contractor keep its bid low enough to win, without risking that price increases will render the job unprofitable?

This really boils down to the question of who is responsible for increases in material costs. If the owner, the project bid can be as competitive as possible given the current material costs. If the contractor, the project bid must take price increase into account.

Escalation Clauses In Contract

Here is the good news for contractors: there are ways you can protect yourself from being held responsible material price increases.

How? Well, your contract of course.

As every contractor and developer should know, the contract is the law between the parties.  An "Escalation Clause" in your agreement will shift the burden of material price increases from the contractor to the property owner, or another party.

ConstructionExec.com has a great overview article on escalation clauses:   Price Adjustment Clauses:  A Solution for Dealing with Changing Material Costs.  Or check out this equally good discussion at ModernContractorSolutions.com:  Material Price Escalation Clauses:  A Modest Proposal.

Essentially, if a contractor agrees to construct something for a lump sum price, the contractor typically assumes the risk of material costs increases.    An escalation clause shifts this risk to the other contracting party.  

Here is what it may look like:

The Contract Price is based upon construction material prices as of the execution of this Agreement.   Any significant price increases in lumber, drywall, _______________, and/or other construction material that occurs during the period of time between contract execution and substantial completion of the Project, shall cause the contract price to be equitably adjusted by an amount reasonably necessary to cover any increase.    As used herein, a significant price increase shall mean any increase in price exceed ____ percent (____%) experienced by the contractor from the date of signing.

Certainly, a contractor is motivated to have this type of provision in its contract...but why would the Owner agree?  One reason an Owner may be interested in an escalation clause is that it would increase the Owner's bidding pool and make contractors more comfortable to lower their bid amounts.

Responsibility for Price Increases When There Isn't An Escalation Clause

So, price increases have affected your project's bottom line and the contract doesn't have an escalation clause....now what?

If you're working under a lump sum contract, you likely have an uphill legal battle to get compensated for the unexpected price increases.   While not the case law everywhere, most U.S. courts will take the approached expressed by the landmark Louisiana decision in Standard Oil Co. v. Fontenot, 198 La. 644 (1941), where the Louisiana Supreme Court stated that in a lump sum contract "It is possible that the anticipated and expected profit may turn into a loss because of a low bid or advances in the prices of materials or the cost of labor."

So, how can you challenge this general principal?   Here are a few possibilities:

• Mistake:   The contractor must argue that its bid contained certain mistakes relating to the material prices....and that the mistake was both the contractors and the other party's.   This is a very tall order.

• Impossibility / Impracticability:   These are legal theories that a party cannot be required to perform on a contract if it is impossible or impractical.  While the contractor may feel like performance of a contract is impossible or impractical if material prices rise too much, courts will not likely share the feeling.   Material and labor price increases are not a secret, and therefore, it will be difficult to show that the increases were not foreseeable when agreeing to the lump sum.

• Force Majeure:  If prices increase significantly because of some act of God (i.e. New Orleanians can think of Hurricane Katrina's effect on material costs), the the contractor may be on to something.   Most construction contracts have a Force Majeure clause, and the contractor could potentially rely on this clause to escalate the contract price in the event an act of God effected material costs.
   

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This article is part of a three part series titled "Alternative Dispute Resolution - Why, When & How." To read the other parts in this series, or to read more articles about ADR, navigate to the Wolfe Law Group ADR page here: ADR.

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Litigation is a frightening word to many yet to others it is seemingly unknown. The world of construction litigation has become massively entwined with confusion as to goals, limits, and the expectations of a litigant. Attorneys are often unable to properly advise a potential client as to the presumed costs and lengths of a legal proceeding simply because there is absolutely no way of knowing.

A legal proceeding depends upon several factors: the types of parties, the extent of the damage; the willingness to settle; the ability to settle; the requirements of outside contracts; the delays which may ensue; the ability to afford to legal representation; and unfortunately personal feelings towards another party. Though attorneys try, it is impossible to predict the extent of the variables and where and how the cookie may crumble. In the end, it is all an unknown.

Because parties are unable to predict the other side's wherewithal to go the distance with a proceeding or arbitration, several dangers bear notice. Is it worth the risk to lose your financing? Is it worth the possibility of losing a good customer? Is it worth the costs of obtaining adequate legal assistance? These are the questions a headstrong business owner should be asking. Whether it be prior to contracting with another party, prior to beginning the work, or immediately after dispute arises, it is important to have a dispute resolution process or plan in mind for each job, contractor, or customer.

The dangers associated with contracting fallout can be prevented in a number of ways by being up front in your contracts with customers, contractors, and others. A good attorney can provide you with options as to strategies to use for dispute resolution. These strategies may encompass the whole project or merely deal with specific aspects. For instance, it may be wise for you to force immediate mediation of change orders or altered job conditions for price resolution, however you may want to utilize binding arbitration or even court intervention for disputes arising out of final payment. These mechanisms should be addressed during the contracting period, and every detail down to the venue, choice of law and choice of neutral should be decided by the parties.

Most people forget the contracting is open to the parties. It seems obvious that most contractors believe that there are only certain things that can go in a contract. Remember, the law of contracts appeals to your creativity. The more creative and forward thinking a party is, the more likely the contractor will have its way when dispute rears its ugly head.

Wolfe Law Group intends to release a series of Contracting Toolkits for construction companies. It is our hope that the Toolkits will spark some conversation amongst your company and your employees as to some of the problems you may face or have faced in the past. The Toolkits will provide a vast assortment of issues that face many contractors today, and the remedies that may save your firm endless time and money.



Whether you are in mold remediation and require extensive environmental obligations; whether you work in asbestos and need proper disclosures and releases; whether you lease heavy machinery to subcontractors and need warranty and release language; whether you provide fire damage services and need safety disclosures; or whether you simply need to ensure specific insurance compliance, Wolfe Law Group's Toolkits can help you find a way to manage your needs.

Please stay tuned for more information. In the meantime, begin to think about what could make your construction process is run smoother.

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Every state has its own statutes -- as well as judicial decisions, or case law -- to regulate the construction taking place within its borders. States can, and do, take widely divergent views on how best to deal with a variety of complex construction issues.

For contractors, subcontractors, owners, or lenders intending to do business in Washington, Louisiana, Colorado, Oregon, or elsewhere, it is wise to know the nuances of construction law encountered in that particular state before agreeing to undertake a project. And this is particularly true when dealing with the issue of construction delays.

Transferring Risk through a "No Damages for Delay" Clause

Delays during construction will happen. Savvy professionals recognize this, and plan accordingly. Rain days are estimated, and handoff times are included in the projected schedules. Some cushion is made for unexpected time lags, as well.

Nevertheless, unexpected events do occur -- e.g., floods hit the project, or a labor union calls a strike -- as well as unethical or negligent actions by one of the parties involved, which cause significant delays that run up costs. Everyone wants to minimize the risk that their bottom line will have to bear the financial responsibility for any of the resulting time delays.

Owners

Owners argue that they need "no damages for delay" clauses in their contracts, because the clauses offer protection from general contractors filing unjustified or extravagantly high delay claims. Owners point to requests they've received from contractors that are so filled with spurious, overblown reimbursement requests that they've labeled them "kitchen sink claims."

General contractors

General contractors argue they need "no damages for delay" clauses in their contracts with subcontractors for the same reason -- they can't take the hit for all the subcontractors' delay costs as they've been presented, especially if the owner has required a "no damages for delay" claim in his contract with the contractor. General contractors point to owners who issue defective plans and specifications, or who take unreasonably long amounts of time in responding to requests for clarification, delaying the project for months, costing the contractor significant damage which skyrockets as subcontractor delay claims are tallied.

Subcontractors

Subcontractors complain that they have no choice. They maintain that they are forced to sign contracts containing what may well be a dangerous provision for their business, because they are afraid of losing the job as well as offending their customer. For many subcontractors, the risk of a "no damage for delay" clause is just a part of doing business.

What is A No Damages for Delay Clause?

Simply put, a "no damages for delay" clause is placed into a written contract between an owner and a general contractor (or a general contractor and a subcontractor), stating that the contractor cannot recover monetary damages from the owner for any financial losses the contractor suffers due to construction delays caused by a variety of things, including actions by the owner or the owner's representatives, e.g., the architects. By agreeing to the contract and its "no damages for delay" clause, the general contractor assumes the full financial risk for any and all delays in construction.

What are Delay Damages?

Delay damages are those financial costs that occur which are over and above the direct costs which must be expended to remedy the cause of the delay -- i.e., change orders, defective plans or specifications, or a differing site condition. They are shown through the documentation of the project's "critical path."

Critical Path itself is an established method for scheduling the construction of a project, from start to finish. Understandably complicated, the "critical path" involves compiling a list, in sequence, of the construction activities that will take the longest amount of time to complete.

The duration of the Critical Path is found by totaling the various activities' time needs. The Critical Path becomes the longest possible "path" through a network of activities, and gives project participants the minimum amount of time that will be needed to finish the job. If a delay impacts the project's Critical Path, then it causes the project to be finished later than the established deadline.

What's not Delay Damage?

Some events don't cause delay. Not all delays impact the Critical Path; for example, a tardy delivery of shrubs when the sprinkler system has yet to be installed will not impact the critical path and is therefore, not delay damage. Similarly, an owner's change of carpet color when construction still involves pouring the foundation isn't a delay damage.

Some events that cause delay aren't considered in delay damage calculations, either. Most contracts give special treatment to delays that are caused by Acts of God or bad weather. In the event one of these occurs, the contractor is usually given an extension of time to complete the project. By extending the deadline, these events technically don't cause a delay in construction.

Why are "No Delay Damage" Clauses Controversial?

Without a "no damages for delay" clause, all project participants would share the same incentive to get the project completed on time. Critics of the clause argue that it prevents wronged parties from suing for breach of contract when a project participant has caused the delay - and thus, their harm. Contractors point to capricious or fraudulent owners who are allowed to escape responsibility for their own bad acts.

States' Responses

Various states have responded to "no damages for delay" clauses in different ways. For example:

Washington State

Washington's legislature has passed a law stating that a clause in a construction contract purporting to waive a contractor's claim for delay damages caused by the owner is "void and unenforceable." This is true for both public and private contracts, making Washington the frontrunner of all 50 states in barring "no damages for delay" clauses in construction contracts.

California, Colorado, Massachusetts, Oregon

Each of these states has passed laws invalidating "no damages for delay" clauses in public contracts. Private contracts have been left to judicial decision, with courts deciding whether not to analogize to the passed legislation in dealing with "no damages for delay" clauses in contracts between private parties.

Louisiana

Louisiana has not passed legislation that specifically deals with "no damages for delay" clauses in construction contracts, although its Public Works Act does prohibit these clauses in contracts governed by the Act.

Moreover, Louisiana courts continue to uphold these clauses, unless the delay occurred because of something that no party had anticipated, or the delay was caused by a party's actual bad faith or active interference.

Finally, Louisiana Civil Code article 2769 provides that if a contractor or subcontractor fails to do the work he has contracted to do, or if he does not execute it in the manner or within the time he has agreed to do it, he will be liable in damages for the losses that result.

Should you use a "No Damages for Delay" clause in your contract?

Obviously, the first step in answering this question would be to determine what state law applies to your agreement. As shown above, Washington and Louisiana view "no damages for delay" clauses differently at this point in time.

However, even if state law will respect the contractual clause, perhaps the more practical determination is how best to prevent its ever being needed. Enforcement of a "no damages for delay" clause can be protracted and extended litigation, and become an exorbitantly high expense in both time and money.

Finding other practical and legal avenues to deal with delay may be the better option.

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It is ordinary for a subcontractor or supplier to execute a lien waiver after it receives payment for services and/or materials. Construction contracts, however, sometimes go one step further by requiring a subcontractor or supplier to waive its lien rights as a condition of accepting the contract.

There is some question in Louisiana jurisprudence as to whether these provisions are enforceable or unenforceable.

The 2004 5th Circuit Court of Appeals case that muddied the water on this issue was captioned Shaw Constructors v. ICF Kaiser Engineers, Inc. In deciding whether a pre-work lien wavier would be valid, the court turned to Louisiana jurisprudence on the requirements for a valid waiver in general.

Generally speaking, a "waiver" in Louisiana occurs only when there is "an existing right, a knowledge of its existence and an actual intention to relinquish it or conduct so inconsistent with the intent to enforce the right as to induce a reasonable belief that it has been relinquished." Steptore v. Masco Constr. Co., Inc., 643 So.2d 1213, 1216 (La. 1994).

In Shaw Constructors, the court reasoned that when the subcontract at issue was formed, Shaw had no known existing legal right to file a claim or lien against the property because no work had been performed. Without an "existing right" to file the lien, there could not be a waiver of that right.

The Court also attacked the pre-work lien waiver from a different angle, by reasoning that the defendants had an obligation to pay Shaw under the contract wherein Shaw waived its lien rights. By not paying its subcontractor, it failed to perform on an obligation of the contract, thereby giving Shaw the right to dissolve the contract entirely. The dissolution of the contract would, according to the 5th Circuit, also dissolve the lien waiver.

The 5th Circuit Court of Appeals therefore held that the lien waiver provision could not be enforced against Shaw.

This ruling should not affect the enforceability of lien waivers executed by subcontractors or suppliers after work is performed.

In contrast to pre-work waivers, post-work waivers occur after the right to lien has vested with the subcontractor/supplier. As a result, the subcontractor or supplier has an actual right to waive, and the waiver would likely be valid.

Furthermore, it is worthwhile to note that while the Shaw decision weighs heavily against "no liens" clauses in contracts, it's not necessarily the final word on the issue.

First, Shaw was decided by the Federal 5th Circuit and not by a Louisiana court. In its decision, the 5th Circuit simply attempts to "predict" what a state court would do if faced with the same legal question. If and when the "no liens" clause issue gets to the state courts, there might be a different outcome.

Second, the Shaw court hints that circumstances might exist when it would uphold a "no liens" clause. In its comparison of the Louisiana Private Works Act to the similar statutes in Illinois, the court highlights that subcontractors and suppliers in Louisiana can lien a project even when there is no breach in the contract. If a sub or supplier finds itself in this situation, and his claim rights were vested at the time of signing the contract, it is possible that the "no liens" clause would be enforced against it.

For all intents and purposes, however, the Shaw decision places great restraints on "no liens" clauses in contracts.

Generals may want to explore other methods of protecting jobs against liens, and will specifically want to get post-work lien waivers from the subs and supplier regardless of whether they have a pre-work lien waiver.

On the other hand, subs and suppliers should discuss their lien rights with an attorney before the expiration of their claim period even if they signed a contract with a "no liens" clause.

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Background on Payment Provisions & What is a "Pay When Paid" Clause

While it's common practice in the construction industry to provide for partial payments from the contractor to subcontractor as work progresses, in Louisiana, unless the contract specifies otherwise, payment from the general contractor to the subcontractor is not actually due until the project is completed. See LA CC Art. 2550; See also Sacco v. Koepp, 169 La. 789, 793-94 (1930).

Therefore, if such progress payments are desired, it's important to have a clause clearly providing for these payments in the contract.

A common contract provision in many contractor-subcontractor agreements provides that progress payments are not payable to a subcontractor until the owner pays the corresponding amount to the general contractor. These contract provisions typically come in two varieties, and are commonly referred to as "pay when paid" and "pay if paid" clauses.

"Pay when paid" and "Pay if paid" clauses are designed to shift the burden of owner non-payment from the contractor to its sub-contractors and suppliers. Accordingly, both provisions can be very onerous for the subcontractor - oftentimes preventing payments to a sub or supplier when the Owner is in an unrelated dispute with the general contractor, or merely becomes financially unable to make payments under the contract.

Enforceability of "Pay When Paid" Provisions

"Pay when Paid" provisions and other conditional payment provisions are not favored in courts, and therefore, it's imperative to carefully draft and review any such provisions in the construction contract.

Hostility towards these types of provisions are fueled by subcontractors and their trade organizations.

Courts in some parts of the country have even gone so far as to call such provisions against public policy and unenforceable. See Capitol Steel Fabricators, Inc. v. Mega Construction Co., 58 Cal App 4th 1049 (2d Dist. 1997). Legislatures in a number of states have considered such provisions as impermissible waivers of the subcontractor's constitutionally protected mechanics' lien rights.

In Louisiana, properly drafted "Pay when Paid" provisions are enforceable, but the wording must be clear and unambiguous.

However, even with an enforceable conditional payment provision, Louisiana courts still require payment to the subcontractor within a "reasonable period of time," thereby watering down the effect of the provision. See Southern States Masonry, Inc. v. J.A. Jones Contr. Co., 507 So.2d 198 (La. 1987). Through this Southern States decision, and similar decisions, the courts re-shift the risk of non-payment back upon the general contractor.

If the parties truly intend for the subcontractor to bear the risk of non-payment, or if payment from the owner is not reasonably certain, this intent should be clearly expressed in the construction contract. In these situations, the contract should have a "Pay if Paid" provision instead of a "Pay when Paid" provision. See C. Bel for Awnings, Inc. v. Blaine-Hays Constr. Co., 532 So.2d 830 (La. App. 4th Cir. 1988).

"Pay When Paid" versus "Pay If Paid"

Although only separated by one word, legally the two provisions are drastically different.

Pay when Paid

This common payment provision stipulates that a general contractor is legally obligated to pay a subcontractor only when it receives a corresponding payment from the owner. As discussed above, however, most courts view such a clause as a timing provision and not the basis for nonpayment.

Accordingly, if payment is never received from an owner, under a "Pay when Paid" payment provision, the general contractor must still make payment to a sub or supplier within a "reasonable time."

Pay If Paid

"Pay if paid" clauses are more specific than their "pay when paid" counterparts. Unlike the "pay when paid" clause, oftentimes considered a timing provision, the "pay if paid" clause more clearly expresses the parties' intention to shift the credit risk of owner nonpayment down through the contracting ranks.

Accordingly, payment to the subcontractor is more likely to be contingent on the general receiving payment from the owner under a contract with a "pay if paid" provision than a "pay when paid" provision.

Conclusion

Deciding when payments are due a subcontractor can sometimes lead to long and complicated legal disputes. As such, it's very important for the parties to clearly express their intent when contracting.

The Wolfe Law Group is experienced in drafting and reviewing construction contracts to clearly reflect the intent of the parties. Contact us today to learn more about how the Wolfe Law Group can be your company's new legal department.

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