Understanding and Negotiating Construction Contracts: A Contractor's and Subcontractor's Guide to Protecting Company Assets [2 ed.] 1394150202, 9781394150205

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Understanding and Negotiating Construction Contracts

Understanding and Negotiating Construction Contracts AandContractor’s

Subcontractor’s Guide to Protecting Company Assets Second Edition

Kit Werremeyer

This book is printed on acid-­free paper. Copyright © 2023 by RSMeans. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-­copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-­8400, fax (978) 646-­8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-­6011, fax (201) 748-­6008, or online at www. wiley.com/go/permissions. Trademarks: Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries and may not be used without written permission. All other trademarks are the property of their respective owners. John Wiley & Sons, Inc. is not associated with any product or vendor mentioned in this book. Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information about our other products and services, please contact our Customer Care Department within the United States at (800) 762-­2974, outside the United States at (317) 572-­ 3993 or fax (317) 572-­4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-­in-­Publication Data Applied for Paperback ISBN: 9781394150205 [LCCN 2023011467] Cover Design: Wiley Cover Images: Courtesy of Geometrica, Inc; joffi/Pixabay, Personal Photo By Kit Werremeyer Set in 12/15pt Warnock pro by Straive, Pondicherry, India

Dedicated to all those contractors and subcontractors who are interested in learning how to negotiate more favorable commercial terms and conditions in their construction contracts and thereby better protect the hard-­earned assets of their companies.

Contents

Acknowledgments About the Author Preface Disclaimer Introduction The Goals of This Book What Are the Benefits of This Book? Contractor & Owner Conventions Private Contracts or Government Contracts? Key Contracting Concepts Two Types of Commercial Terms & Conditions The Most Important Commercial Terms & Conditions The Contracting Process Excuses for Not Negotiating Better Commercial Terms & Conditions The Concept of Risk Transfer This Is a Book Developed Just for Contractors Three Final Suggestions Chapter 1: Contracts: Basic Training What Is a Contract? The Steps to a Contract

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Coming to the Party? 2 The Starting Point 3 “Here’s My Proposal” 4 “Consideration,” or Something of Value 5 The “Happy Test” 5 “Can That Person Sign This Contract?” 6 Call in the Enforcer to Close the Breach! 6 A Contract Example 8 Strange Words & Long Paragraphs 10 Contracting Myths 11 Contract Negotiations 12 Chapter 2: Types & Forms of Contracts 15 Fixed Price & Fixed Schedule Contracts 16 Reimbursable Type Contracts 16 Combined Fixed Price & Reimbursable Contracts 18 Cost Plus Fee Contracts 20 Guaranteed Maximum Price Contracts 21 Target Price Contracts 21 Contracts with Performance Incentives 22 Form of Contracts 23 Some Final Contract Housekeeping—­Definitions 30 Conclusion32 Chapter 3: Scope of Work 33 The Scope of Work Matrix 37 Scoping Drawings 39 Conclusion40 Chapter 4: Terms of Payment & Cash Flow 41 Cash Flow 42 Interest Rates 44 Periodic Progress & Milestone Payments 45 Conclusion59 Chapter 5: The Schedule 61 Float62 Time Is of the Essence 64 Extra Time, but No Money 66 Conclusion68 Chapter 6: Assurances of Performance 69 Guaranties & Bonds 70 What Does “Failure to Perform” Mean? 72 viii

What Is a Bond? 72 Forms of Assurances of Performance 73 Surety Companies 78 Some Language Considerations on Guaranties & Bonds 82 Types of Performance Assurances 82 Conclusion101 Chapter 7: Insurance 103 What Is Insurance? 104 Claims Made vs. Occurrence 105 Types of Insurance 106 Important Issues Associated with Insurance 112 Additional Insured Status 120 Additional Insurance Basics 121 A Typical Insurance Clause in a Construction Contract 134 Safety140 Chapter 8: Indemnity 141 Insurance & Indemnity 142 Indemnity Definitions 142 Transferring the Owner’s Risks to Contractors 143 Fairness Is Not a Consideration 143 Is an Indemnity Required in a Construction Contract? 144 Anti-­Indemnity Legislation 144 Examples of Indemnification Clauses 150 Indemnification, Additional Insured Status, & Contractual Liability Insurance 157 Owners Love CLAIMS! 161 Negotiating Indemnity Clauses 162 Knock-­for-­Knock Indemnities 165 Conclusion166 Chapter 9: Changes 169 Some Ground Rules 170 Protecting the Project Manager 170 Owners’ Directives 171 Constructive Changes 171 Payment for Changes 172 Sample Change Clauses 172 Major Contract Changes 178 Negotiating Change Clauses 179 Conclusion180 ix

Chapter 10: Disputes & Their Resolution 183 What’s a Project Manager to Do? A Short Story to Start With 183 Disputes—­The Construction Contract’s Bad Actor 184 An Ounce of Prevention 186 Dispute Resolution Options 186 The Folks who Negotiate, Mediate, Arbitrate, & Litigate 188 Dispute Resolution Clauses 189 Conclusion192 Chapter 11: Damages 193 Breach of Contract/Failure to Perform 194 Contractors’ Financial Exposure 194 Actual Damages—­A Silent Risk? 194 Liquidated Damages 196 Consequential Damages 204 Conclusion206 Chapter 12: Warranties 207 A Workable Definition of Warranty 207 Warranty Issues 208 The Uniform Commercial Code 214 When Is No Warranty Appropriate? 217 Extended Duration Warranties 219 Limiting Provisions in Warranties 221 Pass-­Through Warranties 221 Latent Defects & Warranty 222 A Sample Warranty 224 Conclusion224 Chapter 13: Termination & Suspension 227 Termination for Cause 228 Termination for Convenience 229 Suspension232 Cancellation236 Conclusion236 Chapter 14: Force Majeure 239 Negotiating Clauses 239 Sample Contract Language 240 Conclusion244 Chapter 15: Other Contract Clauses 245 Site Conditions 246 Use of Completed Portions of the Work 251 x

Patent Indemnity 252 Secrecy & Confidentiality Clauses & Agreements 253 Owner’s Right to Inspect 254 Independent Contractors 257 Assignment258 Acceptance & the Punch List 260 Advance & Partial Waiver of Liens 262 Final Waiver of Liens 265 Audit Rights 268 Severability or Validity Clauses 269 Venue & Applicable Law 269 Florida Civil Code Chapter 47 Venue 270 Texas Business & Commercial Code Annotated §272.001 271 Venue and Choice of Law State Statutes 271 Contractual Rendition? 271 Changes in the Law 272 Some Interesting Clauses to Close 273 Chapter 16: A Construction Contractor’s Contract Checklist 275 Chapter 17: International Contracting 283 International Contracts 284 The U.S. Foreign Corrupt Practices Act 285 Letters of Credit 286 Split Contracts: Onshore & Offshore Contracts 288 Political, Religious, & Economic Risks 289 Overseas Private Investment Corporation (OPIC) 290 Legal Systems in Foreign Countries 290 Local Employees, Partners, & Agents 291 Offshore Companies 292 Currency Risks 293 Applicable Law 297 Joint Ventures 299 Joint Operations 299 Import & Export Considerations 300 Understanding INCOTERMS 302 The Export‐­Import Bank of the United States 305 Where to Get Some Help—­Ask the U.S. Government 306 Lastly, Use the Right Paper Size! 307 Conclusion307 xi

Chapter 18: What’s It Take to Do Business in Southeast Asia? Patience Is Golden Walk the Talk Time and Money The US Foreign Corrupt Practices Act Center for Strategic and International Studies Trans Pacific Partnership (TPP) Backdoor to China and India SPECIAL SECTION—­The Socialist Republic of Vietnam (Vietnam) Resources for Business in Southeast Asia Chapter 19: Some Final Thoughts on Negotiating Contracts Why Negotiate? The Concept of Standard Terms & Conditions Risk Transfer Item 1: Get Rid of the Indemnity Clause! Risk Transfer Item 2: Don’t Provide Additional Insured Status Risk Transfer Clauses, Insurance, & Safety How to Say No without Aggravating the Owner The Worst Contracting Word: “Reasonable” The Best Contracting Word: “Notwith- standing” Win-­Win & Lose-­Lose in Contract Negotiations—­Fairy Tales? Is There a Price for Bad Commercial Terms & Conditions? Terms of Payment Some Tips on Successful Negotiating Three First (and Final) Suggestions Resources Glossary Index

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309 310 310 311 312 313 314 314 316 317 319 320 320 322 323 323 324 324 325 326 327 327 328 328 329 333 349

Acknowledgments I am grateful to the following people who, by sharing their long-­term experience in working with construction contracts, added significantly to this book. John T. (J.T.) Wodarski and Joseph J. Newman Jr., each of whom has over 30 years of valuable experience in negotiating commercial terms and conditions of engineering and construction contracts, provided many suggestions for improvements in how the issues were covered in this book. Neither of these two friends (and tough negotiators) hesitated to challenge me to clarify or expand on some of the contracting and negotiating guidance I drafted. The results were significant improvements to the content of the book. Robert W. Wolfe Esq. has negotiated and reviewed many large and small domestic and international engineering and construction contracts from a legal standpoint for more than 25 years. He kept me straight on the many legal fine points associated with the riskiest commercial terms and conditions found in contracts. He is the most practical and effective lawyer I have ever had the opportunity to deal with in the engineering and construction business. Bruce Wilkinson Esq. has been working with a wide variety of contracts for over 35 years. He provided many insightful and useful comments and suggestions on construction contract commercial terms and conditions. Gwen A. Schroder and Ed Jacobs shared their extensive knowledge of the insurance industry to help guide me through the technical issues associated with insurance for construction projects. xiii

And my wife, Marilyn, a former teacher, reviewed every word in the book at least twice and made every effort to ensure my spelling and grammar were generally correct. While she did an excellent job, she told me she never again wants to read anything about indemnities. Amen.

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About the Author Kit Werremeyer is the owner and president of Southernstar Consultants LLC, of Valrico, Florida, a company that provides training in the understanding and negotiating of construction contracts. The company also offers a broad range of other professional services to United States and international engineering and construction companies. Mr. Werremeyer’s experience includes more than 30 years of sales, contracting, claims settlement, dispute resolution, and EPC project development, including work for a broad range of major U.S. and international companies, such as Bechtel; Kellogg, Brown & Root (KBR); Fluor; J.A. Jones; Black & Veatch; DuPont; Shell Oil; Caltex; Exxon/Mobil; BP/Amoco/ARCO; Air Products and Chemicals; Koch Industries; Florida Power and Light; Chiyoda Corporation (Japan); Japan Gasoline Corp.; Mitsui (Japan); Mitsubishi Heavy Industries (Japan); Petronas (Malaysia); Thai Oil Company; Pertamina (Indonesia); SINOPEC (Peoples Republic of China); Voest-­Alpine (Austria); Daelim (Korea); and Hyundai (Korea). Among prior positions, Mr. Werremeyer served as vice president and area director of sales and marketing in Asia for Chicago Bridge & Iron Company, an international engineering and construction company. This position included responsibility for contracting and the general management of area subsidiaries. He is a graduate of the University of Illinois at Urbana-­Champaign, Illinois, with a master’s degree in mechanical engineering.

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Preface In 1977, I entered a year-­long sales training course presented by my company, Chicago Bridge & Iron Company (CBI), an international engineering, procurement, and construction contractor founded in 1889. CBI believed that all of its salespeople must have a strong foundation in understanding, evaluating, and negotiating the commercial terms and conditions typically found in engineering and construction contracts. Specifically, the course was to prepare its future salespeople to provide clients with “one-­stop shopping.” This meant being able to work out all the technical and constructability details of the contract with the client, and then negotiating appropriate commercial terms and conditions without necessarily having to go back to CBI’s legal department for advice. This extra capability—­evaluating and negotiating commercial terms and conditions for construction contracts—­was designed to give us a clear edge over our competitors. We could work closely with the client on all aspects of the project—­both technical and commercial—­ and then close the deal commercially without ever leaving his side or making an outside telephone call. The sales training program included a lot of classroom time on such seemingly routine contractual considerations as terms of payment, scope of work, schedule, claims and disputes, termination and suspension, and warranties. It also introduced us neophyte contractors to such new and mysterious contractual terms as indemnity, additional insured status, force majeure, advance waivers of rights, specialty insurance

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coverage, and assurances of performance. The instructors told us horror stories about the financial consequences that arose out of accepting a client’s risky commercial terms and conditions for engineering and construction contracts. This training course set the path of my career as, for the next 25 years, I worked in several different sales offices located on the East Coast and the Midwest of the U.S. and for 13 of those 25 years, in Southeast Asia. I participated in and/or managed the negotiations of the commercial terms and conditions for hundreds of engineering and construction contracts ranging in value from small $50,000 repair projects, to major engineering, procurement, and construction (EPC) projects worth over $100 million. Clients ranged from small owners to major international oil, gas, chemical, and petrochemical clients, and major domestic and international EPC contractors from the U.S., Europe, and Asia. There were a huge variety and complexity of commercial terms and conditions in all these contracts over those 25 years. Every owner or EPC contractor had their own favorite idea of what constituted acceptable commercial terms and conditions. Negotiating acceptable terms and conditions for CBI projects was always a challenge; nothing ever was the same. On a few occasions, the client’s commercial terms and conditions were so one-­sided and unacceptable, and the client was so reluctant to change them, that the only thing left to do was close the file and walk out the door. It was time to let some other poor contractor suffer with those lousy commercial terms and associated risks. When I retired in 2001 after 32 years with CBI to form my own company, I looked back at all the diverse practical negotiating experience I had with engineering and construction contracts in the U.S. and internationally and felt it was important to write a practical, user-­friendly, and non-­legalistic book about this subject. It is my hope that my own experience will help contractors, regardless of the size or sophistication of their companies, to negotiate better and less risky commercial terms and conditions for construction contracts—­and thereby better protect their assets. I hope that contractors can learn something from this book and use it as a practical desk reference. If by reading this book, they learn nothing more than to be able to better identify, understand, and evaluate risky commercial terms and conditions, and then negotiate or otherwise seek help to resolve them, I have succeeded.

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Disclaimer During the course of writing this book, I was reminded on several occasions by my good friends and excellent reviewers that I needed to include a written disclaimer regarding the reader’s use of the contracting and negotiating guidance provided—­as it is impossible to anticipate all the circumstances that may arise in a construction contract. I have tried my best to provide what, in my experience and opinion, is practical information gained from my over 30 years in the engineering and construction business. My hope is that this book will help contractors and subcontractors understand, evaluate, and favorably negotiate construction and construction-­related contracts and thereby help protect their assets. I do not provide any express or implied warranty on the use of any of the information contained in this book as it may be applied to understanding, evaluating, and negotiating construction contracts. Readers should consult, as needed, with professionals on their particular contracts and circumstances. – Kit Werremeyer

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Introduction There is no price for bad terms. ~ Construction contractor from Toledo, Ohio

The Goals of This Book

This book was written with three important goals in mind: 1. Assisting contractors in improving their abilities to identify, understand, and evaluate certain high-­risk commercial terms and conditions typically found in all construction contracts. 2. Providing contractors with negotiating suggestions on how to lower or eliminate the risk associated with commercial terms and conditions. 3. Providing straightforward information in as uncomplicated and non-­legalistic a manner as possible. The book will help contractors in their effort to negotiate favorable commercial terms and conditions for their construction contracts. By doing so, this will help lower their commercial risk; assist in improving their terms of payment; and reduce their exposure to claims, disputes, and unnecessary or inappropriate risk transfer and its associated potential financial liability.

What Are the Benefits of This Book?

Contractors must be able to identify, understand, and evaluate all the commercial risks that are accepted by agreeing to an owner’s proposed contract. They must then be able to effectively minimize and manage those commercial risks—­mitigating or eliminating them through negotiations—­and thereby lessen their exposure to any potential financial liabilities. This will ultimately protect the assets of their companies. This is the primary benefit of this book. xxi

Contractor & Owner Conventions

This book refers to contractors and owners—­both in the general sense, and capitalized in actual sample contract clauses. “The contractor” refers to you, the reader of this book—­whether general contractor or subcontractor—­working hard in the construction business trying to make a living. “The owner” refers to the company that the contractor is providing construction work for, and with whom he will sign a construction contract. (Note that throughout this book, the masculine singular “he” is used, for simplicity only, and to avoid the more cumbersome “he/she”/“his/her” construction.) Also for simplicity, the book refers to the construction contract between the owner and contractor. Often, however, the contractor will have a contract with another construction company who works for the owner, perhaps in the role of the owner’s project manager, or the owner’s main contractor. In this case, the contractor would typically be considered a subcontractor, and his construction contract would likely be called a subcontract with the owner’s project manager or main contractor. It doesn’t matter whether the contract is made directly with the owner, or whether it’s a subcontract with the owner’s PM or main contractor—­the information contained in this book about understanding and negotiating construction contracts applies equally to all of these contracting relationships.

Private Contracts or Government Contracts?

The contracting concepts presented in this book apply to contractors working with private U.S. owners, and not federal or state government owners. Construction contracts with U.S. federal, state, and local governments may have different commercial contracting challenges. Sometimes, for instance, government contracts are, by law, nonnegotiable with respect to the types of commercial terms and conditions a contractor must accept. However, the concepts and suggestions in this book can be used to help better understand and manage similar commercial issues in government construction contracts, and can assist the contractor, particularly in those situations where negotiation is an acceptable part of the government’s contracting process. In Chapter 16, “International Contracting,” the additional concepts presented also apply to contracts between a private contractor and a private owner. Contracting with foreign governments and their various departments often presents exceptional contracting challenges that are beyond the scope of this book.

Key Contracting Concepts

Throughout this book, two key contracting issues with construction contracts are discussed: • Commercial Risk: The risk associated with the potential for the contractor to be harmed in some way by accepting the wording

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in an owner’s construction contract’s commercial terms and conditions. • Potential Financial Liability: The possibility of having to pay money, which would arise from the obligations that a contractor agrees to accept in the owner’s construction contract’s commercial terms and conditions, and that might arise also from the contractor’s common law obligations. Common law is the body of law that develops out of decisions made by courts—­ called precedence—­rather than law that is created by statute.

Examples of Commercial Risk

Commercial risk creates an exposure to the potential for financial liability and flows directly from the commercial terms and conditions contained in the owner’s construction contract. Commercial risk is probably the risk a contractor finds most difficult to understand and manage. Some typical examples of a contractor’s exposure to commercial risk found in a construction contract’s commercial terms and conditions are: • Exposure to the financial liability to pay liquidated damages or other consequences of contractor’s late performance. • Exposure to the financial liability to pay for damages that are caused by the owner’s negligence. • Not being paid for legitimate changes for additional work. • Not being able to settle legitimate disputes in favor of the contractor. • Exposure to an owner cashing in a contractor’s performance or payment bond without legitimate reasons. • Exposure to the financial consequences—­not enough cash to pay bills—­of not being paid by the owner on time for progress payments. • Exposure to the financial liability that may arise out of lengthy warranty periods or requests by an owner to perform warranty work that is really not warranty work. • Exposure to the financial liability that may arise out of other risks encountered on a construction project, such as differing site conditions and force majeure.

Two Types of Commercial Terms & Conditions

The commercial terms and conditions typically found in a construction contract can be split generally into two categories: • Administrative terms • Financial liability terms

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Administrative terms are those commercial terms and conditions that have a low probability of creating a significant financial liability for the contractor. Financial liability terms have a high probability of doing so. The focus of this book is to improve the contractor’s ability to understand and evaluate these financial liability terms and conditions and learn ways to lower or eliminate the commercial risk associated with them through effective negotiations. A typical construction contract can be divided between administrative and financial liability terms as shown in Figure 1. This book will discuss only those commercial terms and conditions that tend to create a high probability of financial liability for the contractor. This doesn’t mean, however, that other terms and conditions should be ignored or taken lightly. It just means that if the contractor has to focus his effort primarily on one of these sets of commercial terms, it should be on the commercial terms that have the greatest potential for harm.

Figure 1: Types of Contract Terms xxiv

The Most Important Commercial Terms & Conditions The Contracting Process

The three most important commercial terms and conditions contained in all construction contracts are: 1. Scope of work 2. Pricing and terms of payment 3. Schedule These commercial terms are the three foundation stones of all contracts, as shown in Figure 2. Here’s a bold statement: There is no difference between a construction contract for a new one-­story office building worth $500,000 and a new grassroots oil refinery worth $1 billion. Think about this for moment. The contractor for each project must have a written construction contract to perform the work described. Each contract will have a scope of work section, terms of payment, and a schedule. Further, each contract will likely have contractual obligations for insurance, warranty, changes, dispute resolution, termination and suspension, damages, indemnity, and assurances of performance. Certainly, the complexities of the two projects are significantly different, but the contracting process of understanding and negotiating commercial risk issues and potential financial liability issues are the same, and must be properly dealt with by each contractor in order to protect the assets of their companies.

Excuses for Not Negotiating Better Commercial Terms & Conditions

What are the typical excuses given by contractors when faced with the prospect of having to try to negotiate better commercial terms and conditions in the owner’s construction contract? Some of the most common: • “It’s too hard to deal with the owner and his lawyers.” • “The owner will disqualify me if I take exception to his terms and conditions.”

Figure 2: Three Foundation Stones of a Contract xxv

• “I don’t understand the terms and conditions well enough to negotiate better ones, and I don’t want to hire a contracts expert or a lawyer.” • “The competition accepts the owner’s terms and conditions all the time, so I don’t have much of a chance.” • “I don’t like to negotiate. Maybe the best thing to do is just sign the contract, put it in the bottom drawer of the desk, and hope nothing happens.” The last excuse basically says this: “sign, do nothing, and pray for the best.” This strategy works fine as long as nothing goes wrong during the execution of the contract. However, things often do go wrong during the course of executing construction contracts! Let’s say the owner creates lengthy delays to the construction schedule, refuses to acknowledge his fault, then penalizes the contractor by imposing liquidated damages for late performance. Once something like this happens to a contractor just once in his lifetime, he will wish he had made the effort to negotiate more favorable commercial terms and conditions prior to signing the contract. One good reason to negotiate changes to the owner’s commercial terms and conditions is simply to improve the contract for the benefit of the contractor, and to lower the contractor’s exposure to potential financial liability at the same time. For example, creating a detailed scope of work document that carefully outlines what the contractor, owner, and all other parties involved in the contract are obligated to do will always serve to minimize misunderstandings and disputes over the scope of work. Often the contractor has the best experience and background to assist the owner with developing a detailed and comprehensive scope of work document.

The Concept of Risk Transfer

Another contracting concept that will be discussed throughout the book is the concept of risk transfer. Commercial terms and conditions, such as those associated with insurance and indemnity clauses, transfer the risk of potential financial liability for certain events from one organization to another. Insurance transfers the risk of certain potential financial liabilities from the contractor—­the named insured—­to the insurance company in return for the payment of a premium. An indemnity clause in a construction contract can transfer to the contractor the risk of certain potential financial liabilities that may arise due to the negligence of the owner—­in return for nothing! Contractors must understand the consequences of accepting risk transfer clauses in a construction contract. Negotiating changes to risk transfer clauses can significantly lower exposure to the possibility of unnecessary or unwarranted financial loss.

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This Is a Book Developed Just for Contractors Before the contractor signs the contract, he needs to understand the commercial risks and their possible financial consequences. The contractor’s assets are at stake.

This book is not designed to be antilawyer or anti-owner. It is designed to be pro-contractor.

Every attempt has been made to write this book in as non-legalistic a manner as possible. It was written for those contractors who have no legal training in contract law and are simply in business to engineer, procure, and safely build construction projects. Anyone who is willing to take the time to understand the basic concepts of construction contracting can become effective in understanding, evaluating, and managing commercial risk and negotiating more favorable commercial terms and conditions. Can a lawyer who specializes in construction contracting help a contractor understand and negotiate a construction contract? Certainly he can, but that assistance, and cost, is not always necessary. The book features samples of actual contract language—both the good and the bad, the fair and the unfair. Each chapter contains these easyto-understand clauses, in boxes for quick reference, which show contractors the kind of language that should be used, as well as jargon and unreasonable terms that should be avoided. Having a good working knowledge of the major commercial issues involved in construction contracting will help a contractor understand what he is getting into, the risks he is taking, and the risks he doesn’t want to take. Is the contractor agreeing to a fair contract, or taking on a lot of unnecessary responsibilities and commercial risks? Will he get paid on time? These are the types of questions a contractor will be able to answer and resolve after reading this book—before signing a construction contract. It may appear when reading through this book that owners are cast in a bad light, and that all too often they demand unacceptable commercial terms and conditions. This is not true. Some progressive owners have, or will negotiate, commercial terms and conditions that are fair and balanced for both parties—the owner and the contractor. The contractual issues covered in this book are meant to raise the awareness of contractors to worst-case situations that can arise from accepting certain commercial terms and conditions in a construction contract—and how to edit and reword unfair clauses.

Three Final Suggestions

Finally, contractors should remember these three important things: 1. Read and understand everything in the construction contract. 2. Negotiate better commercial terms and conditions with the goal of reducing commercial risk and the associated exposure to potential financial liability. 3. Get all agreements in writing from an authorized representative of the owner!

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Chapter

1

What Is a Contract?

The Steps to a Contract

Contracts: Basic Training This isn’t a trick question, and it doesn’t have a complicated answer. For the purposes of this book, the following definition will be used: A contract is a written agreement that clearly defines the responsibilities and obligations of each included party, is legally enforceable, and is dated and signed by an authorized representative of each party. A contract may also be called an agreement. The term contract will be used throughout the book. 1. Receive an inquiry or request for proposal (RFP) from the owner. 2. Prepare a proposal for the work and submit it to the owner. 3. Negotiate all the details of the contract with the owner. 4. Sign the contract.

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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It doesn’t appear to be too complicated, does it? However, there are hundreds of issues—­small and large—­to consider and things to do during the process of responding to an owner’s RFP. The contractor must: • Review and analyze all the written bid documents, including any attached plans, drawings, and specifications. • Resolve questions about the scope of work. • Visit the site. • Assess the physical and commercial risks. • Select subcontractors and suppliers. • Prepare an estimate and proposal. • Review and comment on the commercial terms and conditions. • Sort out insurance details. • Negotiate improvements to the contract. This chapter covers the basic concepts of contracting and explains some of the terminology contractors most often encounter.

Coming to the Party?

So who is a party to a contract? In almost all construction contracts, there will be at least two parties. One is the contractor (who is going to build something), and the other is the owner (who has a need for what is being built). If the owner hires a project manager to manage all the contractors on the project, then the owner’s project manager would also be considered a party to the contract. All persons or organizations that have not signed the contract are called third parties. Some typical third parties a contractor might see at or near the project job site are: 1. The owner of the commercial property and buildings adjacent to the project site. 2. An OHSA safety inspector making a visit to the job site. 3. Another contractor, his subcontractors, and their personnel who are also working for the owner on the project site. 4. Subcontractors working for the contractor who are not signatory to the contract with the owner. 5. Local private homeowners or small business owners and tenants adjacent to the site. 6. Environmental protection groups. 7. The general public, who may wander onto the job site.

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The Risk Associated with Third Parties

What’s all the fuss over this business of third parties? The actions of these people or organizations can create serious commercial risks and potential financial liability for both the contractor and owner. Contractors must manage a multitude of job site safety issues in order to avoid employees’ injuries. Damage to a third party’s adjacent property or injury to a third-­party individual, such as a member of the general public, exposes both the owner and the contractor to lawsuits, legitimate or otherwise, that could financially ruin either or both of them. Much of the concept of commercial risk transfer involves transferring risk from the owner to the contractor. Risk includes potential financial liability associated with damage to property belonging to third parties and injury to or death of third-­party individuals, regardless of any contributing fault or negligence of the owner. This transfer of risk is accomplished mainly by the use of indemnity and additional insured clauses. (These topics are covered in detail in Chapters 7 and 8 of this book.) So although the contract is between the contractor and the owner, the contractor has to recognize that individuals or organizations not associated directly with the contract—­third parties—­may have an impact on the contract risk.

The Starting Point

The starting point for a construction contract is when an individual or company decides to construct a new facility to meet its needs.

An Example

Wilson Properties conducts a search of local building contractors and finds several that are qualified, including National Construction Company. Wilson Properties prepares a written inquiry, or as it is commonly called, a Request for Proposal (RFP), and sends it out to several contractors for competitive bids. The RFP would typically include: • A description of the scope of work • Some idea of a schedule • The plans and specifications prepared by a design team and approved by the building department • Applicable codes and standards • Commercial terms and conditions the owner expects the contractor to accept 3

The RFP might also require the contractor to indicate in writing whether he will provide a proposal for the work by the time specified in the inquiry, or whether he will decline to bid.

“Here’s My Proposal”

The written proposal, such as prepared by National Construction Company, to perform the work is called an offer and is the first half of the contracting concept of offer and acceptance. The offer will include the contractor’s price and schedule to perform the work and may contain responses to information requested by the owner’s inquiry. It may also address specific work scope and commercial clarifications, as well as any other concerns of the contractor.

An Example

Offer and acceptance is the technical term used to test whether a contract has been arrived at or not. A more workable and practical definition of the offer and acceptance process is successful contract negotiations. 4

National Construction Company may propose a different completion schedule than required by Wilson Properties’ RFP documents, technical substitutions, or other cost- or time-saving alternatives. National Construction Company may also propose changes to the commercial terms and conditions that were included in the Wilson Properties’ RFP documents. “And I accept, but. . .” Wilson Properties receives the proposal (offer) to perform the work from National Construction Company, reviews it for general compliance with the RFP, and decides that it is a good offer and that they would like to award the project to National Construction Company. However, Wilson Properties has some issues with the schedule, the price, and the clarifications to the commercial terms and conditions proposed by National Construction Company. Wilson Properties has National Construction Company come to their office to negotiate and tells them, “We would like to accept your offer, but. . .” The two companies then proceed to negotiate a mutually agreed-on schedule, price, and set of commercial terms and conditions. The acceptance of the offer in this instance is actually a process. Wilson Properties and National Construction Company negotiate back and forth until they reach a mutually-agreeable deal. The final offer is defined through the negotiations, and both parties say, “Okay, we agree. We have a deal.” This back and forth negotiation is the contract negotiation process. All of the negotiated changes to Wilson Properties’ original RFP are documented in writing. The best way to do this is to make the appropriate changes in the body of the signed contract. An alternate way is to document all the changes in a separate letter signed by

both parties noting that the changes agreed on supersede and take precedence over the contract and any similar or conflicting provisions. Wilson Properties then advises National Construction Company in writing that they have been awarded the project, referencing the original RFP and the letter documenting all the negotiated changes to the RFP. This written notification by Wilson Properties signifies their acceptance of National Construction Company’s offer, as was revised and agreed on through the two companies’ negotiations. These are the first two key steps taken in the process of arriving at a contract: offer and acceptance.

“Consideration,” or Something of Value

Each party to the contract must receive something of value in order for the contract to be legally enforceable. In the previous example, the contract calls for Wilson Properties to receive a new office building that will be built in accordance with the RFP—­and the changes to the RFP mutually agreed to in writing by both parties. The finished building that Wilson Properties will receive is referred to as something of value. National Construction Company receives the agreed-­on contract price to construct the building for Wilson Properties. The money—­ contract price—­that National Construction Company receives is also considered something of value. Both parties to the contract receive something of value, also known as consideration.

The “Happy Test”

Both parties must mutually and freely agree to all the conditions spelled out in the contract. In order for the contract to be legally enforceable, neither party can use coercion to get the other party to sign. A contract cannot obligate one party or the other to do something illegal. An illegal obligation would cause the contract to be unenforceable. For example, if one party to a contract brings in a group of armed thugs and says to the other party, “sign, or else,” then that clearly is coercion, and the resulting contract would not be legally enforceable. This is an extreme example, but it makes the point. If the written conditions in the contract require one of the parties to have the responsibility of periodically bribing the local customs official (an illegal act) in order to have him under-­apply import duties, then the contract would not be enforceable. There can be nothing in a contract that requires one party or the other to do something illegal. The best advice is: when in doubt, don’t agree to do it. 5

“Can That Person Sign This Contract?”

There are two issues here: the first one involves the competency of the person signing the contract, and the second one involves whether that person has the authority to sign. Both parties signing the contract must be competent. If the person signing the contract is under the influence of drugs or alcohol, or has a serious mental incapacity, then that person probably does not have the competency to sign the contract. The contract would likely be legally unenforceable. A more common concern is whether the person signing the contract for one of the parties has the authority to do so.

An Example A contract may be unenforceable if it is signed by someone who does not have the proper authority to commit the party he represents to the requirements in the contract.

A young employee of the owner who has just graduated from college is getting ready to sign a high-value EPC contract on behalf of the owner for a major expansion to a complex petrochemical plant. The contractor for the expansion questions the young person’s authority to sign the contract. The contractor is accustomed to having much more senior representatives of the owner sign contracts for such major projects.

In a situation like this, the contractor might request that the proposed signer of the contract produce a power of attorney document from the company president, or some other senior officer, granting specific authority to sign the contract. This is a simple solution to resolving the issue of proper authority. It’s not too unusual for the owner’s RFP to require the contractor to have an officer of the company sign the contract. If someone other than an officer of the contractor’s company plans to sign the contract, then he must present to the owner an appropriate power of attorney document giving the signer the authority to sign contracts and commit the resources of the contractor.

Call in the Enforcer to Close the Breach!

What does the term legally enforceable mean? A legally enforceable contract exists when: 1. A written contract has been negotiated (offered and accepted), without any coercion, between the owner and the contractor. 2. There is nothing illegal contained in the contract. 3. The contract has been signed by representatives of the owner and the contractor. The contractor and owner (or representatives) have the authority to commit the resources of their companies. If a contract is legally enforceable, the owner can, if necessary, sue the contractor in court to make him live up to his agreed-on obligations as defined by the contract. Likewise, the contractor can, if necessary, sue the owner in court to make him live up to his agreed-on obligations. The court can act as an enforcer of contract obligations.

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Into the Breach!

If the owner or the contractor does not abide by his respective obligations as contained in the contract, then he may be determined to be in breach of contract. This just means that someone who is party to the contract is not living up to what he has contractually agreed to do. Breach of contract is also commonly called failure to perform. It’s mentioned here only because the issue rears its head all the time. How many times have contractors heard it said that, if you don’t do this or that, you are in breach of the contract? There is no reason to get excited; the term is overused to exert leverage on the contractor and is subject to far too many personal interpretations.

An Example

If an owner agrees in the contract to pay the contractor’s payment invoices 30 days from the date of each invoice, and does not pay until the 32nd day, then the owner technically has committed a breach of contract. The owner may have a variety of reasons—­ legitimate or otherwise—­why he didn’t pay the contractor on time as required by the contract, but he is still technically in breach of contract. Unfortunately, the contractor would have to go to court to have it determined that the owner was actually in breach of contract. It’s always better to find a way to resolve the issue with the owner to get him to live up to the terms of payment he agreed to accept.

The court acts as an enforcer in breach of contract disputes by compelling the party who has failed to perform to live up to his contractual obligations, or else pay monetary damages to the other party. Sometimes a contractor will hear the owner use the term material breach of contract. Like many things in a contract, this term is open to much interpretation. In general, a material breach of contract is a failure to perform a contractual obligation, and the failure is extremely serious and damaging to one or both parties. In the previous example, the owner paid the contractor on the 32nd day and so was two days late. That probably would not stand up to the test or interpretation of what constitutes a material breach of contract. However, if the owner paid the contractor 60 days late and did not have a legitimate reason for the delay, it would certainly have a much better chance of being deemed so. 7

A Contract Example

The following is an example of a simple “supply and install” construction contract that illustrates contracting basics.

An Example

National Construction Company responds to Wilson Properties’ RFP for a new office building, negotiates the details (offer and acceptance), and enters into a construction contract, agreeing to supply and construct the office building (something of value for Wilson Properties) in accordance with the drawings and specifications contained in the RFP. National Construction Company also agrees to perform the work within a fixed time period and for a certain fixed price (something of value for National Construction Company). National Construction Company is to receive a downpayment from Wilson Properties prior to starting the work, and will receive the balance upon satisfactorily completing the building. No coercion was used by either party regarding the terms of the contract, and the contract does not include any illegal requirements. The contract document is signed by Wilson Properties’ President and by National Construction Company’s Project Manager (competent parties with authority).

In written form, the contract would look something like this: Article 1 – Scope of Work and Price National Construction Company agrees to supply and build a one-story office building on a site provided by Wilson Properties strictly in accordance with the attached Plans and Specifications for a fixed, lump-sum price of $250,000. Article 2 – Schedule National Construction Company agrees to complete the one-story office building within one year from the date of this Contract. Article 3 – Terms of Payment Wilson Properties agrees to pay National Construction Company $50,000 as downpayment immediately upon the signing of this Contract, and the balance of $200,000 immediately upon the completion of the one-story office building. Dated: January 1, 2007 Signed:

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Wilson Properties

National Construction Company

__________________

_________________________

President

Project Manager

This is an example of a legally enforceable construction contract in its simplest form. But that’s all that’s actually required. It includes all the basics: 1. National Construction Company made an offer. 2. Wilson Properties accepted the offer. 3. National Construction Company provides something of value: the one-story office building. 4. Wilson Properties also provides something of value: the payment of $250,000. 5. The contract document is signed by a representative of each company who is competent, and who also has the authority to commit the resources of the company. 6. No coercion was used and no illegal activities are required. This sample contract is extremely simple, but it would be perfectly legal and enforceable. However, almost all construction contracts will very likely be a lot more complex and will have numerous additional clauses to cover a variety of commercial terms and conditions, such as insurance, indemnity, performance and payment bonds, changes, dispute resolution, safety requirements, and schedule and progress reporting requirements. This example could have been expanded to include an additional clause requiring National Construction Company to provide Workers’ Compensation insurance and other types and amounts of insurance, which would read as follows: Article 4 – Insurance National Construction Company will provide statutory Workers’ Compensation insurance in accordance with state laws, Comprehensive General Liability insurance in the amount of $1,000,000, and Automobile insurance in the amount of $300,000.

These insurance requirements are typical. Most states require contractors to participate in a Workers’ Compensation insurance program, and owners typically require contractors to also provide General Liability and automobile insurance at a minimum. All the clauses in a construction contract are collectively called the commercial terms and conditions. Commercial terms and conditions define all the responsibilities and obligations of each party to the construction contract. 9

Strange Words & Long Paragraphs

There are no requirements—legal, cosmic, religious, or otherwise— for Latin terms to be used in a contract. For example, the Latin term inter alia, which pops up all the time in construction contracts, simply means “among other things.” It’s perfectly okay to say “among other things” if necessary for clarity. Use English! Using only English terms in a simple and concise manner is a much better way to write a clear and understandable contract. Also, there are no requirements, legal or otherwise, for the use of complicated and abnormally lengthy sentences or paragraphs, or any other confusing language that could lead to misunderstanding. The following is an example of an unnecessarily wordy, complex contract clause stating that a contractor has to complete the work in accordance with the contract documents. Article 25 – Contract Completion by Contractor In consideration of all the mutual and independent agreements set forth on the part of the Owner in the Contract as contained herein, Contractor shall, without exception, construct, complete, and maintain the Work in absolute full conformity and in all respects with any and all the provisions of the Contract and Contractor will perform, fulfill, comply with, submit to, and observe all and singular the provisions, conditions, stipulations, and requirements and all matters and things expressed or shown in or reasonably to be inferred from the Contract and which are to be performed, fulfilled, complied with, submitted to, observed by, or on the part of Contractor.

Here’s how this clause could be revised to simplify the usual obligation of the contractor to complete the work in accordance with the contract documents: Article 25 – Contract Completion by Contractor

Being clear, concise, and specific is the preferred way to write a contract, so that all those individuals responsible for executing the contract understand what they have to do. 10

Contractor shall complete all the Work in full conformity with Owner’s Contract documents.

Clear and concise English is the best way to write a construction contract! Being as specific as possible in writing the commercial terms and conditions is okay, too. Broadly worded commercial terms and conditions are subject to broad interpretation, usually to the detriment of the contractor. If there is a dispute over what the language in a particular commercial clause means, the more specific and concise the language, the better the chances are of resolving the dispute.

One thing to remember is that if a contractor ends up in a contract dispute, and a third party, like a court or an arbitration panel, reads the commercial terms related to the dispute, there is no assurance that they will interpret the clause the way the contractor believes it should be interpreted. Be as specific as possible so that the interpretation of the wording is clear to everyone. If a contractor does not understand a paragraph in a proposed contract because of its length, construction, or use of legal terms, then he should negotiate a revision to it so that everyone responsible for actually executing the contract can understand and interpret it, too.

Contracting Myths

One myth to dispel about construction contracts is that of the so-­ called standard construction contract. There is no such thing as a standard construction contract. There can’t be. There’s no such thing as a standard construction project. This “standard construction contract” approach is sometimes used as a negotiating tool to get one party to the contract to accept unnecessary and/ or onerous commercial terms and conditions that are in favor of the other party. Owners will often insist on using their preferred, standard construction contract as a barrier, or stonewall, to try to stop the contractor from negotiating more favorable, less onerous commercial terms and conditions. Their tactic is something like this, “These standard terms and conditions are well established and can’t be changed.” On the other hand, legitimate attempts have been made to try to standardize construction contracts so that the commercial terms and conditions they contain have some balance, are easier to understand and interpret, and are seemingly fair to all parties. This is admirable in its intent, but can lead to laziness in addressing issues unique to individual construction projects, and it may actually increase the commercial risk assumed by one or both of the parties to the contract. Caution should always be taken whenever a “standard contract” is suggested. Examples of standard commercial terms and conditions for construction contracts are those published by the American Institute of Architects (AIA) and the Associated General Contractors of America (AGC). Other options include standard forms from the Engineers Joint Contract Documents Committee (EJCDC) in the U.S. and the International Federation of Consulting Engineers (FIDIC) in Switzerland. There are certainly opportunities to use these standardized terms on construction contracts, but contractors must read them carefully and 11

understand how they apply to the specific project. If some of the standard terms don’t apply, or tend to create excessive commercial risk, then the contractor should modify them or delete them. These standardized terms are not cast in stone, despite the impressiveness of the contract’s appearance.

A Second Contracting Myth

Another myth to dispel is that only lawyers can write construction contracts. Once a contractor has an understanding of the risk and consequences of accepting certain commercial terms and conditions that can create a potential financial liability for his company, he can negotiate favorable changes to any offending commercial terms and conditions and better protect the assets of his company.

Contract Negotiations

One important thing to remember about construction contracts is this: all the wording of all the commercial terms and conditions in a proposed contract is negotiable. This is especially so if the contractor’s proposal for the work contains a good price, an achievable schedule, and is technically solid. As long as what the contractor is trying to achieve by changing or modifying the language in a proposed contract is not illegal, then all the commercial terms and conditions that may create a potential financial liability for the contractor are fair game for change. As noted earlier, many owners will have standardized wording for most all of the commercial clauses in a proposed construction contract. They would like for this wording to be accepted by all their contractors. That’s fine, as much of the standardized wording can probably be classified as administrative terms, or, as it is sometimes called, boilerplate, and may not impose any additional or excessive commercial risk and potential financial liability on the contractor. However, a conscientious and careful contractor needs to make sure he carefully reads the contract terms and conditions and understands all the commercial risk associated with accepting the owner’s standard contract wording. If the commercial risk is unacceptable, then negotiations are necessary in order to change the wording to lower or eliminate the risk. An unfortunate caution: some owners have been known to insert unrelated high-­risk terms and conditions within what might be considered administrative terms, perhaps hoping the contractor will overlook them. A final waiver of mechanic’s liens, for example, is a fairly normal requirement for the contractor to provide to the owner

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There is no substitute for reading and understanding the contract. It is probably the most important part of the contracting process. Of equal importance is the ability to successfully identify and then negotiate changes to any commercial terms and conditions that can create unnecessary commercial risk and financial liability.

at the conclusion of a construction contract. The owner may even have a standard form for this. Sometimes that final waiver of liens also contains extra language that waives all of the contractor’s rights to claim legitimate extras that are outstanding. This is unfair, but it does happen, so be careful. After the basics of contracts are understood, the next step is developing an understanding of the general types and forms of contracts that contractors will commonly encounter. This is discussed in the next chapter.

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Chapter

2

Types & Forms of Contracts Construction contracts do not come in all shapes and sizes. They conform to a fairly well-­defined set of types and forms. Seven common types of construction contracts are: 1. Fixed price and fixed schedule 2. Reimbursable (unit rate and cost plus) 3. Combined fixed price and reimbursable 4. Cost plus fee 5. Guaranteed maximum price 6. Design build 7. Design-­bid-­build Two additional types of contracts that are commonly encountered are similar to the seven listed above, but with an added twist: 1. Target price contracts 2. Contracts with performance incentives

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Fixed Price & Fixed Schedule Contracts

All well-defined work that can be accurately estimated and planned is a candidate for a fixed, lump-sum price and schedule contract.

These are the most common types of construction contracts. The contractor submits a fixed, lump-sum price for the owner-provided scope of work, as well as a finite completion time schedule. This type of contract can be used for small projects, such as a $5,000 addition to a single-family house, to large contracts, such as a petrochemical manufacturing facility worth hundreds of millions of dollars. An example of this would be when a contractor submits a fixed, lumpsum price of $1,000,000 to an owner, with a firm schedule of 52 weeks to complete an office building. In a fixed price contract, the contractor must have the ability to accurately estimate the costs and time required to perform the work. The contractor also must have the capabilities to execute the contract for the price and schedule as promised. This type of contract requires the owner to provide a comprehensive and accurate definition of the scope of work. For the owner, this type of contract will likely provide the lowest cost or best schedule (or both) to get the work done, since he will probably have asked several contractors to compete for the work and provide a formal bid. Having a fixed price and firm schedule allows the owner to plan better for scheduling and for financing or paying for the project. For the contractor, this type of contract requires estimating and execution skills. It also requires him to make a judgment on how high to price the work to compete with other contractors. One good thing about fixed price and schedule contracts is that, if the contractor performs well against his costs and schedule, it’s likely he will have savings and thereby increase his estimated profit, and there’s nothing wrong with that! On the other hand, if the contractor overruns his estimated costs and/or schedule, it’s unlikely he will get much sympathy—or money—from the owner.

Reimbursable Type Contracts

There are two common and similar types of reimbursable contracts: • Unit rate • Cost plus

Unit Rate Contracts

The contractor submits a menu of prices for materials, labor, and equipment to the owner. These prices include all of the contractor’s costs and markups, including profit, for the respective items listed.

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An Example

The owner wants to install approximately one mile of 24" diameter underground cast iron pipe in a 6' deep trench. The contractor provides the following example menu of prices to the owner: • 24" diameter cast iron pipe: $50/linear foot delivered • Project foreman: $75/labor hour worked, no overtime • Laborers: $35/labor hour first 40 hours per week, $55/labor hour overtime • Backhoe: $175/hour fueled and operated • Side-­boom tractor to lay pipe: $175/hour fueled and operated • 12" rock backfill over pipe: $30/cubic yard delivered • Miscellaneous expendables: $250/day At the end of each week during the project, the contractor adds up the length of pipe installed, the labor hours worked by the foreman and laborers, the time of use for the backhoe and the side-­boom tractor, the amount of rock backfill, and miscellaneous expenses. The contractor then applies the reimbursable rates to each, sums them up, and sends the owner a bill.

Cost Plus Contracts

In a cost plus construction contract, the contractor submits a menu of direct costs and associated markups for materials, labor, subcontracts, and equipment to the owner. The markups (the “plus”) include all of the contractor’s overhead and profit applied to the respective items in the menu.

An Example

The owner wants to install approximately one mile of 24" diameter underground cast iron pipe in a 6' deep trench. The contractor provides the following menu of costs and markups to the owner: • All pipe materials delivered to site: direct invoice cost plus 20% • Project foreman: $45/labor hour worked, plus 50% fringes and 20% overhead and profit • Laborers: straight time, first 40 hours/week: $23/hour, plus 35% fringes and 20% overhead and profit • Laborers: overtime, after first 40 hours/week: $34/hour, plus 25% fringes and 15% overhead and profit • Backhoe: $145/hour, fueled and operated, plus 20% overhead and profit

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• Side-­boom tractor to lay pipe: $145/hour, fueled and operated, plus 20% overhead and profit • Rock backfill over pipe delivered to site: direct invoice cost plus 20% • Subcontracts: cost plus 15% overhead and profit • Miscellaneous expenses: direct invoice cost plus 20% At the end of each week during the project, the contractor adds up the invoice costs of all materials delivered to the site, the labor hours worked by the foreman and laborers, the time of use for the backhoe and the side-­boom tractor, the amount of rock backfill, and miscellaneous expenses. He then applies the noted markups to each, sums them all up, and sends the owner a bill. For the owner, these types of reimbursable contracts are useful where the scope of work and schedule are difficult to define. Maybe there’s some rock in the ground, or the terrain is difficult, or the weather is really lousy—­and trying to determine a fair fixed, lump-­sum price might prove difficult or turn out to be very expensive, as the contractor will load up his contingency costs. For the contractor, these types of reimbursable contracts allow him to take on a job without having to provide a large contingency cost for unknown conditions and schedule delays. The contractor probably has to compete with others to get the work, so he’s careful about the level of his reimbursable pricing and the time he estimates it will take to complete the work. On all reimbursable contracts, the contractor should expect that the owner will want to audit his work records for the labor hours billed, the time the equipment was used and billed, and for any other reimbursable work item.

Combined Fixed Price & Reimbursable Contracts

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As the name suggests, this contract is a blend of the two types of contracts. It tends to be used where some of the work is well-­defined, and some isn’t.

An Example

An owner wants to build a standard-­design, 300-­foot-­tall radio relay tower on the top of a 10,000-­foot-­high, heavily-­wooded mountain. There isn’t anything special or unique about the engineering effort required or the supply of the materials for the tower. However, getting the materials from the base of the mountain to the top on an unimproved roadway, and then installing them, is not conducive to a fixed price, as too many undefinable work and schedule issues are involved.

The owner ends up with the following example contract pricing format: • Engineering: $20,000 lump sum • Radio tower material supply: $80,000 lump sum • Transport materials to base of mountain: $5,000 lump sum • Mobilize crew and equipment at site: $5,000 lump sum • Project manager: $100/labor hour worked • Project superintendent: $75/labor hour worked • Steel erectors: $45/labor hour • Clearing and installation labor: $30/labor hour • 10-­ton mobile crane: $125/hour fueled and operated • 5-­ton special transport: $85/hour fueled and operated • Excavation: $5/cubic yard excavated and removed • Portable air compressor and generator: $45/hour fueled and operated • Small tools and expendables: $200/day • Demobilize crew and equipment from site: $3,000 lump sum The contractor bills the owner for the stated lump sums for the engineering costs, supply of materials, transport, mobilization, and demobilization. These scope of work items were well-­defined by the owner in his inquiry documents, and thus are conducive to fixed, lump-­sum pricing. The field installation work proceeds on a “best effort” basis, given the adverse and difficult-­to-­estimate working conditions. The contractor bills the owner for the work performed based on the menu of reimbursable prices provided, just like in the reimbursable contract example. For the owner, this type of contract is useful where some aspects of the scope of work and schedule are easy to define, but some of the work is difficult to define. Trying to get a fair lump-­sum price for the entire project might prove difficult, as the contractor will feel the need to load up his contingency costs for the difficult field working conditions. For the contractor, the combined fixed price/reimbursable contract will allow him to take on a job without having to include a large contingency cost for unknown field working conditions and any delays in schedule. He probably will have to compete with others to get the work, so he’s careful about the level of his fixed, lump-­sum pricing, the level of the reimbursable pricing, and the time he estimates it will take to complete the work. 19

Cost Plus Fee Contracts

A cost plus fee construction contract format is often used for large, complex projects. Typically, these projects require a significant amount of conceptual and design engineering, along with a major effort to procure a lot of expensive equipment and materials. These projects also require construction services, including a large and diverse project management staff and a multi-­disciplined craft labor force. There might be a completion schedule of several years or more. In this type of construction contract, the contractor provides, for example, all permits, studies, design services, detail engineering, major equipment, materials, and field construction management and labor, often in a joint effort with the owner. The contractor then bills the owner for the actual costs, and, in addition, bills the owner a fixed fee, which would typically include the contractor’s project management costs, overhead costs, and profit. All the actual costs associated with engineering, procuring, and constructing the project are billed directly to the owner for payment, or reimbursement if the contractor is paying the bills in the first instance as part of the contract with the owner. In addition, the owner will pay the contractor the agreed-­on fee on a prorated basis based on the physical or cost progress of the project. Many cost plus fee contracts have a provision in them to increase the fee should the estimated costs or scope of work exceed a certain amount, or if the estimated schedule extends beyond what was originally estimated. For the owner, a key benefit of this type of contract is that it allows him to build a project on a fast-­track basis. He can negotiate a contract with a specialized and experienced contractor for the project and proceed immediately with conceptual and detailed engineering and procurement of major, long-­lead-­time pieces of equipment. The owner avoids the lengthy fixed-­price process of selecting a main contractor, then going through the development of engineering and the production of bid documents, the bidding and bid review, and final contractor selection process. The owner might expect to save up to a year or more on the completion schedule of major projects with this contracting approach. This type of contract requires full participation of the owner in the cost control and subcontractor selection process. For the contractor, this approach allows him to be reimbursed for all costs associated with the project and provides him with a fee to cover project management, overhead, and profit for the project. If the project expands beyond what was originally expected, then the contract should allow for an adjustment to the contractor’s fee.

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In this type of contract, all reimbursable actual cost records are auditable by the owner. In addition, the owner might expect to negotiate the amounts in the fee for the contractor’s project management, overhead, and profit.

Guaranteed Maximum Price Contracts

This type of contract would likely be a reimbursable type, or some combination of reimbursable and fixed price contracts. The distinguishing feature of this type of contract is that the contractor would agree with the owner that the final price to the owner would not exceed a fixed, certain value. In other words, the contract would have a guaranteed maximum price. This is a risky agreement for contractors. If the contractor’s cost of the project exceeds the guaranteed maximum price, then that’s too bad for the contractor. The extra money comes out of his pocket. It is especially risky if the scope of work is poorly defined, and if external factors like weather or labor conditions create expenses that he cannot recover through claims or changes to the contract. For owners, this type of contract is useful where he may, for example, have to fund the project with outside financing and want to cap his exposure to project costs.

Target Price Contracts

A target price contract is one where the contractor and the owner agree on a certain fixed, lump-­sum price, the target price, and the contractor tries to execute the contract at or below it. One unique feature is that the contractor shares all the costs in the estimates, including his markups and expected profit, with the owner. The owner understands the contractor’s estimating process and supports it. In a target price contract, both parties agree on the level of costs and contractor markups and profit. This type of contract also requires the contractor and owner to have a working relationship based on a high degree of trust. In the event the contractor completes the project below the estimated cost, there will be a cost savings, and the contractor and owner will share that savings in a previously agreed-­on proportion. In the event the contractor overruns the project costs, then the contractor and owner will share the expense of the overrun in a similar fashion.

An Example

A contractor and owner agree on a price of $3,500,000 to build a new, concrete marine cargo unloading jetty for the owner’s ships. After finishing the project, the contractor manages to save $100,000 on his estimated costs and shares that information with the owner. 21

The contract between the owner and contractor calls for any savings against the target price to be split 50-­50. Therefore, the owner ends up paying $3,450,000 for the project, and the contractor ends up with an additional $50,000 profit. In this type of contract, both the owner and contractor have a strong incentive to work closely together and pool their talents and resources to find legitimate ways to reduce costs and safely expedite the overall project schedule.

Design Build Contracts

In this type of construction contract, the Owner signs a single-­source contract with a Contractor that will cover all the aspects of the design and construction for the project. The theory is that this will eliminate multiple contracts and subcontracts for the Owner, find cost and time savings, reduce paperwork, and streamline the overall bidding and completion schedule. Contractor led design-­build contracts can be considered where the selected contractor has demonstrated engineering, design, and construction strengths in the type of project being proposed. For example, a refinery or petrochemical plant. Architect-­led design-­build contracts can be considered where the project has some complex and nuance design issues. For example, a hospital or custom home. The contractor for the construction might be part of the architect’s organization or perhaps a joint venture partner.

Design-­Bid-­Build Contracts

The difference between this type of contract and a design-­build contract is that the Owner issues a separate contract to an architect for the design of the project and a separate contract for the construction of the project. In a design-­bid-­build contract, the construction contractor does not participate in the project’s design. An example of this type contracting process might be a single-­or multistory commercial building.

Contracts with Performance Incentives 22

Any of the above-­mentioned types of construction contracts can have performance-­based incentives included. Some typical performance-­ based incentives are: • Safety: such as an incentive bonus for no lost time or recordable accidents.

• Quality: such as an incentive bonus for achieving 98% or better flawless x-­rays on all full-­fusion welds in high-­pressure piping. • Subcontracts: such as an incentive bonus for utilizing a certain percentage of minority-­owned subcontractors or suppliers. • Schedule: such as an incentive bonus for finishing ahead of schedule. Performance-­based incentives can play a strong role in achieving certain goals for the owner. For example, if the owner’s company assigns utmost importance to safety, then the owner should be willing to “put his money where his mouth is” by making a pool of extra money available to those contractors on the project who achieve exemplary safety records. On the flip side of this issue are those contracts that contain certain performance disincentives. An example of this may also involve job site safety, a common performance-­based incentive. In addition to the pool of extra money that might be available to the contractor for exemplary safety, the contract may also provide for the contractor to put, say, 2% (or more) of his contract price at risk for poor safety. If the contractor doesn’t meet the project’s minimum stated safety goals for his portion of the work, then the owner has the right to deduct some or all of the 2% from the contractor’s contract price. One common disincentive that can be used by the owner is the imposition of liquidated damages when the contractor fails to meet or beat the contractual schedule. (Liquidated damages and how to deal with them are covered thoroughly in Chapter 11.)

Form of Contracts

Like the types of contracts, the form that a construction contract takes is fairly standard, too. Organization is typically as follows: 1. Preamble 2. General contract and the commercial terms and conditions 3. Special terms and conditions 4. Attachments incorporated by reference 5. Signature block 6. Order of precedence

Preamble

Most contracts begin with what is called a preamble, used to specifically identify the parties to a contract. This is an excellent convention to use, as owners may have many different, independent, and separate business units, both U.S. and foreign subsidiaries, that 23

have the ability to enter into construction contracts and commit the use of corporate resources. Preambles are straightforward in their structure and typically read as follows: This Contract is between Wilson Properties (Owner), an organization registered in the State of Florida and having its registered office at 3160 Ponce DeLeon Way, Orlando, Florida, and National Construction Company (Contractor), an organization registered in the State of Delaware and having its registered office at 125 East Orange Street, New York, New York.

Note the convention of capitalizing and putting “contractor” and “owner” in parentheses after they are identified as a party to the contract. This is done to define important terms to be used throughout the contract. It’s also a simplifying procedure. Rather than using “National Construction Company” to define the contractor throughout the contract, the capitalized term “Contractor” is used. Defined terms and additional examples are more thoroughly discussed later in this chapter.

Recitals

Often following the preamble in a contract is something called recitals. Recitals typically begin with the word “Whereas,” or “WHEREAS,” or “WITNESSETH.” A recital typically states facts, issues, or conditions related to the contract and may read similar to the following: WHEREAS: Owner has decided to build a new 10,000 square foot warehouse on property located in Orlando, Florida. WHEREAS: Contractor warrants that it is qualified, experienced, and competent to perform the work. WHEREAS: Contractor has agreed to do the work subject to the terms and conditions of the Contract.

The recitals section ends with the following, or similar, sentence: NOW, THEREFORE, IT IS HEREBY MUTUALLY COVENANTED AND AGREED AS FOLLOWS:

What follows is the body of the construction contract. The recitals section is an old, and some might say, antiquated practice that doesn’t 24

add much value to the contract. Everything typically stated in the recitals section would normally be agreed to elsewhere in the body of the contract and will be just as enforceable. Many modern contracts no longer use recitals wording. Having said all this, if an owner presents a draft contract containing a recitals section, that’s okay. As long as what’s said in the recitals section is accurate, there is no need to change it or delete it.

General Contract & the Commercial Terms & Conditions

Following the preamble and recitals (if recitals are used) comes the main body of the contract. This part of the contract typically contains a description of the scope of work to be performed by the contractor and the commercial terms and conditions. Together, these typically define the rights, duties, responsibilities, and obligations of the owner and the contractor. The scope of work section in the commercial terms and conditions may be sufficiently detailed to fully describe the work, or the work requirements may be in the form of a separate set of plans and specifications that are attachments to, and form part of, the contract documents. Any plans, specifications, codes, or other requirements that are attached or included by specific written reference in the contract are considered an enforceable part of the contract. The rights, duties, responsibilities, and obligations of the owner and the contractor are stated in separate and numbered paragraphs in the body of the contract. These paragraphs are also called clauses or articles. It doesn’t matter what they are called; these individual paragraphs require careful reading and analysis, as each may expose the contractor to some varying degree of commercial risk. The degree of commercial risk associated with a paragraph in the contract may be acceptable, unacceptable, or somewhere in between. Depending on the level of commercial risk accepted, the contractor may be exposed to the possibility of accepting a large amount of potential financial liability. These commercial terms and conditions are the most likely place in a contract where the contractor will be exposed to risk and require the most careful review. As noted at the beginning of this book, there is no price for bad terms. Often an owner will state, “If the contractor doesn’t like some 25

of the general commercial terms and conditions in our contract, then he should add some money to his price to cover the commercial risk he believes he is assuming.” There isn’t anything wrong with an owner making this requirement, as long as the contractor can somehow accurately measure the value of the commercial risk he is assuming, and place a price on it. However, how can a contractor measure, for example, the commercial risk assumed in a broad form indemnity in the owner’s contract, the consequences of which could bankrupt his company for something he did not do? There is no price a contractor can place on that level of commercial risk.

Just like the commercial terms and conditions in an owner’s proposed contract, the special terms and conditions require the same careful review and analysis.

Special Terms & Conditions

Many large organizations involved in engineering and building projects have a set of standardized general terms and conditions that they like to use for their construction contracting needs. Based on the special needs or issues involved in a particular construction project, they may elect to attach to the contract a set of special terms and conditions. These will typically supersede any similar or like terms and the contract’s general terms and conditions. Many times, they will have a lead-in paragraph that reads similar to the following: These Special Terms and Conditions take precedence over any similar or like terms and conditions found elsewhere in this Contract.

Special terms and conditions can just as easily expose the contractor to unacceptable commercial risk and exposure to potential financial liability, as can the owner’s general commercial terms and conditions discussed above. Just like the comment made for general commercial terms and conditions, there is no price for bad terms—general, special, or otherwise.

Attachments Incorporated by Reference

In addition, many contracts will have a variety of attachments, appendices, or addenda incorporated by reference that spell out specific contractual requirements for different subjects. Typical attachments to an owner’s complete construction contract might include: • Scope of work description • Plans and specifications that apply to the work 26

• • • • • • •

List of applicable codes and standards that apply to the work Project safety program and requirements Overall project schedule Special insurance requirements Form of performance and payment bonds Final acceptance form Final waiver form

All attachments incorporated by reference in a construction contract require the same careful review and analysis. Attachments incorporated by reference can just as easily expose the contractor to unacceptable commercial risk and potential financial liability.

Signature Block

This is the last thing to do: sign the contract. Once this is done, then an enforceable contract is in place. Both parties must perform their parts of the deal as described in the contract. A typical signature block might look like this: IN WITNESS WHEREOF duly authorized officers of the parties hereto have executed this Contract. Date: ___________________ National Construction Company

Wilson Properties

________________________ 

__________________________

Name:

Name:

Title:

Title:

The term in capitals “IN WITNESS WHEREOF” is commonly used, but is another example of an antique contracting convention. If the contractor does not like the “IN WITNESS WHEREOF,” then remove it. A simple alternative: The parties to this Contract are in agreement and have signed and dated it below:

Order of Precedence

On most construction projects, the contractor will provide a written proposal in response to the owner’s inquiry or request for proposal. 27

In that proposal, the contractor will make an offer to perform the work specified in the owner’s bidding documents. The contractor’s proposal will also respond to the bidding requirements, if any, in the owner’s bid documents. In addition, the contractor may state some of his own requirements, such as better terms of payment. He may also take written exception to some of owner’s general terms and conditions or special conditions because they impose an unacceptable level of commercial risk on him. The contractor may also offer alternative technical solutions to the owner’s requirements. The owner and contractor then meet, work out details, and negotiate a final price, schedule, and contract. The contractor may find that the owner accepted his proposal without any changes to his proposed better terms of payment and all of his exceptions to the owner’s general terms and conditions and special conditions. The contract and all attached documents then are given to the contractor for his acceptance and signature. Then, in the general terms and conditions, under order of precedence of documents, there may all of a sudden appear a new paragraph that states: Article 3 – Order of Precedence 3.1 In the event of any conflict or dispute arising in or out of this Contract, the order of precedence of documents shall be as follows: a.) Owner’s Special Terms and Conditions b.) Owner’s General Terms and Conditions c.) Owner’s Plans and Specifications d.) Contractor’s Proposal dated July 7, 2006

If the contractor accepts this order of precedence, signs the contract, and returns it, he is basically out of luck on getting his preferred terms of payment and the changes he wanted made to the general terms and conditions and special conditions. Even though the contractor proposed some modifications, those modifications stand little chance of being recognized or enforceable because the contractor’s proposal is in last place in the order of precedence. The unfavorable payment terms in the owner’s general terms and conditions take precedence over the favorable payments terms stated in the contractor’s proposal. The risky commercial terms that appear in the special terms and conditions will now take precedence over the similar, but less risky, commercial terms stated in the contractor’s proposal. During the execution of the work, the contractor sends in his first payment invoice specifying his terms as stated in his proposal. 28

The invoice will probably be rejected, as the owner will be able to enforce the order of precedence clause to use the terms of payments specified in his general terms and conditions. When faced with an order of precedence situation described above with respect to a conflict between the owner’s terms and the contractor’s proposal, it is recommended that revised wording similar to the following be negotiated and used: Often, the negotiations between the owner and the contractor result in some form of compromised wording that ends up somewhere in between what the owner wants in his general or special terms and conditions and what the contractor wants and has stated in his proposal. Article 3 – Order of Precedence 3.1 In the event of any conflict or dispute arising in or out of this Contract, the order of precedence of documents shall be as follows: a.) Owner’s Special Terms and Conditions except those modified by Contractor’s proposal dated July 7, 2006, which shall take precedence. b.) Owner’s General Terms and Conditions except those modified by Contractor’s proposal dated July 7, 2006, which shall take precedence. c.) Owner’s Plans and Specifications except those modified by Contractor’s proposal dated July 7, 2006, which shall take precedence. d.) Contractor’s Proposal dated July 7, 2006.

In this event, a compromise might be agreed to in a separate letter signed by both the owner and contractor. The revised Article 3.1 a.), b.), and c.) wording might read similar to the following: a) The Owner’s Special Terms and Conditions with the modifications to them as agreed upon in the letter from Contractor dated August 15, 2006. b) The Owner’s General Terms and Conditions with the modifications to them as agreed upon in the letter from Contractor dated August 15, 2006. c) The Owner’s Plans and Specifications with the modifications to them as agreed upon in the letter from Contractor dated August 15, 2006. d) Contractor’s Proposal dated July 7, 2006.

At issue here with order of precedence is getting the contractor’s negotiated modifications to the owner’s terms and conditions recognized as taking precedence over any of owner’s similar or conflicting provisions. 29

Acceptable revisions to the owner’s terms and conditions are usually fought for by the contractor, and it would be a shame for those revisions to not apply due to an overlooked order of precedence clause in the contract.

Some Final Contract Housekeeping— Definitions

Construction contracts, regardless of their type or form, can be wordy and unnecessarily difficult to understand. Defining contract terminology is a practical way to understand concepts in the commercial terms and conditions of a construction contract. Providing defined terms, or definitions, in a contract is just good contract housekeeping. How is a defined term defined? Often, when a contractor is reading through the many different clauses in a construction contact, he will notice that in many of the clauses there are capitalized terms, like “Contractor,” or “Owner,” or the “Work,” and so on. These are examples of defined terms.

An Example

At the beginning of this chapter, there is a typical preamble that begins with a line that states:

This Contract is between National Construction Company (Contractor), an organization. . .

The defined term here is the capitalized word “Contractor” and is contained in parentheses. Everywhere else in the contract, without exception, wherever the capitalized defined term “Contractor” is used it means “National Construction Company,” as was stated in the preamble. Also in the sample preamble, the third line states: . . .and Wilson Properties (Owner), an organization registered. . .

The defined term is the capitalized word “Owner” and it is also contained in parentheses. Everywhere else in the contract, without exception, wherever the defined term “Owner” is used, it means Wilson Properties, as was stated in the preamble. It is also not unusual to see a defined term fully capitalized, such as CONTRACTOR or OWNER. Use of partial capitalization or of full capitalization of defined terms is just a matter of different writing styles. There is no difference in meaning between a defined term that is partially capitalized or one that is fully capitalized. 30

Typically, the first time a defined term is used in a contract is where the shortened form is capitalized. It may appear in parentheses, and is typically placed immediately following the defined term. Thereafter, throughout the contract, the capitalized and shortened form is used. This is practical when, for example, the scope of work is lengthy and complex and can be defined simply and more easily by using the capitalized term “Work.” Some contracts may use an alternative writing style that states in parentheses: “(hereinafter, Contractor)” immediately following the term it defines. The use of the term “hereinafter” is another antique contracting form and means something like, “wherever you see this term elsewhere in this contract, this is what it means.” Many contracts have a separate section called “Definitions.” In this section, terms used frequently throughout the contract are clearly identified, and their capitalized short form definition is noted. It’s not unusual for “contractor” and “owner” to be defined again in a definitions section, just as they may have been earlier defined in the preamble. Some typical terms that may appear in a definitions section are as follows. Article 1.0 – Definitions 1. Contract: all terms and conditions contained in the General Conditions, the Special Conditions, the Plans and Specifications, the Attachments to the Contract, and the Contractor’s Proposal. 2. Contractor: the contractor. 3. Owner: the company or individual who requests and is funding the project. 4. Work: all activities, including design, engineering, supply of materials, manpower, equipment, and field construction necessary to complete the 10,000-square-foot, single-story building as fully described and detailed in the Plans and Specifications attached to this Contract. 5. Job Site: the area of land on which the Work will be constructed as identified on the map and survey included in the Plans and Specifications attached to this Contract. 6. Construction Equipment: all equipment supplied and used by Contractor for the performance of the Work. 7. Acceptance Certificate: a dated and signed document issued to Contractor by Owner certifying that the Work is completed in accordance with all the provisions of this Contract. 8. Defect Liability Period: the period of time beginning with the date of the issuance of the Acceptance Certificate for the Work and ending 12 months later.

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Clearly defining contract terms is good contracting practice. Definitions play an important housekeeping role in keeping the language of the contract readable and somewhat less complex, especially where multiple references to complicated definitions, like the work, are required. This helps everyone involved in the actual administration and execution of the contract—­the real work—­better understand the contract requirements. Clarity in construction contracts is essential and helps avoid misunderstandings. Defined terms help provide this clarity.

Conclusion

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Just about every contract a contractor will see will conform generally to the types and forms of contracts described in this chapter. Regardless of the type of contract, the most important part of any construction-­related contract is the scope of work section, the subject of the next chapter.

Chapter

3

Scope of Work

It’s a given that in any construction contract requiring the contractor to build, repair, upgrade, or modify something, an accurate and concise description of the work should appear. That description of the work—­which defines what the contractor is obligated to provide—­is called the scope of work. An accurate, detailed, and comprehensive scope of work is the most important part of a construction contract and one of the foundation stones of a good contract. It is not uncommon for the owner to believe, perhaps correctly, that he should be getting more, or something different, than what the contractor is providing. It’s also not uncommon for the contractor to believe that he should be providing less, or something different, than what the owner believes he should receive. Each party will have his own interpretation of a poorly written scope of work. All construction projects, even those that appear simple and straightforward, require comprehensive scope of work documents to be included as part of the contract. The more complex a construction Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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A comprehensive description of the work to be performed is an absolute necessity. It enables the contractor to more precisely price, plan, and schedule the work. It better assures the owner that he will receive what he really wants. And, a well-written scope of work will significantly minimize the possibility of claims, change orders, and disputes arising during the course of the project over what work is, or is not, required.

project is, the more important it is that the scope of work documents be thorough and detailed. On large projects where there are a number of contractors working side by side at the same time, the scope of work documents should clearly define the interfaces between them all. This is especially important if the work being done by one contractor must hook up or somehow be attached to the work of another. For example, if two contractors are providing piping on a project, and the piping of both must interconnect smoothly at some point, who makes the welded or bolted interconnection between the two pieces of pipe? Maybe it’s not a big deal if only one piping connection is required to connect the piping of both contractors. But what happens if there are several hundred pipe connections to be made? Who’s responsible now to make the connections? That interface responsibility should be clearly defined in the scope of work documents. The owner has the primary responsibility for preparing the scope of work documents. After all, it is his project. He may prepare them himself or hire an independent company. In either case, the contractor must carefully review these documents and, in his proposal for the work, make as many written clarifications as may be required to further define the work that is included in his pricing. More importantly, it is absolutely necessary for the contractor to define what’s not included in the scope of work. Too many claims and disputes arise out of a difference of opinion between the contractor and the owner over what is required in the scope of work, and who is to provide it.

An Example

Let’s consider the single-story office building used in the sample construction contract in Chapter 1. All the drawings and documents included in Wilson Properties’ Request for Proposal (RFP) describing and detailing the building were well-prepared by a local engineering consulting company hired by Wilson Properties. The contractor, National Construction Company, put a price and schedule together to construct the building based on these documents, but made no clarifications to them in the proposal to the owner. National Construction Company’s project management, site manager, work force, and equipment show up at the job site on the contractually designated date. The site has been cleared and evenly graded. There is plenty of space for all job site offices and equipment, and all local gas, water, telephone, and electric power are in place ready for hook up.

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As National’s site manager inspects the site, he notices that the foundations for the building are not there. Uh-­oh! Looks like a problem. National’s site manager calls his boss, National’s project manager, on his cell phone. He tells his boss, “I think we have a small problem here. There aren’t any foundations in the ground, and they aren’t in my scope of work.” National’s project manager reviews the Wilson Properties contract documents, scope of work section, and all referenced attachments. The scope of work is several pages long and provides a general description of the building to be constructed. There is no mention about the building foundation. Included in the RFP are some off-­ the-­shelf standard specifications on excavation, concrete, and rebar, which would be considered normal for this type of project. However, there is nothing specific about the building’s foundations or, more importantly, who is to design, supply, and install them. There are also no engineering sketches or detail drawings on the foundation attached in the contract. National’s project manager re-­reads his company’s proposal for the work, and the only thing it says is that, “National Construction Company will provide the work in accordance with the contract documents.” There is no further clarification. It’s time to call the owner for a meeting. National Construction Company’s project manager meets with Wilson Properties’ project director for this building project. After a review of the contract documents, Wilson Properties’ project director claims that the supply and installation of the foundation for the building is part of National’s scope of work. National’s project manager says, “I’m not sure how you can come to that conclusion, as there’s no reference in any of the documents that the foundations are in our scope of work.” “You’re right, there’s no specific reference,” says Wilson’s project director. “But you guys have built buildings for us on several previous occasions and have always designed and installed the required foundations. It’s actually one of your company’s strengths.” “So you’re telling me we have to provide the building’s foundations?” National’s project manager asks. “Yes, the foundations are implied in the contract,” says Wilson’s project director. “You can’t build a building without foundations, and the concrete and rebar specs are in the contract for a good reason.” “But there’s nothing in the scope of work that actually says we have to provide the foundations,” says National’s project manager. 35

“Well, that’s true, but there’s a paragraph in the Commercial Terms and Conditions section that requires National to do all work reasonably implied from the contract documents,” replies Wilson’s project director. “So what you’re telling me is that the building’s foundations are implied by the contract specifications to be part of National’s scope?” asks National’s project manager. “That’s right. You guys have been in the business for a long time and have done a lot of this type of work. If you overlooked the foundations, then that’s your problem, but as far as Wilson Properties is concerned, the building’s foundations are in your scope.” There is nothing pretty about this picture. Here are all the classic beginnings of a major contract dispute. The cost to supply and install the building’s foundations will make the overall contract a financial loser for National. Wilson Properties doesn’t seem willing to accept a major change order to the contract. The schedule will also be greatly impacted. Is this an oversight on the part of National Construction Company? Perhaps it is. As National’s project manager considers what he is going to do next to resolve this situation, he recalls an earlier conversation with Wilson’s project director, who said, “You guys really have a good price this time on this building bid.” He now understands why that comment was made. He reviews the contract’s commercial terms and conditions section and all paragraphs concerning the scope of work once again. He comes across the following paragraph: Article 8 – Contractor’s Scope of Work 8.1 Contractor shall perform all work strictly in accordance with this Contract and the Plans and Specifications attached to this Contract, and shall be solely responsible to perform all work as may be reasonably implied from the Plans and Specifications that may be necessary to completely and satisfactorily finish the Work.

He thinks again to himself, “We could have done a better job of defining what we were going to provide in our proposal. It looks like Wilson Properties has stuck it to us with some slick terms and conditions.” It seems like National Construction Company is out of luck and will have to put in the foundations. Alternatively, they could make an issue out of it with Wilson Properties. Either way, it’s a lousy situation to be in for a contractor, and not a good one for an owner either. 36

It also appears the relationship between National Construction Company and Wilson Properties may become adversarial. That’s not good for either company. How could a situation like this have been avoided? National Construction Company should have carefully clarified the scope of work in their proposal, including that the building’s foundations were to be designed, supplied, and installed by others. In this case, National Construction Company should have more carefully reviewed all the contract documents for inconsistencies and addressed any they found in their proposal to the owner. National could also have requested that the contract paragraph noted above be changed to read similar to the following: Article 8 – Contractor’s Scope of Work 8.1 Contractor shall perform all work specifically described in the attached plans and strictly in accordance with the specifications attached to or referenced in this Contract.

Such a revision might not avoid a dispute over who provides the building’s foundations, but it would give National Construction Company a much stronger position in claiming that the foundations are not part of their scope of work. The use of words like “reasonably implied” in the scope of work section of a contract can allow open season on the contractor by the owner regarding the owner’s requested changes to the scope of work. On the other hand, it can protect the owner from a host of small and unnecessary requests for changes from the contractor. What is “reasonable” to an owner may not be “reasonable” to a contractor, and vice versa. The best way to avoid situations like this is to make sure the scope of work description in the contract is very specific and detailed; this is as much the contractor’s responsibility as it is the owner’s. If certain items of work are excluded, then all those exclusions to the scope of work should be specifically detailed in the contractor’s proposal, and also in the final contract documents. Plans and specifications and the associated terms and conditions always have to be carefully reviewed to avoid situations like this. If there is any doubt as to whether or not something is included in the work, it’s best to clarify it in writing with the owner prior to signing the contract.

The Scope of Work Matrix

This is a useful contracting tool that will benefit both the contractor and owner. It provides a line-by-line listing of all of the work items included in the contract. The scope of work matrix can be lengthy 37

Figure 3.1 Example of Scope of Work Matrix for One-­Story Office Building and extremely detailed. Not only does it provide a better overall description of the work to be performed, but it also requires the owner and the contractor to more carefully understand what needs to be provided to complete the project. A detailed scope of work matrix is always worth the effort and can play an important role in minimizing claims and disputes over work scope issues. A scope of work document can also clarify the interfaces in work scope between different contractors on the same project. Figure 3.1 is a sample scope of work matrix for a one-­story office building project, such as what might have been developed by Wilson Properties for inclusion in their RFP documents. It really doesn’t matter whether the owner and the contractor use a scope of work matrix, or some other form or means of description to accurately define the work. What does matter is that the scope of work to be performed by the owner, the contractor, and all others 38

who will be working on the job site is comprehensive and accurately detailed. Not only does this process produce a better, more well-­thought-­out project, it also minimizes the chances of claims and disputes arising over misunderstandings about what is included in the scope of work for everyone working on a project.

Scoping Drawings

Scoping drawings are another excellent tool (similar to the scope of work matrix) for helping to better define the scope of contractors’ and owners’ work, responsibilities, and boundaries. These drawings relate to the project and indicate for the contractor what is “in scope” for his scope of work and what is “not in scope.” General arrangement and detail drawings of the project are particularly useful and can be marked up for this purpose. Figure 3.2 is an example of how scoping drawings can be used by an owner or a contractor.

Figure 3.2 Example of a Scoping Drawing 39

Scoping drawings are also useful to outline multiple scopes of work when there is more than one contractor on the job site, each working in close proximity to the other.

Conclusion

40

To restate: a well-­defined, carefully detailed, and comprehensive scope of work document, or scope of work matrix (including scoping drawings), is probably the most important part of a construction contract. If contractors could get their clients—­the owners—­to read just one chapter of this book, this chapter is the one.

Chapter

4

Terms of Payment & Cash Flow Three Rules of Business: 1. Have cash. 2. Have cash. 3. Have cash. ~ Overheard in a seminar on business Why does it seem to be so difficult for contractors to negotiate acceptable payment terms for their work with owners on a construction contract? Is it just too hard to ask for better terms of payment? Are contractors afraid their requests for better terms will be turned down? Does it have something to do with owners’ claims that they have nonnegotiable “standard terms of payment?” Good terms of payment are another one of the foundation stones of a good contract. It is best to again remember that in any construction contract, there is no such thing as “standard terms” or “standard terms of payment.” Everything is negotiable, as long as what’s being negotiated is not illegal. It certainly is not illegal to get favorable and timely terms of payment for the contractor’s construction activities. Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Owners often like to have terms that defer payment to the contractor for as long as possible. This is a normal situation in the construction industry. It’s better for the owner to have the contractor’s money in his pocket for as long as possible.

Cash Flow

To many, cash flow is considered an accounting or financial term. But understanding and managing cash flow is really just good business practice. Cash flow refers to how much cash an organization—­or a construction project—­generates, or fails to generate, over a specific period of time. It can be positive (that’s good!), neutral (which may be an illusion), or negative (that’s bad!). This chapter focuses on positive cash flow—­the engine that keeps the contractor in business. Positive cash flow: Simply put, positive cash flow means that the periodic payments a contractor receives from the owner for the performance of the contract’s construction work amount to greater than what he will pay out during the same period for expenses associated with the work. The money coming in is greater than the money going out. That’s good, and that’s what contractors want. Neutral cash flow: This is simply a concept, and does not exist in reality. While it may be theoretically calculated, achieving neutral cash flow is almost impossible, as far too many activities and events have to happen precisely as planned and predicted. If a contractor could predict with absolute accuracy and precise timing the outflow of his hundreds of individual contract expenses, and if he could predict exactly when he would receive his periodic payments from the owner, then this would be neutral cash flow. That level of precision is virtually impossible on a construction project! Negative cash flow: This is when less money comes into the business than is going out. If a contractor is spending money paying his expenses on a construction project, and payments from the owner are coming in late (or not at all), then the contractor won’t be able to cover those expenses and must have an alternative source of funds to pay them. He could pay them from his own cash reserves, or borrow money until the owner’s payments come in. But if he doesn’t have ample cash reserves or can’t borrow money, he may be out of business. All businesses—­and contractors—­must have cash to stay in business. Negative cash flow can put a contractor out of business (and then he wouldn’t need this book). If the contractor does not take in more money than he pays out during any time period over the duration of the project, then he is financing part of the construction project during that time period for the owner. Is the contractor a bank, and in the lending business?

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Some contractors have the ability to provide financing to owners for the owner’s construction projects, either internally, or through their association with different types of lenders. With contractor-provided financing comes, of course, the award of the project, and certainly at a price and on commercial terms and conditions that are favorable and reflect the provision of the financing. But even these contractors are not charities. They are making money by having the resources or ability to provide the owner with some form of financing. Contractors are in business to make a profit through their construction activities. What does cash flow have to do with determining the terms of payment? Everything. A cash flow calculation for a construction project determines the contractor’s minimum acceptable terms of payment required in order to remain cash-positive. When a contractor accepts terms of payment for a project that are less favorable than what his cash flow calculations show he requires to remain cash-positive, then he is probably going to end up in a negative cash flow situation. This negative cash flow may occur during part of, or all of, the time it takes the contractor to complete the project. That’s bad.

Find out more about cash flow by searching for articles online—or check the business section of your library for publications on calculating cash flow. Business software programs also offer a variety of cash flow calculators.

Typically, a contractor would perform several cash flow calculations for a project. If the owner has his own preferred terms of payment, then those terms need to be analyzed to see if the contractor can remain cash-positive throughout the duration of the project. If the owner’s preferred terms of payment place the contractor in a negative cash flow situation, then the contractor may do one of the following: 1. Finance, out of his own pocket, some of the project costs for the owner. 2. Use his established line of credit to borrow funds to cover negative cash flow periods, and include these financing costs in his price. 3. Negotiate more favorable terms of payment. This chapter focuses on the third option, negotiating favorable terms of payment that result in a positive cash flow.

Calculating Cash Flow

There are a variety of computer software programs available to help contractors calculate cash flow for a project. Or, cash flow calculations can be performed on a simple homemade spreadsheet. Whatever is the simplest and easiest to perform is best. It really is not too difficult to calculate cash flow for a construction project.

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One of the main issues addressed in this chapter is getting contractors to think about the linkage between cash flow and terms of payment. These two issues are joined at the hip. They are not exclusive events. Understanding how a construction project will receive and allocate cash will help the contractor determine how he should negotiate with the owner for terms of payment. Calculating cash flow for a project is all about timing. When does a contractor have to pay for direct costs, such as materials, supplies, subcontractors’ invoices, equipment rental, and job site labor? When does the contractor ideally want to recover these direct costs plus overhead and profit? Should he recover overhead and profit over the duration of the project, skewed up front, all at the end of the project, or in some other ratio? Once the contractor understands the timing of his project’s direct cost payouts and decides on the timing of his overhead cost and profit recovery, then he can determine the terms of payment that best keep his project cash flow positive. All cash calculations should be performed on a conservative basis. For example, in analyzing an owner’s proposed terms of payments, which state that the contractor’s payments will be made 30 days from receipt of his invoices for goods and services, it’s better to use 45 to 60 days for receipt of owners’ payments in the cash flow calculations. Invoices for payment get delayed or rejected by owners for a variety of reasons, some legitimate, others not. Too many unforeseen things happen over the life of a construction project to make the prediction of receipt of owners’ payments perfectly accurate. So, it is important to stay conservative in the approach to cash flow calculations. It doesn’t need to be analyzed on a worst case basis, although that’s not a bad way to understand the consequences of the owner not paying on time and significantly delaying payments. A useful tool for contractors to gain some knowledge on the payment history of companies is the Dun & Bradstreet® (D&B®) report, which often includes significant detail about recent payment histories of companies, including owners’! It may be worth the nominal cost of a basic D&B® report to gain some insight into the owner’s payment history.

Interest Rates

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Contractors should also be realistic with respect to the interest rate they use in analyzing an owner’s proposed terms of payments. Typically, this might be the contractor’s interest rate on his established line of credit that he may have to draw on to cover negative cash flow situations. Interest rates go up and down ­ over time based on a variety of factors, and over the course of a lengthy construction project, the cost of borrowing money can vary significantly.

If the contractor has an established line of credit with a local bank, then that’s a good starting point for determining an interest rate to use. The interest rate is reviewed from time to time by the bank, and there is no assurance that it will remain the same over the life of an extended project. A contractor should not be afraid to add a percent or two to the going interest rate when he performs his cash flow calculations, in order to determine the cost of financing he is providing and include this cost in the price.

Periodic Progress & Milestone Payments

There are all kinds of reimbursable, deferred, and periodic payment programs used on construction projects. Periodic progress and milestone types of payments for construction work are common. For payment purposes, periodic progress and milestones are very much the same. The contractor gets paid for doing some measurable amount of the construction project. Periodic progress is a measurement of how much of the project has been completed over some fixed time period, such as one month. At the end of this time period, the contractor bills the owner for the value of the work performed during the previous month. A milestone is just another specific, predetermined measurement of the completion of a project that’s probably not tied to a fixed completion time. For example, the completion of the concrete foundations for a structure could be a payment milestone. Completion of concrete foundations may take place sometime during a two-­to three-­month window in the overall construction schedule. When the contractor is finished with this element of the project, he gets paid for it.

Progress Payments

With monthly (or similar) progress payments, the contractor has a better opportunity to keep the cash coming in regularly—­and in some relationship to how he is spending cash on the project. It’s important with this type of payment that an agreement is reached in advance with the owner on how progress is to be measured. The agreement should be put in writing and made a part of the contract. One way to better ensure that the contractor will get paid on time with periodic progress payments is to provide the owner with an estimate of progress a week or so prior to the end of the time period for which progress will be claimed. If the contractor turns in a request for a progress payment, and the owner has questions about the extent of progress claimed, then it may take more time to get paid than had been planned. This procedure to provide an early estimate of periodic progress needs to be required in writing and included as a part of the commercial terms and conditions in the construction contract. 45

Early submittal will also ensure that, when received, the contractor’s invoice for payment of periodic progress is entered into the owner’s payment system without disagreements.

Milestone Payments

With milestone payments, the contractor may have to wait several months or longer to be paid for a portion of the work, depending on how long it takes to achieve a project milestone. Meanwhile, the contractor is paying for the work being done, and the owner is keeping the cash in his pocket. Unless the contractor’s price includes costs associated with not receiving timely payment for his efforts, milestone payments can be just like free mini-financing schemes for the owner. Milestones should be described in the contract in as general terms as possible. The more specific and detailed a milestone is described, the more difficult it may be to claim payment for the completed work. For example, payment for all the materials required to construct a project may be tied to the payment milestone in the contract that states something like: Delivery of all contract materials to the job site. All contract materials are identified and described in detail in the following list: (followed by a lengthy and detailed list of all project materials).

The difficulty with this milestone is the use of the term “all” and the requirement for a detailed listing of the project materials. Let’s say the contractor has a $500,000 payment milestone that is tied to the delivery of a specific and detailed list of project materials. Once the contractor can demonstrate to the owner that he has delivered all the materials on the list to the project site, then he can submit his invoice for the $500,000 milestone payment. If the contractor is missing several boxes of custom-manufactured nuts and bolts defined in the list as worth $500, the owner technically would not have to pay the contractor for that milestone until he delivered that box of nuts and bolts. Meanwhile, the contractor is further financing $495,500 worth of materials collecting dust on the job site, while he tries to locate or expedite delivery of the missing nuts and bolts. When dealing with a milestone payment that is linked to some kind of list, it would be better to describe the milestone in the contract with wording similar to the following: Delivery of all major contract materials to the job site. Major contract materials are defined as follows: (provide a listing of only the major materials, described as generally as possible).

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In this example, the contractor and the owner agreed to describe in a general fashion the major project materials required for the construction project. Here, the generally defined major contract materials are actually worth $450,000. The other $50,000 of miscellaneous nuts and bolts and bits and pieces are not specifically described. The cost of these materials has been spread across the major contract materials. They are on order and on their way to the job site. They will arrive in due course, and the contractor will be paid in a timely fashion for the project materials. One way to make generally described milestone payments work better for the contractor and assist in promoting positive cash flow is to develop a lot of small milestones. This will take some extra administrative time and effort, but will be well worth it when the cash flow for the project is consistently positive. For example, a typical milestone payment for a large, complex concrete foundation may read similar to the following: Milestone 3: $250,000 – Completion and testing of concrete foundation.

In the above example, the contractor would be paid $250,000 by the owner when the concrete foundation is complete. However, the time to excavate, supply, install, and test the foundation will take about four months. During this time period, the contractor foots the bill to pay all expenses associated with the foundation, plus he delays recovery of all his overhead and profit markups related to this part of the project. The contractor may have a negative cash flow for this portion, due to the time it takes to finish and to get the payment from the owner. In order to improve his cash flow—and try to make it positive—the contractor could break down the large milestone payment into smaller ones that would allow him to receive payments from the owner on a more frequent basis. The sample clause could be revised to read similar to the following: Milestone 3A: $65,000 – Excavation for concrete foundation Milestone 3B: $35,000 – Installation for concrete foundation formwork Milestone 3C: $125,000 – Installation of rebar and concrete for foundation Milestone 3D: $15,000 – Backfill of concrete Milestone 3E: $10,000 – Testing of concrete foundation

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If the contractor collects one milestone payment each month, for example, he has significantly improved his cash flow by breaking down the large milestone into smaller increments, rather than receiving one sum for all the foundation work at the end of four months.

Time & Manner of Payments

Thirty days from the date of invoice is a typical time period allowed for owners to pay contractors’ invoices. This allows enough time for the invoice to go through the owner’s approval, accounting, and payment process. However, there is nothing wrong with proposing that payments be made within 15 days from the invoice date. Most owners do have the ability to make payments quickly, although they may seem reluctant to do so except in special cases. Contractors should not be afraid to try to negotiate a shorter period of time for being paid. Electronic Funds Transfer (EFT) is common today—­and is becoming the preferred way to receive payments from owners. While payment isn’t received instantaneously, it is normally secured over a one-­to-­three-­day period. EFT can take longer, however, if payment is made over a weekend, and for international payments. Today, all banks are set up to disperse and receive funds through electronic funds transfers. Payment by check is also still common. The owner telling the contractor that “the check is in the mail” is common, too. (It’s amazing how much slower the U.S. and international mail system can become when an owner uses it to mail a payment check to the contractor!)

Downpayments & Advance Payments

Is a contractor entitled to a downpayment? There is an easy answer to this—­yes, because a downpayment is just another element of the terms of payment that can be negotiated. The contractor’s invoice for the downpayment is typically submitted to the owner when the contract is signed, or very shortly thereafter. The best way to come to grips with whether a contractor needs a downpayment or not is through cash flow analysis. Sales; marketing; estimating; proposal preparation; preliminary engineering; travel to inspect the work site; mobilizing people, materials, and equipment; meetings with the client; and other similar front-­end expenses for a construction project can be high. Also, the contractor may need to make some early commitments for specialty or long-­lead-­time materials and supplies, which may require an early outlay of cash. A contractor should review several cash flow analyses with different levels of downpayment to see how this affects his ability to remain 48

cash-­positive throughout the duration of the project. As a general rule, the larger the downpayment the contractor can negotiate, the better the chance to have a positive cash flow for the duration of the project. Often owners will resist agreeing to a downpayment at or near the time the contract is signed simply because it’s called a downpayment, a word considered by some to be taboo. So, don’t call it a downpayment. Owners who resist a downpayment might more easily agree to an early progress, mobilization, contract initiation fee, or milestone payment. This may help owners sell the idea within their own organization, as it probably fits better into the way they are used to paying for services provided. If receiving a downpayment isn’t possible, contractors can try to find a way to establish a large early payment, such as one or two weeks after contract signing. Such payment can be based on the submission of the first set of preliminary engineering drawings, delivery of evidence of insurance certificates, commencement of mobilization at site, or something similar. There are so many activities that take place at the front end of a construction project that it is not too difficult to find one that could be priced and added together to form the basis for an early payment. Perhaps the contractor receives cash a week or two later than he might have otherwise through an initial downpayment, but the early payment will end up having the same beneficial effect—­ successfully achieving a positive cash flow for the project. Don’t worry about the semantics; get some form of an early payment. Here’s a question for contractors to ask themselves: How much would you discount your price for the project if the owner agreed to a 50% downpayment? Sound unrealistic? Try it out sometime and see how the owner reacts. Contractors might be pleasantly surprised. If the contractor is working with an owner who has a lot of cash and wants a good price for his next construction project, toss this idea out to him. How much might a 50% downpayment be worth? One way to find out would be to perform a cash flow analysis on the project assuming a 50% downpayment and see if that results in a positive cash flow (very likely) for the project. Apply a current level of interest to the amount of the positive cash flow calculated, and use that value as a contract discount for the large downpayment. That amount may be in the 2% to 4% range. Savvy contractors might consider adding 1% (or 2% or 3%) to the contract price to negotiate away for good concessions from the owner, like this level of downpayment. Those contractors with lots of hard-­ earned construction experience will intuitively know that the receipt of such a large downpayment is good for their project, without having to do much in the way of calculating cash flow, or dwell too long on whether to give the owner a 2%, 3%, 4%, or even 5% discount, for example. 49

Retention

Retention refers to an amount of money that is withheld by the owner from a contractor’s periodic payments. The typical reason an owner would want to hold back some amount of money is to provide an assurance that the contractor will perform the work satisfactorily and in full accordance with the contract. If the contractor performs all the work satisfactorily, then the owner will make a final payment in the full amount of the withheld retention. If the contractor does not perform as expected, or fails to complete the work, the owner can use the amount of the retention money withheld to have someone else complete some or all of the contractor’s unfinished work.

An Example

Let’s say a contractor is executing a contract valued at $1,000,000, which is to be completed in one year. The owner’s terms of payment require that 10% retention be withheld from each of the contractor’s periodic progress payments to ensure full performance of the contract. During the course of the contract, the owner retains a total of $100,000 from the contractor’s periodic payments. If the contractor performed all the work on time and in accordance with the contract, the owner would make a final payment of retention to the contractor in the amount of $100,000.

Money withheld from the contractor’s payment invoices as retention can make it difficult to maintain a positive cash flow for the duration of the project. Contractors should strongly resist having retention withheld from their payment invoices. This is particularly true if the owner requires, in addition to withholding retention, another performance assurance like a guaranty from a surety company or an on-­demand bond or standby letter of credit from a bank. If the contractor must agree to retention, then it is important to negotiate the retention to be as small as possible. Often a retention value of 5% to 10% is proposed by the owner in his terms of payment. Perhaps he claims that retention of some amount is his “standard” requirement. Again, it’s important to remember that there is no such thing as a “standard” requirement in contracting for construction projects. Maybe 2% retention makes sense if a contractor has to agree to it. The less, the better, and no retention is the best. When negotiating retention, owners will often claim that they require some sort of assurance that the contractor will complete the project on time and in accordance with the plans and specifications. That’s fine. If the issue of using retention as performance assurance is a major roadblock to negotiating the 50

contract, then perhaps the owner will agree to the contractor providing a guaranty or an on-­demand bond or parent company guaranty in lieu of providing cash retention. This is a perfectly acceptable way of providing assurance of performance and prevents the owner from keeping some amount of the contractor’s money for the duration of the project, or longer. Sometimes an owner will want to keep the retention agreed to in the contract until the end of the warranty period. Again, this is done under the premise of providing an assurance of performance of the contractor’s obligations during the warranty period. Here’s another situation where a guaranty from a surety company or an on-­demand bond from a bank may be a better way to go—­thereby freeing up the contractor’s cash. (See Chapter 6, “Assurances of Performance,” for more information on guaranties, bonds, and letters of credit to offer in lieu of agreeing to retention.)

Terms of Payment Examples

Figures 4.1 through 4.4 are cash flow analyses of four sample terms of payment that might typically be used in construction contracts. They are designed to demonstrate the positive effect of having a downpayment and the elimination of retention. The project used in the example is a small engineering and construction project that is completed over a period of 10 months. The cash flow analysis for each of the terms of payment examples is straightforward, but could easily be expanded to analyze much longer and more complex projects. The examples show one typical method of performing a cash flow analysis. The last line of all the analyses is titled “Accumulated Interest.” This is the amount of interest the contractor would theoretically expect to pay on money borrowed to finance any negative cash flow of the project. (Negative interest implies a negative cash flow, and a positive interest implies a positive cash flow.) The terms of payment on the last example, Figure 4.4, indicate a positive cash flow and would be the ones the contractor would want to try to negotiate with the owner. The four terms of payment and cash flow examples are as follows: 1. Monthly progress, Net 30 days, 10% retention, no downpayment 2. Monthly progress, Net 30 days, 10% retention, 10% downpayment 3. Monthly progress, Net 30 days, 0% retention, 10% downpayment 4. Monthly progress, Net 30 days, 0% retention, 20% downpayment 51

Owner’s Payment Terms: Monthly Progress, Net 30 days, 10% Retention, 0% Downpayment

Figure 4.1 Terms of Payment Example Number 1 Owner’s Payment Terms: Monthly Progress, Net 30 days, 10% Retention, 10% Downpayment

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Figure 4.2 Terms of Payment Example Number 2

Owner’s Payment Terms: Monthly Progress, Net 30 days, 0% Retention, 10% Downpayment

Figure 4.3 Terms of Payment Example Number 3 Owner’s Payment Terms: Monthly Progress, Net 30 days, 0% Retention, 20% Downpayment

Figure 4.4 Terms of Payment Example 4 53

These examples show the benefit to the contractor of being paid on a timely basis, receiving a downpayment, and having no retention withheld from his payment invoices. Terms of payment that have these key elements have the best chance of providing a positive cash flow for the contractor.

Set-offs

Sometimes hidden away in the fine print of a construction contract is a paragraph allowing the owner to make what are called set-offs from payments that are legitimately due to the contractor for performance of the work. If the owner performs some of the contractor’s work on a project, then he is, of course, entitled to deduct some amount from what he owes the contractor on one or more of his periodic payment invoices. That’s fair, as long as the amount the owner subtracts (sets off ) is fair and agreed to in writing by both parties. However, the greater risk to a contractor occurs when he has several projects under way or recently completed with the same owner. In this situation, the contractor needs to be careful that in any new contract he signs with the owner, he does not give the owner the unilateral right to subtract money from the new project’s invoices for claims the owner may have outstanding against the contractor on other projects. This is probably the greatest risk associated with a set-off, and can place the contractor at a significant level of commercial risk. The owner may have what he believes to be legitimate claims or issues with the contractor on other ongoing or completed projects. However, the resolution of those claims and issues should remain independent of the other projects. The owner should not be allowed the unilateral right to subtract money from the contractor’s invoices to pay for unresolved claims and issues on other projects. Set-off provisions in a construction contract that allow the owner to subtract money from the contractor’s invoices for claims related to other projects should be deleted. In the event the owner feels he must have a set-off provision in the contract, the contractor may consider negotiating wording similar to the following: . . .all proposed set-offs from Contractor’s invoices shall be in writing and mutually agreed on by both Owner and Contractor.

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Wording similar to the above allows the owner to keep the set-­off provisions in the contract, if that’s important to him. It also provides protection for the contractor against the owner making unilateral deductions from the contractor’s invoice for claims and issues that are unresolved and associated with other projects. One final note of caution for contractors on set-­offs: The owner’s provisions for allowing him to take set-­offs may not always be contained in the proposed terms of payment clause, but may appear elsewhere in the commercial terms and conditions. It pays to read all parts of the owner’s proposed construction contract.

“Paid When Paid” & “Paid If Paid”

Although these two types of payment terms can seem acceptable at first glance, both can create significant commercial risk for the unsuspecting contractor. These payment terms are more likely to apply or be seen when there is a subcontractor/main contractor relationship, rather that a contractor/ owner relationship. So we will switch gears in this section and talk about subcontractors and main contractors. It’s not too difficult to understand what these payment terms mean: Paid When Paid: This means that when the main contractor receives payment from the owner for work that includes the subcontractor’s work, then the main contractor will pay the subcontractor. Paid If Paid: This means that if the main contractor receives payment from the owner for his work that includes the subcontractor’s work, then and only then will the main contractor pay the subcontractor. The subcontractors’ commercial risk with both of these types of payment terms is that they basically relieve the general contractor of the obligation to pay them on a timely basis for their work. Claims, disputes, or other issues may arise between the owner and the main contractor, which may cause the owner to delay paying the contractor on a timely basis. The main contractor may or may not suffer from this payment delay, but one thing is for sure—­the subcontractor will certainly suffer from the delay in payment of his invoices. Main contractors like to use these payment terms because they can avoid having to use their own cash to pay subcontractors. That’s understandable, but it doesn’t mean that subcontractors have to agree to these types of payment terms.

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The bottom line is that the main construction contract for the project is between the owner and the main contractor, not the subcontractor and the owner. The subcontractor goes through the lengthy exercise of estimating, pricing, bidding, and negotiating the work solely with the main contractor, and the resulting construction contract and its commercial terms and conditions are negotiated with the main contractor, not the owner. The commercial terms and conditions that are negotiated between the owner and the main contractor are their business, and the subcontractor has little or no influence or say in the matter. How can the subcontractor perform a cash flow analysis of his work without really knowing the time period he can use to receive payments from the main contractor? The main contractor may agree to the subcontractor’s 30-­day payment terms, but with a paid when paid or paid if paid provision also applying. In this case, what does the subcontractor use as timing in his cash flow analysis for his receipt of payments? Thirty days, forty-­five, sixty, or more? Maybe it’s okay for the subcontractor not to rock the boat and to agree to these types of payment terms and just keep his fingers crossed that the main contractor will pay him on time, but that’s a formula for a cash flow problem. When paid when paid or paid if paid provisions arise, it’s important for the subcontractor to try to take some measure of control over the payment terms for his own benefit. Two good negotiating options are: 1. Delete the contractor’s paid when paid or paid if paid payment terms in the contract, and substitute the subcontractor’s preferred terms of payment. 2. Find some compromise payment terms that include the main contractor’s paid when paid or paid if paid payment terms, but with some time limitations on receipt of payment that favor the subcontractor. The first option is self-­explanatory. If the subcontractor can negotiate including his preferred payment terms into the commercial terms and conditions of his construction contract, then that, of course, is the best way. However, it may be difficult to get the main contractor to delete the paid when paid or paid if paid terms. The main contractor may agree to some time limit to pay the subcontractor. Therefore, if the main contractor agrees to the subcontractor’s 30-­day payment period subject to the paid when paid or paid if paid 56

provisions, he might also agree to payment terms wording similar to the following: Article 44 – Terms of Payment 44.1 Subcontractor’s payment invoices shall be paid within 45 days of receipt by Main Contractor, provided that Main Contractor has also been paid by Owner for the work performed under Subcontractor’s invoices. 44.2 Notwithstanding the above, Main Contractor agrees to pay Subcontractor’s payment invoices in any event no later than 70 days from date of receipt by Main Contractor of Subcontractor’s invoice.

Allowing the main contractor 70 days to pay the subcontractor’s invoices is certainly not the best. But considering that the contractor might not have to pay the subcontractor’s invoices for a much longer time under the paid when paid or paid if paid terms of payment, at least there is a maximum time period in place within which the contractor must pay the subcontractor’s invoices. Article 44.2 obligates the main contractor to pay the subcontractor, regardless of whether or not he has been paid for the subcontractor’s work by the owner. That’s good. The subcontractor could have tried to negotiate a shorter time period in Article 44.2, such as 45 days.

Example: Terms of Payment

The following are two sample terms of payment clauses that can be considered for use in a construction contract that would likely result in positive cash flow for a contractor. Example 1: Progress payment terms might read similar to the following: Article 27 – Terms of Payment (Periodic Progress) a.) 20% of the Contract Price as downpayment shall be paid upon signing of the Contract, or Notice of Award, whichever occurs first. b.) 80% of the Contract Price as progress payments shall be paid based on approved monthly progress by Contractor for work performed the previous month. c.) There shall be no Retention withheld by Owner from Contractor’s downpayment or any of Contractor’s monthly progress payments. d.) The downpayment is due in full, in cash, within 15 days of the signing of the Contract, or Notice of Award, whichever occurs first. e.) All progress payments are due in full, in cash, within thirty (30) days after receipt by Owner of Contractor’s invoice. f.) All payments shall be made by electronic funds transfer to (Name of Contractor’s bank), account number XXXXXX, routing number YYYYYY with all transfer costs for the account of Owner.

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Example 2: Milestone payment terms (percentages are for example only) might read similar to the following: Article 27 – Terms of Payment (Milestones) a.) 20% of the Contract Price upon mobilization by Contractor at the Project Site, or no later than (insert appropriate date) in the event mobilization is delayed by Owner. b.) 15% of Contract Price upon completion of installation of the foundations for the building. c.) 10% of the Contract Price upon completion of hook-up of all site utilities. d.) 25% of the Contract Price upon completion of the building, ready for interior work. e.) 20% of the Contract Price upon completion of all building interior work. f.) 5% of the Contract Price upon receipt by Contractor of Certificate of Occupancy. g.) 5% of the Contract Price upon demobilization by Contractor from the Project Site. h.) There shall be no retention withheld by Owner from any of Contractor’s milestone payments. i.) All milestone payments are due in full, in cash, within thirty (30) days after receipt by Owner of Contractor’s invoice. j.) All payments shall be made by electronic funds transfer to (Name of Contractor’s bank), account number XXXXXX, routing number YYYYYY with all transfer costs for the account of Owner.

Prompt Pay Statutes

All 50 states have “Prompt Pay Statutes.” These statutes require that contractors be paid in a certain amount of time from the submission of a payment invoice. These statutes are specific to Private, Public, and Government contracts. However, not all the states have statutes for prompt payment on private contracts (the main subject of this book). For example: Arizona’s Prompt Payment Act covers Private contracts. Arizona Revised Statutes 32-1129, require, basically, that contractor invoices must be paid within 21 days from receipt, unless the Owner provides reason(s) why the invoice was not approved. Approved invoices not paid within the 21 days accrue interest at the rate of 18% per annum. A complete, extensive listing of all the 50 states Prompt Payment Statutes is available online. Check your state’s Prompt Payment 58

Statute, so you understand its conditions, requirements, and exceptions. If your state has a Prompt Payment Statute for Private contracts, put the reference to that statute on all your invoices to the Owner.

Conclusion

As noted throughout this chapter, terms of payment that result in a positive cash flow are the most desirable for a contractor. Positive cash flow keeps cash in the contractor’s bank account, and allows the contractor to stay in business and prosper. First, remember the three rules of business: Have cash, have cash, and have cash. It can’t be said much better than that! Cash is the engine of a business. Second, remember, everything in a construction contract is negotiable. Since terms of payment are one of the foundation stones of a good contract, start negotiations with them!

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Chapter

5

The Schedule

A well-­defined completion schedule is one of the foundation stones of a good contract. All construction contracts will include some sort of stated completion schedule requirements. Meeting the completion schedule is a key contractual obligation for the contractor. It exposes him to varying types and amounts of risk—­and potential financial liabilities if the completion dates are not met. (In some instances, there may also be the possibility of a bonus if the project is completed ahead of the agreed-­on completion schedule.) A completion schedule is defined as the time period stated in the contract within which the contractor is obligated to complete the construction project. Completion schedules can be simple, single-­ page bar charts outlining the time durations required to complete all the major activities in the construction project. They can also be highly complex—­a bedsheet-­sized listing of hundreds of interrelated major and minor activities, and their required time durations, necessary to complete the project. There are also many sophisticated computer-­based scheduling tools, as well as numerous books and Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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publications on scheduling techniques. These are directed at improving the scheduling skills of the person responsible for executing the construction project—­the contractor’s project manager and his assistants. It’s important that the project manager be aware of the consequences of not meeting the completion schedule, making changes to it, or beating it. Two risk issues regarding completion schedules that are commonly found in a construction contract’s terms and conditions are: 1. Float 2. Time is of the Essence

Float

Float is an issue that typically comes up in contracts that have fixed, contractually agreed-­on completion schedules. Float refers to an amount of additional time, or contingency, in a contractor’s fixed completion schedule that is over and above what he believes is actually needed to finish the project, provided everything goes according to plan. If the contractor believes he can complete the project in 48 weeks, and he contracts with the owner for a completion schedule of 52 weeks, then technically there are four weeks of float in the completion schedule. This additional time gives the contractor, and, arguably, the owner, a little time cushion in the event unexpected or unrecoverable delays occur, such as: • A day or so lost due to unexpected rain • A few days for a material supplier who doesn’t meet a delivery date for important materials • Labor union disputes Contractors generally have a good feel for how much of a time cushion needs to be included in a project completion schedule. During contract negotiations, the float in the completion schedule also allows the contractor to improve his proposed completion schedule, if necessary, in order to win out over other bidding contractors. An issue that often arises is: who owns the float, or extra time, in a contract’s completion schedule? If the contractor automatically assumes he owns it, he may be in for a surprise if he didn’t carefully read and understand all the commercial terms and conditions in the construction contract. There may be a paragraph similar to the following:

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Article 10 – Contract Completion Schedule 10.1 Contractor shall complete the project within the time allowed in the Contract Completion Schedule. 10.2 Any float in Contractor’s Completion Schedule shall be for the exclusive benefit of Owner and shall be identified in Contractor’s Completion Schedule. 10.3 Any extensions to the Contract Completion Schedule that may be granted by Owner will be granted only to the extent that such extensions exceed the total stated float in Contractor’s Completion Schedule.

In the above example, the owner, not the contractor, clearly owns and controls the float. The contractor has agreed to this transfer of float ownership by signing the contract, leaving this wording unchanged.

An Example

Let’s use the one-story office building construction contract from Chapter 1 to see what happens when a contractor, National Construction Company, wants a one-week extension to the completion schedule from Wilson Properties for some additional work. After discussing the situation, Wilson Properties agrees a one-week extension to the completion schedule would be required in theory to install several small additional features in the foundation they asked National Construction to provide. However, they insist that National Construction keep its original contract completion schedule. This poses a problem for National, because they feel they need the extra week—or maybe even two—to complete the new, additional foundation work they hadn’t planned for. The contract terms and conditions clearly state that Wilson Properties owns the four weeks of float time. Although the extra week National needs would reduce the float to three weeks, this time is owned by Wilson, so cannot be used by National to absorb any increases in the completion schedule, as they see it. It appears National is out of luck in getting that extra week of time they need to do the additional work for the owner. National agreed to the completion schedule terms and conditions, like the one noted in the sample Article 10, contract completion schedule. National would have been better off to have deleted the completion schedule float ownership paragraph from the draft contract during negotiations, or simply submitted a schedule that showed no float in the contract schedule.

Taking a look at the issue of float from a different perspective, completion schedule float is just like the extra dollars put in a cost estimate to cover contingencies. This extra money is the contractor’s

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to save, to cover true contingencies, or to use as he sees fit. It is part of the fixed, lump-sum price, and it does not belong to the owner. It’s hard to imagine a contractor who would agree with contractual language that gave away his estimated cost contingency to the owner! Why, then, give away a contractor’s float? The important thing to remember is that the contractor owns the float in a completion schedule, not the owner. This is true unless the contractor contractually gives control of the float to the owner, as National Construction Company did in the above example.

Time Is of the Essence

Completion schedules are very important to owners, as they can be critical to the owner’s business success. In many instances, the owner’s revenues are dependent on a facility being completed and starting to operate by a certain date. That means the owner can start paying down the loan he took out to build the facility, and hopefully will begin making a profit. The owner’s business plan will likely be based on the on-time completion of the project. The whole issue of the importance of meeting completion schedule commitments is clearly understood by everyone working for the owner and the contractor. Sometimes there will be a paragraph in the commercial terms and conditions emphasizing the importance of the completion schedule, similar to the following: Article 11 – Time Is of the Essence 11.1 Time is of the essence* in this Contract, and Contractor shall immediately begin work upon receipt of the Notice to Proceed and shall complete the Work within the time allowed by the Contract Completion Schedule, unless granted an extension to the Contract Completion Schedule by Owner.

* Note: Sometimes alternative wording is used, such as, “time is an essential element. . .” The italicized words “time is of the essence” are another example of antique contracting language used to contractually emphasize that the completion of the contract within the agreed-on time frame is very important. Failure to meet the completion schedule, or getting behind enough that the completion date or intermediate contract milestones are unachievable, may immediately place the contractor in breach of contract and subject him to potential financial liability. If the contractor does not meet the completion schedule commitment and ends up in some form of litigation over failure to 64

perform, having the term “time is of the essence” in the contract will benefit the owner. The emphasis added by this wording makes it much more difficult for the contractor to avoid being ruled in breach of contract. Contractors want to finish on time on lump-sum, fixed-completion schedule projects, because it costs extra money to keep personnel and equipment on a job site beyond what was estimated, which eats into their profits. Owners want their projects completed on time and as planned, as loan payments, revenues, and their own profits are planned to begin at the successful completion of the contractor’s agreed-on completion schedule. Time is always an important factor in any construction project contract, regardless of whether or not it is stated to be “of the essence.” However, the legal significance changes when the words “time is of the essence” are stated in the contract. These words draw specific attention to the fact that time-related functions, like the owner’s completion time schedule or payment of the contractor’s invoices on time, are very important. If a claim arises over these issues, one party or the other can’t argue that they didn’t know or realize that meeting the specified time-related contractual obligations was an important issue.

Time Is of the Essence – For the Owner

Time can be of the essence for the owner, too, in terms of meeting his obligations to the contractor. This is particularly applicable to the timely payment of the contractor’s invoices for work. When a contractor encounters a “time is of the essence” clause, he might consider agreeing to it with a revision to the clause similar to the following:

Article 11 – Time Is of the Essence (revised) 11.1 Time is of the essence in this Contract, and Contractor shall immediately begin work upon receipt of the Notice to Proceed and shall complete the Work within the time allowed by the Contract Completion Schedule, unless granted an extension to the Contract Completion Schedule by Owner. 11.2 Owner agrees that time is of the essence in the prompt payment of all of Contractor’s periodic payment invoices and agrees to pay such invoices within the time period stated on each invoice. 11.3 Owner agrees that time is of the essence in the timely return of Contractor’s submittals, the supply of any Owner-supplied equipment, and all responses to Contractor’s request for information from Owner.

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Getting the owner to agree that time is of the essence for certain obligations he has to the contractor, such as prompt payment of contractor’s payment invoices, adds balance to this type of clause. Both the owner and contractor should agree that in certain matters, it’s important to do things on time.

Extra Time, but No Money

There are a multitude of events that can occur during the course of a construction project that can cause delays to a contractor’s fixed completion schedule. Delays may be caused by: • The contractor’s or owner’s actions or inactions • Interference or lack of progress by other contractors/subcontractors • Labor unions striking or slowing down the work • Weather or other external events The list of what causes delays in a project construction completion schedule is probably endless! For a contractor, dealing with delays in the construction completion schedule is a common event. If the contractor causes them, then he has to deal with the time and financial consequences, which is only fair to the owner. If the owner causes the delay, or if other contractors working for the owner cause the delay, then the contractor should expect to be compensated in some fashion, and revise the completion schedule accordingly. If external events cause a delay to the contractor’s construction completion schedule, and neither the contractor, nor the owner, nor other contractors on the site are at fault, there needs to be a way for the contractor to resolve the problem with the owner. In this instance, the resolution process needs to be fair to both the contractor and the owner.

Example 1

Sometimes a clause appears in the owner’s commercial terms and conditions similar to the following: Article 12 – Delays in Completion Schedule 12.1 In the event that delays to Contractor’s Completion Schedule are caused by Owner or by other contractors, subcontractors, or suppliers hired by Owner and working on the site, Contractor shall be allowed only an extension of Contractual Completion Schedule.

That clause sounds fair enough. Or does it? It’s more what the clause does not state that’s the problem. It is fair enough to allow the contractor to extend his completion schedule for delays caused by 66

the owner or other contractors, subcontractors, or suppliers working on the site. However, what about costs the contractor will incur that may be associated with the delay? For example, if the contractor on a fixed price project has a major piece of heavy lifting equipment on the job site that is costing him $5,000 a day to rent, and the owner has caused a 10-day delay in the use of that equipment, the contractor could possibly have up to $50,000 of extra costs he hasn’t estimated.

Example 2

The contractor may want to consider revising the clause to read similar to the following: Article 12 – Delays in Completion Schedule 12.1 In the event that delays to Contractor’s Completion Schedule are caused by Owner or by other contractors, subcontractors, or suppliers hired by Owner and working on the site, Contractor shall be allowed an extension to Contractual Completion Schedule and shall be allowed an increase in Contract Price for documented additional costs incurred during the delay.

Such a revision is fair to both the owner and the contractor. Most owners will have additional funds in their project estimates as a contingency to cover such delays and associated extra costs. However, some owners may develop heartburn over simply agreeing to increase the contractor’s price as suggested in the above example.

Example 3

An alternative wording to consider might be similar to the following: Article 12 – Delays in Completion Schedule 12.1 In the event that delays to Contractor’s Completion Schedule are caused by Owner or by other contractors, subcontractors, or suppliers hired by Owner and working on the site, Contractor shall be allowed an equitable adjustment in Contractual Completion Schedule and an equitable adjustment in Contract Price for documented additional costs incurred during the delay.

The only issue with this revision is the use of the words “equitable adjustment.” The owner and contractor may disagree on what constitutes an “equitable adjustment” to the schedule and price. Nevertheless, this wording is a lot better than just agreeing to a change in the schedule only. 67

Example 4

Another alternative for this delay clause might read something like this: Article 12 – Delays in Completion Schedule 12.1 In the event that delays to Contractor’s Completion Schedule are caused by Owner or by other contractors, subcontractors, or suppliers hired by Owner and working on the site, such delays shall be treated as a change under the Changes Clause of this Contract.

In this third revision of the original, the contractor is allowed to pursue the effects of the delays through the changes clause in the contract. If the changes clause allows for both time and price changes, then the contractor has a better chance of being paid for the consequences of the delay—and having his completion schedule extended as well. (See Chapter 9 for examples of changes clauses that treat contractors fairly.) Other issues related to the contract completion schedule, such as liquidated damages for failure to finish on time and force majeure events, are covered separately in Chapters 11 and 14, respectively.

Conclusion

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The schedule is always a key element of any contractor’s construction contract and a foundation stone of good contracting. Owners are notorious for asking contractors to reduce the amount of time in the schedule—or improve the schedule once the construction project is underway. When faced with demands to reduce the schedule once the contract has commenced, contractors need to make doubly sure that the clauses for delays and changes in the contract are fair and allow enough time and money for schedule adjustments. When faced with reducing the schedule at the proposal stage, remember that schedule adjustments do not have to be free to the owner. It’s perfectly acceptable to increase the contractor’s price for a schedule reduction.

Chapter

6

Assurances of Performance This chapter could have been titled, “Surety Bonds, Performance Bonds, Contract Bonds, True Guaranties, On-­Demand Payment Instruments, and Other Forms of Contract Assurance.” But that’s really a mouthful for what is commonly referred to in the construction business as guaranties and bonds. To make things even more confusing, the terms “guaranties” and “bonds” are sometimes used interchangeably to mean the same thing, which is not correct! The challenge is how to define and explain the owner’s contractual requirement that the contractor provide some form of assurance, typically monetary, of his performance. (This is in addition to the contractor’s other written assurances provided in the contract.) The owner’s requirement for an assurance of performance sounds simple and easy enough to agree to on the surface, but it can be confusing, with contradictory and misused language—­and can potentially expose the contractor to a high level of unnecessary commercial risk. Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Guaranties & Bonds

In a construction contract, the requirement for an assurance of the contractor’s performance is likely to be titled or referred to as a performance guaranty or a performance bond. What are they? What kind of company provides them? Are there different types and forms? What is the commercial risk a contractor assumes by providing them to an owner? Is a standby letter of credit a bond or a guaranty, or neither? What is a surety? Can a bank issue a true guaranty? What is a parent company guaranty, and is it good enough? Can the contractor change the owner’s preferred wording on a guaranty or bond? These are all valid questions that this chapter will address. Guaranties and bonds are the two most common terms used—and misused—to generically describe the type of performance assurance the owner wants the contractor to provide. Although these terms tend to be used interchangeably, they are not the same. They can be significantly different in their scope of coverage, and they can expose the contractor to significantly different levels of commercial risk. To illustrate, take a look at the following five examples of how an owner might word the contractual requirement for a contractor to provide an assurance of his performance: Article 23 – Performance Guaranty (Example 1) 23.1 Contractor shall provide a guaranty of his obligations under the Contract in the form of a Performance Guaranty provided by a surety company acceptable to Owner.

Article 23 – Performance Guaranty (Example 2) 23.1 Contractor shall provide a Performance Guaranty in the form of an irrevocable bank guaranty in the amount of 10% of the Contract Price payable on first demand of Owner to guarantee the performance of Contractor’s obligations under the Contract.

Article 23 – Performance Guaranty (Example 3) 23.1 Contractor shall provide a guaranty of his performance under the Contract by providing a Performance Bond in the amount of 10% of the Contract Price and in the form of an irrevocable guaranty payable on Owner’s first written demand.

Article 23 – Performance Guaranty (Example 4) 23.1 Contractor shall provide a guaranty of his performance under the Contract by providing a Performance Bond in the form of a standby letter of credit for the full value of the Contract Price.

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Article 23 – Performance Guaranty (Example 5) 23.1 Contractor shall provide a guaranty of his performance under the Contract by providing a Parent Company Guaranty.

All of the previous examples require exactly the same thing, just in somewhat different forms, regardless of the use of the words “guaranty” and “bond.” They all provide an assurance by a third party—someone not signatory to the contract between the contractor and the owner—that the contractor will complete all his obligations as stated in the construction contract. Even if the contractor has a successful track record and financial strength, many owners will always be concerned about the contractor’s ability to remain solvent, finish the project on time, and complete all obligations in the construction contract. This concern is likely an important element of the owner’s standard approach to managing the risks associated with a construction project. If the contactor fails to perform, or becomes insolvent, how will the owner complete the contract? Will enough funds be available to pay any outstanding balances to material suppliers and subcontractors? Will the owner be able to restart the project with another contractor or contractors? What happens if the contractor can’t, or refuses to, meet the warranty obligations in the contract?

A contractor needs to be knowledgeable about the use and application of performance guaranties and performance bonds and the commercial risk associated with them. He needs to understand whether he is really providing a true guaranty or some form of a pay-on-demand instrument.

Due to this legitimate concern about the possibility of a contractor’s failure or inability to perform, owners will typically want a separate company to provide assurance that the contractor, or the company providing the assurance, will perform all of the obligations in the construction contract. Alternatively, in the event of the contractor’s failure to perform, certain funds will become immediately available to the owner for use in completing the project. Performance assurances can come in different forms: • Another company agreeing to complete the contractor’s work in the event the contractor fails to perform or becomes insolvent. • The parent company of the contractor agreeing to complete the contractor’s work in the event the contractor fails to perform or becomes insolvent. • A payment instrument that the owner can cash in without requiring specific proof of the contractor’s insolvency or failure to perform. • A payment instrument the owner can cash in, but that requires specific evidence of the contractor’s insolvency or failure to perform. 71

Detailed explanations of these various forms of assurances of performance can be found later in this chapter.

What Does “Failure to Perform” Mean?

A construction contract consists of a number of different obligations that the contractor has agreed to perform, such as: • Providing certain types and amounts of insurance, typically referred to as a “commercial obligation.” • Building a structure. • Having to complete the project within an agreed-­on time frame (the schedule). If a contractor does not meet or fulfill the obligations as agreed to in the construction contract, then he has technically failed to perform. Failure to perform is also called breach of contract, or simply, default. Following are five examples of a contractor’s failure to perform, which would cause an owner to be seriously concerned: 1. Stopping project work due to insolvency or bankruptcy. 2. Not paying subcontractors and material suppliers who are working for the contractor on the project. 3. Not providing agreed-­on warranty repairs or replacements. 4. Refusing to enter into a contract with the owner when the contractor has provided a bid bond (an assurance that the contractor will enter into the contract with the owner). Perhaps the contractor discovers his price is way too low, for example, and the contract would be a financial failure for him, in which case it may be less expensive to have the owner cash the bid bond. 5. Failing to meet the contract schedule.

What Is a Bond?

This is probably the most common term used and misused in construction contracts, in terms of obligating the contractor to provide an assurance of performance. The contract may read, “Contractor will provide a bond,” but what actually is a bond as the term is used in construction contracts? In the construction business, a bond is a written risk transfer contract between three parties—­the owner, the contractor, and a third party. The third party who provides the bond for a fee is typically a surety company, an insurance company, a bank, or the parent company of the contractor. In the event of the contractor’s unwillingness or inability to perform, the bond contractually transfers the owner’s risk of the contractor’s failure to perform to the third party. The third party provides the owner with certain remedies in the event of the contractor’s failure to perform.

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.

It is important to remember that a bond is just another contract. It doesn’t have to conform to an owner’s or a bank’s preferred wording. As a contract, the requirements contained in any bond are negotiable. The contractor can put in his two cents worth, too.

Forms of Assurances of Performance

There are three basic forms of commercial instruments that the contractor can purchase to provide the owner with assurance of performance. They are: 1. True performance guaranty (true guaranties) 2. On-demand bond (pay-on-demand instruments, usually without conditions) 3. Standby letters of credit (pay-on-demand instruments, usually with conditions) True performance guaranties are very different than on-demand bonds or standby letters of credit. (On-demand bonds and standby letters of credit are very similar.) Any of these may be used to provide owners with a form of assurance that, in the event of the contractor’s insolvency or failure to perform, the owner’s project will be completed or, alternatively, he will receive funds to aid in its completion. In a construction contract, a contractor might see the requirement for the above forms of assurance described similarly to one of the following: 1. Contractor shall provide a Performance Bond in the form of a guaranty from a surety company. 2. Contractor shall provide a Performance Bond in the form of an on-demand bond from a bank. 3. Contractor shall provide a Performance Bond in the form of a standby letter of credit from a bank.

True Performance Guaranties

A true performance guaranty is a risk transfer device. In this instance, the risk of rectifying some form of a contractor’s failure to perform on a construction project is transferred to a specialized company called a surety. A surety’s main business role in the construction industry is to provide performance-related guaranties, which are referred to as performance guaranties or guaranty bonds. They may also be referred to as surety bonds or contract bonds. For the purposes of this book, the following is a working definition of a performance guaranty for use in construction contracting: 73

A performance guaranty is a written risk transfer contract between three companies: the contractor, the owner, and a separate company, called a surety. The surety will provide a guaranty of the performance of the contractor’s obligations in the construction contract with the owner. In the event the contractor fails to perform his contractual obligations, the surety will step in and find a way to fulfill the contractor’s obligations up to the maximum stated monetary value of the guaranty. This is a true guaranty. It involves a third, totally separate company, a surety, guaranteeing the performance required of the contractor under the owner’s construction contract. If the contractor fails to perform or becomes insolvent, the surety will be obligated to take on the contractor’s unfinished contractual obligations and finish the project, or instead pay the owner an amount of money not exceeding the maximum stated value of the guaranty.

Example 1

The owner’s contractual requirement for the contractor to provide a true guaranty might be similar to the following: Article 23 – Performance Guaranty 23.1 Contractor shall provide a guaranty of his obligations under the Contract in the form of a Performance Guaranty provided by a surety company acceptable to Owner.

Also, this is as good a place as any to interject that a guaranty is not a warranty. (See Chapter 12. Often, the terms guaranty and warranty are used interchangeably, which is not correct.) Here’s the basic difference: • A guaranty is a contract between three companies: the surety, owner, and contractor. The surety guarantees the performance of the contractor’s contractual obligations as stated in the construction contract for the benefit of the owner. • A warranty is a contract between two companies: the contractor and owner. The contractor warrants that the work he performed for the owner is free of defects, and if any defects are found within a certain time period, he will repair or replace them. Figure 6.1 is an example of a true guaranty as might be issued by a surety company.

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Figure 6.1 Typical Performance Guaranty Bond Wording and Format

On-­Demand Bonds

On-­demand bonds are a popular form of performance assurance required by owners. Why? The answer is simple. As its name correctly implies, an on-­demand bond is payable to the owner on his demand, typically by a bank. The conditions for cashing in an on-­ demand bond are generally few, if any. With most of these types of bonds, all the owner has to do is take the on-­demand bond to the bank who issued it, state that the contractor has failed to perform, and collect the value of the bond. The issuer of the on-­demand bond (the bank) is generally under no obligation to verify the owner’s claims that the contractor has failed to perform. This is a pretty good deal for the owner!

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An on-demand bond is not a guaranty! The issuer of the on-demand bond will not step in and complete the contractor’s work in the event he fails to perform. The only obligation the issuer has is to pay the owner the face amount of the bond. The only similarity between an on-demand bond and a true guaranty is that it is a contract between three companies.

Example 2

The owner’s contractual requirement that the contractor provide an on-demand bond might be similar to the following: Article 23 – Performance Guaranty 23.1 Contractor shall provide a Performance Guaranty in the form of an irrevocable bank guarantee in the amount of 10% of the Contract Price payable on first demand of Owner to guarantee the performance of Contractor’s obligations under the Contract.

Example 3 Article 23 – Performance Guaranty 23.1 Contractor shall provide a guaranty of his performance under the Contract by providing a Performance Bond in the amount of 10% of the Contract Price and in the form of an irrevocable guaranty payable on Owner’s first written demand.

The key words for contractors to look for in reviewing these types of clauses are: “on first demand,” or “on owner’s first written demand,” or something similar. These code words identify what the owner really wants: an on-demand bond, even though the commercial language talks about a guaranty. Figure 6.2 is an example of an on-demand bond as might be issued by a bank.

Standby Letters of Credit

A standby letter of credit is similar to an on-demand bond and is typically provided by a bank. The most common use of letters of credit is in sales transactions between two companies.

An Example

The buyer of certain goods is located in a foreign country, and the seller of those goods is in the U.S. The buyer arranges for his bank to establish a letter of credit for payment and lists the documents required for the seller to submit to the bank for payment.

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Figure 6.2 Typical Performance-­On-­Demand Bond Wording and Format The seller produces the goods and takes all of the required documents to the bank for presentation. If the bank determines that required documents are in order, the bank pays the seller under the terms of the letter of credit. The use of letters of credit for sales transactions significantly reduces the seller’s risk of nonpayment for his goods. This type of letter of credit is typically called a commercial letter of credit, and the bank assumes it will make payment to the seller under the terms of the letter of credit. 77

A standby letter of credit is not a guaranty! Like an on-demand bond, a standby letter of credit is an ondemand payment instrument. Ondemand bonds and standby letters of credit are essentially the same thing.

In construction, a similar letter of credit may be established by a contractor to meet the owner’s requirements that he provide an assurance of his performance on a construction project. Like the letter of credit used in sales transactions, there may be requirements for the owner to provide certain documents to the bank stating or proving that the contractor has failed to perform. The bank will review these required documents, and if they are in order, the bank will pay the owner under the terms of the letter of credit. The bank is under no obligation to verify that the contractor failed to perform. Its only obligation is to make sure that the documents required by the letter of credit are in order, and if they are, then they pay the owner the value of the letter of credit. With this standby letter of credit, the bank does not assume it will make payment to the owner under the terms of the letter of credit. It assumes the contractor will properly complete the contract. In the event the contractor fails to perform, the bank or issuer will not step in and complete the contractor’s work. The only obligation the issuer of the standby letter of credit has is to pay the owner the face amount of the bond upon presentation of certain required documents. The only similarity between a standby letter of credit and a true guaranty is that it is a contract between three companies.

Example 4

The owner’s contractual requirement for the contractor to provide a standby letter of credit might be similar to the following: Article 23 – Performance Guaranty 23.1 Contractor shall provide a guaranty of his performance under the Contract by providing a Performance Bond in the form of a standby letter of credit for the full value of the Contract price.

Figure 6.3 is an example of a typical standby letter of credit issued by a bank and as might be used as an assurance of performance.

Surety Companies

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For the construction industry, a surety company specializes in providing true performance guaranties. Performance guaranties typically have two primary obligations for the surety of key interest to the owner: 1. The surety will step in and make arrangements to complete the contractor’s contractual obligations in the event the contractor becomes insolvent or fails to perform them. 2. Alternatively, the surety will pay the owner up to a maximum of the stated face amount of the guaranty, and the owner can use the money as he sees fit to help finish the project.

Figure 6.3 Typical Irrevocable Standby Letter of Credit

Surety companies have the financial strength and project management resources to back up the true performance guaranties they issue. In the case of the contractor’s insolvency, failure to perform, or failure to pay subcontractors or material suppliers, the surety company can step in and take over completion of the work, assist the contractor in finishing his work, find new contractors to finish it, or pay the owner up to the face value of the performance guaranty and let the owner finish the work as he may choose. The surety company’s maximum financial liability is limited to the stated face value of the performance guaranty it provides. 79

The Surety Company Qualification Process

Before a surety company will agree to provide a performance guaranty to the contractor, they will scrutinize the contractor’s management, project, financial, and other detailed corporate history. This is the surety company’s prequalification process, which gives owners an additional assurance of the contractor’s ability to perform. It’s unlikely a surety would provide a guaranty of performance for a contractor who didn’t meet its prequalification criteria. In addition, the surety company will require that certain contractor’s assets, both personal and corporate, be pledged to the surety as collateral in return for issuing performance guaranties on their behalf. The contractor will have to sign an indemnification agreement with the surety company providing that, in the event the contractor defaults on its contractual obligations and the surety company must step in and pay to have the obligations completed, the contractor will reimburse the surety company for all costs and expenses required to finish the contract for the owner.

Bonding Capacity

The surety company will place a maximum dollar limit on the total, or aggregate, amount of the value of all the performance guaranties that the contractor can have outstanding at any one time for all the projects he is working on. This is typically referred to as the contractor’s bonding capacity. All performance guarantees provided by a surety will have a stated start date and expiration date. These dates would normally correspond with the commencement and completion dates of the construction project, and may or may not include the warranty period.

An Example

Suppose a contractor’s bonding capacity established with his surety company is $10,000,000. He may find it difficult or impossible to contract for a new project if the dollar amount of the performance guaranty required on that project, when added to the total value of his other outstanding performance guaranties, exceeds the $10,000,000 limit set by his surety company. Let’s say the contractor defaults, and the surety company steps in and makes arrangements for and pays someone else to have the contractor’s contractual obligations completed. But the contractor has a separate indemnity agreement to reimburse the surety for all costs and expenses associated with completing the defaulted

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c­ ontract. If the contractor defaults, how can he repay the surety company for finishing his contract? If the surety has to take over the contract due to contractor’s default, it has some, or all, of the contractor’s assets pledged as collateral to help cover the surety’s costs and expenses associated with completing the contractor’s work. Plus, the surety will be paid by the owner for all remaining unpaid amounts under the contract as the work is completed. For a fee (the premium for the performance guaranty), the contractor gets to use the financial strength and assets of the surety company to stand behind the performance of his work. Most owners realize that the cost of the performance guaranty will be included in the contractor’s price for the construction project; they may feel it’s a small price to pay to be able to sleep better at night and not worry too much about what happens if the contractor defaults or fails to perform on the contract. It is also common for the cost of a required performance guaranty to be shown separately as an extra amount in the contractor’s pricing. At the option of the owner, he can elect to pay the extra amount to have the contractor provide the guaranty.

Surety Terminology

Common terminology associated with true performance guaranties and surety companies is as follows: • The surety company who provides the performance guaranty is called the obligor. • The contractor who buys the performance guaranty is called the principal. • The owner who receives the benefit of the performance guaranty is called the obligee. • The maximum dollar value of the performance guaranty that the surety company may be obligated to pay out is called the penal sum, or the limit of liability.

How to Locate a Surety

A good source for finding surety companies is the U.S. Government’s Circular Number 570, “The Treasury List,” which lists all the sureties qualified to provide performance guaranties on federal projects. These companies provide performance guaranties to private companies as well as to the U.S. government. The list can be found on the U.S. Treasury’s website at www.ustreas.gov 81

Some Language Considerations on Guaranties & Bonds

Confusion sometimes arises in the use and misuse of terms for assurances of performance. What does the owner really want? Owners often request a guaranty in the commercial language in the construction contract, when what they really want is an on-­demand bond or a standby letter of credit issued by a bank. As noted earlier, a standby letter of credit is just another on-­demand type of payment instrument. On-­demand bonds and standby letters of credit do not provide a guaranty of the contractor’s performance; they provide a monetary payment to the owner in the event of the contractor’s failure to perform. Banks and surety companies both use the term “bond” to generically describe the kind of performance assurance they provide. The contractor needs to take the time to read past the terms “bond” and “guaranty” to see what the owner really wants: an on-­demand type of payment instrument, or a true guaranty.

Types of Performance Assurances

The five most common types of performance assurances a contractor will likely encounter on a construction project are: 1. Willingness to enter into a contract 2. Use of money advanced 3. Performance of contractual obligations 4. Payment of subcontractors and suppliers 5. Performance of warranty obligations

Willingness to Enter into a Contract

Bid bond is the generic term used to describe the owner’s requirement that the contractor provide a performance guaranty or an on-­demand bond assuring the owner that the contractor will honor his bid and will enter into a signed contract with the owner. Bid bond requirements are most often found on federal and state government-­ related contracts. They are rarely required on private construction contracts. They are also sometimes required on international projects where the owner is in one country, and the contractor is in another. Why would an owner require a bid bond? Three typical reasons: 1. To determine the seriousness of the bidder. 2. To cover the owner’s possible cost of re-­bidding the project in the event the contractor refuses to contract with the owner. 3. As a penalty for inconvenience to the owner if the contractor is awarded the work and does not accept the project. Typically, the owner requires that a bid bond be submitted along with the contractor’s bid, or proposal, to do the work. The value of the 82

required bid bond may be a small percentage of the contractor’s bid price for the project, say, 5%. Alternatively, the owner may require in the bid documents that the contractor supply a bid bond in a fixed amount, such as $50,000.

An Example

A contractor submits a bid in the amount of $2,500,000 for the design, supply, and construction of a small water treatment plant for a private local factory. The bid documents require that the contractor provide a bid bond in the amount of 5% of the total amount bid in order to provide the owner with an assurance that the contractor will enter into a contract with him. The contractor’s bid must remain open for acceptance by the owner for a period of 60 days. In this instance, the contractor decides to supply a bid bond, in the form of an on-­demand bond issued by a bank, in the amount of $125,000, which is 5% of the amount he bid. When the contractor secures the bid bond at his local bank, the bank charges him a fee of 3% of the $125,000 face value of the bid bond. The bank is now at risk for the $125,000. The bid bond states that it will be in effect for a period of 60 days, as required by the owner’s bid documents. The contractor’s out-­of-­pocket cost for the bid bond is 3% of $125,000, or $3,750, which of course he adds to his price to the owner.

Let’s say that the contractor’s proposal to the owner for the work is not accepted. The owner will now return the bid bond to the contractor along with a notification that he was unsuccessful. The bid bond will become null and void, and the contractor will return the original of the bond to his bank. Unfortunately, the bank doesn’t refund his $3,750. That’s just the cost of doing business. Alternatively, the owner can’t seem to make up his mind what to do, and does not award the contract within the 60-­day time period. After 60 days, the bid bond lapses and becomes null and void; so does the contractor’s bid validity. In a different situation, the contractor receives notification from the owner 45 days after submitting his bid that the owner accepts his bid and wants to enter into a contract with him. By this time, the contractor has run into some financial difficulties, and tells the owner he just can’t enter into the contract for the price and terms he submitted. The contractor is now in default, and he and his bank are at risk that the owner will cash in the bid bond. The owner has several choices here: he can negotiate another deal with the contractor and not cash in the bond, or he can award the 83

contract to another, perhaps higher-­priced bidder and cash in the bid bond supplied by the defaulting contractor. If the owner decides to cash in the contractor’s bid bond, he must notify the contractor’s bank that the contractor has refused to enter into a contract with him. In this instance, since the bid bond is actually an on-­demand bond, all the bank requires is the owner’s statement that the contractor has failed to enter into a contract with him, and the bank will pay the owner the face amount of the bid bond, or $125,000. The bank is under no other obligation to investigate why the contractor failed to enter into a contract with the owner. A bid bond is supposed to provide the owner with an assurance that the contractor will honor his bid and contract with the owner. That’s the theory, and it works in most cases, but sometimes that’s not what really happens. As in the previous example, the contractor (for whatever reasons, financial or otherwise) decides he won’t sign a contract with the owner. The contractor has failed to perform, and the owner has the right to cash in the on-­demand bid bond he supplied with his bid. The owner gets the face value (the penal sum) of the contractor’s on-­demand bid bond. If the money received from cashing in the on-­demand bid bond is equal to or greater than the difference between the contractor’s low bid and the next acceptable bid, then the owner is probably okay, dollar-­wise. However, what if the next acceptable bid is $500,000 higher than the contractor’s bid? Well, maybe the contractor knew his estimate and pricing were too low. Maybe he felt that suffering through the call on the bond was cheaper than trying to perform on a contract that would surely end up being a huge financial loser, significantly in excess of the $125,000 that he will ultimately have to reimburse the bank that provided the on-­demand bid bond to him. If the owner receives the $125,000 from the contractor’s bank, maybe that’s enough to help him go through the exercise of rebidding the work, or working out a deal with one of the acceptable bidders for the project. Contractors also need to be aware of the commercial risk associated with providing guaranties or on-­demand bid bonds for private projects. The owner’s proposed commercial terms and conditions for the project may be undesirable or difficult for the contractor to accept without modification. In this case, the contractor would have to add specific wording in the guaranty or on-­demand bid bond stating that he is willing to enter into a contract with the owner, 84

subject to the owner agreeing to the commercial terms and conditions modifications outlined in contractor’s proposal. If the contractor didn’t do this, the owner could require the contractor to enter into a contract with him under the owner’s undesirable terms and conditions. If the contractor refused, the owner could have legitimate grounds to enforce a guaranty or cash in an on-­demand bid bond. Also, if an owner has a preferred or standard format for a guaranty or an on-­ demand bid bond, the contractor needs to carefully read it and make sure that by agreeing to use the owner’s preferred format he doesn’t jeopardize his ability to further negotiate acceptable commercial terms and conditions in the construction contract.

Use of Money Advanced

The generic term for the assurance provided to the owner that any money advanced to the contractor will be properly used against the contractor’s costs is an advance payment bond. It is sometimes called a downpayment bond. Like other assurances of performance, an advance payment bond may be in the form of a guaranty or an on-­demand bond. It is usually issued in the full amount of the advance payment that the contractor receives from the owner. Probably the most common form for this type of performance assurance is an on-­demand bond, rather than a true guaranty. The advance payment-­on-­demand bond is designed to protect the owner from the contractor failing to perform on the contract prior to spending the advance payment on proper contract activities. In the event the contractor fails to perform, the owner has the ability to recover some or all of the advance payment made to the contractor. An advance payment-­on-­demand bond is provided only when it is a contractual condition of the construction contract. It is normally provided to the owner after he awards the contract, but before he pays the contractor the agreed-­on advance payment, or downpayment. Typically, the contractor gives the owner the advance payment-­on-­demand bond along with his invoice for the agreed-­on downpayment. It’s unlikely an owner will pay the downpayment to the contractor before he receives the required advance payment-­on-­ demand bond. Although the owner might want the advance payment-­on-­demand bond to be in effect for the full duration of the contract, there is no 85

good reason for that to be the case. Typically, the advance payment made to the contractor is used to pay for contract costs that are incurred very early in the project, such as front-­end costs incurred in the first three months of the contract. If that’s the case, then there is no reason why the advance payment-­on-­demand bond should not expire after three months, or shortly thereafter.

An Example

A contractor signs a contract with an owner to build a large health and fitness complex for $8,000,000. The duration of the contract is two years. The contractor negotiates a 15% downpayment (and receives a gold star from the company president for this accomplishment). The commercial terms in the contract require an advance payment-­ on-­demand bond in the full amount of the downpayment, or 15% of the contract price. They also require that any advance payment-­on-­ demand bond be in effect for the duration of the contract, which, in this case, is two years.

The 15% advance payment-­on-­demand bond is worth $1,200,000, which reduces the contractor’s bonding capacity with his bank by the same amount. That may be okay if the contractor has a high bonding capacity, but in the last six months of the project, when there is only $1,000,000 worth of work remaining, it sure doesn’t seem to make sense to have that $1,000,000 worth of remaining work covered by a $1,200,000 advance payment-­on-­demand bond, plus the value of any other types of performance assurance the owner may have required. Also, if the contractor finished and invoiced more than the full value of the advance payment bond in the first six months of the contract, by keeping the advance payment bond in force, the owner is technically getting some extra, and unnecessary, bond coverage. In this case though, the contractor could have tried to negotiate a shorter time period for the advance payment-­on-­ demand bond to be in effect. This would free up valuable bonding capacity, or credit limit capacity, with his bank. The contractor could have also considered negotiating a step-­down value for the on-­demand bond.

Time Limits & Step-­Down Values for Advance Payment-­on-­Demand Bonds

There are no laws that require an advance payment-­on-­demand bond to be in effect, or in full value, for the duration of the contract. 86

The contractor normally is going to put in place work with a value that equals or exceeds the value of the advance pay-on-demand bond in much less time than the full duration of the project. In the health and fitness center example, the contractor could have negotiated advance payment bond wording similar to the following:

Article 24 – Advance Payment Bond 24.1 Prior to the downpayment being made, Contractor shall provide to Owner an Advance Payment Bond payable on Owner’s first written demand from a bank acceptable to Owner in the amount of 15% of the Contract Price, guaranteeing Contractor’s performance of the Work in this Contract. 24.2 The Advance Payment Bond shall be in effect for a period of six months from the date of signing of the Contract. During the period in which the Advance Payment Bond is in effect, it shall reduce in value according to the following: At the end of the first month – 12.5% of the Contract Price At the end of the second month – 10% of the Contract Price At the end of the third month – 7.5% of the Contract Price At the end of the fourth month – 5% of the Contract Price At the end of the fifth month – 2.5% of the Contract Price At the end of the sixth month – Advance Payment Bond expires and is no longer in effect

In this example, the on-demand advance payment bond is supplied in the amount of 15% of the contract price upon award of the contract and with the invoice for the downpayment. The bond is in effect for only six months, and the value of the bond decreases 2.5% per month. This step-down provision better reflects the value of the work put in place by the contractor. There is nothing that requires the contractor to agree to keep an on-demand bond at its full original value for any period of time. If a contractor can negotiate a declining value of the on-demand bond to better represent the value of the work outstanding on the contract, then that’s fine. The contractor keeps his bonding capacity, or credit limit, at a higher level, and the owner gets a valuable form of assurance for the contractor’s performance. The following is another way to word the contract clause that describes reducing the value of the advance pay-on-demand bond, over a longer period of time, for the contract’s duration. 87

Article 24 – Advance Payment Bond 24.1 Prior to the downpayment being made, Contractor shall provide to Owner an Advance Payment Bond payable on Owner’s first written demand from a bank acceptable to Owner in the amount of 15% of the Contract Price, guaranteeing Contractor’s performance of the Work in this Contract. 24.2 The value of the Advance Payment Bond shall be reduced by 15% of the value of each progress invoice submitted by Contractor to Owner for the Work.

In this example, the advance payment bond’s value steps down by an amount equal to 15% of the value of the periodic progress invoices submitted to the owner for the work performed by the contractor. The difference in this example is that this advance payment-ondemand bond remains in effect for the full duration of the contract, but with a steadily declining value. With this method, the advance payment bond has no value at the end of the contract period. Figure 6.4 is an example of an advance payment-on-demand bond with step-down values.

Subcontractor & Material Supplier Payment Guaranties & Bonds During the course of a construction contract, the contractor typically will utilize the services of various subcontractors and material suppliers who will have subcontracts with the contractor and will look to the contractor for payment for the services or materials they supply. The obligation to provide a payment guaranty or a payment-ondemand bond is another common type of performance assurance that owners require from contractors. In the event the contractor does not pay subcontractors or material suppliers for their services or materials, they may be able to file a lien against the owner’s property in an attempt to get their due payment. A legitimate lien filed in a timely manner by a subcontractor or material supplier against the owner’s property serves mainly to motivate the owner to pressure the contractor to pay his bills. It gets the owner’s attention that there is a problem in the making. Perhaps the owner will withhold enough money from the contractor’s progress payments to pay the subcontractors or material suppliers. Owners don’t like to have liens filed against their property, because it interferes with their ability to sell the property or use it to secure a loan. They expect the contractor to pay his subcontractors and material suppliers on time. 88

Figure 6.4 Advance Payment-­on-­Demand Bond with Step-­Down Values When the owner feels he requires additional assurance that the contractor’s subcontractors and suppliers will be paid, he will require the contractor to furnish a payment guaranty or payment-­on-­demand bond. The subcontractors and suppliers can make claim for their unpaid amounts under the bond, which should keep them from filing liens against the owner’s property. The subcontractors and suppliers can be added as beneficiaries of the guaranty or the on-­demand bond, but they may not know that such a guaranty or payment instrument exists. For convenience and simplicity, this book uses the contractual relationship between the owner and the contractor as the standard example. But, as mentioned previously, the contracting issues 89

discussed in this book apply equally to any contractual relationship between a subcontractor and a main contractor, or a subcontractor and the owner’s main contractor. Let’s take a look at how a payment guaranty or payment-­on-­demand bond benefits the owner and any of the main contractor’s subcontractors and suppliers.

An Example

An owner contracts with a main contractor to build a $25,000,000 food processing facility. The owner realizes that the main contractor will have to have a variety of specialty subcontractors and material suppliers involved in the project. The contract that the main contractor signs with the owner obligates the main contractor to provide the owner with 10% of the contract value payment guaranty through a surety company. The payment guaranty is to be in place for the duration of the contract, including the warranty period. During the course of the contract, the main contractor encounters financial difficulties and stops paying his subcontractors and suppliers. The subcontractors and suppliers cease work, but all have outstanding invoices for work performed or materials supplied. This is an unfortunate and unpleasant situation, but it happens. The subcontractors and suppliers begin filing liens against the owner’s property to protect their interests in the work performed or materials supplied that they have not been paid for. By this point, the owner has notified the main contractor’s surety company that the main contractor has failed to perform by not paying his subcontractors and suppliers. After the surety company receives the notice from the owner and investigates the claim, it steps in and works with the main contractor to find a way to pay the subcontractors and suppliers. In the event the main contractor can’t make the payments, the surety company is obligated to pay the subcontractors and material ­suppliers directly, up to an aggregate amount of the value of the guaranty, which in the example used is 10% of $25,000,000, the contract value, or $2,500,000.

In this example, the payment guaranty provided by the main contractor acts, to some extent, to insulate the owner from having liens filed against him by unpaid subcontractors and suppliers. The value of the payment bond in this example was 10% of $25,000,000, or $2,500,000. The $2,500,000 is the maximum amount of money available to the owner and the amount that the surety would have to pay out to subcontractors and suppliers if required. However, if the 90

subcontractors and suppliers had $3,000,000 in unpaid invoices submitted to the main contractor, then the owner would be faced with the probability of having to pay the additional $500,000 out of his pocket, or else be faced with the subcontractors and suppliers filing liens against his property for that amount. Alternatively, if the subcontractors and suppliers had $2,000,000 outstanding in unpaid invoices, the owner would likely escape having any liens filed against his property. He would look to the main contractor’s surety company that provided the payment guaranty to fully settle all the unpaid amounts, since they were less than the payment guaranty’s maximum value of $2,500,000. For subcontractors and material suppliers, the moral of the story on payment guaranties and payment-­on-­demand bonds is twofold: 1. First, subcontractors and material suppliers are likely to be in a strong position to be beneficiaries of a payment guaranty provided by a surety, although they may not be beneficiaries of a payment-­on-­demand bond, or a payment standby letter of credit. 2. Second, subcontractors and material suppliers to a main contractor on a project should find out if the owner requires a payment guaranty or payment-­on-­demand bond from the main contractor. If so, they should get a copy of it and read it. Subcontractors and material suppliers need to make sure they understand the conditions in the payment guaranty or payment-­ on-­demand bond under which they will be paid if the main contractor does not pay them. Just because a payment guaranty or payment-­on-­demand bond is in place doesn’t necessarily mean it will be easy or straightforward to claim and receive payments due.

Performance Guaranties & Performance Bonds A performance guaranty, or performance-­on-­demand bond or standby letter of credit, typically covers all of the contractor’s obligations in a contract, including payment of subcontractors and material suppliers and warranty obligations. A performance guaranty or performance-­on-­demand bond is normally in effect for the full duration of the contract and may include the warranty period as well. It will expire at some fixed future completion date, or it may expire earlier upon the receipt of a document stating that the work is complete and accepted by the owner. 91

The maximum value of the performance guaranty or performanceon-demand bond can be any amount required by the owner or negotiated between the contractor and the owner. However, typical amounts are between 5% and 20% of the value of the contract. All performance guaranties issued by surety companies and all performance-on-demand bonds issued by banks will have a fixed starting date and a fixed expiration date. Typically, the starting date would be the date the contract is signed, and the expiration date will be 30 days after the anticipated, or contractual, contract completion date. In the event the completion schedule extends beyond the bond’s expiration date, the owner may require the contractor to extend the expiration date to at least meet the new contract completion date. The example below is typical wording for a requirement to provide a performance guaranty: Article 32 – Performance Guaranty 32.1 Within seven (7) days of the date of the Notice to Proceed, Contractor shall provide to Owner a Performance Guaranty in the amount of 10% of the Contract Price guaranteeing the faithful performance of the Work under this Contract. 32.2 The Performance Guaranty shall be issued by a surety company acceptable to Owner, and shall be on terms and conditions that are acceptable to Owner. 32.3 The Performance Guaranty shall remain in effect throughout the scheduled execution of the Work, and any extensions to the schedule, and shall expire upon the completion of the Warranty Period.

Noted below is a typical example of a requirement to provide a performance-on-demand bond: Article 32 – Performance Bond 32.1 Within seven (7) days of the date of the Notice to Proceed, Contractor shall provide to Owner a Performance Bond payable on Owner’s first written demand in the amount of 10% of the Contract Price guaranteeing the faithful performance of the Work under this Contract. 32.2 The Performance Bond shall be issued by a bank acceptable to Owner, and shall be on terms and conditions that are acceptable to Owner. 32.3 The Performance Bond shall remain in effect throughout the scheduled execution of the Work and any extensions to the schedule, and shall expire upon the completion of the Warranty Period.

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In these sample clauses, the contractor is required to provide a performance guaranty or a performance-­on-­demand bond as an assurance of his performance of all the obligations in the construction contract. The performance guaranty or on-­demand bond is to be in effect from the time the contractor receives a notice to proceed with the work from the owner up to the expiration of the warranty period. The value of this bond is 10% of the initial contract price. In the example of the fitness center contract (mentioned earlier in this chapter), the performance bond provided under Article 32 requirement would be in effect for a period of three years (two years completion plus one year of warranty), plus any extensions agreed on between the contractor and the owner. For a period of three years, the owner has available a performance guaranty or performance-­on-­demand bond in the amount of $2,500,000. The contractor’s capacity to secure new guaranties or on-­demand bonds for new projects is likely reduced, as he will typically have some limit imposed on him on the total aggregate value of guaranties or bonds he can have outstanding at any one time. At issue here is how the contractor can meet the owner’s performance guaranty or performance-­on-­demand bond requirements in a way that provides the owner with what he wants, yet does not unnecessarily tie up the contractor’s guaranty or on-­demand bonding capacity. There are three possible ways to achieve this: 1. Supply a separate guaranty or on-­demand bond of lesser value to cover the performance obligations of the warranty period. 2. Step down the value of the performance guaranty or performance-­on-­demand bond to better represent the value of the outstanding work. 3. Use both of the above methods.

Warranty Guaranties & On-­Demand Bonds Since a contractor’s performance obligations will usually continue through a contractually agreed-­on warranty period, the owner will likely require that the performance guaranty or performance-­on-­ demand bond extend through this warranty period as well. Although a performance guaranty or performance-­on-­demand bond can be in effect during the warranty period, it is not unusual for a contractor to provide a separate warranty guaranty or warranty-­on-­demand bond covering the contractor’s obligations during the warranty period. Also, the maximum value of the warranty guaranty or warranty-­on-­ demand bond can be less than that of the performance guaranty or 93

performance-on-demand bond; there is no legal or other requirement for its value to be the same. The value just needs to be negotiated with the owner. Lower value is, in fact, better for the contractor. If the value of the performance guaranty or performance-on-demand bond is 10% or more of the contractor’s price, then a warranty guaranty or warranty-on-demand bond with a value of 5% or less of the contractor’s price could be negotiated. The amount of the warranty guaranty or on-demand bond may not necessarily represent the cost of repairs, but serves more like an incentive for the contractor to perform any required warranty work in a timely manner. The contractor’s completion schedule for the actual performance of the work can expand and compress for many reasons. It’s just easier to provide a new warranty guaranty or warranty-on-demand bond covering the warranty period once the actual contract completion date of the work is known or achieved. In this way, the starting and expiration date of the warranty guaranty or warranty on-demand bond will coincide with the actual contractual warranty period. When there is a provision for separate performance and warranty guaranties or on-demand bonds, it is not unusual for an owner to require that the warranty guaranty or warranty-on-demand bond covering the contractor’s obligations during the warranty period be submitted along with the contractor’s final invoice for the work. Receipt by the owner of the warranty guaranty or warranty ondemand bond is often used to trigger release of the contractor’s final payment or withheld retention, or both. The following is an example of a contract requirement for a warranty period assurance of performance: Article 33 – Warranty Bond 33.1 Within fourteen (14) days of receipt of the Certificate of Mechanical Completion, Contractor shall provide to Owner a Warranty Bond in the amount of 5% of the final Contract Price guaranteeing the faithful performance of Contractor’s warranty obligations under this Contract. 33.2 The Warranty Bond shall be in effect for a period of one year from the date of Mechanical Completion.** 33.3 The Warranty Bond shall be payable on Owner’s first written demand and issued by a bank acceptable to Owner, and shall be on terms and conditions that are acceptable to Owner.

**Note to contractors: make sure the warranty bond is issued with a definite date of mechanical completion, so that it is clear that there is a fixed time period. 94

One important thing to note is that the warranty period on-demand bond need not be the same value as the performance guaranty or performance-ondemand bond required by the owner. Its value can be less, subject to the contractor’s negotiations with the owner.

In the above example, once the contractor receives the certificate of mechanical completion, he is then required to immediately provide a warranty period on-demand bond. This will provide an assurance to the owner that the contractor will meet any contractual obligations that may arise during the warranty period. The value of this warranty period on-demand bond is 5% of the final contract price. Typically, the contractor’s final payment or release of any retention withheld (or both) would require him to have already issued his warranty period guaranty or warranty period on-demand bond to the owner. The terms of payment section of a construction contract often includes this requirement. As a final note, always consider providing a warranty guaranty or bond in lieu of having the owner hold any retention money until the end of the warranty period. It’s much better to have the cash in the contractor’s bank account.

Step-Down Values for Performance Guaranties & Performance-on-Demand Bonds It’s unlikely that a contractor would be allowed to provide any sort of performance guaranty or performance-on-demand bond that expires prior to the completion of the work required under the contract. It’s also unlikely a contractor would be allowed to provide a warranty guaranty or warranty period on-demand bond that expires prior to the end of the contractually required warranty period. It is likely, though, that a contractor can negotiate terms that would allow for the value of any required guaranties or on-demand bonds to decline over time, as follows: In the health and fitness center example used earlier, the contractor could have negotiated a performance guaranty requirement that read similar to the following: Article 32 – Performance Guaranty 32.1 Contractor shall provide a Performance Guaranty from a surety company or an insurance company acceptable to Owner in the amount of 10% of the Contract Price, guaranteeing Contractor’s performance of the Work under this Contract. 32.2 The Performance Guaranty shall be in effect for the duration of the Contract until such time as Contractor achieves Mechanical Completion and obtains the Certificate of Occupancy for the facility. 32.3 During the period of time in which the Performance Bond is in effect, its value shall decrease according to the following table: At the end of the 6th month – 8% of the Contract Price At the end of the 12th month – 6% of the Contract Price At the end of the 18th month – 4% of the Contract Price

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In this example, the value of the performance guaranty starts out at 10% of the value of the contract and declines in accordance with the table to a value of 4% of the contract price at the end of the 18th month. The value of the performance bond remains at 4% of the initial contract price until the contractor’s work is finished. Why should a contractor concern himself with negotiating lower or declining values for performance guaranties or performance-­on-­ demand bonds? In the health and fitness center example, the value of the contract is $8,000,000. The contractor is required to provide a performance guaranty in the amount of 10% of contract value, or $800,000, which is to remain in place for the duration of the contract which (on this project) is two years. This means that the contractor’s aggregate bonding capacity will be reduced by $800,000 for the next two years. If the contractor had negotiated a declining value performance guaranty as in the previous example Article 32, the value of the performance guaranty at the end of the first year would be 6% of the contract price, or $480,000. This frees up $320,000 of bonding capacity ($800,000–$480,000) for the next 12 months. Looking at this situation from another vantage point, freeing up $320,000 in bonding capacity allows the contractor the opportunity to provide a 10% performance bond on a new contract worth $3,200,000. It would be unfortunate for a contractor to be looking at an attractive project and not have enough available bonding capacity to bid and execute the work. Contractors should always consider negotiating lower bond limits on their projects. If the owner wants a 15% performance guaranty, maybe he will agree to a value of 10%, maybe he’ll agree to a value of 5%, or maybe he’ll agree to a declining value guaranty. Better yet, if the contractor has an excellent track record, maybe the owner will delete the requirement for a performance guaranty or performance-­ on-­demand bond. It sure doesn’t hurt to ask. The same arguments apply for any required warranty period guaranties or warranty period on-­demand bonds. Keep these separate from the required performance guaranties or performance-­on-­ demand bonds. Don’t forget that there is no requirement that the warranty period guaranty or warranty period on-­demand bond must be the same value as the performance guaranty or performance-­on-­ demand bond. It should be less. Sometimes an owner will want to keep the retention withheld from the contractor’s invoices for the duration of the warranty period to ensure the contractor’s performance of his warranty obligations. 96

This simply is not fair to the contractor—­and it is not helpful to the contractor’s cash flow. In this instance, the substitution of a warranty period guaranty or warranty period on-­demand bond in lieu of withholding retention may be an acceptable alternative to negotiate with the owner. This provides the owner with a form of assurance of similar value that the contractor will meet contractual obligations that may arise during the warranty period.

Parent Company Guaranties Sometimes, the subsidiary of a company will be allowed to substitute a parent company guaranty for a performance guaranty or performance-­on-­demand bond. One argument for this is that the financial, physical, and technical assets of the parent company are often greater than those of the surety company that would supply the required performance guaranty. In this situation, the parent company provides a guaranty of the performance of the subsidiary. In the event the subsidiary company fails to perform, the parent company guarantees that it will step in and complete the work and all other contractual obligations of the subsidiary. The parent company guaranty acts just like a performance guaranty provided by a surety company, only without a dollar limit. In some ways, this is better for the owner, especially if the parent company is a successful and financially strong organization.

An Example

Canadian Construction Company Limited, of Toronto, Canada, a wholly-­owned subsidiary of American Construction Company Inc., of San Francisco, California, receives a contract to design and build a $20,000,000 bulk storage facility for wheat at a site located in Saskatchewan, Canada. The owner of the new bulk storage facility has in his proposed construction contract a standard requirement for a 10% performance on-­demand bond. Canadian Construction Company negotiates with the owner for its parent company, American Construction Company Inc., to provide a parent company guaranty in lieu of the 10% performance-­on-­demand bond. The owner agrees that this is an acceptable alternative, as he is familiar with the success and financial strength of the parent company.

Figure 6.5 is an example of how a Parent Company Guaranty might be worded. 97

Figure 6.5 Sample Parent Company Guaranty

Guaranty & On-­Demand Bond Wording In private contracts, an important thing to remember is that performance-­related guaranties and on-­demand bonds are contractual agreements between three parties, and their wording is negotiable. The wording of any performance guaranty or performance-­on-­demand bond can be negotiated to meet the needs or concerns of any one of the parties involved in the contract. The owner may have a standard format for performance-­related guaranties and performance-­related on-­demand bonds, which will likely be favorable to his position and allow him a large degree of freedom to exercise the provisions of the guaranty or on-­demand bond with as little hassle as possible. For a contractor with strong capabilities and financial resources, this is probably not a big risk, especially if the owner also has a good track record with contractors and has the financial resources to pay the contractor for building the project. However, like the different risks associated with any construction project, all owners will have different risk profiles for the contractor. If the contractor believes more protection is needed from an unwarranted call on any of the guaranties or on-­demand bonds he has to provide on a construction project, he can modify the wording in these guaranties and on-­demand bonds through negotiations with 98

the owner. The contractor is under no obligation to accept the standard wording an owner may prefer. If the owner provides a standard, preferred format for the guaranties and on-demand bonds with his inquiry documents, the contractor should advise of any changes he requires in his proposal for the work. If the contractor does not revise the wording to something more acceptable, then he is stuck with the owner’s standard guaranty or on-demand bond wording and requirements after the contract is signed. This could be costly or risky for the contractor. Often, however, there will be guaranty and on-demand bond requirements in the contract terms and conditions, but without any standard forms attached with the inquiry. In this case, the contractor can provide his preferred wording after the award of the contract and at the time he submits the guaranties or on-demand bonds to meet the owner’s contractual requirements. In the event the contractor is concerned about a performance-related on-demand bond being cashed without good reason, he can consider adding to the conditions of the on-demand bond, wording similar to one of the following examples. Owner shall notify Contractor in writing 15 days prior to making a demand or claim under this Bond, advising Contractor in detail of the reasons he is in default and providing Contractor the 15 days to rectify the default. OR All demands or claims under this Bond shall be detailed in writing and shall be verified by an independent, third-party engineering consultant, mutually acceptable to both Owner and Contractor.

The second option introduces an independent third party into the process of determining whether or not the contractor is in default, and the owner has a legitimate call against the on-demand bond. The main point to remember is that the wording of any guaranty or on-demand bond is negotiable, just like the other terms and conditions in a construction contract.

Why Negotiate Bonding Limits? The main reason is to keep the contractor’s unused bonding limit as high as possible—to give him the opportunity to consider bidding and executing additional projects.

An Example

Let’s say the contractor has an aggregate bonding limit with his surety company of $50,000,000. This means he can have an aggregate maximum of $50,000,000 face value of guaranties 99

outstanding at any one time. If the value of all his outstanding guaranties averages 10% of contract value, this means he is executing $500,000,000 of work. He can’t take on any new projects if the amount of the new work’s guaranty or on-­demand bond requirements, when added to his current outstanding aggregate bond amount, exceeds the $50,000,000. The contractor is having a good year and wants to bid on a new project worth $60,000,000, which will take three years to complete. He currently has $45,000,000 worth of bonds outstanding. The new project’s two bonding requirements are as follows: 1. An advance payment bond or guaranty that will be in place for the duration of the work in the amount of any downpayment made to the contractor. (In this case, the contractor will require a 15% downpayment in his bid for the work.) 2. A performance and payment bond or guaranty in the amount of 10% of the contract price for the duration of the work, including the warranty period. The contractor puts pencil to paper and figures this new contract will require an advance payment guaranty of $9,000,000 (15% of $60,000,000), and a performance and payment guaranty of $6,000,000 (10% of $60,000,000), for a total of $15,000,000 in new guaranties with his surety. This $15,000,000 in new guaranties will be in place for three years. His surety company is reluctant to issue the required new guaranties because the contractor’s aggregate outstanding bond amount would then be $60,000,000, which is $10,000,000 higher than his agreement with the bonding company. What to do? Negotiate with the owner on the bond requirements. Consequently, the contractor proposes the following bond program in his proposal to the owner: 1. An advance payment guaranty in the amount of 10% of the contract price. The advance payment guaranty will decline to zero value in 12 equal monthly increments beginning from the date of contract. 2. A performance bond in the amount of 5% of the contract price that will be in place for the duration of the contract. Under this proposal, the contractor initially puts in place two guaranties for this new project that have a combined value of $9,000,000: $6,000,000 for the advance payment guaranty and $3,000,000 for the performance guaranty. After one year, the value of 100

the advance payment guaranty goes to zero, and therefore, the total value of the guaranties on the project reduces to $3,000,000, which is now just the value of the performance bond. This alternative method allows the contractor to bid the work and stay within the maximum bonding limits he has with his surety. But, wait a minute. Wasn’t the owner’s original requirement for the advance payment guaranty for the full value of the contractor’s 15% downpayment? Yes, it was. Sometimes outside-the-box thinking is in order. There’s nothing cast in stone that says an advance payment guaranty or on-demand bond has to equal the downpayment value. After all, this is an agreement between the owner and the contractor, and everything is negotiable. It doesn’t hurt to try to negotiate with the owner for a better deal. A contractor should never feel constrained by self-imposed or ownerimposed limits or conditions. Everything is negotiable.

Conclusion Contractors should be very careful with the use of standby letters of credit and on-demand bonds. Make sure the terms are acceptable

Contractors with excellent long-term track records of completing projects on time and in accordance with all the contractual conditions should consider resisting requests to provide any sort of performance-related guaranties, on-demand bonds, or standby letters of credit, to private companies. The contractor’s excellent track record and financial strength should be enough of an assurance for the owner of the private company. It certainly doesn’t hurt to try to negotiate this with the owner. Guaranties, on-demand bonds, and standby letters of credit are all contractual agreements. When absolutely required, the face values and commercial terms can be negotiated with the owner and the company providing them to make them fairer to one or more of the parties involved. There is no such thing as a standard format for these items. Subcontractors should find out if the main contractor must provide a payment guaranty, on-demand bond, or standby letter of credit to the owner. Ask for a copy of it and review it. Subcontractors may be noted as beneficiaries and will need to understand its conditions if it has to be used to get paid.

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Chapter

7

Contractors should consider their ability to procure appropriate insurance for their construction activities as a valuable company asset.

Insurance

Understanding insurance is another part of the process of managing the risk on a construction project, and will assist contractors in becoming more successful negotiators when it comes to commercial terms and conditions. This chapter will cover common insurance issues that will likely be encountered as part of any construction project and contract. If a contractor is unable procure insurance, or if insurance becomes unaffordable, this will severely affect his ability to compete and secure construction work. The fact is that the construction job site is among the riskiest of work places. Protection (through insurance) for claims arising from these risks is absolutely essential. For a contractor, the major physical risks on a construction job site are loss of/damage to property, and injury or death of personnel. These risks are the most likely to expose the contractor to a significant financial liability. Insurance can provide contractors

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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a certain level of protection from these and other types of risks, such as errors and omissions, and the cost of legal defense for claims covered under the insurance policy. Owners almost always require contractors to provide written evidence of insurance coverage in the types and amounts required in the construction contract—­before the contractor is allowed to mobilize at the site and start construction activities. For the contractor’s own risk management process, it is equally important not to start construction activities without adequate insurance to cover the risks he expects to encounter on the job site. Since every construction project has its own unique set of risks (both physical and commercial), trying to select appropriate insurance can be difficult and confusing. There are a multitude of possible risks that may arise out of any construction contract. Just because an owner requires certain types and amounts of insurance for a construction project doesn’t mean the contractor is appropriately covered. Also, the insurance industry has its own standardized language, commercial terms and conditions, exclusions, and financial limits that further complicate things. To make matters worse, there are numerous—­sometimes conflicting—­court interpretations of the standard language used in insurance contracts to include or exclude coverage. A competent insurance broker can be a real asset to a construction company in helping to analyze all the risks on a construction project (physical and commercial) and providing appropriate insurance to cover them. It is still necessary, however, to have a solid understanding of insurance types, conditions, and limits. There are also significant risks to be aware of when providing certain types of insurance for an owner, such as being required to add the owner as an additional insured to the contractor’s Commercial General Liability policy. Naming the owner as an additional insured gives him full access to the contractor’s policy, which may even cover accidents caused by the owner that are completely unrelated to the construction project. The consequences of adding the owner as an additional insured are more fully covered later on in this chapter.

What Is Insurance?

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Insurance provides a fixed amount of financial protection for the contractor from the financial liability that arises out of certain defined events—­risks—­that may occur on a construction project. The insurance industry calls these risks perils, and defines them as unexpected and unintentional events. In other words, the contractor

did not plan for these events (accidents) to happen, nor did they occur intentionally. The risks covered by insurance can be physical or commercial: • Damage to property or injury to persons are examples of physical risk. • Payment of the owner’s legal defense costs incurred in a lawsuit arising out of property damage is an example of a commercial risk. Payment of liquidated damages by the contractor for failure to meet the owner’s schedule is also an example. Insurance is considered a contract between an insurance company and the contractor. It does all of the following: 1. Defines the various physical and commercial risks covered and excluded. 2. Has a deductible amount that must first be paid by the ­contractor on any claim. 3. Has a stated maximum financial limit to be paid by the ­insurance company. 4. Has a fixed time period for which the policy is in effect. 5. Has other commercial terms and conditions related to ­notification, payment, and legal defense of claims made by the contractor or others. Insurance is provided for a fee, or premium. Insurance companies expect to pay claims that arise from the occurrence of physical and commercial risk events specified and covered in the insurance contract.

Claims Made vs. Occurrence

Insurance policies purchased by contractors will pay claims on the following two situations.

Claims-­Made Basis

The claim must be made during the insurance policy period. For example, if the insurance purchased by the contractor is for one year and is a claims-­made basis policy, any claims presented to the insurance company for payment must be made during the one-­year period that the insurance policy is in effect. If the contractor presents a claim after the policy has expired, the insurance company has no obligation to pay the claim.

Occurrence Basis

The claim can be made after the policy has expired, as long as the accident resulting in the claim occurred during the period of time the insurance policy was in effect. For example, if the insurance

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Delays between the time an accident takes place (occurrence) and the submission of a claim (lawsuit) for that accident are common. They can often be lengthy depending on the nature and complexity of events that caused the accident.

Types of Insurance

purchased by the contractor is in force for one year, a claim can be presented for payment after the expiration of the one-year period. However, the accident that resulted in the claim must have occurred during the period of time the insurance was in force. A contractor’s preference should always be to have insurance on an occurrence basis. Why? Let’s say an accident injuring a person occurs on the contractor’s job site one month before his General Liability insurance policy expires. Six months later, and five months after the contractor’s general liability policy expired, the injured person files a claim (lawsuit) for medical and other expenses. Since the contractor’s General Liability policy was an occurrence basis policy, and the accident—the occurrence—happened during the time the policy was in effect, the policy would almost certainly cover some, or all, of the injured person’s claim. There are many types of insurance coverage available to construction companies that can cover a wide variety of risks. The types of insurance commonly required by most owners are defined in the following pages.

Commercial General Liability Insurance

Commonly called CGL, this type of insurance provides coverage for claims for injury to persons, including death and property damage. It typically covers property damage or personal injury that occurs while any of the following are taking place: 1. During ongoing operations on the construction job site 2. As a result of the products the contractor has supplied 3. As a result of completed operations after the contractor has left the job site Also, CGL can cover the contractor’s liability that may arise from his assumption of the owner’s risk by way of the construction contract. (See “Contractual Liability Insurance.”) In order for a claim to be paid, the person making the claim must have suffered damages generally as a result of some degree of negligence for which the contractor would be legally liable.

An Example

Suppose a contractor digs a hole in the ground on his job site, neglects to properly and safely barricade it, and an individual who works for another contractor falls in the hole and breaks a leg. The individual can file a claim for medical and other expenses,

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i­ ncluding legal expenses, against the contractor claiming negligence for not properly barricading the hole. CGL is typically provided on an occurrence basis. It is also sometimes referred to as Comprehensive General Liability Insurance, a term that was in use prior to 1986, or Third-­Party General Liability Insurance.

Contractual Liability Insurance

This insurance provides the contractor with coverage for financial liability connected with claims that may arise from the contractor’s assumptions of the owner’s liability typically as stated in an indemnity obligation in the construction contract. Contractual Liability Insurance (CLI) coverage is normally included as part of most standard format Commercial General Liability insurance policies. It is almost always specified by the owner in the contract’s commercial terms and conditions to be provided as an addition to the contractor’s Comprehensive General Liability policy. CLI does not provide coverage for business-­related assumptions of liability, or for liability associated with breach-­of-­contract situations. For example, CLI would not cover any claims for the payment of liquidated damages, consequential damages, unpaid extra work, and the like. It covers the contractor’s assumption of financial liability for claims against the owner associated with personal injury, death, or property damage only, and for the legal defense of those claims. The indemnification provisions contained in the owner’s construction contract may obligate the contractor to assume the owner’s potential financial liability for claims related to personal injury, death, or property damage caused by the negligence of the owner, and to also pay for the owner’s legal costs associated with such claims. These are the specific assumptions of owner’s liability that Contractual Liability insurance covers. Having the contractor provide CLI gives the owner an extra measure of assurance that, in the event the contractor can’t or is unwilling to meet the financial obligations of the construction contract’s indemnification provisions, the contractor’s insurance company will meet them. The insurance company backs up the contractor with this type of insurance coverage; this is important coverage for the contractor, too. Requiring the contractor to provide CLI is also an important risk transfer consideration for the benefit of the owner. Simply defined, CLI covers the contractor’s contractual assumptions of liability as specified in a contract’s indemnity clause. The coverage is generally 107

restricted to those claims and associated defense costs for personal injury, death, and damage to or loss of property, which may be attributable to the owner’s negligence. CLI is designed to protect the contractor first, unless he adds the owner as an additional insured. (See Chapter 8 for further discussion of indemnity and its linkage with Contractual Liability insurance and additional insured status.) Since CLI is an integral part of almost all CGL policies, it is provided on an occurrence basis.

Automobile Insurance

This is coverage for injury to persons and damage to property caused by the contractor’s owned or leased automobiles. It is typically provided on an occurrence basis.

Workers’ Compensation Insurance

Often called Coverage A, it is typically required to meet the requirements of worker protection laws that have been enacted in most states and many countries. It is designed specifically to protect workers employed by the contractor. It provides a statutory level of financial compensation to the contractor’s workers for injuries or death or, in some instances, certain illnesses arising out of the worker’s employment with the contractor. It also limits the contractor’s liability, to some degree, to his employees. Premiums for Workers’ Compensation are regulated by the states, as are the benefits paid to claimants. It is typically provided on an occurrence basis.

Employer’s Liability Insurance

Often called Coverage B, this type of insurance provides protection for the contractor in the event an injured employee makes a claim arising out of employment with the contractor that is outside of the specific defined coverage provided by the state-­required Workers’ Compensation insurance, Coverage A. It’s been said that Employer’s Liability insurance coverage “fills in the cracks” in Workers’ Compensation insurance coverage. It is typically provided on an occurrence basis.

Builder’s Risk Insurance

This covers loss or damage to the work in progress during the course of construction. Contractors may be required to provide this insurance for the value of the work they are performing for the owner. Owners may provide it, and pay its premium, to cover the total value 108

of their project. As such, the protection it affords may be available to all the contractors working on the owner’s project. When Builder’s Risk insurance is provided by the owner, it’s important for contractors to make sure that the value of the policy is kept up to date with the value of the construction work. They must also make sure the insurance is in place at the commencement of construction activities and continues until the owner takes occupancy of the project. Failure to keep up with this may leave the contractor financially responsible for property damage without insurance. Builder’s Risk is also typically provided on an occurrence basis.

Professional Liability/Errors & Omissions Insurance

This insurance covers claims or losses caused by the contractor’s professional errors or omissions. Probably the most typical use and application of this type of insurance is to provide coverage for the contractor’s design and engineering activities associated with a construction project. It is typically provided on a claims-­made basis.

Transport Insurance

This type provides coverage for loss or damages to materials and equipment while they are being transported from one place to another. Typically provided on an occurrence basis.

Completed Operations Insurance

This covers claims for personal injury and property damage that occur after the contractor has completed his work on the project, demobilized, and left the job site. Claims made under Completed Operations are usually related in some fashion to faulty workmanship or materials and can be very costly. If the insurance company can prove that the contractor knew about the faulty workmanship or purposely used less than adequate materials, it will likely not pay the claims, which may then have to be paid out of the contractor’s pocket. Typically required by owners as an addition to the contractor’s Comprehensive General Liability insurance, Completed Operations insurance is provided on an occurrence basis.

Travel Accident Insurance

This provides coverage for the contractor’s employees while they are traveling on company business and is typically provided on an occurrence basis. 109

Owner-­Provided Wrap-­up Insurance

Usually put together and purchased by owners of large construction projects, it provides coverage for them and for the many different engineers, main contractors, subcontractors, inspectors, suppliers, and others working on the job site. All these other parties are named as being insured under the policy. This type of insurance typically covers claims associated with loss of or damage to property, or injury or death to persons that occur on the construction job site. It also sometimes covers Workers’ Compensation insurance requirements. Wrap-­up insurance can lower the owner’s overall insurance cost for a large project, since it takes the place of similar, overlapping, insurance coverage bought by each engineer, main contractor, subcontractor, and others working on the site. This method can reduce the insurance expense on large, multi-­disciplined projects. It’s important to understand what Owner-­Provided Wrap-­up insurance covers and what it doesn’t. Contractors should ask to see the details of its coverage, deductibles, and exclusions. While wrap-­up insurance can be a good deal for the contractor, he may still wish to provide additional insurance to cover his work if it doesn’t cover all risks. Wrap-­up insurance is also called an Owner-­Controlled Insurance Program (OCIP). It typically covers just one project. A Rolling OCIP (ROCIP) covers a series of the owner’s projects, rather than just one. It is typically provided on an occurrence basis.

Contractor-­Provided Wrap-­up Insurance

Some contractors are now providing and managing their own Contractor-­Controlled Insurance Programs (CCIP), which cover all their subcontractors working on a project. This solves the problem of some subcontractors having trouble getting or maintaining liability and property insurance. It also allows the contractor to control the safety program for the whole project. It is typically provided on an occurrence basis.

Owner’s & Contractor’s Protective Liability (OCP)

Purchased and provided by the contractor for the exclusive benefit of the owner, this insurance names the owner as the insured and beneficiary of the policy. The contractor can either pay the premium for this policy or charge the owner for it, which may be negotiated. 110

An OCP covers the owner for claims against him for personal injury and property damage incurred by third parties, as well as any associated legal defense costs that arise out of the contractor’s operations on the construction job site. It typically also covers claims for the owner’s vicarious liability. Third parties in this instance would include everyone (and all property) except the owner’s employees and property. OCPs are often provided by the contractor for the benefit of the owner in lieu of adding the owner as an additional insured to the contractor’s Comprehensive General Liability or other insurance policies. Claims against an OCP would likely be charged to the owner’s loss history, since the owner is the named insured, and likely not against the contractor’s loss history. The contractor simply purchases this type of policy for the owner’s benefit. OCPs are typically provided on an occurrence basis.

Umbrella or Excess Liability Insurance

This type provides additional liability coverage for the Comprehensive General Liability and automobile policies in the event the occurrence or aggregate limits are exceeded on these policies. Payment of claims under this type of coverage would not be made until the limits of the basic, or underlying, CGL or auto policies were exhausted. This type of insurance is typically provided on an occurrence basis.

Business Interruption Insurance

This covers the contractor when there are construction delays due to the covered risks (spelled out in the terms of the insurance policy). It is designed to retain key employees on salary when work cannot be performed. It can also cover the extra expense of obtaining rental equipment if the contractor’s equipment has been damaged. This type of insurance is typically provided on an occurrence basis.

Terrorism Insurance

Contractors will likely find that any type of coverage for acts of terrorism is specifically excluded from their insurance policies. This coverage can possibly be added, but will likely be very expensive.

Specialty Insurance

Many different and unusual risks can be covered to some extent by specialty insurance policies—­for a price, of course. For example, it is possible to purchase insurance to cover the contractor’s potential exposure to liquidated damages, extended warranty time periods, 111

force majeure consequences, and political risk, to name a few. For unusual risk situations, or for special insurance coverage required by the owner, it is best to consult a professional insurance broker. Bear in mind that such types of specialty insurance will likely be expensive to procure.

Captive Insurance

A captive insurance program is an insurance program wholly owned and controlled by its insured parties. The purpose of a captive insurance program is to insure the various risks of its owners. The owners of captive insurance programs put their own financial resources at risk with respect to claims made against their captive insurance program. Owners may also receive broader insurance benefits that may be available on the commercial insurance market.

Subcontractor Default Insurance

Subcontractor default insurance (SDI) can be used by general contractors to lessen the risk of a default by one of its subcontractors on a project. It can be used as an alternative to a surety bond (see Chapter 6, Assurances of Performance). Sometimes a surety reacts slowly to a default claim. Since SDI is insurance, the insurance program can react in a timelier manner to resolve the default. The deductible for an SDI policy can be very high.

Important Issues Associated with Insurance

The issues discussed in this section will come up time and time again in a contractor’s negotiations on insurance for a construction contract. Some of these points can significantly increase the amount of risk the contractor agrees to accept on a construction project, so it’s important to understand them.

Named Insured

Typically this is the company—­the contractor—­that purchases the insurance policy, pays the policy premium, and assumes payment of the policy deductible. The contractor would be the named insured on the Comprehensive General Liability, automobile, and Workers’ Compensation policies, the three most common insurance policies required by owners on a construction contract. If the contractor purchases a separate Owner’s and Contractor’s Protective Liability policy (OCP) for the benefit of the owner, then the owner becomes the named insured on this type of insurance policy. 112

Experience Ratings & Loss History

These are measures used by the insurance industry to assist in determining the premium to charge a contractor for an insurance policy. If the contractor is a safe worker and has had few or no accidents injuring people or damaging property that have resulted in claims, then his experience rating and loss history would tend to be low, which would be reflected in lower premiums for his required insurance. If the contractor is a not a safe worker, and has had some accidents that injured people or damaged property (and resulted in claims), then his experience rating and loss history would tend to be high. This would be reflected in higher premiums for his required insurance or, in the worst case, an inability to procure the required insurance.

Additional Insured

A person or a company, other than the named insured to an insurance policy, who can get some or all of the protection provided by the policy is called an additional insured. Owners will often try to require the contractor to add them as an additional insured on the contractor’s Commercial General Liability insurance policy for their construction project. Granting additional insured status to the owner should not be taken lightly. The contractor assumes significant risk in naming others to his insurance policies. (This issue is discussed in more detail later on in this chapter.)

Deductible Amount Granting additional insured status is sometimes referred to as free insurance for the owner.

This refers to the portion of any claim paid for by the named insured to an insurance policy. For example, in a $1,000,000 Commercial General Liability insurance policy with a $10,000 deductible, the named insured (the contractor) would pay the first $10,000 of a claim (the deductible), and the insurance company would pay the balance of the claim, up to the policy limit amount of $1,000,000.

Self-Insured Retention (SIR)

In practice, this is basically the same as the insurance policy’s deductible amount. Some large, long-established contracting companies may elect to set aside a reserve or establish some other type of account to pay for insurance claims and deductibles. For example, a large contractor may decide to self-insure the first $250,000 of claims against his Commercial General Liability policy. The contractor’s insurance company would provide insurance to cover claims in excess of the $250,000. By electing to “self-insure” 113

the first $250,000, the contractor is attempting to lower his insurance premiums. As an SIR, the contractor may elect to perform some of an insurance company’s typical functions, like paying claims under a certain amount.

Combined Single Limit

This is the maximum amount an insurance policy will pay for combined injury to persons and property damage. For example, the combined single limit on a contractor’s Comprehensive General Liability insurance policy for injury to persons and property damage might be $1,000,000. In the event of a $700,000 personal injury claim and a $500,000 property damage claim, the insurance company would pay only $1,000,000, which is the combined single limit of the policy. This would leave a shortfall of $200,000, which would most likely have to be paid by the contractor. Having umbrella or excess liability coverage would benefit the contractor in this instance, as it could provide coverage for the $200,000 shortfall.

Occurrence Limit

This is the maximum amount an insurance policy will pay for all injury to persons, property damage, and medical expenses that arise as the result of a single occurrence. Legal defense costs are usually provided in addition to the stated occurrence limits, but contractors should always check with their insurers on this.

Aggregate Limit

This refers to the maximum amount an insurance policy will pay for all personal injury claims and property damage claims that may arise as the result of multiple occurrences. Legal defense costs are usually covered in addition to the stated aggregate limits, but contractors should always check with their insurers on this. Contractors should make sure the aggregate limit in their general insurance policies applies separately to each project.

Waiver of Subrogation

Subrogation, a term that crops up all the time when determining insurance requirements in a construction contract, can be confusing. It refers to a waiver of the insurance company’s right to sue the owner for recovery of money it pays the contractor for an accident caused by the owner’s negligence. Essentially, in the insurance business, subrogation is the legal right and procedure that allows company A (the insurance company) to try and recover costs it paid to company B (the contractor) for an accident caused by party C (the owner). 114

An Example

Suppose that an accident occurs on the contractor’s construction job site and causes damage to the contractor’s property. It results in an insurance claim being filed by the contractor under his Commercial General Liability insurance in the amount of $100,000. The accident was caused by the owner’s negligence. The insurance company pays the contractor for the full value of the claim and exercises its right to sue (subrogate against) the owner, the negligent party causing the accident, to try to recover the $100,000 it paid to the contractor.

It’s best not to take waiver of subrogation too lightly. Just like any other contractual term or condition in a construction contract, it is possible to put limits on waiver of subrogation requirements.

Contractors are almost always required by the owner’s commercial terms in the construction contract to waive their insurer’s rights of subrogation, especially with respect to Commercial General Liability insurance. In the above example, if the contractor had waived his insurer’s subrogation rights under the Commercial General Liability policy, then the insurer would not be able to sue the owner for recovery of the $100,000, even though the owner was negligent and caused the accident. Insurers routinely allow the contractor to waive subrogation, as long as the waiver is provided prior to a claim being made. Contractors should be careful with agreeing to waive rights of subrogation, especially if they have a large deductible or self-insured retention on an insurance policy. In the event of a claim, the contractor would be waiving his own legal right to recover (subrogate) his deductible amount, which comes out of his pocket, not from the insurance company or the negligent party. And if the insurance company also can’t recover the funds it paid out from the negligent party, then the contractor’s loss history will likely increase. This means the potential of higher premiums in the future.

An Example

Suppose the contractor has to provide a $1,000,000 Comprehensive General Liability policy for the owner’s construction project, and the proposed contract terms and conditions require the contractor to waive his insurer’s rights of subrogation. The contractor could consider negotiating limiting language in the insurance section similar to the following:

To the extent of the first $100,000 payable under Contractor’s Comprehensive General Liability insurance policy, the insurance company providing this insurance shall waive its rights of subrogation against Owner. This waiver of subrogation shall not apply to the sole negligence of Owner.

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What does this limiting language do for the contractor? If there were an accident on the contractor’s construction job site caused by the owner, and it resulted in a claim of $250,000 that was eventually paid by the insurance company, then the insurance company could sue the owner for recovery of any amount paid in excess of the first $100,000. If the accident was judged to be caused by the sole negligence of the owner, the full $250,000 could be recovered by the insurance company in a lawsuit against the owner. One of the significant benefits to the contractor here is that his loss history would be less affected by the insurance company being able to recover at least some of the amount of the claim it paid out. This is a favorable condition for keeping the contractor’s future insurance premiums down. Another benefit is that if the accident were caused solely by the owner’s negligence, then the contractor could recover his deductible amount or self-­insured retention, and the insurance company would recover the amount it paid out for the claim. The contractor can accept, reject, or modify the owner’s requirement in the construction contract for the contractor to waive his insurer’s rights of subrogation. It’s just another commercial term among many in the construction contract that is open to negotiation.

Care, Custody, & Control

Let’s say the owner procures an expensive piece of mechanical equipment on his own and delivers it to the contractor’s storage yard at the construction job site. The contractor is required to install this piece of equipment as part of his construction contract with the owner. After receipt of the equipment, the contractor now has what’s called care, custody, and control of that piece of equipment. The contractor needs to make sure that his insurance for the construction project will cover a claim in the event of loss or damage to this equipment while it is in his care, custody, and control. Denial of coverage for damage to property of others that is in the care, custody, and control of the named insured (the contractor) is a frequent exclusion in insurance policies. The exclusion can be removed in consultation with the insurer, probably for an increased premium. Care, custody, and control of another’s property is an area in which the contractor’s CGL insurance policy will likely have a sub-­limit. For example, a $1,000,000 CGL policy may have a sub-­limit of $25,000 for property in the care, custody, and control of the contractor. It is important to be aware of sub-­limits, as they can 116

sneak up. The sub-­limit value of care, custody, and control can vary greatly from project to project, and should be checked to be sure that it is adequate.

Cross-­Liability

Often an insurance policy will insure two or more companies. A cross-­liability clause requires the insurance company to protect each insured company separately in the same manner as if a separate insurance policy were in place for each company. For example, when one of the insured companies causes a loss for the other, the insurance company pays the claim to the company incurring the loss. A cross-­liability clause requires the insurer to protect each insured company separately. However, even though there may be more than one insured company under the insurance policy, the monetary limits for all claims will not be increased. Cross-­liability is also referred to as severability of interest.

Primary & Non-­Contributory

These are two requirements that often appear in the insurance terms and conditions in a construction contract. 1. Primary defines the first level of insurance and means that the insurance provided by the insured (likely the contractor) will pay its stated financial limits first (primary) with respect to any claim paid. 2. Non-­contributory means that the primary insurance will not require the contribution (non-­contributory) of any other ­insurance that might be available (likely the owner’s) before it pays its limits.

An Example

Let’s say the owner and contractor have similar insurance that provides coverage for a claim arising out of the contractor’s work. In the event of a claim, the contractor’s insurance will pay out first if this primary and non-­contributory language is a part of the insurance requirements in the construction contract between the owner and the contractor.

Riders & Endorsements

These are special provisions to an insurance policy, which are noted and separately attached to the policy. All insurance policies have a lot of standard boilerplate language defining the basic terms and conditions of the insurance contract, including coverage inclusions and exclusions. Where special situations or circumstances need to be 117

defined or explained, or further additions and exclusions to the policy coverage are required, then these are made a part of the policy by adding a rider or an endorsement. This is exactly the same as adding a special appendix or attachment to a construction contract modifying certain terms and conditions or better defining work scope or other contractual issues. Insurance companies have standard wording for a variety of endorsements modifying the basic coverage of their insurance policies. Some are commonly referred to as ISO endorsements, short for Insurance Services Office, Inc. (One of the services this company provides is standardized language for insurance policies and endorsements.) Endorsements that are unique and contain special wording as agreed on between the insurance company and the named insured are called manuscript endorsements. Like any other contract, an insurance policy (contract) can have modifications made to it to meet the specific needs of the named insured.

Stacking

This is best illustrated by an example. Let’s say a contractor agrees to provide a $1,000,000 Commercial General Liability insurance policy for a construction project, and also agrees to name the owner as an additional insured to the policy. The contractor also agrees to indemnify the owner against losses he may incur during the construction of the project for a maximum of $1,000,000. During the construction of the project, an accident occurs on the contractor’s job site and the owner incurs a $2,000,000 loss. The insurance company pays the owner $1,000,000, the limit of the Comprehensive General Liability policy. Next, the owner claims an additional $1,000,000 from the contractor under the terms of the indemnity agreement in the construction contract. By adding the maximum amount available under the indemnity to the maximum amount from the insurance policy, the owner stacks the available coverage of both to try to cover his total loss. Protection against this type of stacking can be negotiated in the contract with wording similar to the following: The limit of the indemnity provided by Contractor shall be reduced by any payments made under the Commercial General Liability insurance policy provided by Contractor with Owner named as additional insured.

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With wording like this, the owner gets $1,000,000 of coverage, either through the insurance policy or by way of the indemnity agreement, but doesn’t get the benefit of the sum of both.

Notification Provisions Stacking should be avoided by careful contracting.

All insurance policies require some form of formal notification procedure in the event of a claim. Typically, there will be a time period within which the insurance company must be notified that the contractor has a claim to file with them. If the contractor fails to notify the insurance company within the stated time period, then he may be unable to file the claim and receive benefits of the policy. Insurance policies, especially property policies, will usually require that a proof of loss be filed within a certain period after a loss. The proof of loss is the insured’s list of all damaged equipment or property. Contractors should make this list as complete and comprehensive as possible. It is much easier to adjust it down upon the discovery that damage is not as significant as the contractor thought.

Evidence of Insurance Certificate

This refers to an insurance company document to be given to the owner stating the types and amounts of insurance provided by the contractor. This document provides the owner with evidence that the contractor has the insurance required by the construction contract. It is not a copy of the contractor’s insurance policies. As a general rule of thumb, contractors should resist providing copies of their insurance policies to owners. Why? Let’s say the contractor has a $5,000,000 Commercial General Liability policy in place that will cover all his construction activities in the United States. The fact that the contractor has this amount of insurance in place should be considered a confidential matter. If an owner requires only $1,000,000 of Commercial General Liability insurance for a project, then the contractor’s insurance company will provide the owner with an evidence of insurance certificate showing this amount. As long as the certificate proves that the contractor has the $1,000,000 of Commercial General Liability as required by the owner’s construction contract, then that’s all that needs to be shown on the certificate of insurance. In the event that there is a claim and lawsuit against the contractor’s Commercial General Liability policy, it’s best that the maximum limits of the policy are not generally known or advertised to others. It’s best if only the contractor knows how deep his pockets are. 119

Additional Insured Status

Granting the owner additional insured status is an extremely important insurance issue and cannot be taken lightly by the contractor. Contractors need to completely and fully understand the commercial risk and potential financial consequences associated with adding the owner as an additional insured to their insurance policies. Contractors should realize that receiving additional insured status on the contractor’s insurance policies is one of the most important risk transfer mechanisms desired by owners.

Why Is Additional Insured Status Wanted by Owners?

Owners would like to transfer as much project risk as possible to the contractor, regardless of whether the owner is negligent or otherwise at fault with respect to claims arising out of that risk. The main risks that the owner would like to transfer are associated with his own liability to third parties for negligent or wrongful acts resulting in: 1. Claims involving personal injury or death 2. Claims involving damage to property 3. Legal defense costs associated with defending the above claims Owners most typically try to transfer these risks to contractors in two ways: 1. Through indemnity agreements contained in the construction contract for the project, and/or, 2. By requiring the contractor to name the owner as an additional insured on the contractor’s CGL insurance policy, and further requiring that the CGL policy provide for contractual liability coverage. Because (in most instances) the contractor will resist voluntarily complying with the owner’s indemnity claims, the owner will likely find it difficult or impossible to collect under the contractor’s indemnity obligations without going to court. Also, the contractor may not have the resources to cover the financial consequences of a claim he may be responsible for under an indemnity agreement. The contractor could also go bankrupt and be unable to perform the obligations under the indemnity agreement. Therefore, the preferred risk transfer mechanism for the owner is to be named as an additional insured on the contractor’s CGL policy, which includes contractual liability coverage. This way, the owner can get his defense costs paid by the contractor’s insurer, who will also pay claims up to the contractually required policy limits. The contractor’s insurer may, in addition, have to pay claims that arise 120

from the contractor’s obligations as stated in the construction contract’s indemnity agreement. The contractor’s personal willingness or financial ability to defend against a claim (or pay for a claim from his own resources) is not an issue now; the contractor’s insurance company will foot the bill.

Additional Insurance Basics

Following are commonly asked questions regarding insurance terminology. • Who is the named insured? This refers to the owner of the insurance policy and the organization or individual who pays the premium and deductible for the insurance—­in this case, the contractor. • Who is an additional insured? This is another organization(s) or individual(s) who can claim some rights and benefits of the named insured’s (the contractor’s) insurance policy, but does not pay the premium and deductible. Typically, the additional insured is the owner, but may also be other individuals and organizations that are closely associated or affiliated with the owner • Who is an additional named insured? This may be an affiliated company of the contractor who may share in paying the premium and deductible for the insurance policy with the contractor. It is not the same as an additional insured. • What is an endorsement? An addition to the standard insurance policy terms and conditions. The written terms and conditions of the endorsement may modify, limit, add, or take away certain insurance coverage provided in the standard insurance policy’s terms and conditions. Endorsements help tailor the insurance coverage to meet the specific needs and requirements of the person or firm that owns the insurance policy, the named insured. An endorsement is also called a rider. Additional insured status for an owner may be automatic under some policies, or it may be conferred in other policies by an endorsement to the contractor’s CGL and other insurance policies. • What type of insurance is most commonly sought by the additional insured? Coverage under the contractor’s Commercial General Liability insurance policy as an additional insured. The contractor’s CGL insurance can provide the owner with coverage for claims for its legal liability for injury or death to persons, including death of persons, and property damage. It also covers the owner’s legal defense of such claims. An owner can be named as an additional insured to other contractor’s 121

insurance policies, such as automobile insurance, and even the contractor’s umbrella or excess policies. • How is additional insured status obtained by the owner? The owner’s construction contract will have a clause, usually under the insurance requirements section, which might read simply as follows: Contractor shall name Owner as an additional insured on Contractor’s Commercial General Liability policy.

Such wording makes it a contractual obligation for the contractor to name the owner as an additional insured on his CGL policy Failure to add the owner as an additional insured, or to add the owner as an additional insured on terms and conditions other than as may be specified in the owner’s contract, can place the contractor in breach of contract. • What has to happen in order for the owner to benefit from being an additional insured? First, an accident must occur on the construction job site that results in personal injury or property damage. Next, a claim or lawsuit needs to be made against the additional insured (the owner) for damages resulting from the personal injury or property damage. Next, the additional insured (owner) files with the contractor’s insurance company to defend them against the claim and pay any resulting award of damages.

Nine Key Issues Associated with Additional Insured (AI) Status

There are a number of technical and commercial issues associated with granting additional insured status to the owner. It’s important that contractors take the time to understand these issues to assist them in negotiating to eliminate or otherwise limit the serious commercial risk associated with granting additional insured status. 1. Generally, an AI (the owner) is provided insurance coverage only for what is called the vicarious liability of the AI (the owner) for claims that are attributable to the acts or omissions of the named insured (the contractor). This is the typical position of the insurance companies who provide additional insured coverage. Vicarious liability is imposed by law on the owner simply because of the relationship between the owner and the contractor. In the construction business, this relationship is 122

typically established by the construction contract, as the contractor is working for the owner, building something. Even though the owner was not involved in any way in causing the accident that occurred on the job site, and which caused the injury and subsequent claim, the owner still has a liability for the claim because the law imputes (imposes) that liability on him based on the owner/contractor relationship. This relationship is like an employer/employee relationship as far as the law is concerned. An employer (the owner) is generally responsible for the negligent actions of its employees (the contractor) that take place in the course of their employment (building the construction project). Legal issues related to the supervision of the contractor by the AI (the owner), the degree of the owner’s control over the contractor’s work, and the owner’s maintaining a safe workplace underlie this employer/ employee relationship and vicarious liability legal concept.

An Example

A contractor’s employee is injured by a falling piece of metal on the contractor’s job site. The employee’s only recourse against the contractor is a claim limited by the prevailing state Workers’ Compensation laws. Not satisfied, the injured employee now files a claim against the owner based on the owner’s vicarious liability, claiming perhaps that the owner failed to properly supervise the contractor. This type of claim by an employee of the contractor against the owner is called a third-­party over action. The employee, a third party (someone not signatory to the contract), goes above the contractor he is working for and sues the owner. If the owner was named as an AI on the contractor’s CGL, the owner would look to the contractor’s insurance company to first defend against the claim, pay for the cost of the legal defense, and then pay out any damages (up to the insurance policy limits required by the construction contract) if a settlement is reached or damages are awarded by a court. The bottom line here is that the contractor’s insurance company will have to pay for the cost of the owner’s legal defense, and reimburse the owner for any damages he is required to pay (up to the insurance policy limits required in the construction contract). This will certainly affect the contractor’s insurance experience rating. As a result of this claim, the contractor’s future premiums for similar CGL insurance will likely increase. The insurance company could even elect not to renew—­or even cancel—­the contractor’s CGL policy because of what it now considers a poor experience rating. 123

2. Generally, the AI (the owner) is not provided insurance coverage for claims for accidents associated with the contractor’s work that are the result of the AI’s (the owner’s) sole negligence. This is the typical position of the insurance companies who provide AI coverage. AI coverage is likely available to the owner for claims for accidents associated with the contractor’s work that are the result of some contributory form of negligence of both the AI (the owner) and the contractor. Insurance coverage available to the owner in this situation will cover the owner’s proportionate liability to the degree of negligence attributable to the owner as determined by a court or through some negotiated settlement. The language in the endorsement providing AI status may include or exclude claims that are attributable to all or some of the AI’s (the owner’s) own negligence. The wording of the endorsement providing AI status to the owner is important. (See issue number 9.) 3. The contractor’s insurer has an obligation to defend the AI (the owner) in the event of a claim against the owner and to pay for the costs of the legal defense. This is an extremely important risk transfer strategy of owners, and perhaps the main reason owners want to be covered as an additional insured on a contractor’s CGL policy. In the first instance, legal defense costs associated with a claim must be paid, and who better to pay them (at least from the owner’s standpoint) than the contractor’s insurance company. Legal defense costs can be significant for a complex and lengthy construction-­related claim that is somehow attributable to the contractor’s work. It is possible a claim against an owner could be denied by the court, but the owner’s legal defense costs will have to be paid, regardless. It’s better from the owner’s perspective to be an additional insured and have the contractor’s insurance company pay these costs rather than having them paid by the owner’s insurance company or out of the owner’s own financial resources. The contract of insurance between the named insured/ additional insured (contractor and owner) and the insurer (contractor’s insurance company) requires the insurer to defend a named insured (the contractor) or an additional insured (the owner) in the event of a claim that may be covered by the insurance policy. 4. When does the insurance coverage provided to an AI (the owner) cease? Does insurance coverage extend to completed 124

operations for claims that may be attributable to the contractor’s work after it is completed and the contractor has left the job site? Or is AI coverage only for claims that are attributable to the contractor’s work during the course of construction (prior to completion) and while the contractor is working on the job site? The general position of the insurance companies is that completed operations coverage is not provided to the AI unless specifically added in the AI endorsement. Again, wording of the AI endorsement is critical. (See issue number 9.) 5. If the contractor is considered an independent contractor (which may be so stated in writing in the contract), then insurance coverage for claims for the vicarious liability of the owner may not be available to the AI (the owner). However, it is likely that defense coverage would be available from the insurer to help the owner prevail on the defense of that claim. What’s going on here? The owner hires an independent contractor to produce specified results. In theory, the owner simply stands back and does not exercise any degree of direct control over the manner in which the contractor performs all aspects of the work and ultimately achieves the desired result—­the owner’s finished construction project. The contractor performs the work in accordance with terms of the construction contract and without any direct control over the work by the owner, so perhaps there is no employer/employee relationship in effect. If there is no employer/employee relationship (and theoretically there is none with an independent contractor), then the owner can’t have any vicarious liability, or insurance coverage for claims for vicarious liability. That seems to be the theory, anyway. Contractors should definitely check with insurance professionals on this matter. This AI issue is definitely complex. The underlying theory seems to follow logic similar to the following: • As an AI on the contractor’s CGL policy, the owner expects insurance coverage for third-­party over actions that base their claim on some form or degree of owner’s vicarious liability arising from the employer/employee (owner/ contractor) relationship. • The construction contract with the owner clearly states in the commercial terms and conditions that the contractor is an “independent contractor.” • As an “independent contractor,” the owner does not in theory exercise, for example, any degree of control or 125

general supervision over the contractor; the owner simply hires the contractor to produce a certain result. • Since there is no control or general supervision of the contractor (implied from the term “independent contractor”) by the owner, there can’t be any vicarious liability of the owner. • Since, as the logic goes, there can’t be any vicarious liability on the part of the owner in this situation, the contractor’s insurance company may contend that it provides no coverage of the claim for the owner as AI. 6. Is the insurance provided to the owner by the additional insured endorsement primary or excess to the owner’s ­insurance? If the insurance coverage provided to the owner by an AI endorsement on the contractor’s CGL policy is ­considered primary, then the contractor’s insurance policy would pay for claims up to the required policy limits in the first instance. The owner’s insurance would pay for the balance of a claim (up to its policy limits) only after the contractor’s ­insurance limits were exhausted. If the insurance coverage an AI endorsement provides is ­considered excess, then the contractor’s insurance policy would pay the balance of the claim (up to its required policy limits) only after the owner’s own insurance limits are exhausted. Example of primary: The construction contract requires an owner to be an AI on a contractor’s $1,000,000 CGL policy. The contractor’s insurance is required by the construction contract to be primary. A claim against the owner in the amount of $1,500,000 is made. It is found to be covered by the AI coverage under the contractor’s CGL policy. Since the contractor’s ­insurance is considered primary, his insurance will pay the first $1,000,000 (the required policy limits), and the owner’s ­insurance company will pay the excess, which is the balance of the claim, or $500,000, subject to the owner’s deductible. Example of excess: The construction contract requires the owner to be an AI on a contractor’s $1,000,000 CGL policy. The contractor’s CGL insurance is required by the construction contract to be excess as a result of the contractor’s good ­negotiating skills. A claim against the owner in the amount of $1,500,000 is made and settled. The owner is entitled to the AI coverage under the contractor’s CGL policy. Since the ­contractor’s insurance is considered excess, the owner’s ­insurance pays the first $1,000,000 (the owner’s policy limits), 126

subject to the owner’s deductible, and the contractor’s insurance company pays the excess, which is the balance of the claim, or $500,000. Who pays the owner’s legal defense costs in this excess example? It may be the owner regardless of the primary or excess issue, or perhaps the owner’s and contractor’s insurance companies would share the defense costs in some negotiated arrangement. Negotiating AI coverage as excess is a way for the contractor to reduce the possible effect a claim can have on his insurance experience rating, premiums, and future ability to secure insurance. 7. How many parties may be afforded additional insured status on a contractor’s CGL policy? There will always be at least one party required in the contract to be named as an additional insured, typically the owner. Naming the owner as AI is the common requirement found in the insurance section of the owner’s construction contract. However, the owner’s construction contract may require that, in addition to the owner, the owner’s project manager, engineer, parent company, or employees, agents, and representatives, for example, all be included separately as additional insureds on the contractor’s CGL policy. It’s risky enough to add the owner as an additional insured on the contractor’s CGL policy, but to add an unknown group of extra people over which the contractor has little or no control is just inviting them to help themselves to the insurance coverage bought and paid for by the contractor. Remember that everything in a contract is negotiable. Contractors don’t have to add the owner as an AI (or anyone else, for that matter), regardless of what the owner might want. It’s all a matter of negotiations with the owner as to whether AI status is granted, and if it is, who is included as an AI. 8. The contractor’s CGL policy deductible is always at risk. In order to keep insurance premium costs down, a contractor may elect to have a larger than normal deductible, or self-­insure, as it’s often called, to cover the first part of a claim. If a claim is made against the owner, and the owner is an additional insured on the contractor’s CGL policy, the deductible portion of that claim may have to be paid out of the contractor’s pocket, with the contractor’s insurance company paying the balance of the claim up to the required policy limits. For contractors with large policy deductibles, this is a serious risk, with potentially serious financial consequences. 127

9. The specific wording of the additional insured endorsement in the contractor’s CGL policy that provides legal defense and breadth of insurance coverage of claims is important. However, the critical issue is not so much the wording of the actual AI endorsement, but rather the wording in the owner’s ­construction contract that requires the owner to be named as an ­additional insured. The wording of the AI endorsement can’t change, amend, or supersede the AI requirements specified in the contract. The contractor is obligated to provide AI coverage exactly as specified in the contract’s commercial terms and conditions. Failure to provide AI coverage as specified in the contract may place the contractor in breach of contract.

Insurance Services Organizational AI Forms

Standardized wording for different types of common insurance policies, like the Commercial General Liability policy, and for their optional endorsements, like the additional insured endorsement, are provided to many insurers in the U.S. by the Insurance Services Organization Inc. (ISO). For example: ISO provides a form called CG 20 10 11 85, which is the November, 1985 (11 85) edition of the additional insured endorsement (CG 20 10) for Commercial General Liability insurance policies. The title of this common ISO AI endorsement form is “Additional Insured – Owners, Lessees, or Contractors – Scheduled Person or Organization.” This endorsement may be used when a contractor elects to schedule a specific owner as an AI and also specifically schedules the associated construction project. Interpretation of the wording on these standard ISO AI forms has been the subject of many court rulings in the U.S. Not surprisingly, different courts in different jurisdictions have made creative rulings on what the wording in the AI endorsement includes or excludes in the way of coverage for the AI. Some of these rulings appear to benefit the contractor, while others appear to benefit the owner. Not many seem to benefit the insurance industry. Although there are over 30 additional insured endorsements available to the construction industry in a standardized format from ISO, the following five are most likely to be encountered by a construction company. 1. ISO CG 20 10 11 85: Wording in this AI endorsement includes the broadly interpreted words, “arising out of (named insured’s—­the contractor’s) work.” It also has been interpreted to include very broad defense and claims coverage for the owner, which will likely include completed operations 128

c­ overage and may even include claims attributable to the sole negligence of the AI (the owner). Contractors should note that because of the broad coverage provided to an AI under this endorsement, it is not readily available anymore from insurance companies. The caution for contractors is that if this particular ISO endorsement is specified in an owner’s construction contract, and the contractor is not able to get his insurance company to supply it, he therefore may find himself in breach of contract. 2. ISO CG 20 10 10 93: Wording in this AI endorsement includes the broadly interpreted, “arising out of (named insured’s—­the contractor’s) ongoing operations.” This revised wording is an attempt to exclude completed operations coverage for the AI. 3. ISO CG 20 10 03 97: Revised wording in this AI endorsement also includes the broadly interpreted “arising out of (named insured’s—­the contractor’s) ongoing operations,” and the ­additional revised wording is an attempt to exclude completed operations coverage for the AI. 4. ISO CG 20 10 10 01: Coverage is provided for claims that arise during the “ongoing operations of the named insured (the contractor).” Includes a list of exclusions to better define that completed operations coverage is not provided, and is more specific. The intent is to cover only those claims that arise during the period of the on-­site construction. 5. ISO CG 20 10 07 04: Coverage is provided to the AI (the owner) for claims that arise from the “acts or omissions of (named insured—­the contractor) in the performance of (named insured’s—­the contractor’s) ongoing operations.” No coverage is provided for the sole negligence of the AI (the owner), or completed operations. The intent is to cover only those claims that arise during the period of the on-­site construction. 6. ISO CG 20 10 04 13. Similar to the 07 04 edition in 5 above, but with the following limiting conditions: “1. The insurance afforded to each additional insured only applies to the extent permitted by law.” “2. If coverage provided to the additional insured is required by contract of agreement, the insurance afforded to such additional insured will not be broader than that which you are required by the contract or agreement to provide such additional insured.” “3. If coverage provided to the additional insured is required by contract or agreement, the most we will pay on behalf of the additional insured is the amount of insurance: 1. Required by the 129

contract or agreement, or 2. Available under the applicable Limits of Insurance shown in the Declarations, whichever is less.” 7. ISO 20 10 12 19. The same as 04 13 edition in 6 above, except that C.2. was revised to read: “Available under the applicable limits of insurance.”

Additional Insured Endorsements for Completed Operations

Additional insured status for Completed Operations was included by a new form ISO 20 37 10 01, followed by the 07/04, 04/13, and 12/19 editions. The language and coverage in these three editions of ISO 20 37 for completed operations are the same as the language and coverage in the corresponding ISO CG 20 10 10/01, 07/04, 04/13, and 12/19 editions.

Manuscript AI Endorsements

The contractor or owner can also elect to use what is called a manuscript endorsement to add the owner as an AI to the contractor’s CGL policy. A manuscript endorsement is written by either the owner or the contractor for the specific construction project and adopted by the insurer. It is not made in a standardized format, such as that used in the standard ISO AI endorsements examples noted above. A manuscript AI endorsement may contain any additional insured requirements or limitations that meet the insurance needs of either or both parties. It could also be written to include the provisions of a standard ISO AI endorsement as a base, plus any other provisions, limitations, or additions the owner and/or the contractor choose to agree upon. Contractors should note that a manuscript AI endorsement can be developed by either the owner or the contractor. A contractor may elect to add an owner as AI to his CGL policy, but only under the negotiated terms of a manuscript AI endorsement developed by the contractor, or developed through negotiations with the owner. When using a manuscript AI endorsement, it is best to have the specific terms of the AI endorsement contained, or referenced, in the insurance section of the construction contract, or otherwise included as an attachment to the construction contract. This ensures that what is provided by the contractor’s insurance company in the way of AI coverage is what was actually negotiated and/or agreed to by the owner and the contractor. 130

Wording AI Endorsements Carefully

Let’s take a look at the following two examples of how an owner might require the contractor to add him as an additional insured to the contractor’s CGL policy.

Additional Insured (AI) Example 1 Article 45 – Insurance 45.1 Contractor shall add Owner as an Additional Insured to Contractor’s Commercial General Liability insurance policy.

Additional Insured (AI) Example 2 Article 45 – Insurance 45.1 Contractor shall add Owner as an Additional Insured to Contractor’s Commercial General Liability insurance policy per ISO Form CG 20 10 11 85.

There is a big difference in the commercial risk to a contractor in the requirements of these two seemingly similar insurance requirements for AI status. In the first example, the contractor could arguably comply with the obligation under the construction contract by using any standard ISO AI endorsement. He could even elect to provide a highly limited manuscript endorsement that mandates that his deductible be paid by the owner, completed operations coverage be excluded, and AI insurance coverage be considered excess over the owner’s primary insurance. In the second example, the contractor has no choice but to provide AI insurance coverage in accordance with the terms of ISO AI endorsement CG 20 10 11 85. This broad-based AI coverage calls for completed operations coverage and likely covers those claims that arise out of the owner’s sole negligence. If the contractor provides AI insurance coverage in some form other than as required by this contract clause, he risks being in breach of contract.

Some Final Comments on Additional Insured Status

Being named as an additional insured on the contractor’s Comprehensive General Liability policy is a good deal for the owner. It’s important for the contractor to fully understand the consequences of agreeing to it, as the results could be disastrous. It’s also important to remember that just because the owner requests being named as an 131

additional insured, it doesn’t mean the contractor has to agree. The owner always has other insurance options available to him to purchase. When the owner is named as an additional insured to contractor’s CGL policy, the contractor is giving him the benefit of the protection afforded by that policy at no cost to the owner. Free insurance! Now, that’s a good deal for the owner! When the owner is named as an additional insured on contractor’s CGL policy, he may be able to make a claim under that policy for an accident on the job site completely unrelated to the contractor’s own work. That’s also a great, free deal for the owner! Furthermore, the contractor risks losing control of the claims process, as the insurance company is obligated by the terms of the policy to deal directly with the owner as an additional insured, not the contractor. Whenever the contractor loses control of the claims process, it will cost him. If the contractor also agrees to waive his insurance company’s rights of subrogation, then the insurance company will be unable to use the legal process (subrogation) to try to recover the claim money from the owner (the additional insured) even if the accident were actually caused by the owner’s negligence. The owner doesn’t have to use his own insurance policy to cover a claim in this case, and the contractor may even have to pay the deductible. When the owner is named as an additional insured to the contractor’s CGL policy, the insurance company must pay the owner for a claim. Since the claim was made under the contractor’s insurance policy, his loss history is affected, and his future insurance premiums will likely increase. The insurance company could even refuse to provide insurance on future work. In summary, adding the owner as an additional insured to the contractor’s CGL policy significantly increases the risk a contractor takes on a construction project. The contractor doesn’t receive any payment for taking this additional risk. The risks are increased insurance premiums or cancellation of the contractor’s insurance policy.

Anti Additional Insured State Statutes The following 8 states outlaw additional insured status in construction contracts

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Texas

Kansas

Montana

New Mexico

Oklahoma

Oregon

Utah

Colorado

State statutes that outlaw additional insured status. 1. Texas Insurance Code §151.001 2. Colorado Revised Statutes §12-­21-­111.5(6)(b) 3. Kansas Statutes Annotated 16-­121(c) 4. Montana Code Annotated §28-­2-­2111 5. New Mexico Statute §56-­7-­1 6. Oklahoma Statute §15—­221(b) 7. Oregon Revised Statutes §30.140 8. Utah Code Annotated §13-­8-­1 The text of these statutes is available through an online search. Also, there is a lot of commentary available online regarding issues with the requirement to provide additional insured status in construction contracts.

How to Deal with an Owner’s Demand for Additional Insured Status

There are four ways a contractor can deal with an owner’s request to be added as an additional insured: 1. Encourage the owner to buy his own separate, project-­specific CGL policy to meet his insurance requirements. 2. Purchase a project-­specific Owner’s and Contractor’s Prot­ ective Liability (OCP) policy for the owner and charge him for it. 3. Negotiate wording in the construction contract significantly limiting the owner’s use of the policy and its benefit to him as an additional insured. 4. Negotiate the use of, for example, an ISO AI standard endorsement that is less broadly worded and more restrictive for coverage provided. Also, if the owner is ultimately added as an additional insured, he should agree to pay for the policy’s deductible in the event he files a claim. (Otherwise, the contractor would have to pay the policy deductible.) This is fair because in most situations where the owner provides wrap-­up or builder’s risk policy with the contractor named as an additional insured, he will require the contractor to pay the policy deductible for claims paid. In the event the contractor must agree to provide additional insured status to the owner on his CGL policy, then he should try to negotiate wording that limits the coverage to accidents that are related to his work only. This won’t completely eliminate the risk associated with 133

Like all other provisions in a contract, commercial terms and conditions associated with granting the owner additional insured status are negotiable. With respect to granting insured status to the owner, contractors need to ask themselves if they are in the construction business, or if they are in the insurance business.

A Typical Insurance Clause in a Construction Contract

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a claim made by the owner, but may minimize it. An example of typical wording that might be agreed to in the construction contract is as follows. Contractor will name Owner as additional insured on Contractor’s Comprehensive General Liability insurance policy for the liability of Owner only with respect to Owner’s general supervision of Contractor’s ongoing work, and only while Contractor is physically present and working at the job site. The policy shall have a deductible of $20,000 per occurrence and limit of $1,000,000 per occurrence and in the aggregate. Owner agrees to be responsible for and pay the deductible portion of any claim made by Owner. Owner also agrees that this coverage, including the payment of any defense costs, will satisfy and offset any indemnification obligation of Contractor contained in the contract.

Agreeing to the above sample wording or something similar won’t completely eliminate the risk associated with having an owner file a claim under the contractor’s CGL insurance policy. However, it can help limit the exposure to events that are strictly related to the contractor’s work and occur or arise only during the time the contractor is working on the job site. The owner can’t use this policy coverage to make claims for events unrelated to the contractor’s work or that take place away from the site, before the contractor arrives, or after he leaves the site. This is an important consideration on large, multi-disciplined projects that have construction activities occurring over a prolonged period of time and with multiple engineers, suppliers, inspectors, contractors, and subcontractors working for the owner. It’s helpful to take a look at a typical clause in a construction contract and break it down to better understand its requirements, and therefore, be able to take some action to limit unnecessary or excessive risk. Each of the subarticles in the following example are accompanied by explanatory notes (i.e., See Note 1) that follow the example. These notes provide analysis of the individual subarticles, and some offer suggestions for negotiating changes to the wording to lower the contractor’s commercial risk.

A Negotiating Tactic for the Elimination of Additional Insured Status

Here’s something to consider when negotiating additional insured status: make it conditional. Take a look at the below example language that might be negotiated to be included in the final contract’s commercial terms and conditions: It is agreed and understood that the Contractor’s obligation to provide additional insured status is contingent on the Contractor being paid on time and in accordance with the Contract’s payment terms. In the event the Contractor is not paid on time, or not in accordance with the Contract’s payment terms, the obligation to provide additional insured status is immediately deemed null and void.

Just remember, everything about a construction is negotiable, as long as it is not illegal. It is certainly not illegal to have a conditional obligation in the final construction contract. A Contractor could also consider using similar language to make a broad or intermediate form indemnity in the Contract a conditional obligation.

Why Do Owners Want Additional Insured Status?

The following issues are from an Owner’s perspective on why they would like to be named as an additional insured on the Contractors General Liability insurance policy. 1. Having someone else’s insurance pay a claim and provide defense (i.e. the Contractors’), the Owner’s own insurance experience rating that affects the Owner’s insurance premium is not affected. 2. The Owner likely can avoid paying from his own self-insured retentions (a self-insured retention is like a large insurance policy deductible). 3. The Owner receives insurance coverage that, perhaps, it may not have or be able to obtain. Bottom line: Additional insured status is a very, very good deal for the Owner and a lousy deal for the Contractor who agrees to provide this coverage.

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Article 20 – Insurance Requirements 20.1 Contractor shall purchase and maintain at his own expense the following minimum insurance covering the Work to be performed by Contractor under this Contract. (See Note 1.) 20.1.1 Workers’ Compensation and Employer’s Liability Insurance. Contractor shall provide Workers’ Compensation insurance, including occupational disease, as required by the applicable laws, and Employer’s Liability insurance with a limit of not less than $1,000,000 per occurrence. Contractor shall provide a waiver of subrogation in favor of Owner for the Employer’s Liability insurance. The insurance provided shall provide coverage for liabilities under the U.S. Longshoremen and Harbor Workers’ Compensation Act and the Jones Act, if applicable. (See Note 2.) 20.1.2 Automobile Insurance. Contractor shall provide automobile insurance for all owned, non-owned, hired, or leased vehicles. Such insurance shall have a combined single limit of not less than $1,000,000 per occurrence for bodily injury and property damage. (See Note 3.) 20.1.3 Comprehensive General Liability Insurance. Contractor shall provide Comprehensive General Liability insurance for bodily injury and property damage with a combined single limit of not less than $2,000,000 per occurrence. Such insurance shall also provide coverage for: a.) Premises and Operations b.) Underground Explosion and Collapse (XCU) c.) Products and Completed Operations d.) Broad Form Blanket Contractual (See Note 4.) 20.2 Builder’s Risk Insurance. Owner will provide Builder’s Risk insurance for damage to Owner’s property. Contractor will be named as an insured and will be responsible for the policy deductible of $10,000. (See Note 5.) 20.3 Owner shall be named as an additional insured on Contractor’s Comprehensive General Liability insurance. Such insurance shall include the cost of defense, shall be primary and non-contributory to any other insurance available to Contractor, shall provide a waiver of subrogation in favor of Owner, and shall contain a cross-liability or severability of interests clause. (See Note 6.) 20.4 Within 15 days after notice of award of this contract, but prior to any work being performed, Contractor shall provide for Owner’s approval and acceptance, certificates of insurance evidencing that the insurance required by this contract has been obtained and is in full force and effect. (See Note 7.) 20.5 Owner reserves the right to request from Contractor original or certified copies of insurance policies and endorsements for all insurance required to be provided by Contractor under this contract. (See Note 8.) 20.6 All insurance required by this contract shall remain in full force and effect with full policy limits applicable to the work to be performed under this contract and shall provide for not less than thirty (30) days written notice to Contractor prior to the effective date of any cancellation or material change of the insurance. (See Note 9.) 20.7 Any self-insured retention or deductible applicable to any policy shall be satisfied at the sole expense of Contractor. (See Note 10.)

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At first glance, this typical insurance clause requirement looks pretty straightforward and doesn’t seem to have unrealistic financial limits. Looks can be deceiving. The following notes contain an analysis of these insurance requirement clauses as they might apply to a construction project. Suggestions are provided on how to reduce the risk the contractor might otherwise have accepted without any changes, limitations, or deletions. Note 1: The only consideration here is the reference to minimum insurance. Contractors can’t buy minimum insurance. Insurance policies come in fixed amounts of coverage with fixed maximum limits. It’s best to delete the word “minimum.” Owners would love to be able to have stated minimum insurance coverage in the construction contract, with no maximum applicable, particularly insofar as they are an additional insured. Note 2: This is a standard requirement to provide Workers’ Compensation insurance and Employer’s Liability insurance with a typical financial limit. Note that the owner wants the contractor to waive his insurer’s subrogation rights. The contractor can do this as long as he understands that in the event the owner is responsible for a claim under employer’s liability, then his insurer will subsequently not be able to recover any money from the owner that is paid out for claims that arose from the owner’s negligence. The Jones Act provides coverage for sailors employed on American vessels. If the contractor’s project is on or near the water, then he should check to determine if the U.S. Longshoremen and Harbor Workers’ Compensation Act and/or the Jones Act apply. (The U.S. Longshoremen and Harbor Workers’ Compensation Act provides for the payment of compensation and medical benefits for the disability or death of an employee engaged in maritime employment.) Coverage for U.S. Longshoremen and Harbor Workers’ Compensation and the Jones Act must be added by endorsement to the contractor’s Workers’ Compensation Insurance. If this type of coverage is required, contractors need to advise their insurers so the coverage is actually provided. Note 3: This is a standard requirement for automobile insurance. Contractors would probably want to revise this paragraph to read: “$1,000,000 per occurrence and in the aggregate.” Contractors can’t buy insurance without some aggregate limit to the amount of claims that the insurer will pay out. Note 4: A standard requirement for Comprehensive General Liability insurance. Contractors would want to revise this paragraph to read: “$2,000,000 per occurrence and in the aggregate” for the same reason 137

as noted above under automobile insurance. Additional coverage required in the CGL policy: • Premises and Operations: for claims arising out of premises owned, rented, leased, or used by the contractor and for his operations at the construction site. • Underground Explosion and Collapse (XCU): for claims arising from explosion, collapse, or damage to underground property, such as foundations and piping. • Products and Completed Operations: coverage for claims after a manufactured product has been sold and after the contractor has completed his work. Typically covers claims that arise from defective work. • Broad Form Blanket Contractual: provides against claims for the liability of others assumed by the contractor under the contract with the owner. Note that the term “broad form” refers to coverage for claims made that involve the owner’s negligence, likely including those claims that arise out of his sole negligence. Contractual coverage typically includes the contractor’s assumption of the liability of others under any indemnification and/or hold harmless provisions of the contract. The term “blanket” just means that the contractor has the right to name someone as an additional insured to his CGL policy without specifically notifying the insurance company, as long as that requirement for AI is specifically contained in the commercial terms and conditions of the construction contract. (See Chapter 8 for more on indemnification and broad form indemnities.) Note 5: The owner is providing a Builder’s Risk insurance policy for coverage against property damage to the facility that he has hired the contractor and others to construct for him. The owner will name all contractors and others working on his project as additional insureds. Contractors are responsible for the first $10,000—­the policy deductible—­of any claim they make under this insurance policy. The owner should be willing to provide evidence of insurance, outlining the insurance coverage and exclusions. If details of the Builder’s Risk policy, including any exclusions, are not clearly noted in the contract provided by the owner, the contractor should ask for a copy of the actual builder’s risk policy for review. Note 6: There is a lot of risk to assume if this paragraph is accepted, with or without significant modification. The owner wants to be named as an additional insured to the contractor’s CGL insurance policy, thereby getting free insurance from the contractor. 138

This additional insured status also creates the possibility of claims being made by the owner for accidents occurring on the job site that may be totally unrelated to the contractor’s work. The owner also wants his additional insured status under the CGL insurance to include payment of any legal defense costs incurred by him in defense of a claim. Legal costs can of course be significant. The waiver of subrogation requested by the owner will prohibit the contractor’s insurer from using the legal process of subrogation to recover any money from the owner for claims it pays where the owner is actually the negligent party. To recap the consequences of agreeing to this paragraph: The owner would receive $2,000,000 worth of free insurance. His legal costs would be paid for if he has to defend against a claim. He may be able to make claims for accidents unrelated to the contractor’s work. He also has control over the claims process with the insurance company on claims he submits. Waiving the insurer’s rights of subrogation means the insurance company would not receive any money back from the owner for claims paid even though he was negligent. And, finally, any claims made by the owner will likely be charged against the contractor’s loss history, and his insurance premiums will probably increase. In the worst case, the insurer may not be willing to provide the contractor insurance for future projects. What to do with a requirement like this? Consider deleting the entire clause as part of the overall commercial negotiations for the contract and suggest that the owner buy an Owner’s and Contractor’s Protective policy (OCP) instead. Alternatively, limit the claims allowed to be made by the owner to only those directly related to the contractor’s work, and only to the time the contractor is physically present on the site. It’s also a good idea to: • Limit the defense costs to a relatively low dollar value, such as $25,000 or less.* • Limit the value of the subrogation waiver to the first $50,000 of claims paid.* • Contractually agree to a joint claims process in the event the owner files a claim under the policy. • Exclude any claims by the owner that are the result of his negligence. (* Note: Contractors should use dollar amounts that they are comfortable with and that make sense with respect to the value of the work they are performing.) Note 7: This is a normal request to provide some form of written evidence to the owner that the contractor has put in place the types and amounts of insurance required in the contract. 139

Note 8: The evidence of insurance the contractor is required to provide to the owner is a normal request. However, the contractor should not agree to provide original or certified copies of his insurance policies to the owner. The reason is that if there is a very large claim made, the total value of the contractor’s insurance policy will be public knowledge and he may be at risk. Let’s say the contractor has a CGL policy with a limit of $10,000,000 that provides coverage for one year for all his construction operations, wherever they may take place. He would not want to disclose this upper limit if all that the owner requires is $2,000,000 of CGL. The insurer will provide the owner with acceptable evidence of insurance acknowledging that the required $2,000,000 of CGL is in place for the project. Providing evidence of insurance certificates is a normal and standard practice; providing original insurance policies is not. The owner has no right, legal or otherwise, to compel contractors to provide original copies of their insurance policies, unless they agree contractually to provide such. Note 9: This is a standard notification requirement in the event that the contractor’s insurance policies are cancelled or changed. Contractors should make sure their insurance policies have similar notification times included. Note 10: This paragraph states that the contractor is responsible for the deductible portion of any insurance coverage. While this may be stating the obvious, it is inserted here so there is no confusion over who is responsible for the deductible for insurance provided by the contractor.

Safety

The best insurance policy a contractor can have is a good safety program for employees and construction activities.

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After all is said and done, there is still no better risk management tool than a first-class job site safety program. As stated earlier, the construction job site is probably one of the riskiest places to perform work. Contractors don’t want to be responsible for someone getting injured or property being damaged while they’re working. More and more construction contracts are requiring formal safety programs and dedicated safety personnel to be a part of the contractor’s construction activities. Many progressive owners develop construction projects that include incentive programs to financially reward safe contractors. While the specifics of implementing safety programs are beyond the scope of this book, these measures are well worth noting here, because contractors with exemplary safety records and effective safety programs will always be able to get the best insurance rates to cover their construction activities. They will also get more work, as unsafe contractors should be excluded from the workplace. So, safety pays!

Chapter

8

Indemnity

An indemnity clause is probably one of the most high-­risk commercial terms and conditions in a construction contract and has the potential to bankrupt a construction company. Simply stated, an indemnity clause is essentially a risk transfer device, often seemingly designed to be unfair to contractors. Sound harsh? Perhaps it is. On most construction projects, however, an owner’s risk management goal is often to find a way to protect himself from all risks and claims against him that may arise before, during, or after the construction project (regardless of whether or not he is negligent with respect to causing the claims). In a construction contract, an indemnity clause is a contractual risk and a potential financial liability transfer device. What does risk transfer by way of the construction contract mean to the contractor? It means that the contractor agrees, in writing, to accept the financial responsibility that may arise from certain types of claims against the owner, even when the owner’s negligence was the cause of those claims.

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Insurance & Indemnity

There is often confusion over the difference between insurance and indemnity. While the two terms are similar in the sense that both serve to contractually transfer certain risks to other parties, they are different in the following ways • Insurance protects the owner, through an insurance company, against certain defined risks and associated potential financial liability. The insurance company pays the claims from its own financial resources. • An indemnity clause protects the owner against certain defined risks and their associated potential financial liability. The contractor, who generally takes on the risk, may have to pay any claims from his own financial resources.

Indemnity Definitions

The following is one definition of indemnity: • A contractual obligation by which the contractor agrees to protect the owner from certain risks and the associated financial liabilities that may be incurred by the owner. Here is an alternative: • An indemnity clause transfers the potential financial liability of certain owner’s risks to the contractor. Finally, here is another, more straightforward definition of indemnity between an owner and a contractor: • An indemnity is a contractual obligation by which the contractor agrees to be responsible for certain risks and the associated financial liabilities that arise out of claims attributable to some or all of the owner’s negligence. This last definition is a good one to remember, because it is specifically designed to emphasize the risk the contractor will accept, by way of the contract, when agreeing to an indemnity clause. All three definitions are essentially correct. There certainly are more complex and precise legal and commercial definitions available, but these are designed to get right to the heart of the matter as simply as possible as they apply most often to construction contracts. There are a few basic terms and concepts that are important for contractors to understand when reviewing indemnity clauses. They are: • Tort liability: The financial liability that arises from a negligent act that causes harm to persons or property. Courts usually

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resolve tort liability claims by awarding monetary damages. Broad form and intermediate form indemnity clauses seek to transfer the owner’s tort liability arising out of his negligent acts to the contractor. • Broad form indemnity: The contractor assumes the potential financial liability for claims arising out of any amount of the owner’s negligence, including the owner’s sole negligence. • Intermediate form indemnity: The contractor assumes the potential financial liability for claims arising out of any amount of the owner’s negligence, except those claims attributable to the owner’s sole negligence. • Limited form indemnity: The contractor assumes the potential financial liability for claims arising only out of his own negligence. The contractor does not assume the financial liability for claims arising out of any amount of the owner’s negligence.

• To indemnify: The contractor agrees to accept financial responsibility for a loss suffered by the owner. • To hold harmless or to save harmless: The contractor agrees to reimburse the owner for a loss.

Transferring the Owner’s Risks to Contractors

The most common risks for which the owner would want the contractor to assume potential financial liability are: • Personal injury: When a person is injured on the owner’s construction project, and the owner is, to some degree, negligent in causing the injury. • Death of a person: When a person is killed on the owner’s construction project, and the owner is, to some degree, negligent in causing the death. • Property damage: When property is damaged or destroyed on the owner’s construction project, and the owner is, to some degree, negligent in causing the damage or destruction. • Owner’s defense costs: The legal defense costs that an owner would incur in defending himself against a claim for personal injury, death, or property damage on the project site.

Fairness Is Not a Consideration

It makes no sense to be subtle about what indemnities are designed to do; in construction contracts, they are designed to get the contractor to pay for the financial liabilities that arise out of claims attributable to the owner’s negligence. An analogy is that an indemnity is an owner’s “get out of jail free card” for those readers who are familiar with the board game of Monopoly™.

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The indemnity clause in the construction contract is designed to shift some or all of an owner’s risks and their associated potential financial liability to the contractor.

Is an Indemnity Required in a Construction Contract?

How can the contractor be responsible, for example, for an injury to a person on the job site, or for some property damage on the site that the owner may have caused? Easy. The contractor agrees to accept this responsibility by agreeing to the wording in the indemnity clause in the construction contract. Although it may sound harsh, there is no such thing as a fair indemnity clause in a construction contract. Indemnities are not designed to be fair; they are designed to contractually transfer the responsibility for potential financial liabilities from the owner to the contractor. The fairest indemnity is when there is no indemnity in a construction contract. There is no requirement—statutory, moral, or otherwise—that a construction contract must have an indemnity clause. Contractors should not get their hopes up too much, however, on convincing an owner to delete the indemnity provisions in his construction contract. A progressive owner may consider deleting the indemnity clause in the construction contract, but for many owners, indemnity provisions occupy an exalted position in their risk management program for construction contracts. By eliminating the indemnity clause, both the owner and the contractor end up being responsible for the financial consequences for claims attributable to their own negligence. No risk transfer to the contractor from the owner takes place. Although it tends to be difficult to convince owners to delete their favorite indemnity clause, it doesn’t hurt to propose doing so. Owners often will agree to modify the language of the indemnity clause to be less onerous, but they probably will insist on keeping some form of the clause in the contract. Often, through good negotiation, the language in an indemnity clause can be modified so that the final wording provides little, if any, transfer of the owner’s risk to the contractor. This would meet the owner’s goal of keeping some form of an indemnity clause in the construction contract, even though it may only state what the contractor is legally responsible for.

Anti-Indemnity Legislation

Unlike any other commercial terms and conditions that may be found in a construction contract, indemnity clauses have historically been so unfair in some cases that they have caught the attention of the lawmakers in many states. Several states have enacted some form of legislation declaring that an indemnification agreement in a construction contract obligating one party to a contract (contractor) to assume the potential financial responsibility arising out of claims attributable, to some degree, to

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Remember, everything is negotiable in a construction contract, as long as it’s not illegal. And it is certainly not illegal to negotiate more favorable contract language to reduce the amount of risk a contractor accepts in a construction project.

the negligence of the other party (owner) is against public policy and is, therefore, void and unenforceable. Anti-indemnity legislation varies state to state. Some states have anti-indemnity laws that exclude the contractor’s assumptions of liability only for the sole negligence of the owner. Other laws exclude the contractor’s assumptions of liability for the partial and sole negligence of the owner. Some allow for contractors to provide insurance coverage of their assumptions of owner’s liability, yet others only address public works, professional services, or oil- and gasrelated projects. As of the publication of this book, the 37 states in tables have enacted some form of anti-indemnity legislation applicable to the construction industry for private and/or public work:

Anti-Indemnity State Statutes

The following 26 states outlaw both Broad and Intermediate form indemnities in Private Contracts. California

Colorado

Connecticut

Delaware

Florida

Illinois

Iowa

Kansas

Kentucky

Minnesota

Mississippi

Missouri

Montana

Nebraska

New Hampshire

New Mexico

New York

North Carolina

Ohio

Oklahoma

Oregon

Rhode Island

Texas

Utah

Washington

Wisconsin

The following 17 states outlaw only Broad Form indemnities in Private Contracts. Alaska

Arizona

Arkansas

Georgia

Hawaii

Idaho

Indiana

Maryland

Massachusetts

Michigan

New Jersey

Nevada

South Carolina

South Dakota

Tennessee

Virginia

West Virginia

The following 6 states allow Broad and Intermediate Form indemnities. Alabama

Maine

North Dakota

Pennsylvania

Vermont

Wyoming

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Since the degree of protection afforded contractors by the anti-indemnity legislation in each state varies, contractors should always take the time, or seek professional assistance, to understand the antiindemnity laws in effect in the state in which they are working or the laws of the state as may apply to the contract.

The text of the anti-indemnity statutes can be found through an online search. Also, there is a lot of information regarding indemnities in construction contracts, and information on the anti-indemnity statutes noted above. The American Subcontractors’ Association Inc. provides excellent and timely information on the various states’ anti-indemnity legislation (http://www.asaonline.com). No question about it— anti-indemnity legislation is good for contractors, but don’t clap yet. There are several ways that owners can circumvent the law. Agreeing to any form of indemnity in an anti-indemnity state, with the belief that it is unenforceable, doesn’t guarantee the contractor that his insurance carrier won’t end up paying the bill for some amount of the owner’s negligence.

Sample State Statutes

The following are examples of anti-indemnification legislation for three states, South Carolina, Montana, and Alabama, along with some accompanying notes.

South Carolina State Statute South Carolina State Statute 32-2-10: Hold Harmless Clauses in Certain Construction Contracts Void as Against Public Policy Notwithstanding any other provision of law, a promise or agreement in connection with the design, planning, construction, alteration, repair, or maintenance of a building, structure, highway, road, appurtenance, or appliance, including moving, demolition, and excavating, purporting to indemnify the promisee (typically, the Owner), its independent contractors, agents, employees, or indemnitees against liability for damages arising out of bodily injury or property damage proximately caused by or resulting from the sole negligence of the promisee (typically, the Owner), its independent contractors, agents, employees, or indemnitees is against public policy and unenforceable. Nothing contained in this section shall affect a promise or agreement whereby the promisor (typically, the Contractor) shall indemnify or hold harmless the promisee (typically, the Owner) or the promisee’s (typically, the Owner’s) independent contractors, agents, employees, or indemnitees against liability for damages resulting from the negligence, in whole or in part, of the promisor (typically, the Contractor), its agents or employees. The provisions of this section shall not affect any insurance contract or Workers’ Compensation agreements; nor shall it apply to any electric utility, electric cooperative, common carriers by rail and their corporate affiliates or the South Carolina Public Service Authority.

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1. The italicized words in parentheses have been added by the author for clarification to identify who is a typical promisee or promisor, e.g., (typically, the Owner). 2. The statute bars indemnities for sole negligence (typically, a broad form of indemnity where the owner requires the contractor to indemnify him for claims arising out of the owner’s sole negligence). 3. The statute allows insurance, such as having the owner named as an additional insured on the contractor’s General Liability policy, to cover indemnity obligations. 4. The statute does not apply to certain South Carolina public or quasi-public organizations. For example, a contract with the South Carolina Department of Transportation (a public organization) would likely be exempt from the provisions of this anti-indemnity statute.

Montana State Statute Montana State Statute 28-2-2111: Construction Contract Indemnification Provisions (1) Except as provided in subsections (2) and (3), a construction contract provision that requires one party to the contract to indemnify, hold harmless, insure, or defend the other party to the contract or the other party’s officers, employees, or agents for liability, damages, losses, or costs that are caused by the negligence, recklessness, or intentional misconduct of the other party or the other party’s officers, employees, or agents is void as against the public policy of this state. (2) A construction contract may contain a provision: (a) requiring one party to the contract to indemnify, hold harmless, or insure the other party to the contract or the other party’s officers, employees, or agents for liability, damages, losses, or costs, including but not limited to reasonable attorney fees, only to the extent that the liability, damages, losses, or costs are caused by the negligence, recklessness, or intentional misconduct of a third party or of the indemnifying party or the indemnifying party’s officers, employees, or agents; or (b) requiring a party to the contract to purchase a projectspecific insurance policy, including but not limited to an owner’s and contractor’s protective insurance, a project management protective liability insurance, or a builder’s risk insurance. (3) This section does not apply to indemnity of a surety by a principal on a construction contract bond or to an insurer’s obligation to its insureds. (4) As used in this section, “construction contract” means an agreement for architectural services, alterations, construction, demolition, design services, development, engineering services, excavation, maintenance, repair, or other improvement to real property, including any agreement to supply labor, materials, or equipment for an improvement to real property.

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Notes on Montana’s legislation: 1. The statute bars indemnities for sole and/or partial negligence (typically, a broad form or intermediate form indemnity where the owner requires the contractor to indemnify him for claims arising out of the owner’s partial and/or sole negligence). 2. The statute allows indemnities that apply only to the extent of the parties’ negligence (limited form indemnity). 3. The statute allows project-specific insurance, e.g., an OCP, to be purchased to cover liabilities that might typically be transferred in an indemnity. 4. The statute appears to apply to both public and private projects.

Colorado State Statute Colorado Revised Statute Title 13, 13-50.5-102, Section 8(a) (8)(a) Any public contract or agreement for architectural, engineering, or surveying services; design; construction; alteration; repair; or maintenance of any building, structure, highway, bridge, viaduct, water, sewer, or gas distribution system, or other works dealing with construction, or any moving, demolition, or excavation connected with such construction that contains a covenant, promise, agreement, or combination thereof to defend, indemnify, or hold harmless any public entity is enforceable only to the extent and for an amount represented by the degree or percentage of negligence or fault attributable to the indemnity obligor or the indemnity obligor’s agents, representatives, subcontractors, or suppliers. Any such covenant, promise, agreement, or combination thereof requiring an indemnity obligor to defend, indemnify, or hold harmless any public entity from that public entity’s own negligence is void as against public policy and wholly unenforceable.

Notes on Colorado’s legislation: 1. The statue outlaws broad and intermediate form indemnities. 2. The statute allows indemnities that apply only to the extent of the party’s negligence (limited form indemnity). 3. Contractors should also take the time to read the lengthy and comprehensive Colorado Revised Title 13, Section 13-21-111.5. a. This Sections allows limited form indemnities. b. This Section reaffirms that broad and intermediate form indemnities are void and unenforceable. c. This Section voids, with conditions, providing additional insured status.

Alabama State Statute

As of the publication date of this book, Alabama does not have an anti-indemnity statute. 148

Without an anti-indemnity statute in place, a contractor may not have any legal protection against a broad or intermediate form indemnity in a construction contract. In other words, a contractor who agrees to a broad or intermediate form indemnity in a construction contract where Alabama state law applies—even though he may not even be working in Alabama—could potentially be held liable to pay for claims for personal injury and property damage, and legal defense of those claims, that arise out of the owner’s sole or partial negligence.

Texas State Statute Sec. 151.102. AGREEMENT VOID AND UNENFORCEABLE. Except as provided by Section  151.103, a provision in a construction contract, or in an agreement collateral to or affecting a construction contract, is void and unenforceable as against public policy to the extent that it requires an indemnitor to indemnify, hold harmless, or defend a party, including a third party, against a claim caused by the negligence or fault, the breach or violation of a statute, ordinance, governmental regulation, standard, or rule, or the breach of contract of the indemnitee, its agent or employee, or any third party under the control or supervision of the indemnitee, other than the indemnitor or its agent, employee, or subcontractor of any tier. Sec. 151.103. EXCEPTION FOR EMPLOYEE CLAIM. Section 151.102 does not apply to a provision in a construction contract that requires a person to indemnify, hold harmless, or defend another party to the construction contract or a third party against a claim for the bodily injury or death of an employee of the indemnitor, its agent, or its subcontractor of any tier. Sec. 151.104. UNENFORCEABLE ADDITIONAL INSURANCE PROVISION. (a) Except as provided by Subsection (b), a provision in a construction contract that requires the purchase of additional insured coverage, or any coverage endorsement, or provision within an insurance policy providing additional insured coverage, is void and unenforceable to the extent that it requires or provides coverage the scope of which is prohibited under this subchapter for an agreement to indemnify, hold harmless, or defend. (b) This section does not apply to a provision in an insurance policy, or an endorsement to an insurance policy, issued under a consolidated insurance program to the extent that the provision or endorsement lists, adds, or deletes named insureds to the policy.

Notes on the Texas legislation; 1. The statute outlaws broad and intermediate form indemnities. 2. The statute outlaws additional insured status. 3. The above Sections were taken from Texas Statute 151. Contractors should take the time to read the entire Section as there are other provisions and exclusions. 149

Examples of Indemnity Example Number 1: 53 Words Indemnification to Bankrupt a Contractor below is an example of an indemnity clause that might be Clauses Noted found in a typical construction contract: Article 20 – Indemnity 20.1 Contractor shall defend, indemnify, and save Owner harmless from all claims for injuries to, or death of, any and all persons, and for loss of or damage to property arising under or by reason of this Contract, except claims resulting from the sole negligence of Owner, his employees, his subcontractors, agents, or representatives.

• “Contractor shall defend. . .” means that contractor will take responsibility to defend the owner in a legal action, and pay for the cost of defense, for all claims of personal injury, death, or property damage (made by anyone). • “Contractor shall. . .indemnify. . .” means that the contractor agrees to be financially responsible for any court judgments against the owner that are associated with claims for personal injury, death, or property damage. • “Contractor shall. . .save owner harmless. . .” means that the contractor agrees to pay or reimburse the owner for any financial judgments against him a court may award for claims associated with personal injury, death, or property damage. • “. . . from all claims for injuries to, or death of, any and all persons, and for loss of or damage to property. . .” broadly and without exception describes the type of claims (risks) the contractor agrees to defend the owner against, assume responsibility for, and pay for any resulting court awarded monetary damages. • “. . . arising under or by reason of this Contract. . .” means that all claims for personal injury, death, or property damage that the owner can somehow, rightly or wrongly, attribute to the contractor’s work, regardless of fault, are covered under this indemnity clause. The use of the phrases “arising under. . .this contract” and “or by reason of this contract” are left to broad interpretation that the owner, and ultimately the court, may choose to apply in the event a claim and legal action is made against the owner by some third party associated with the contract. In the event a claim is made against the owner for an accident that took place on his work site, or even away from the site or before construction begins, then he will look to the contractor 150

to protect him under the broadly interpreted “arising under or by reason of this Contract” wording in the indemnity clause. Note that these words say nothing at all about whether the contractor had any responsibility for the claims, only that the contractor just accepts the responsibility to pay for them. Typically, when the owner notifies the contractor about a claim, the contractor would deny that the claim met the test of “arising under or by reason of this Contract” and refuse to defend the owner, or pay for the owner’s defense costs and/or the amount of any financial judgment against the owner. A lawsuit would most likely be initiated by the owner and left to the court to decide if the claim actually met the test of “arising under or by reason of this Contract” Leaving the courts to interpret this language can be a risky roll of the dice for the contractor—­and expensive! If 100 people were asked what the words “arising under or by reason of this Contract” mean, 100 different answers would probably be given. Contractors take on a lot of risk by allowing a judge in a court of law to interpret these words. It’s not difficult to imagine what might happen if the judge has not had any construction-­related experience. Rather than taking the risk of allowing a court to interpret a broadly worded indemnity clause, it’s more responsible contracting to negotiate less risky wording in an indemnity clause, or get rid of the indemnity clause in its entirety. • “. . . except claims resulting from the sole negligence of Owner, his employees, or his subcontractors, agents, or representatives.” This wording means that the owner, his employees, subcontractors, agents, or representatives agree to be responsible only for those claims resulting from their sole negligence. The only reason this “sole negligence” wording is included in the indemnity clause is because of the anti-­ indemnity legislation enacted by various states. Many of the anti-­indemnity states prohibit the owner from making someone else, like the contractor, responsible for the potential financial liability associated with claims attributable to the owner’s sole negligence. Sole negligence means the owner is 100% responsible for the circumstances that caused the claim resulting in the lawsuit. Contractors should bear in mind that on a job site with multiple contractors, subcontractors, material suppliers, inspectors, owner’s representatives, and the like, it may be extremely difficult to prove “sole negligence.” 151

What happens if the court determines the owner to be 95% negligent, and the contractor is found to be 5% negligent in a claim? In this sample clause, the contractor may still have to pay the entire claim because the owner was not determined to be solely (100%) negligent. In this event the court may decide to enforce the indemnity clause and make the contractor pay the full amount of the claim, since the owner was not solely negligent, as well as require him to reimburse the legal defense costs of the owner. The contractor should not overlook the diverse group of people he is agreeing to indemnify. In the earlier sample clause, the people defined as the “owner and his employees” is straightforward and easy enough to understand. However, the people defined as “subcontractors, agents, and representatives” is unclear. Are the subcontractors of the owner even on the job site? Who is an agent or representative of the owner? Where are all these people located? Are they all following proper safety procedures, such as refraining from smoking and wearing safety goggles, shoes, and hard hats? The contractor, and maybe even the owner, may have little or no control over the behavior of this diverse group of people, yet the contractor is agreeing to be financially responsible—­by way of the indemnity clause—­for claims that may be the result of their negligent behavior. This situation could result in a significant claim and possibly a large financial loss for the contractor. In addition, there is nothing contained in this indemnity clause that limits the potential financial liability of the contractor. Theoretically, the contractor would be liable to pay for unlimited legal defense costs of the owner, and unlimited financial awards a court would make for a claim covered under this indemnity agreement. A large award made by a court under this indemnity clause could bankrupt a contractor. It could also exhaust a contractor’s insurance coverage if he has contractual liability insurance to cover this type of potential financial liability. Should this example indemnity scare a contractor? Yes, it should. There is an enormous amount of owner’s risk transferred to the contractor when he accepts the 53 words of this indemnity example.

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Clear and Unequivocal

Take a look at Article 20 – Indemnity, presented below is a different manner. Article 20 – Indemnity 20.1 Contractor shall defend, indemnify, and save Owner harmless from all claims for injuries to, or death of, any and all persons, and for loss of or damage to property arising under or by reason of this Contract, except claims resulting from the sole negligence of Owner, his employees, his subcontractors, agents or representatives.

Or, you might see the same Article 20 – Indemnity, presented below in another different manner. Article 20 – Indemnity 20.1 CONTRACTOR SHALL DEFEND, INDEMNIFY, AND SAVE OWNER HARMLESS FROM ALL CLAIMS FOR INJURIES TO, OR DEATH OF, ANY AND ALL PERSONS, AND FOR LOSS OF OR DAMAGE TO PROOPERTY ARISING UNDER OR BY REASON OF THIS CONTRACT, EXCEPT CLAIMS RESULTING FROM THE SOLE NEGLIGENCE OF OWNER, HIS EMPLOYEES, HIS SUBCONTRACTORS, AGENTS OR REPRESENTATIVES.

Some States may allow such indemnities as shown above because they are “clear and unequivocal.” The “clear and unequivocal” consideration comes because the indemnities as written are in either bold print or bold capitalized print. This sets the indemnity clause apart from all the other clauses in the contract that are not written in bold or bold and capitalized print. The compelling argument seems to be: “Mr. Contractor, how could you possibly not miss or misunderstand this clause?”

Indemnity Example Number 2: More Words to Bankrupt a Contractor

Following is an example of a lengthier indemnity clause that was designed to cover anyone remotely associated with the owner—and just about every conceivable situation that could happen on a construction job site.

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Article 20 – Indemnity To the fullest extent permitted by law, Contractor shall indemnify and hold harmless Owner, Lender, Construction Adviser, and all their respective parents, subsidiaries, affiliated companies, agents, representatives, and employees (each individually and all collectively referred to hereinafter as “Indemnitee”), from and against (i) all claims, suits, actions, and proceedings (Claims), whatsoever which may be brought or instituted on account of, grow out of, occur from, be incident to, or result directly or indirectly from any and all injuries to persons (including death) or damage to property (whether property of the parties hereto or of others) in connection with or growing out of the Work or the performance or nonperformance by Contractor of its obligations under this Contract, and (ii) all losses, costs, damages and expenses related to the Claims, including, but not limited to, attorney’s fees and other costs of defending the Claims. Contractor’s indemnity given herein shall apply with full force and effect whether or not any such injury, death, or damage results from or is claimed to have resulted from, in whole or in part, the negligence of any Indemnitee. Contractor shall conduct with due diligence and in good faith the defense of all Claims against any Indemnitee, even if such Claims be groundless, false, or fraudulent and shall bear the cost of all judgments and settlements in connection therewith; provided, however, without relieving Contractor of its obligations under the Contract, and Indemnitee, at its election, may defend or participate in the defense of any Claim against such Indemnitee. Maintenance by Contractor of insurance covering the liability of Owner hereunder shall not affect Contractor’s obligations hereunder, and the limits of such insurance shall not constitute a limitation of Contractor’s liability under this indemnity.

There are a lot of words contained in this clause, but the end result is the same as in the first example—the contractor assumes an unlimited amount of potential financial liability for the owner’s defense costs and claims for personal injury and property damage that may be caused by any amount of negligence of the owner and the other diverse groups and individuals identified. The amount of risk transferred to the contractor is similar to the first example, just more wordy. Let’s break it down and see what the contractor is actually agreeing to accept. • The words “to the fullest extent permitted by law, Contractor shall indemnify and hold harmless Owner, Lender, Construction Adviser and all their respective parents, subsidiaries, affiliated companies, agents, representatives, and employees (each individually and all collectively referred to hereinafter as ‘Indemnitee’)” obligate the contractor to take responsibility for (indemnify) and pay for (hold harmless) claims made against the large group of companies and individuals listed. This is legalese. It is hard to imagine an owner agreeing to wording that read, for example, “only to 50% of that permitted by law.” 154

The phrase “To the fullest extent of the law” is used in an effort to keep the clause from being totally voided by a court. These words are inserted so that, if the indemnity clause is ruled unenforceable or void by a court, then the owner can try to argue, “What is the fullest extent of the law that can be applied for an indemnity in this situation? We’ll take that, thank you.” These words are sometimes referred to as a “survival clause,” in the sense that it’s better to get something out of the indemnity rather than nothing. Note that the diverse group of companies and individuals is made capitalized and therefore a defined term: indemnitee. This helps simplify the wording when the group is referenced later on in the indemnity clause. This is good contracting form, but it is still a large, undefined, and uncontrollable group of people to be responsible for, especially if a claim arises from their negligent actions or behavior. • The next words: “from and against (i) all claims, suits, actions, and proceedings (Claims), whatsoever which may be brought or instituted on account of, grow out of, occur from, be incident to, or result directly or indirectly,” define the different events that make up the capitalized and therefore defined term “Claims,” and go on further to define in detail how any claim is related to the contract and to the contractor’s work. • Reworded, the relationship of the claims covered by this indemnity to the contractor’s work might read: “brought or instituted on account of Contractor’s work, grows out of Contractor’s work, occurs from Contractor’s work, as may be incident to Contractor’s work, or results directly or indirectly from Contractor’s work.” Basically these words mean that if the owner can attribute a claim made against him to the contractor’s work for any reason whatsoever, it’s likely he will attempt to get the contractor to pay for the claim under the provisions of this indemnity clause. • Continuing on, the next words: “from any and all injuries to persons (including death) or damage to property (whether property of the parties hereto or of others) in connection with or growing out of the Work or the performance or nonperformance by Contractor of its obligations under this contract, and (ii) all losses, costs, damages and expenses related to the Claims, including, but not limited to, attorney’s fees and other costs of defending the Claims.” This defines what types of claims are to be covered by this indemnity clause. Note there is no financial limitation available to the contractor in this clause with respect 155

to his assumption of these losses, costs, damages, expenses, and defense costs. • Next: “Contractor’s indemnity given herein shall apply with full force and effect whether or not any such injury, death, or damage results from or is claimed to have resulted from, in whole or in part, the negligence of any Indemnitee.” This clause obligates the contractor to take full and complete responsibility for the potential financial liability for claims that may be the result of the indemnitee’s negligence, possibly including the indemnitee’s sole negligence, as sole negligence is not specifically excluded.

An Example

Let’s say a claim is made against the owner by one of the contractor’s employees, who is injured at the job site, and this results in a $1,000,000 court award. The owner was deemed 100% responsible (solely negligent) for the injury resulting in the claim. The owner now takes the contractor to court to try to recover all his defense costs and the full amount of the $1,000,000 court award. He argues that this protection is provided to the owner by the contractor per the terms of the construction contract’s indemnity clause. In an anti-­indemnity state, it’s likely the court would declare the indemnity as void and unenforceable, as it provides for the contractor being responsible for the sole negligence of the indemnitee. Indemnities that transfer the potential financial liability for claims attributable to the sole negligence of the owner are generally held to be unenforceable in anti-­indemnity states. In this case, the contractor would likely have a good chance of being relieved of any payment obligations under the indemnity clause. However, if this situation occurred in a state (or country) that did not have any anti-­indemnification statutes, then the court could choose to enforce the provisions of the indemnity clause, and the contractor (or his insurer, or both) would get stuck with having to pay the owner the $1,000,000 plus the owner’s defense costs. That’s a lousy deal for the contractor. Given the size of personal injury awards made today, the $1,000,000 may be small! It could be much, much more.

• Finally, the clause states, “Maintenance by Contractor of insurance covering the liability of Owner hereunder shall not affect Contractor’s obligations hereunder, and the limits of such insurance shall not constitute a limitation of Contractor’s liability under this indemnity.” The last part of this indemnity just says that the amount of the contractor’s contractual liability insurance available to cover this type of contractual obligation 156

can’t be construed to be a limit on how much the contractor would have to pay out for a claim. A little better explanation is that if a judgment under the indemnity required the contractor to pay a claim of $1,000,000, and his contractual liability insurance paid only $500,000, then the contractor would be stuck paying $500,000 out of his own pocket. The contractor could not claim that his financial liability was limited to the $500,000 available through his contractual liability insurance coverage. This second indemnity example was written to make the contractor financially responsible for just about anything that would happen on or off the job site—­before the work started, during the course of the work, and after the work was completed. A claim would not necessarily have to have any relation to the contractor’s work, and regardless of the degree of negligence attributable to anyone in the long list of companies and individuals defined as the indemnitees, the contractor would still have to pay. The responsibilities described in this second indemnity example, and in similar broadly worded indemnities, have actually been accepted by contractors. Maybe those contractors who accept such indemnity language just close their eyes, cross their fingers, and pray nothing bad happens on the job. Some contractors will say that they have Contractual Liability insurance to cover the potential financial liability exposure contained in an indemnity clause. They may believe that they don’t need to worry about how onerous the terms of an indemnity clause are. It’s true that contractual liability insurance can provide some measure of protection against the financial liability that may arise from an indemnity. However, contractors should not forget that once an insurance company pays out a large claim, the relationship between the contractor and the insurance company will likely change. In the future, the insurance company might charge significantly higher premiums for similar coverage, or they might decide to cancel the contractor’s policy or not provide coverage on future projects.

Indemnification, Additional Insured Status, & Contractual Liability Insurance

Many standard formats of Commercial General Liability insurance policies include a separate provision to provide the contractor insurance coverage for what is called contractual liability. Contractual Liability insurance is typically provided as a component of the Commercial General Liability (CGL) policy. It is designed to provide insurance coverage for the named insured (the contractor) for the potential financial liability that can arise from the contractor’s assumption of the owner’s liability for claims associated with personal 157

Contractual Liability insurance covers the contractor for the financial liability under a construction contract’s indemnity agreement. It applies to personal injury and property damage claims attributable to the negligence of the owner, and the owner’s associated legal defense costs.

injury, damage to or loss of property, and legal defense of such claims. These assumptions of the owner’s liability are typically found in the owner’s indemnity clause in the construction contract. Some insurers may require contractual liability coverage to be added to the contractor’s CGL policy by way of a specific endorsement. From an insurance industry standpoint, Contractual Liability insurance covers the personal injury, property damage, and legal defense costs risks assumed by a contractor under what the insurance industry calls an “insured contract.”

What Is an Insured Contract?

As it applies to a typical construction contract, an insured contract is defined by the insurance industry as that part of an agreement (a construction contract) in which the contractor assumes the tort liability of the owner for claims involving injury to persons, death of persons, and property damage. The tort liability of the owner usually arises from an accident attributable in whole or in part to the owner’s negligent acts or behavior. These assumptions of liability for claims for personal injury and property damage arising from the negligence of the owner, and the additional liability for payment of the owner’s defense costs for such claims, are typically found in the construction contract’s indemnity clause. Of particular note is that there is often nothing contained in the insurance industry’s definition of an insured contract that defines what degree of owner negligence is covered by the insurance. The owner could be anywhere from barely (1%) negligent all the way to solely (100%) negligent for the accident that caused the claim. This insurance can, unless specifically limited, cover the risks associated with the assumptions of liability contained in a broad form indemnity (defined earlier).

Additional Insured Status & Contractual Liability Insurance

When a contractor adds an owner as an additional insured to his CGL policy, the owner receives the free benefit of having full access to the coverage provided by the included contractual liability insurance. This is on top of the free insurance coverage he receives as an additional insured for claims involving his vicarious liability, maybe his own negligence, and perhaps even for claims arising out of completed operations. It might appear that all of this insurance coverage required by the owner in his standard construction contract (additional insured 158

status plus contractual indemnity) is overlapping or redundant. This apparent “doubling up” of coverage by having additional insured status/contractual liability plus the addition of an indemnity agreement is a good deal for the owner, as his risk transfer department or consultant is keenly aware. Why not just require one or the other risk transfer mechanism to cover the risks the owner wants to transfer to the contractor or to the contractor’s insurance company? Why are two similar risk transfer provisions commonly required? The consequences of this “doubling up” of coverage are best described by the following example: • The insurance clause of the owner’s construction contract requires the contractor to: “add owner as an Additional Insured to Contractor’s Commercial General Liability insurance policy, which policy shall also include Contractual Liability insurance covering Contractor’s contractual obligations under the Indemnity clause contained in the Construction Contract.” • The indemnity clause of the owner’s construction contract requires the contractor to: “defend, indemnify, and save Owner harmless from all claims, including any claims which may involve Owner’s negligence, for injuries to persons, or death of persons, and for loss of or damage to property arising under this Contract.”

An Example

Let’s say that an accident injuring a person occurs on the ­contractor’s job site. The cause of the accident turns out to be the result of the sole (100%) negligence of the owner. The injured person sues the owner for damages and is awarded $500,000. The owner’s defense costs for the claim amount to $100,000. In total, the owner is out $600,000. The owner then sues the contractor, demanding that the contractor indemnify and hold him harmless for the amount of award plus all his accrued defense costs (in simpler words: accept responsibility for the claim and reimburse him $600,000) in accordance with the terms of the indemnity agreement contained in the construction contract. The indemnity clause transferred the complete financial liability, including all of the owner’s defense costs, to the contractor, even though the owner was solely negligent. The state in which the court case takes place is an anti-­indemnity state that prohibits ­agreements in construction contracts that require the indemnitor (the contractor) to indemnify, hold harmless, and defend the ­indemnitee (the owner) for claims involving the indemnitee’s (the owner’s) sole negligence. 159

The court determines that the indemnity clause contained in the construction contract between the owner and the contractor violates the state’s anti-indemnity statute. Therefore, it rules the owner’s indemnity clause void and unenforceable. As a result, the owner’s risk transfer coverage for claims arising out of his negligence that he believed he had under the indemnity clause is eliminated. Not to be deterred, the owner’s risk management group now demands that the insurance company that provided the contractor’s CGL policy (to which the owner was named as an additional insured) reimburse the cost of the claim and the defense costs associated with the claim. If the court ruled that the indemnity clause was void and unenforceable, how can it be, then, that the contractor’s insurance company must now reimburse the owner for the amount awarded under this claim, as well as the owner’s defense costs, since the accident that caused the claim was attributable to the sole negligence of the owner? The “doubling up” effect mentioned earlier of having an indemnity from the contractor, plus having the additional insured status on the contractor’s CGL policy now pays wonderful dividends for the owner. The state anti-indemnity statute, which was enforced by the court in this example and voided the indemnity clause, unfortunately for the contractor, contains the following exception: This section does not affect the validity of any insurance contract, Workers’ Compensation, or any other agreement issued by an insurer.1

What this exclusion in the anti-indemnity statute means is that it’s okay for the contractor to insure the assumption of liability risks contained in the owner’s indemnity clause. This is what the owner received when he became an additional insured on the contractor’s CGL policy, which also included contractual liability coverage. The owner received the full benefit of this insurance coverage for the contractor’s assumptions of liability under an indemnity clause. The contractor’s insurance company would likely now have to reimburse the owner for the amount it had to pay under the claim, plus the owner’s defense costs. The owner gets reimbursed the full $600,000 by the contractor’s insurance company, less the policy deductible, which the contractor has to contribute. The reasoning behind the typical insurance exception shown in the sample anti-indemnity statute is simple: this is what insurance 1 Excerpted from the State of Maryland Code Ann. § 5-401 (1999). Certain Construction Industry Indemnity Agreements Prohibited. This state anti-indemnity statute prohibits indemnities in construction contracts allowing for the indemnitor (the contractor) to provide coverage of claims arising out of the sole negligence of the indemnitee (the owner), but allows for insurance to provide coverage and defense of such claims. The Maryland Code is similar in scope and exception to anti-indemnity legislation in other states.

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companies do for a living. Insurance companies provide coverage for certain risks in return for a premium. They also expect to pay claims as part of their business. In this instance, the risks covered were the assumption of liability risks by the contractor that were contained in the owner’s indemnity clause. Just to make matters worse, the payout by the insurance company, $600,000, now goes against contractor’s insurance industry experience rating, since it is his policy. The owner’s experience rating for insurance may be unaffected. The contractor may now be faced with an increased premium for his CGL coverage on future projects, or his insurance company may decide not to renew—­or may even cancel—­his policy. All of this happens to the contractor for an accident caused by the sole negligence of the owner, and, arguably, the poor contract negotiating on the part of the contractor.

Owners Love CLAIMS!

Contractors should note that when owners are establishing construction contracts, they are always thinking about CLAIMS— not claims for extra work or disputes, but: Contractual Liability insurance, plus Additional Insured status equals Money Saved for the Owner Just because a contractor is performing a construction contract in a state that has some form of anti-­indemnity legislation in place, doesn’t mean he can accept, without risk, an owner’s broadly worded indemnity clause. A court’s decision on the enforceability or unenforceability of a particular indemnity clause with respect to a state’s anti-­indemnity statute is unpredictable at best. There may not be as much “anti-­ indemnity” protection available to the contractor as he might believe. In any event, responsible contracting, or contract negotiating, is a much better course of action for the contractor. It can be difficult for an owner to force a contractor to defend him or reimburse him for a claim under the provisions of an indemnity clause in the construction contract, short of taking the contractor to court. Smart owners also have a method that provides them with extra protection in the event an indemnity clause is ruled unenforceable or the contractor is unwilling or financially unable to 161

meet the obligations in the indemnity clause. The owner’s “extra protection” is achieved through two contractual requirements: 1. Require the contractor to add the owner as an additional insured to the contractor’s Commercial General Liability policy for the project, and; 2. Specifically require that the contractor’s CGL policy include contractual liability coverage for the indemnity contained in the construction contract. Being named as an additional insured to the contractor’s CGL policy, which has contractual liability included, is the owner’s fallback position in the event the indemnity is ruled to be unenforceable by a court. The contractor escapes defense and payment obligations under the indemnity, but his insurance company will have to pay for the defense costs of the owner and the claim. It is also the owner’s fallback position if the contractor is unwilling or unable to meet the obligations of the indemnity clause. The owner now has insurance available to him to cover his defense costs and some or all of the contractor’s indemnity obligations. In the final analysis, the owner may be able to have coverage for claims attributable to his own negligence, including the defense costs against such claims, under the indemnity and insurance clauses either directly from the contractor or from the insurance company, or perhaps both.

Negotiating Indemnity Clauses

In most construction contracts, it is unlikely that the owner’s proposed indemnity clause will be favorable to the contractor. As noted throughout this chapter, indemnity clauses are not designed to be fair. It is likely that the owner’s proposed indemnity clause will expose the contractor to a significant level of transferred risk and associated potential financial liability. The contractor’s goal in negotiating an indemnity clause should be to limit, to the greatest degree possible, his exposure to transferred risk and associated financial liability for accidents that were caused by the negligence of others. This means negotiating with the owner the following: 1. Indemnify only the owner and his employees, not a long list of other undefined and unknown individuals and associated companies. 2. Eliminate being responsible for claims attributable to any degree of negligence by the owner. 3. Be responsible only for those claims attributable to the ­contractor’s negligence. 4. Have the indemnity be applicable only to claims for personal injury, death, and existing property damage.

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5. Limit the events that are covered under the indemnity only to those that take place while the contractor is performing his work and is physically present at the owner’s job site. 6. Place a fixed, maximum limit on the financial liability of the contractor. Let’s reword the first sample clause in this chapter to include the issues just listed. (Note: changes are shown in bold) Article 20 – Indemnity 20.1 Contractor shall defend, indemnify, and save Owner harmless only to the extent a claim is caused by the negligence of Contractor and only for injuries to, or death of, any and all persons, and for loss of or damage to existing property occurring only during the on-site performance of Contractor’s work under this contract and only while Contractor is physically present on the job site. Article 21 – Limitation of Liability (new clause) Contractor’s total liability under this Contract, including any defense costs on behalf of Owner, shall not exceed US$1,000,000  in the aggregate.

Note that the indemnity clause was revised to cover the owner and employees and no one else. Adding the new words “to the extent a claim is caused by the negligence of Contractor and only” means that the contractor agrees to be responsible for the portion of a claim attributable only to the degree (amount) of his negligence. It also means the contractor does not agree to accept responsibility for any portion of the owner’s negligence that caused the same claim.

Being absolutely specific with the wording of an indemnity clause is critical and helps minimize opportunities for judges to creatively interpret the indemnity wording in a way that is adverse to the contractor.

This typical “to the extent” wording covers the indemnity negotiating issues numbers 2 and 3. For example, if a court determines that the owner is 75% negligent, and the contractor is 25% negligent in a claim, then the contractor would pay 25% of the amount awarded under the claim. Adding the new word “only” just gives more strength and clarity to the fact that the indemnity provided only covers claims for injury to persons, death of persons, or property damage. Nothing else is covered, not even the owner’s defense costs. This covers indemnity negotiating issue number 4. Adding the new words, “occurring only during the on-site performance of Contractor’s work under this Contract and only while Contractor is physically present on the job site,” specifically defines when and where the indemnity applies. The contractor’s indemnification of the owner is applicable for claims that occur only 163

when the contractor is doing his construction work at the owner’s job site. It’s very important to be specific about what the indemnity applies to, how it applies and where it applies. It’s better to have highly specific wording in place in the event the contractor has to go to court to defend against a claim brought by the owner to enforce the indemnity in the construction contract. Broad-based and open-ended wording can be interpreted loosely by the courts.

When the contractor is not physically present on the site, he has no control over any of the activities taking place there and should not have any exposure to an indemnity. When the contractor is present and working, it is more likely he will be able to exercise more effective control over his work activities and safety practices to prevent personal injury and property damage. The contractor should be responsible only to the extent of his negligence under an indemnity, unless it is determined that he left the job site in an unsafe condition. 164

Creative interpretation by the courts of an indemnity could be to the significant financial detriment of the contractor. So, it’s better to try to negotiate wording that is simple and easy to understand, and most importantly, specific. Tighten it up; vaguely worded indemnities left open to interpretation are very dangerous, and expensive! The original wording in the indemnity example stated that it covered all claims “arising under or by reason of this Contract.” This wording is too broad and subject to creative interpretation. Keep in mind that the greatest risk for personal injury, death, or property damage is present when the contractor and others are physically working on the job site. The words “arising under” and “by reason of ” could be construed to mean that the indemnity would apply prior to the contractor arriving at the site, while the contractor is on the site, or after the contractor leaves the site. That is a lot of risk to accept, and probably for no increase in the contractor’s price for the project. The construction contract typically will span all the time periods noted above. There are contractual issues to take care of prior to arriving at the job site, things to build while working there, and contractual issues to attend to after leaving the site and prior to the conclusion of the contract. It makes no sense to take the chance of getting stuck with the financial liability for an accident that happened while the contractor was not even on the site, and is attributable to the negligence of the owner! One of the issues often used in negotiating indemnities is the concept of control. Owners like to argue that since the contractor is in control of the site, he should be fully responsible for whatever happens on the site and should accept the indemnity as written. This sounds logical enough at first glance. It is a good negotiating tactic by the owner, but it is unrealistic. When the contractor is physically present on the site, he has much better control (better, not total) over his day-to-day working and safety activities, or lack of activities, that could cause personal injury, death, or property damage. He may not have any control whatsoever over the activities of the owner, his employees, agents,

representatives, affiliated companies, and the like who might be included as beneficiaries of the contractor’s indemnity. It’s possible that a person could be injured on the contractor’s job site after the contractor leaves, and it could be construed in court that the indemnity would apply, if not specifically limited as noted. Likewise, when a contractor concludes his work and leaves the site, he should have no exposure under an indemnity. Limiting the time in which an indemnity applies to when the contractor is physically present on the job site covers indemnity negotiating issue number 5. An added clause (new clause Article 21 – Limitation of Liability) limits the amount of money the contractor agrees to pay to the owner in the event a court makes an award under the provisions of the indemnity statement. This financial limit is only with respect to the contractor’s liability to the owner and does not stop the court from making a larger award in the event of a claim.

An Example

A person is injured on the contractor’s job site and later sues the owner for $2,000,000. The court rules in favor of the injured person. The owner is required to pay the full amount of the claim and then sues the contractor under the provisions of the ­indemnity clause in the construction contract to try to recover the $2,000,000. The court agrees that the indemnity and limitation of liability clauses are enforceable and awards the owner $1,000,000, the limit of liability specifically stated in the construction contract. The contractor must pay the owner $1,000,000.

The idea here is that the contractor was required to pay $1,000,000, not $2,000,000, because he successfully negotiated an enforceable limitation of liability clause in the construction contract. If the contractor hadn’t negotiated this, he could have been required by the court to pay the full $2,000,000 to the owner. This limitation of liability covers indemnity negotiating issue number 6.

Knock-­for-­Knock Indemnities

Another approach that appears to be generally fair to both the contractor and the owner is to use what is commonly referred to as a knock-­for-­knock indemnity. This type of indemnity establishes that the contractor and the owner agree to be responsible for claims associated with personal injury and property damage for their own employees and their own property, regardless of how it was caused and the other party’s negligence. A knock-­for-­knock indemnity might read similar to the following: 165

Article 20 – Indemnity 20.1 Owner agrees to indemnify and hold harmless Contractor from any claims, regardless of how caused and regardless of Contractor’s negligence, that arise out of personal injury to or death of Owner’s employees and loss of or damage to Owner’s property during the on-site performance of the Work. 20.2 Contractor agrees to indemnify and hold harmless Owner from any claims, regardless of how caused and regardless of Owner’s negligence, that arise out of personal injury to or death of Contractor’s employees and loss of or damage to Contractor’s property during the on-site performance of the Work.

This indemnity is silent on responsibility for claims from third parties (other than the owner’s or contractor’s employees or property), so assignment of blame and assessment of damages for such claims would likely be left to the courts to decide. An indemnity clause like this one might possibly be construed by a court to involve indemnification against the negligence of one party or the other. As such, it might then run afoul of a particular state’s anti-indemnity legislation, and contractors should check with contracting professionals on the use of knock-for-knock indemnities.

Conclusion

Indemnity clauses are designed to transfer as much risk and exposure to potential financial liability as possible to the contractor from the owner, even if the owner is almost completely responsible for the event resulting in a claim. Indemnity clauses can create significant financial risk for the contractor. Contractors need to understand the level of risk they accept when agreeing to an indemnity clause, as well as how to try to negotiate away the unacceptable risk contained in these types of clauses. Contractors must also make sure their insurance companies’ endorsement of additional insured status for the owner and the contractual liability insurance endorsement on the CGL policies are both in line with all the limitations set out in the final negotiated indemnity provisions of the construction contract with the owner. Many construction contracts will simply require the contractor to add the owner as an additional insured to the contractor’s CGL policy and also require that contractual liability coverage be included. There may not be any specific contractual provisions in the contract for how the endorsements must read in the contractor’s CGL policy that provides for additional insured status and contractual liability coverage. Contractors should make sure that the endorsement adding contractual liability conveys what they want to agree to in limited indemnity clauses. That endorsement will likely be scrutinized by the court in the event of a claim or lawsuit. The endorsement should be

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specific as to limitations of coverage so that the chances are better that the endorsement’s wording won’t be too broadly, or creatively, interpreted by the courts against the contractor. Broad interpretation by a court of law of contractual wording (construction contracts or insurance contracts) is a significant risk for the contractor. This can be managed by understanding how to negotiate limited indemnity clauses—­and by making sure insurance policy endorsement language for additional insured status and contractual liability coverage tracks with the indemnity limitations agreed to by the contractor. Last, always remember that a construction contract does not need an indemnity clause; the contractor and the owner should each be responsible for the consequences of their own actions.

Some Last Thoughts on Indemnity and Additional Insured Status

Alessandro Grandini/Adobe Stock. Dinosaurs once roamed the Earth; now they are extinct. Contracting dinosaurs exist today and they are the unfair risk transfer clauses of indemnity and additional insured status roaming the landscape of construction contracts. Some day they will be extinct, too, just like the T-­Rex. Good bye indemnosaurs! Extinction is on the way and it can’t be too soon. It’s on the horizon and it’s quickly approaching. Good bye additional insuredosaurs! Extinction is on the way and it, also, can’t be too soon. The majority of the states in the United States have some sort of anti-­indemnity legislation in place, or common law decisions, voiding 167

indemnities in construction contracts branding them as unenforceable and against public policy. A growing number of states have outlawed or restricted additional insured status. Negotiate hard to eliminate unfair risk transfer indemnity clauses and the equally unfair requirement to provide additional insured status.

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Chapter

9

Changes

Disagreements related to changes in the contract scope of work or to the schedule are probably the number one cause of emotionally charged exchanges between an owner and a contractor during the course of a construction contract. Of all the clauses found in a construction contract, the change clause seems to be the one that has the greatest variation in the way it is written. Every contract writer has his or her own way of defining how changes will be handled. Owners and contractors, too, often have their own take on changes. Owners may believe that every time they ask contractors to do something that isn’t definitively spelled out in the contract documents that contractors will request more time and money. Most contractors have heard owners say, “there’s no way this contractor thinks he’s going to make his profit at my expense due to changes.” On the other hand, contractors may believe that owners look to have new work, overlooked work, or new schedule considerations added to the contract for free—­and to be done within the original contract schedule. Most owners have heard contractors say, “there’s no way Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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this owner thinks he’s going to get a bunch of work for free at my expense.” In short, most contractors and owners have been in the situation of dealing with changes and their effects on the contract’s schedule. Both will agree it’s not fun. It does seem, though, that there must be a better way to deal with work scope and schedule changes so that both are treated fairly. Keeping tempers below the boiling point when negotiating changes is always beneficial for both sides, as well as for the project as a whole. Neither side should feel the need to come out with guns blazing regarding this issue.

Some Ground Rules

A few ground rules for contractors and owners are in order here when dealing with changes: 1. The contractor should expect to be paid by the owner for ­legitimate scope of work changes. 2. The contractor should expect the owner to allow schedule adjustments for legitimate scope of work changes. 3. The owner should expect to be treated fairly by the contractor with respect to how much he is charged for legitimate scope of work changes. 4. The owner should expect to be treated fairly by the contractor with respect to schedule adjustments required by the contractor for legitimate scope of work changes. 5. All changes and associated cost and schedule consequences should be agreed to in writing. No exceptions! Rule #5 stops short of saying that all changes must be in writing “prior to performing the change.” This is because sometimes that is not possible or practical in order to keep the project moving forward, or for safety reasons. However, it is best to have all changes agreed to in writing prior to actually doing the work contemplated in the change order whenever possible. If the change isn’t agreed to in writing prior to doing the work, then there needs to be a written procedure in the construction contract requiring the parties to process the verbalized change as soon as possible afterwards.

Protecting the Project Manager

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One thing that’s important for contractors to remember is that when they are in the negotiating phase of the contract, getting a fair and well-­written change clause into the contract is vital. This is because the contractor’s project manager will have to abide by its provisions during the course of the project. If the change clause is poorly written or heavily in favor of the owner, the contractor’s project manager may find it difficult, or impossible, to recover the value of changes and

associated increases in the project’s schedule. Therefore, when contractors are negotiating the change clause in a contract, they need to remember that, in addition to protecting their company’s financial and scheduling interests, they need to protect the project manager’s ability for changes and schedule time. If the construction contract has a liquidated damages clause in it for failure to meet the schedule, it’s even more important that the project manager have a fair and workable changes clause. This is so he can get appropriate extensions to the contract schedule for changes and not end up being unfairly exposed to a liquidated damages clause associated with failure to meet a schedule. (For a more detailed discussion of liquidated damages, see Chapter 11.)

Owners’ Directives

Most owners will agree to issue some sort of simple written field directive to perform small amounts of new or emergency work, which will end up being an authorized change to the contractor’s scope of work and/or schedule. This is easy enough to enforce. Contractors should have something in writing directing them to perform the change before proceeding with it. Oral directives from the owner to perform work that can be considered a change should be avoided. Many owner’s contracts expressly forbid the contractor from proceeding with a non-­written change except when personnel or property are at risk. When the job is over, or even during the course of the job, trying to get paid for additional work that was never written down is difficult at best. Despite what the owner may say about processing such verbal directives, the bottom line is that it’s poor contracting by both parties. All verbal requests for changes—­big or small—­from the owner should be immediately followed up with some form of written confirmation as to the price and schedule consequences.

Constructive Changes

A constructive change refers to any of the following: 1. A change allowed for over-­inspection by the owner’s inspectors, and the associated slow-­down or extra expense to the contractor. 2. A change eventually allowed for the owner’s failure to grant a legitimate schedule extension. 3. A change associated with the owner’s failure to coordinate other contractors on the job site, and the associated schedule and cost consequences. By nature, constructive changes may be difficult to prove, unless very good record-­keeping is maintained by the contractor and his project manager. 171

Payment for Changes

How should a contractor be paid for the increased cost of changes to the schedule and/or scope of work? If the increased costs aren’t too significant with respect to the original contract price, the contractor should be paid the full value of the change, without any retention withheld, and without having to increase the value of any bonds or security instruments in place for the project.

An Example

Let’s say a contractor is working on a $1,000,000 fixed-price construction project. The terms of payment provide for deducting 5% retention from all progress payments. The contractor also has provided the owner with a performance bond in the amount of 5% of the contract price, or $50,000. During the course of the project, the owner authorizes in writing a $10,000 change for some additional work. Once the work in the owner’s change order is completed, the owner should be billed for the entire $10,000 without its value being reduced by the 5% retention provided for in the contract’s terms of payment. The contractor should also not be required to increase the value of the performance bond, or surety guaranty, he provided to the owner. This is fair. The additional work was not contemplated during the original negotiations for the project, nor was increasing the value of the performance bond.

It’s okay to have a different set of payment terms for changes or to avoid going through the cost and administrative exercise of increasing the value of any form of on-demand performance bond, surety guaranty, or standby letter of credit used as an assurance of performance.

Sample Change Clauses

There is a variety of ways to write a change clause; following are a few examples.

Example 1 Article 22 – Changes 22.1 Owner has the right to make changes in the Work, including alterations, reductions, or additions. Upon receipt by Contractor of Owner’s written notification of a change, Contractor shall: (1) provide a written estimate for the increase or decrease in cost due to the change, and; (2) notify Owner in writing of any estimated change in the existing completion date. 22.2 If Owner instructs in writing, Contractor shall suspend work on that portion of the Work affected by a change, pending Owner’s decision to proceed with the change. 22.3 If Owner elects to make the change, Owner shall issue a change order for the change, and Contractor shall not commence work on any change until the written change order has been issued.

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All things considered, this change clause is fairly simple and straightforward. It basically says that no changes will be made unless they are in writing (good!), and that the owner will issue a written change order to the contractor prior to the start of any work under the change (even better!). The clause provides a simple procedure to follow for changes. The only thing this sample clause doesn’t do is provide a mechanism for the contractor to initiate a change if he thinks one is necessary. However, the contractor could circle back through the owner, advise him of the change, and, if the contractor is persuasive, have the owner initiate the change. When the relationship between the owner and the contractor is good, this will usually work.

Example 2

The following is an example of an unfair change clause, fully in favor of the owner, and one that would need some major editorial surgery to make it more fair to the contractor. Article 22 – Changes 22.1 Owner shall have the right, without notice to or the consent of the surety or sureties on Contractor’s bond or bonds to order changes in the Work, or to order the omission of any of the Work, or to order extra work or material within the general scope of the Work. 22.2 Contractor shall proceed with the Work in accordance with all orders given by Owner. Should any such order materially increase or decrease the cost of the Work, an equitable adjustment of the contract price shall be made. 22.3 The party desiring such an adjustment shall submit to the other party, within fifteen (15) days after receipt of the relevant order, a written claim setting forth the amount of the desired adjustment and the other party hereto shall either approve or disapprove the proposed adjustment in writing within ten (10) days after receipt of the claim therefore. 22.4 If any adjustment so proposed is not approved within the time above specified, and if the matter is not settled by mutual agreement after written notice or disapproval has been given or after expiration of the time allowed for approval, then the amount of increase or decrease in the Contract Price, if any, shall be determined in the Dispute clause in this Contract.

Getting treated fairly for cost and schedule changes under the provisions of this change clause might prove tough for the contractor, maybe even impossible. The first paragraph, 22.1, gives the owner the right to unilaterally order the contractor to perform extra work associated with a change made by the owner. Paragraph 22.2 says, “Should any such order materially increase or decrease. . .” Who is the judge of whether or not an owner-directed change is “material”? “Material” is another one of those words used in 173

Contractors will likely have different experiences with resolving changes with different owners. Some owners will be fair to contractors in determining what is “material” and what is “equitable.” Others will not.

contracts that is open to too much interpretation. In this particular clause, the owner would be the judge of what is “material.” It’s possible the owner could decide that a $10,000 change in a $1,000,000 contract was not “material,” and the contractor was not entitled to a change in that amount. Too bad for the contractor. Looks like a dispute is brewing. Good luck with getting his money due for the change or any necessary schedule adjustment. Paragraph 22.2 goes on further to say, “an equitable adjustment shall be made. . .” if the owner judges the change to be “material.” What does an “equitable adjustment” mean? Who decides what’s “equitable”? “Equitable” is another one of those words used in contracts that is open to broad interpretation. In this case, the owner would also be the judge of what should be an “equitable adjustment.” If the contractor submits a bill for $10,000 for the ordered change and the owner deems an “equitable adjustment” is only $2,000, what’s the contractor to do? Again, this is a recipe for dispute. Paragraph 22.3 goes on further to provide for some timing of submitting costs and approvals or rejections of the submitted costs— not much meat here other than an administrative effort.

Any time the owner is allowed by the contract to interpret ambiguous words like “reasonable,” “equitable,” and “material” in a contract clause, the owner has an unfair advantage in deciding their meaning.

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The last paragraph, 22.4, basically indicates that if no agreement on the value of the change is reached, then the issue will be settled in accordance with the contract’s disputes clause. But the contractor must proceed with the work in the meantime. Again, too bad for the contractor, especially if the disputes clause is as unfair to the contractor as the changes clause is! Note, too, that nothing is said in this changes clause about providing the contractor an extension to the schedule that may by occasioned by a change in the scope of work. What’s “reasonable, equitable, and material” to the owner may not be to the contractor. These types of words, sometimes appropriately called “weasel words” are best left out of a contract. Discovering this type of wording in an owner’s contract should immediately raise a red flag. It’s not difficult to negotiate and put in writing a fair and unambiguous change procedure, replacing ambiguous wording with words that have a more precise meaning. It’s always better to butt heads over the negotiating table prior to signing a contract than to do so later over the change order table.

Example 3

The following example addresses a typical situation where a subcontractor has a separate contract with a prime contractor. The prime contractor has his own separate contract (the prime contract) with the owner. (The prime contractor is in-between the subcontractor and the owner.)

Article 22 – Changes 22.1 This Subcontract is subject to the right of Owner to make changes in the Drawings and/or Specifications that are associated with the Prime Contract. 22.2 In such event, Prime Contractor shall make required changes in the Drawings and Specifications, require additional products, materials or services, or suspend or omit all or portions of the requirements covered by this Subcontract. 22.3 If such changes cause an increase or decrease in the Subcontract Price or in the time for the Subcontract’s completion, then the price and completion time of this Subcontract shall be modified in writing; provided, however, that any such adjustment is also made in Prime Contractor’s contract with Owner to incorporate the adjustment in the price or in the completion time for the Prime Contract. 22.4 In the event that the adjustment submitted by Subcontractor is not approved or accepted by Owner, Subcontractor may at own expense dispute the decision of Owner in accordance with the disputes procedures set forth in the Prime Contract, provided, however, that nothing shall excuse Subcontractor from proceeding with the supplying of the products, materials, or services as changed by Owner. 22.5 All changes involving increases or decreases in the Subcontract price or changes in the completion time shall be considered accepted by Subcontractor unless they are rejected in writing by Subcontractor within the time allowed in the Prime Contract to dispute any changes.

Paragraph 22.3 provides for the subcontractor’s cost and schedule changes and requires them to be approved in writing. While this is a good idea, the clause goes on to imply that these subcontractor changes must be approved by the owner, and that the same changes be made to the prime contract as well. There is nothing wrong with this requirement in theory, but what happens if the owner does not approve the changes? Paragraph 22.4 says that if the owner does not approve the changes, the subcontractor still has to perform the changes and may, at his own expense, dispute the owner’s decision. That’s not good for the subcontractor. This paragraph goes on to require the subcontractor to perform the changes regardless of whether or not he is paid for them. This change clause won’t be too difficult to live with if the subcontractor negotiated the complete removal of paragraph 22.4 and the last half of paragraph 22.3.

Example 4 The following changes clause is poorly-written and an example of confusing wording that needs editing. 175

Article 22 – Changes 22.1 Owner may order extra work or changes to the Work by altering, adding to, or deducting from the Work. Any extra work or changes ordered by Owner shall be executed by Subcontractor in accordance with all the terms and conditions of this Contract. 22.2 Any claim by Contractor for an adjustment in the Contract Price or the Contract Completion Schedule under this Article must be submitted to Owner in writing within seven (7) calendar days from the date any extra work or a change is ordered. 22.3 In the event Owner and Contractor fail to agree upon the extent or amount of an adjustment to the Contract Price or Contract Completion Schedule, Contractor shall nevertheless proceed with the completion of the extra work or change. 22.4 If Contractor does not notify Owner of any increase in Contractor’s cost or time within the seven (7) calendar days, it shall be presumed by Owner that there is no increase in the Contract Price or the Contract Completion Schedule and Contractor shall forfeit its rights to any increases. 22.5 Owner shall have the authority to order minor changes in the Work that do not involve extra costs, but otherwise, no extra work or changes shall be done without a written order from Owner, except in an emergency endangering life or property. 22.6 For all extra work or changes, the amount of the Contract Price shall be adjusted as may be agreed upon between the parties.

The above example is problematic for the following reasons: • Paragraph 22.1 gives only the owner the authority to order extra work or changes. • Paragraph 22.2 gives the contractor only seven days to provide a cost and schedule change proposal. Note that it says “calendar days,” which means both days worked and those not worked, like Saturdays, Sundays, and holidays. • Paragraph 22.3 states that if the owner doesn’t like the contractor’s price and schedule proposal for extra work or a change, the owner can reject the proposal, yet the contractor has to perform the work anyway. • Paragraph 22.4 says that if the contractor doesn’t provide the owner, within seven calendar days, a proposal for the cost and schedule changes for extra work or a change, then the contractor must to do the work at no cost to the owner and without any schedule adjustment. • Paragraph 22.5 gives the owner the authority to order the contractor to do “minor work” for free. The owner’s definition of “minor work” may not be same as the contractor’s definition. 176

• Paragraph 22.6 says the contract price will be adjusted. While this might be okay, what about changes to the contract completion schedule? The contractor’s project manager may have a difficult time trying to get price and schedule changes agreed upon with the owner if this clause ends up being in the contract as written. Let’s take example Article 4 and make some revisions to it that would make it more fair for a contractor. Article 22 – Changes (New wording is in bold) (Continued) 22.1 Owner may order extra work or changes to the Work by altering, adding to, or deducting from the Work. Any extra work or changes ordered by Owner shall be executed by Subcontractor in accordance with all the terms and conditions of this Contract. 22.2 Any claim by Contractor for an adjustment in the Contract Price or the Contract Completion Schedule under this Article must be submitted to Owner in writing within fourteen (14) calendar days from the date any extra work or a change is ordered. 22.3 Owner and Contractor shall agree in writing upon the extent or amount of an adjustment to the Contract Price or Contract Completion Schedule prior to the work being performed by Contractor. 22.4 If Contractor does not notify Owner of any increase in Contractor’s cost or time within the fourteen (14) calendar days it shall be presumed by Owner that there is no increase in the Contract Price or the Contract Completion Schedule and Contractor shall forfeit its rights to any increases. 22.5 No extra work or changes shall be done without a written order from Owner, except in an emergency endangering life or property. 22.6 For all extra work or changes, the amount of the Contract Price and Contract Completion Schedule shall be adjusted as agreed upon between the parties in accordance with the provisions of Article 22.3.

One final exceptional example of an unfair change clause:

Example 5 Article 22 – Changes 22.1 Owner will not agree to any cost or schedule changes in the Work during the course of the Contract. 22.2 If Contractor believes there may be changes in the Work occurring during the course of the Contract, he should provide for them in his firm lump-sum price and fixed schedule for the Work.

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This is just a joke, right? There couldn’t possibly be such an unfair change order clause in a contract. A contractor should never underestimate what he might find written in a construction contract. This is especially so when it comes to change order clauses, of which there are many, many creative varieties in favor of the owner. (A clause very much like this one was found hidden in an actual construction contract). Read the contract!

Major Contract Changes

Sometimes on large and complex projects, a major change to the scope of work will be considered by the owner. In this event, the contractor may have to utilize the services of engineers and/or other specialists to put together a proposal for the changes being considered. It may also take a significant amount of the contractor’s time and effort to study, evaluate, estimate, and properly price the proposed change. Large changes (15% or more of contract price) may also require increasing the value of any assurance of performance the contractor has provided and may significantly increase indirect costs associated with project management and home office costs (overhead). The development of large, complex change proposals can turn out to be an expensive and time-­consuming effort by the contractor. Who pays for this? It’s one thing if putting together a change proposal for the owner costs several hundred dollars; this may just be the cost of doing business. It’s another matter entirely if the cost to put together a proposal for changes amounts to thousands or tens of thousands of dollars. The owner should pay for this effort in the event he does not accept the changes being considered. If the owner accepts the changes, then presumably the contractor has included his costs to develop the change proposal in his price for the changes he submits to the owner. To guard against the situation where a major change is not accepted by the owner, and the contractor wants to be paid for the cost of his development efforts, language similar to the following can be included in the change clause in the contract.

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Article 23 – Major Changes 23.1 Owner agrees that in the event Contractor’s cost to prepare a proposed major change to the Scope of Work requested by Owner exceeds $1,500 (or some other value as may be appropriate), Owner will reimburse Contractor for such costs if the proposed change is not accepted by Owner. 23.2 For such major changes, Contractor shall submit to Owner an estimate of his costs to prepare a proposal for the major change. 23.3 Owner will approve or disapprove in writing the cost submitted by Contractor to prepare the proposal for the major change. 23.4 If the cost submitted by Contractor is approved, then Contractor will develop the proposal for the major change and submit it to Owner. 23.5 If the proposal for the major change is not accepted by Owner, the cost to prepare the proposal will be reimbursed to Contractor.

Negotiating Change Clauses

Prior to negotiating modifications to a change clause in a contract, contractors may want to discuss with the owner the five ground rules noted at the beginning of this chapter. Starting the negotiation process for a particular clause with a simple philosophy of fairness to both parties often leads to a successful negotiation for the contractor. If these five ground rules can be agreed on by both the owner and the contractor, then a fair change clause can probably be negotiated.

A Model Change Clause

Here’s an example of a change clause that contractors can consider using as a basic model for negotiating purposes: Article 22 – Changes 22.1 Owner and Contractor will agree in writing to all changes in the Work and prior to the changes being performed. An adjustment in the Contract Price and in the Contract Completion Date shall be made to reflect the changes. Contractor shall submit to Owner a written proposal describing the change in the Scope of Work, its value, and any applicable schedule impact. Owner shall approve or disapprove in writing Contractor’s proposal within seven (7) days of receipt by Owner. 22.2 If no agreement can be negotiated between Owner and Contractor as to the value of the change and impact on the Contract Completion Date, if any, then Owner may request Contractor to perform the change on a cost reimbursable basis and all time required to complete the changes will be added to the Contract Completion Date. 22.3 All agreed-upon pricing changes to the Scope of Work shall be paid at full value at the completion of the changes, or other agreed-upon payment terms, without the withholding of any retention and without the modification of any payment or performance related bonds, including surety guaranties, provided by Contractor for the Scope of Work.

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What does a contractor get out of a change clause like this one? • All changes to the contractor’s price and schedule are agreed on in writing before the work required under the change order is performed. • If no agreement is reached on cost and schedule, work is done on a reimbursable basis. (Many owners have contractors provide an extensive list of unit rates and markups to use for extra work, included as part of the contract.) • All changes are paid in full without retention. • There are no changes to any on-­demand bonds or surety guaranties. (This keeps the contractor’s administrative costs and time to a minimum.)

The Contract Change Matrix

A good way to make contract changes is to agree before the contract begins with a predetermined way to price contract changes. This process would be included as part of the final contract documents. An example follows: The following shall be used to determine the price of contract changes. Rates include contractor’s overhead and profit.

Conclusion

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Category

Rate

Project manager

$150/hr

Project superintendent

$100/hr

Field engineer

$75/hr

Engineering

$100/hr

Craft labor

Craft rate: i.e. Boilermaker Welder: $75/hr

Equipment

Rental rate: i.e. 15 Ton Mobile Crane Fueled and operated: $150/hr

Materials

Cost plus 20%

Subcontracts

Cost plus 20%

When reviewing, analyzing, and negotiating change clauses, watch out for the following issues: 1. Imprecise words in the change clause that are open to the owner’s sole interpretation, such as “reasonable,” “material,” and “equitable.” These words increase the contractor’s risk of not being paid for legitimate changes and not being allowed legitimate extensions to his schedule.

2. Cost-­only type of change clauses that don’t allow the contractor the ability to change his completion schedule. Extensions to schedule are important, especially if the contract provides for liquidated damages for late completion. 3. Unilateral change clauses that allow the owner to direct the contractor to make a change with the sorting out of cost and schedule changes to take place at some later date. This is sometimes described by contractors as a “20 cents on the dollar clause.” 4. Verbal change clauses that don’t require all changes documented in writing. All changes must be in writing. No excuses allowed! 5. Any change clause that is written in an unnecessarily complicated and overly obtuse legalistic manner. The use of plain and understandable English is a benefit to everyone, especially the contractor’s project manager, who has to work with the requirements of a contract. Cost and schedule changes are inevitable on construction contracts. One of the best ways to minimize them is for both the owner (mainly) and the contractor to take all the time necessary to develop and agree on a detailed and comprehensive scope of work, such as described in Chapter 3 of this book.

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Chapter

10

What’s a Project Manager to Do? A Short Story to Start With

Disputes & Their Resolution At the end of a long day of trying to resolve one problem after another on the job site, a project manager storms into the job site office, tosses his hard hat in a corner, and announces loudly to his assistant, “These guys we are building this project for are really amazing. We’re getting frustrated out there on the site with the behavior of the owner’s inspectors, and it’s starting to cause ­problems. I finally got fed up today with the three inspectors who were assigned to look over our piping work. I tried to be as d ­ iplomatic as possible when I told them what the problem was all about.” The project manager continued, “Not one of the owner’s inspectors assigned to our piping work has more than three months of ­construction experience. They stop us and slow us down because they just don’t know what they are doing. We have lost hundreds of productive hours and wasted equipment rental and project management time while these inspectors stop the work to try to determine if the piping is installed according to the

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specs and the code. I don’t think these guys have ever seen a pipe job before! All we are doing out there is running a training program for these three guys, at our cost, of course. “After we take the time to guide them through the job specs and the piping codes, they finally allow us to go back to work. Yesterday, they stopped us for almost half a day and finally said everything looked okay and we could go back to work. Those welders and fitters and equipment operators on our payroll, and my project staff, sure don’t stop getting paid during this downtime. “I calculated the other day that we have lost about $50,000 in downtime and related delays due to the inexperience of these three inspectors. We haven’t got nearly that much extra money in the estimate. The owner should have some sort of obligation to put experienced inspectors on the job, and so I’m going to put in a claim for what I think we’ve lost in this exercise to train his piping ­inspectors. Where’s a copy of the contract, so I can take a look at how to resolve this dispute?” It appears as if a serious dispute is brewing on this project. The contractor feels that the owner has a contractual obligation to provide experienced inspectors. The contractor didn’t include money in his estimate for running a training program for inspectors! On the other hand, the owner needs to have the flexibility to assign his own people to the job to represent and oversee his interests, and he feels the contractor has a contractual obligation to work together with the people he assigns to the project.

Disputes—­The Construction Contract’s Bad Actor

It’s unlikely disputes will ever go away in construction contracting. Every contractor has had them. Disputes will continue to occur in future contracts because they are written by human beings, and no one is perfect. A contractor doesn’t need to write his yearly business plan around resolving disputes, but it does make good sense to be knowledgeable about how to contract for, manage, and resolve them. It’s just about impossible to write a contract that perfectly describes the scope of work and all the responsibilities of the contractor and the owner. The larger and more complex the contract, the higher the probability a dispute will occur. Disputes arising out of disagreements over the scope of work and commercial terms, and misunderstandings between the contractor and the owner, are going to take place during the course of all contracts. Many times these disputes are small, and the contractor just deals with them as a normal, if disagreeable, part of being in the construction business.

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An Example

Let’s suppose a contractor on a new office building project reads the contract’s plans and specifications to include 100 new doorways in office areas. During the course of the work, the owner points out to the contractor that 105 doors are actually required. The contractor disagrees, which causes the potential for a dispute. The cost of each new doorway is $500, so the contractor is looking at an extra cost of $2,500. His total project value is $600,000. He has had a good relationship with the owner prior to this disagreement. The ­contractor makes a business decision to install the extra doors, absorb the extra cost himself, and schedule the time, to avoid a dispute with the owner. Hopefully, the owner will remember this small favor on the next project the contractor bids to him.

Sometimes it’s best for an owner, too, to resolve a potential dispute to the contractor’s satisfaction. On the other hand, sometimes a dispute creates a major cost or scheduling problem, with both the contractor and owner claiming it’s the other party’s problem. Consequently, the contractor often must take some sort of action to try to resolve it, hopefully in his favor. A major dispute can be very disruptive to a contractor’s organization. It can involve a lot of valuable time and resources that would otherwise be put to good use selling and building profitable projects. A major dispute can erode a good working relationship with an owner that may have been carefully cultivated over a long period of time—­and can make it difficult or impossible to get future business from him. No contractor plans to have disputes in a contract—­nor, for that matter, does the owner. Both try, to the best of their abilities, to put together a good contract with a definitive scope of work and clear commercial terms spelling out each other’s duties and responsibilities. Unfortunately, despite the best efforts of both the owner and the contractor, misunderstandings and disagreements can develop that are difficult to resolve, and then both parties find themselves mired in a dispute. It’s been said that once the contract has been signed by the owner and the contractor, it gets put in a bottom desk drawer and doesn’t again see the light of day until there is a dispute. Then everyone involved decides it’s time to pull it out, dust it off, and read it. Most construction contracts have a clause outlining a process to be used to resolve a dispute. Some, however, will not have a full dispute resolution clause in them; the contract may be silent on how to resolve disputes, and that’s a problem for the contractor. 185

An Ounce of Prevention

Dispute Resolution Options

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The following steps outline the best way to minimize the possibility of disputes developing during the course of a construction contract. 1. Define the Scope of Work: Include a well-­defined and detailed scope of work in the contract documents. The extra time spent developing a detailed scope of work will always benefit both the owner and contractor by reducing the possibility of disputes arising. The scope of work document should outline all the known responsibilities of both parties, and all others directly involved in the construction project. This is particularly ­important where there are interfaces that will take place with other contractors or parties, like the owner’s third-­party ­inspectors, project manager, or architect. 2. Include a Disputes Clause: Make sure that the construction contract has a dispute resolution clause included that clearly outlines a process for resolving disputes and is satisfactory to the contractor. Including a disputes clause is key to good, basic construction contracting and is also part of the risk management process associated with any construction contracting effort. 3. Document Everything in Writing: Written documentation of all activities associated with a dispute is absolutely critical to resolution in favor of the contractor. This process is often ­difficult to make happen when project management and staff are busy with building the project. Filling out extra paperwork on something that may or may not be disputed all too often isn’t a high priority, but should be. The better documented the ­contractor’s case, the better the chances of a successful ­resolution of the dispute. The contractor’s project manager and staff also must be alert to situations that may cause disputes. 4. Practice Early Identification: Bring a potential dispute to the attention of the owner as early as possible. Keep it on the table as long as necessary, and document it in the minutes of job site meetings. Owners don’t like disputes any more than contractors, so early identification of a potential dispute makes satisfactory resolution more likely. The worst thing to do is to wait until the end of the project to try to settle disputes; if you do, good luck. There are four basic ways of resolving disputes that develop during the course of a construction contract: 1. Negotiation: This is by far the best way to resolve disputes and helps maintain a good working relationship between the owner and contractor. The negotiation process also requires ­understanding and compromise on the part of both the

c­ ontractor and the owner, and the final resolution usually leaves both parties feeling equally good or bad about the outcome, but ready to get on with completing the project. 2. Mediation: This is the simplest and most straightforward form of what is commonly called Alternative Dispute Resolution, or ADR for short. A neutral professional mediator is hired by mutual agreement of the contractor and the owner. The ­mediator is trained in resolving disputes and should be selected from candidates who have strong construction backgrounds. The goal is to get both groups to the bargaining table and talking to each other, and to ultimately help them compromise on a solution to the dispute. The mediator does not impose a ­solution, but helps each side find one they both can live with. The contractor and the owner split the cost of the mediator—­a low-­cost way to settle disputes. The details of the settlement remain private. The mediation process is simple and effective, and works well where both sides are interested in finding a peaceful solution. Professional mediators are available from a wide variety of firms and organizations that offer ADR services. 3. Arbitration: This is another form of ADR, although it is more formal and complex than mediation. The contractor and owner agree on a single arbitrator who will listen to the details of the dispute from both sides and then make a decision. Alternatively, the contractor and owner can each separately nominate one arbitrator, and then the two nominated arbitrators will appoint a third to fill out a three-­person arbitration panel. The arbitrator selected by the contractor should have construction experience, but nothing compels the owner to select an arbitrator with a construction background. This three-­person panel will listen to the details of the dispute from both sides and give a decision. Arbitration may or may not be binding, depending on the ­decision made by the contractor and owner during the contract negotiation process. Binding arbitration simply means that both parties agree ahead of time to abide by the arbitrator’s decisions. However, binding arbitration can sometimes be subject to appeal, so it’s important to understand the circumstances of any binding arbitration process. Nonbinding arbitration is just that: neither contractor nor owner has to accept the decision of the arbitrators. The contractor and owner share the costs of arbitration, but not necessarily in equal parts. Lengthy arbitration proceedings can

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be expensive and time-­consuming. The proceedings and any decisions made by the arbitrators are private. Note that there is a downside to using a three-­person arbitration panel. The arbitrator selected by the owner and the third arbitrator selected by the other two arbitrators do not necessarily have to have construction backgrounds, so two of the arbitrators on the panel may have little or no experience in the construction industry. However, professional arbitration boards and organizations are widely established, have common rules and procedures, and are readily available to help contractors and owners resolve disputes. 4. Litigation: This is a costly and lengthy adversarial process, and requires both parties to take the dispute to court for a decision. The contractor and owner will engage lawyers, go through a lengthy discovery process of document review and testimony from individuals involved in the dispute, and then both sides will go to court to present their cases. If the contractor or the owner does not like the decision made by the court, they may be able to appeal the court’s verdict to a higher court. Litigation is costly and time-­and resource-­consuming for the contractor and the owner. Decisions made by the courts can be unpredictable and become public information.

The Folks who Negotiate, Mediate, Arbitrate, & Litigate

When trying to resolve a dispute related to a construction project, who would likely be better at resolving the matter? Would someone experienced in the construction business be better? Or would someone who may be good at just interpreting the words in a contract be better? In negotiations, the experience and background of the people involved with the settlement process is very important. The negotiators for the owner and the contractor are more likely to have construction backgrounds, which aids in finding a solution. In mediation, however, the owner and contractor normally select a mediator jointly (as described earlier) who should ideally have a strong construction background. He can help both sides work through the dispute without getting unnecessarily bogged down in the legal/commercial aspects of the written contract. The mediator should be looking for a fair compromise between the parties, rather than strictly interpreting the words in the contract in favor of one party or the other. Mediators with strong construction backgrounds are widely available.

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In arbitration, it is not uncommon to find that the individuals who are available to act as arbitrators are lawyers or retired judges. While they may be good at interpreting—based on their own perceptions— what they believe the wording in a contract means and how it may or may not apply to a dispute, they may not have any experience in the construction business.

The negotiating table is by far the best place to resolve a dispute.

Despite the assurances that may be made by a contractor’s legal representatives, the decisions made by courts are unpredictable at best. The chances of a favorable outcome for the contractor are about the same as throwing a winning roll of the dice at the craps tables— and maybe less. As previously noted, the litigation process is expensive, extremely time-consuming, and the outcome is highly unpredictable. The legal representatives for the contractor or owner may not have any practical construction experience. The judge, who will listen to the facts and the evidence in the case and render a decision, may not have any practical construction experience either. Many times, one party will file a lawsuit just to try to drive the other party to the negotiating table. An aside here worth mentioning is that in some other countries, such as in Asia, going to court to resolve a dispute is an absolute last resort and is considered to be a personal failure on the part of all the individuals involved in trying to resolve the dispute.

Dispute Resolution Clauses

All construction contracts should have a fair dispute resolution clause that allows for ADR (mediation or arbitration) as part of the commercial terms and conditions. Such a clause doesn’t need to be lengthy or complex, but should clearly outline the process the contractor and owner agree to use to settle any disputes that may develop during the course of the contract. Having a fair dispute resolution clause as part of the commercial terms and conditions allows the contractor to apply pressure on the owner to settle any dispute, since there is an agreed-on procedure to use. Focusing on resolving disputes as soon as they develop is extremely important to achieving a resolution that is favorable to the contractor.

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Example 1

Following is an example of a one-sided dispute resolution clause. Article 31 – Disputes 31.1 During the course of this Contract, any dispute between the parties arising out of the performance of this Contract which is not disposed of by agreement shall be decided by Owner, which shall reduce its decision to writing and then mail or otherwise furnish a copy thereof to Contractor. 31.2 The decision of Owner shall be final and conclusive unless, within 30 days from the date of receipt of such copy, Contractor mails or otherwise furnishes to Owner a written appeal. The decision of Owner on such appeals shall be final and conclusive. 31.3 In connection with any appeal of Owner’s decision under this paragraph, Contractor shall be afforded an opportunity to be heard and to offer evidence in support of its appeal. 31.4 Pending final decision of dispute hereunder, Contractor shall proceed diligently with the performance of the Contract and in accordance with Owner’s decision.

The owner holds almost all of the cards in this example. The words “which is not disposed of by agreement” appear to give the contractor a chance to negotiate a resolution of the dispute with the owner. If those negotiations fail, then, by contract agreement, the owner becomes sole judge, jury, and executioner in the resolution of disputes with the contractor. Even the appeals process noted in the clause gives the owner all the decision-making powers, with none allocated to the contractor.

Example 2

The example below, may not be the best dispute resolution clause, but is more fair. It is a good example of one that is short, simple, and to the point, specifying the process of consultation and negotiation as a first step toward dispute resolution. Article 31 – Disputes 31.1 Owner and Contractor shall attempt to settle amicably by consultation and negotiation any dispute arising out of the performance or interpretation of this Contract. 31.2 If the dispute cannot be settled in an amicable manner, then the dispute shall be settled by binding arbitration in accordance with the Construction Industry Arbitration Rules of the American Arbitration Association before a single arbitrator selected in accordance with such rules. 31.3 The arbitration shall take place in Toledo, Ohio and shall be conducted in the English language.

Including a clause similar to the above in a construction contract will at least give the contractor a good chance of resolving disputes in his favor. 190

Note, however, that the conditions of this clause require binding arbitration. If the decision of the arbitrator is against the contractor, he has to accept that decision. If the decision is in favor of the contractor, the owner must accept it.

Example 3

The following third example, while not too different from the previous one in that it provides first for settling disputes in an amicable manner, requires that a panel of three arbitrators be used if necessary. Article 31 – Disputes 31.1 Any dispute or differences arising out of or in connection with the Contract or the implementation of any of the provisions of the Contract that cannot be settled amicably through negotiation shall be submitted to arbitration under the auspices of the New York Regional Center for Arbitration and the reference shall be to a panel of three (3) arbitrators, one to be appointed by each party and the third, who shall be Chairman, to be jointly appointed by both sides. In the event the two appointed arbitrators fail to appoint the third arbitrator, the said Center shall be the appointing authority. 31.2 The arbitration shall be conducted in New York, New York, in accordance with the rules of arbitration of the New York Regional Center for Arbitration. The language of the arbitration shall be the English language. The arbitration proceedings, including the making of the award to the arbitrators, shall be final and binding upon the parties.

Example 4

The fourth and final example, below, calls for Alternative Dispute Resolution to be used if initial negotiation doesn’t work. This leaves the door open to use mediation or arbitration to settle the dispute, as may be appropriate. If all efforts to resolve the dispute fail, then both parties still have the option “to pursue a legal remedy,” which simply means that both parties can resort to using litigation in an attempt to resolve the dispute. Article 31 – Disputes 31.1 Any claim arising out of or attributable to the interpretation or performance of this Contract that cannot be resolved through negotiation shall be considered a dispute within the meaning of this clause. 31.2 The parties agree to consider resolution of the dispute through some form of an Alternative Dispute Resolution (ADR) process that is mutually acceptable to the parties. 31.3 Should the parties agree to pursue an ADR process, each party will be responsible for its own expenses incurred to resolve the dispute during the ADR process. 31.4 If the parties do not agree to an ADR process or are unable to resolve the dispute through ADR, either party shall than have the right to pursue a legal remedy.

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Conclusion

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Disputes are always going to be a part of being a contractor in the construction business. Having a designated method of resolving them spelled out in the contract is key to good contracting. Keeping written details of events and activities related to actual or possible disputes is essential, and cannot be overemphasized.

Chapter

11

Damages

There are three main types of damages to which a contractor will likely be exposed during the course of a construction contract. These are: 1. Actual damages 2. Liquidated damages 3. Consequential damages A fourth type of damages, punitive, may come into play, though is generally not applied to situations involving breach of contract/failure to perform. As the name implies, punitive damages may be imposed as punishment by a court of law for fraud or illegal activity, or for grossly negligent, intentional, reckless, malicious, or willful types of behavior. Punitive damages can be awarded in addition to actual or other types of damages. This chapter will focus mainly on the other three types of damages listed above.

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Breach of Contract/ Failure to Perform

The terms breach of contract and failure to perform are used interchangeably. They simply mean that a party to the contract did not do what he was supposed to do, as specifically required and agreed on in the written contract. For the balance of this chapter, failure to perform will be used to describe this situation. A typical failure to perform on the part of the contractor, for which he may be exposed to monetary damages, is not meeting the schedule to complete the work without a legitimate reason. A legitimate reason why the contractor may not be able to meet the schedule might be, for example, an unusual three-­week-­long period of rain at the job site that severely slows down the construction effort. A typical failure to perform on the part of the owner, for which he may be exposed to monetary damages, would be not paying the contractor on time without a legitimate reason. A legitimate reason for this might be, for example, that the contractor did not include, with his request for payment, all the necessary inspection reports that were required as a condition of payment.

Contractors’ Financial Exposure

To many contractors, the chance of financially exposing their companies as a result of damages awarded to an owner for their failure to perform seems remote. This is something that only happens to other contractors, they think. After all, the contractor plans to complete all work safely, in accordance with the plans and specifications, the contract schedule, and all the other various commercial terms and conditions of the contract. If everything goes according to plan, the contractor will safely complete the work, finish on time, make a profit, and satisfy the owner. However, things don’t always proceed according to the plan. As a part of the risk management process for contracts, contractors need to consider and minimize the potential for any financial exposure that might arise out of damages assessed against them for failure to perform certain aspects of the contract. Owners and their contracting teams are already considering the possibility that contractors will fail to perform some portion of the contract and will attempt to protect themselves from the financial consequences by including special protective clauses in the contract. These clauses provide for the payment of monetary damages in the event of the contractors’ failure to perform certain aspects of the contract.

Actual Damages—­A Silent Risk? 194

Actual damages can be assessed against the owner or the contractor if either or both fail to perform their respective responsibilities and obligations as outlined in the construction contract. Actual damages are considered economic (monetary) damages that can be clearly proven

and determined, typically awarded by a court of law as the result of a lawsuit brought by one of the parties to the construction contract. Neither party can just step up in front of the judge and tell him that they believe the other party caused him $10,000 in damages; the judge will want some legitimate facts and figures to prove the claim is valid. The imposition of actual damages on a contractor could bankrupt him, making it critical to understand this risk. It’s unlikely that an owner will include a separate paragraph in a construction contract that specifically addresses actual damages, which is why they can be considered a “silent risk.” There is no need to include an actual damages clause in a construction contract. The owner—and the contractor, too—always has the right to file a lawsuit to try to recover actual damages they believe they can prove.

Both the owner and the contractor are expected to perform in accordance with all the terms and conditions of the construction contract. If one party fails to perform as agreed, then the other party may suffer some legitimate amount of economic damage as a result of that failure. The monetary damages awarded to one party are meant to compensate the other party for some or all of the actual value of the economic damages he suffered due to the other party’s failure to perform.

A lawsuit for actual damages can be initiated by either party. The owner can file a lawsuit against the contractor for actual damages he feels were the result of the contractor’s failure to perform one or more of his contractual requirements. Likewise, the contractor can file a lawsuit for actual damages he feels were the result of the owner’s failure to perform one or more of his contractual requirements. The court would examine the contract, take a look at the facts and figures, sort out the details, and, if appropriate, make a determination of the amount of monetary damages, if any, to be awarded. Awarding monetary damages to the aggrieved party will supposedly make him “whole.” The award on monetary damages is based on the court’s assessment of how much the failure to perform by one party costs the other.

An Example

Let’s say a contractor installs an incorrect piece of equipment on a construction project, and it costs the owner an additional $25,000 for plant downtime to replace it with the correct equipment. If he can prove these costs in court, then the court may award monetary damages in the amount of $25,000. This award reimburses the owner for his extra costs and makes him “whole.” It restores him— financially/economically—to the point where he would have been if the contractor had installed the correct piece of equipment.

Can the owner or contractor negotiate a clause into a construction contract that relieves one or both of them from exposure to actual damages? They might try, but the short answer is no. It’s very unlikely that an owner or contractor would agree to some form of commercial language that would take away their right to pursue compensation for actual damages caused by the other party’s failure to perform. It is possible, though, to include a clause to exclude consequential 195

damages (which could be construed as a type of actual damages), put in a limitation of liability clause, or limit the contractor’s exposure to damages through a liquidated damages clause. (More information about these special types of damages and limitations are provided later in this chapter.) In general, contractors understand that if they do not perform in accordance with the terms and conditions of a construction contract, then they have failed to perform. As a result, the owner may suffer some amount of economic damage. If the owner can prove in court that he has actually suffered economic damages on account of the contractor’s failure to perform, the court may order the contractor to pay some amount of monetary compensation for such actual damages. Likewise, actual damages may be awarded to a contractor by a court if the owner fails to perform. There are two sides to the coin here. The moral of the story is: there are no excuses. The owner and the contractor are both at risk for actual damages, and both need to perform the construction contract in accordance with the mutually agreed-­on terms and conditions.

Liquidated Damages

Liquidated damages—­LDs as they are commonly called—­are the owner’s estimate of how much he is financially “damaged” in the event the contractor fails to perform. The idea behind LDs is that the owner feels it is not possible to accurately determine the precise amount of the actual damages he will incur by the contractor’s failure to perform. Therefore, the amount of the LDs stipulated in the contract’s commercial terms and conditions is an agreed-­on estimate of the value of the economic damages incurred by the owner by the contractor’s failure to perform. When a liquidated damages clause appears in a construction contract, it has usually been drafted by the owner. In most construction contracts, this clause will provide for some specific amount of monetary damages to apply against the contractor for his failure to meet the contractual schedule. For example, if a contractor agrees to a 12-­month completion schedule for the work and finishes in 13 months, the liquidated damages clause would typically call for the contractor to pay a certain amount of money to the owner for every day, week, or month that the completion date exceeds the completion date indicated in the contract. Liquidated damages are also common in contracts where a certain process or performance is guaranteed. For example, if a contractor builds a chemical plant using his own proprietary chemical

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manufacturing process, and the final output of the plant is less than what was stipulated in the contract, the liquidated damages clause might call for some financial payment to the owner for every percentage or unit of output less than agreed on in the contract.

An Example

Suppose a contractor builds a chemical manufacturing plant, and that plant’s required output (as agreed on in the contract) is 10,000 tons of a specific chemical every month. Once the plant is up and running, it only produces 9,500 tons of the chemical every month. In this instance, there was a liquidated damages clause in the contract obligating the contractor to pay the owner $20,000 ($4,000 per ton per month reduced output) per month in liquidated damages until the plant was fixed to produce the required output. The $20,000 is the owner’s estimate of how much he would be damaged by the reduced output. Perhaps the owner had to purchase the chemical from a competitor to meet his customer’s needs.

Sometimes owners can be very creative in the application of liquidated damages clauses. For example, the owner may have an LD clause in the contract relating to the contractor’s project manager. If the contractor pulls his project manager off the project prior to the end of the job, the LD clause may come into play against the contractor. Presumably, in this situation, the owner had some part in the selection process of an experienced project manager, likes his skills and capabilities, and wants to discourage the contractor from pulling him off the project prior to the completion of the work. The example and sample LD clauses that follow outline what may occur when the contractor fails to meet the schedule—­probably the most common situation where the owner would want to apply liquidated damages.

An Example

Let’s say an owner wants to build a marine jetty, complete with cargo loading and unloading facilities to handle ocean-­going ships. The owner hires a contractor to design and build the jetty and associated loading facilities on a turnkey, engineering, procurement, and construction basis. They agree on a final price of $10,000,000 and an 18-­month overall completion schedule. The contract requires that at the end of the 18 months from the date of signing the contract, the jetty and facilities will be complete and ready to load or unload cargo from ships. Because it takes a significant amount of lead time to schedule ships and organize exported and imported cargo, the owner proceeds 197

immediately after awarding the contract to schedule the arrival of the first ship to coincide with the completion of the jetty and unloading facilities, relying on the contractor to finish on time. As it turns out, the contractor does not finish the marine jetty and associated loading and unloading facilities within the contractual completion time and is 20 days late. Since the jetty and unloading facilities were not completed on time, the ship scheduled by the owner now has to sit at anchorage in a nearby harbor waiting to unload. The owner is subject to demurrage (waiting time on the ship) of $7,000 per day by the shipping company. There are also other financial considerations the owner has to face, such as being penalized by his own customers for not being able to deliver the product that is on the ship waiting to unload at the unfinished jetty. The owner may also have to pay for unloading the ship at an alternate and more expensive location. The owner, to protect himself against any such consequences of the contractor not finishing on time, had included a liquidated damages clause in the contract. It stipulated that the contractor will pay the owner $10,000 per day for each day it takes to complete the jetty beyond the contractual completion date of 18 months. In determining the amount of liquidated damages, the owner estimated that the demurrage cost on the ship would escalate to about $7,000 per day by the time the jetty and unloading facilities were completed. He also estimated another $1,000 per day to cover the extra costs and penalties he would likely incur by not being able to deliver the product that was on the ship to his customers on time. He further estimated another $2,000 per day in the event he had to use alternative unloading facilities if the new jetty and unloading facilities were not completed on time. The $10,000 per day in liquidated damages represents a fair estimate of what the owner would have to pay if the jetty and unloading facilities were not completed on time. The liquidated damages clause in the contract for the marine jetty read as follows: Article 40 – Liquidated Damages 40.1 In the event Contractor fails to complete the Work within the schedule and completion dates established in the Contract, Contractor agrees to pay Owner liquidated damages in the amount of $10,000 per calendar day of delay in final completion calculated from the Contract Completion Date up to and including the actual date of completion.

Since the contractor was twenty days late in finishing the jetty and associated loading and unloading facilities, he failed to perform the 198

contract in accordance with one of the key contract requirements—­ the requirement to finish the job in 18 months. Because the ­contractor failed to perform and had no legitimate reason for the delay, the owner is exposed to additional costs. Consequently, the owner has the right to enforce the terms of the liquidated damages clause in the contract and charge the contractor 20 days multiplied by $10,000 per day, for a total of $200,000 in liquidated damages. If the contractor refuses to pay, the owner would most likely be able to have a court of law enforce the liquidated ­damages clause. If the contract allowed the owner to withhold r­ etention from the contractor’s monthly progress invoices, he may subtract the full amount of the liquidated damages from the amounts retained. The above example was straightforward. It was designed to show how an owner can estimate a value for liquidated damages and specify it in a contract, as well as how it can be legitimately applied against the contractor for his failure to perform without valid reasons for the failure. The practice of using liquidated damages to reimburse an owner for the financial loss he may incur by a contractor’s failure to perform on a construction contract is fair and acceptable, in theory, as long as it’s not abused. Unfortunately, the application and use of liquidated damages in a construction contract is not always as fair and straightforward as in the above example. The imposition of liquidated damages on the contractor by an owner, or by a major engineering, procurement, and construction (EPC) contractor, on lower tier contractors and subcontractors without due regard to fairness can be a serious risk and potential financial liability for a contractor or subcontractor. From a risk management perspective, it’s important for the contractor to protect himself by negotiating limits and conditions to any liquidated damages clause in a construction contract. The following are eight important issues for contractors to consider when analyzing and negotiating a liquidated damages clause in a contract: 1. Does the amount of liquidated damages proposed by the owner make sense with respect to the price, schedule, and risk for the work? 2. Will the owner agree to put a financial cap (maximum) or other limiting provisions on the amount of liquidated damages? 3. Does the contract have good changes and delays clauses that require the owner and contractor to agree in writing on the price and schedule? This is especially important if there are LDs related to schedule compliance. 199

4. Has the owner insisted on an unrealistic completion schedule? 5. Will the possibility of liquidated damages being imposed on the contractor create an adversarial relationship among the ­contractor, his project manager, and the owner during the course of the contract? 6. Are liquidated damages really necessary for the contract, or are they included to apply pressure on the contractor to perform? 7. Does it appear that liquidated damages are really a penalty? 8. If the contractor agrees to accept liquidated damages for failure to complete the work on time, will the owner then agree to pay the contractor a bonus for early completion?

Amount of Liquidated Damages

The amount of liquidated damages that might be imposed on a contractor for failure to perform should bear some relationship to the value of the contract and the risk associated with the completion schedule and the nature of the work. For example, if the contractor’s price to perform a construction project with a tight schedule is $1,000,000, and the owner insists on $25,000 per day in liquidated damages for failure to meet the schedule, it wouldn’t take many days of schedule overrun to put the contractor out of business. Maybe, in reality, $500 per day is a more realistic amount for any liquidated damages. In this case, if the owner refuses to negotiate a lower amount of LDs that makes sense with respect to the value of the contract, its profit potential for the contractor, and the level of risk associated with the work, then this might be a good example of a project to let the competition have. It’s not worth “betting the company’s future” on a contract like this.

Limiting Provisions

If the contractor has to agree to a liquidated damages clause in the construction contract, then he should try to negotiate some limiting conditions so that the potential financial exposure for failure to perform can be understood and not unlimited.

An Example

Let’s say that a contractor has a $10,000,000 contract to build a new office building on a design and construct basis. The contractual completion schedule is 24 months from the date of signing the contract. The owner wants liquidated damages to apply in the amount of $5,000 per day for each day the contractor fails to meet the agreed-­on completion schedule.

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The contractor is comfortable with the $5,000 per day amount, but is concerned that there is no limit to the maximum amount he may have to pay for his failure to meet the schedule.

Example 1: Financial Cap

In the example, the contractor and owner could negotiate the following clause that limits the total amount of liquidated damages: Article 41 – Liquidated Damages 41.1 Should Contractor fail to complete the Work within the schedule and completion dates established in the Contract, Contractor agrees to pay, as its sole liability to Owner for delays, liquidated damages in the amount of $5,000 per calendar day of delay in final completion calculated from the Contract Completion Date up to and including the actual date of completion, to a maximum amount of 2% of the Contract Price, or $200,000.

In the above example, the contractor’s maximum financial exposure, or cap, is $200,000. In another example of financial caps, let’s say the owner in the same example is agreeable to a financial cap but now wants $10,000 per day in liquidated damages.

Example 2: Financial Cap & Steps

The owner and contractor may agree to the following clause that limits, in a little different way, the total amount of liquidated damages: Article 41 – Liquidated Damages 41.1 Should Contractor fail to complete the Work within the schedule and completion dates established in the Contract, Contractor agrees to pay, as his sole liability to Owner for delays, liquidated damages as follows: a.) $5,000 per day for the first 20 calendar days of delay in final completion calculated from the Contract Completion Date, and; b.) $10,000 per day thereafter for delay up to and including the actual date of completion, and; c.) Contractor’s maximum liability for liquidated damages shall not exceed 3% of the Contract Price, or $300,000.

In this example, the contractor gets a little relief from the full $10,000 per day for the first 20 days of delay, but has to pay $10,000 per day after that for delays, up to a maximum combined amount of $300,000. This “stepped” approach can be expanded by contractors as necessary to lower the amount of liquidated damages they are exposed to for short delays in the completion schedule. 201

Example 3: Financial Cap & Grace Period

Sometimes an owner will accept the fact that it is difficult to exactly meet a contractual completion date, even though the contractor is applying his best efforts and doing a good job. In this case, the owner, even though he wants liquidated damages in the contract, might agree to a liquidated damages clause containing a “grace period” similar to the following: Article 41 – Liquidated Damages 41.1 Should Contractor fail to complete the Work within the schedule and completion dates established in the Contract, Contractor agrees to pay, as his sole liability to Owner for delays, liquidated damages in the amount of $5,000 per calendar day of delay in final completion calculated from a time period commencing 15 days after the Contract Completion Date up to and including the actual date of completion, to a maximum amount of 2% of the Contract Price, or $200,000.

In this example, the contractor is allowed to exceed the contractual completion date by 15 days before liquidated damages begin to apply. The 15 days is the “grace period.” Limiting or eliminating liquidated damages may also be a good idea when a main contractor working for the owner has contracted with subcontractors for certain portions of the work. The main contractor has accepted liquidated damages in his contract with the owner and may want to include similar liquidated damage provisions in contracts with all his subcontractors on the project. In this situation, a subcontractor may be completely finished with his part of the project well in advance of the contractual completion date in the main contract. Depending on the nature of the subcontractor’s work, his failure to meet his own schedule may or may not have any impact whatsoever on the achievement of the main contract’s scheduled completion date. The conflict is this: suppose the subcontractor fails to finish on time, and the main contractor imposes liquidated damages on him. However, the main contractor finishes the overall project on time and pays no liquidated damages to the owner. Is it fair, then, that the main contractor be allowed to impose the liquidated damages on the subcontractor who did not meet his schedule? Maybe, if the main contractor could prove that he had to spend money to finish on time as a result of the subcontractor’s delay. 202

Example 4: Financial Cap for Subcontractors

Let’s say the subcontractor has a subcontract in the amount of $5,000,000 for civil and site work on an industrial project. The subcontractor’s completion schedule is 12 months from the date of signing the subcontract with the main contractor. The main contractor has a contract with the owner to complete the overall project in 36 months from the date of signing of the contract. The main contractor wants all subcontractors who are working for him to agree to a liquidated damages clause in their subcontracts. In response to the main contactor’s requirement for a liquidated damages clause, the subcontractor for the civil and site work may want to try to negotiate a liquidated damages clause similar to the following: Article 41 – Liquidated Damages 41.1 Should Subcontractor fail to complete the Work within the schedule and completion dates established in the Subcontract, Subcontractor agrees to pay, as his sole liability to Main Contractor for delays, liquidated damages in the amount of $5,000 per calendar day of delay in final completion calculated from the Subcontract Completion Date up to and including the actual date of completion, to a maximum amount of 2% of the Contract Price, or $100,000. 41.2 Notwithstanding the above, Subcontractor shall not be required to pay liquidated damages to Main Contractor in the event Main Contractor does not have to pay any liquidated damages to Owner.

This is a simple “no harm, no pay” liquidated damages clause. A subcontractor who was late in meeting his schedule would not be exposed to liquidated damages if the main contractor did not have to pay any liquidated damages to the owner. This clause could be further expanded to include “steps” such as noted in Example 2. A “grace period” could be added as well, similar to Example 3.

Delays in the schedule on account of legitimate changes and delays must be recognized and incorporated into a revised project schedule and completion date.

Change & Delay Clauses with Liquidated Damages

If an owner insists on having a liquidated damages clause in the construction contract, then it’s important to carefully review the changes and delays clauses as well, and negotiate changes to them as necessary to take into account the exposure to liquidated damages for failure to meet the completion schedule. Legitimate changes and delays need to have their effect on the project schedule recognized by the owner as soon as they occur. If schedule delays are not recognized and not added to the time for completion, then the contractor may be unfairly exposed to paying liquidated 203

damages in the event he does not meet the original completion schedule. As a matter of good contracting, all changes and delays need to be accepted in writing by the owner. This is even more important where the contractor may be exposed to paying liquidated damages for failure to meet the completion schedule.

The Adversarial Effect of Liquidated Damages The contractor’s project manager is responsible for completing the project work on time, among about a thousand other things he is responsible for achieving. If a contract is not completed on time and the owner decides to invoke the provisions of the liquidated damages clause, not only does this affect the contractor financially, but it also may impact the reputation of the contractor’s project manager. A good project manager will make sure that every change or delay occasioned by the owner is addressed, and that the effects are properly added to extend the project’s completion date.

What this means is that all delays, regardless of how small, will attract the attention of the project manager, and he will insist that the owner extend the project completion date accordingly so that the project is not unfairly exposed to liquidated damages. On a project without LDs, many of the small delays may be just absorbed into the existing schedule by the project manager. Constantly presenting the owner with lots of small delays can create an unnecessary adversarial relationship between the owner and the contractor and his project manager. Bringing up the possibility of this adversarial relationship developing at the contract negotiating stage is a good tactic to negotiate less onerous LD clauses, or eliminate them completely.

Consequential Damages

Consequential damages are those that may occur indirectly as the result of a failure to perform or as a consequence of some damage to property or injury to people.

An Example

A contractor is building a new manufacturing facility. During the course of the construction, the contractor’s 100-­ton crane ­accidentally hits the edge of some newly installed structural ­columns. The columns fall over and destroy a main pump that is part of an operating system of the owner’s adjacent facility. The destroyed pump causes the adjacent facility to completely shut down. The owner claims actual damages for all his costs associated with the replacement of the pump, and also claims for the loss of profit he

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suffered by the plant having to shut down for three weeks while the new pump was procured, installed, and tested. The additional claim for reimbursement of the owner’s loss of profit is a type of consequential damage. The loss of profit the owner incurred from the existing facility being shut down was a consequence of the contractor’s accident that occurred on the new facility being built by the contractor. The contractor’s project value in the above example was $5,000,000. The cost to replace and install the new pump in the owner’s adjacent facility was $150,000. The contractor can probably deal with that type of cost exposure on this size of a contract, and probably has insurance to cover this cost. However, the owner claims that the loss of profit from the three-week shutdown of his operating facility was $500,000, and has backup information to substantiate it. The contractor doesn’t have insurance to cover this type of loss, so in the event the owner was successful in a lawsuit, the $500,000 would come out of the contractor’s pocket. Could the contractor have done anything to avoid this type of financial exposure? The answer is yes. During the contract negotiations with the owner, the contractor could have negotiated a waiver, or exclusion, of consequential damages into the terms and conditions of the contract. The following is a typical exclusion of consequential damages clause that could be considered for inclusion in the terms and conditions of a construction contract: Clause 50 – Exclusion of Consequential Damages 50.1 Regardless of how caused, Contractor shall not be liable to Owner for any special, indirect, incidental, or consequential damages, including loss of profits or revenues, or damage to adjacent facilities.

The inclusion of a simple exclusionary clause like the above has the potential to save the contractor from financial liability that could arise out of consequential damages, which could put his company into bankruptcy and out of business. Often, the owner may object to the exclusion of consequential damages applying to the contractor only, but may agree to revised wording similar to the following: Article 50 – Exclusion of Consequential Damages 50.1 Regardless of how caused, neither Contractor nor Owner shall be liable to the other for any special, indirect, incidental, or consequential damages, including loss of profits or revenues or damage to adjacent facilities.

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It is not sufficient to be silent in the contract terms and conditions on the issue of consequential damages; a separate clause is required specifically excluding consequential (and similar) damages. Exposure to consequential damages is a significant risk to a contractor and must not be taken lightly!

Conclusion

The above clause is a mutual agreement between the contractor and the owner that neither will be liable to the other for consequential damages. The following are two key reasons why it is important to have a separate clause for consequential damages: 1. If the exclusionary language were included elsewhere in the contract, such as in the indemnity clause, and the entire indemnity clause is later ruled unenforceable as the result of a lawsuit, the contractor could potentially lose the protection of the exclusion of consequential damages. 2. As a separate clause, it’s more clear to a judge and/or jury in a lawsuit that the owner and the contractor were both aware at the onset of the contract of the exclusionary language. This gives the contractor a significantly better chance of avoiding any type of consequential damages the owner may try to receive in a lawsuit. Is it fair for a contractor to seek a waiver of consequential damages? Certainly it is. Contracts are two-way streets; they are not just for the exclusive and sole benefit of the owner. Liquidated damages will likely be the most common type of damages a contractor, and his project manager, will be exposed to in a construction contract. Contractors who accept these clauses should make sure the value of the LDs is fair with respect to the total value of the contract and limiting provisions should always be negotiated. Better yet, LD clauses should just be eliminated. Despite an owner’s persuasive arguments to the contrary, many LD clauses are included in contracts to act as pressure on the contractor to meet the schedule or as a penalty. Consequential damages could theoretically be financially unlimited. They must always be specifically excluded in a separate clause in a contract. The imposition of consequential damages on a contractor could place him in bankruptcy.

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Chapter

12

Warranties

A warranty is a contractor’s pledge that he will stand behind the work he performs—­and fix it if it doesn’t work. But, is it really that simple? No, it’s not, in fact. Like all commercial terms and conditions contractors must deal with in a construction contract, warranties can range from simple to complex, and may expose them to the potential for unnecessary or unacceptable financial liability.

A Workable Definition of Warranty

A definition is in order for this term as it applies in a construction contract: A warranty is an agreement provided by a contractor giving an owner assurance that the work performed will be done in accordance with the contract and its plans and specifications, and will be free of defects. The warranty definition may go on to say: The contractor will fix or replace any defective work discovered within a fixed time period that starts at the completion date of the project. Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Like other contract clauses, warranties are optional in the contract. There is no rule that requires a contractor to provide an owner with a written warranty; it’s just another negotiable clause. Sometimes, in fact, there are good reasons not to provide a warranty, and other times the contractor provides a warranty without even knowing it! Both of these warranty situations will be explained later on in this chapter.

Warranty Issues

There are two basic issues with warranties that need to be carefully addressed: 1. If defects in the work are found, what is the process for the contractor to fix them? 2. Does the work function as intended? If not, what is the process for the contractor to fix the problem?

Warranty & Guaranty—­What’s the Difference?

A guaranty is not the same as a warranty, though the terms are frequently—­and incorrectly—­used interchangeably. A warranty is an agreement between two parties, typically the contractor and the owner. The contractor agrees to provide the owner with a warranty for his work, which promises that the work will be built in accordance with the contract and be free of defects. A guaranty is an agreement between three parties, typically the contractor, owner, and a third party, called a guarantor. A guaranty is typically provided by a specialized company called a surety, which provides a guaranty to the owner for the performance of the contractor in a construction project. If the contractor fails to perform as outlined in the contract, the surety company will step in and find a way to finish the remaining contractual obligations or perhaps pay the owner. (Guaranties are more fully discussed in Chapter 6.)

What Do Warranties Provide an Owner?

Owners expect the contractor to properly build the project, and if a defect is found within the warranty’s allowable time period, then the owner expects the contractor to fix it. Building projects on time and in accordance with the plans and specifications, and without defects, is what establishes the good reputation of a contractor. If some portion of the work is found to be defective, the contractor’s reputation is enhanced by promptly fixing it without any hassles to the owner. No one likes to make mistakes in building a project, but they happen; it’s part of being in the construction business, as is properly fixing any defects. 208

Examples of Warranty Clauses

Warranty clauses can range from simple to complex. The following are several examples and explanations of what they cover (or don’t). The first is straightforward and provides for the major assurances an owner will likely want from a contractor in a warranty agreement: 1. All work performed by the contractor will be free of defects. 2. The warranty period will be 12 months from the date of completion (in this case the issuance of the certificate of Mechanical Completion, a document that states the work is finished). 3. The contractor agrees to repair or replace all defective work at his expense.

Example 1 Article 28 – Warranty 28.1 Contractor warrants that all Work performed by him shall comply with the terms of this Contract and all of its Plans and Specifications, and that all Work performed by Contractor will be free of defects in design, materials, and workmanship. 28.2 The warranty period shall be 12 months and shall commence upon the date of Owner’s issuance of the Mechanical Completion certificate to Contractor for his Work. 28.3 Any defect found in the Work within the warranty period shall be promptly replaced or repaired by Contractor at no cost to Owner.

Example 2

The following example is the same warranty with an added twist that will increase the contractor’s risk: Article 28 – Warranty 28.1 Contractor warrants that the Work performed by him shall be suitable for the purposes intended, shall comply with this Contract and its Plans and Specifications, and will be free of defects in design, materials, and workmanship. 28.2 The warranty period shall be 12  months and shall commence upon Owner’s issuance of the Mechanical Completion certificate. 28.3 Any defect found in the Work within the warranty period shall be promptly replaced or repaired by Contractor at no cost to Owner.

What’s so different about this warranty clause and the first one? Though very few words have been added, there is more risk in the 209

second line of paragraph 28.1, “Work. . .shall be suitable for the purposes intended.” In this second example, the contractor is responsible for the design of the project, in addition to supplying materials and constructing it. Of course it’s likely that the contractor has knowledge of the original purpose for which the project is being built. However, the owner could decide to use the facility later on for something other than what the contractor—or the owner, for that matter—envisioned in the original design. This may expose the contractor to unnecessary potential financial liability if the facility fails or doesn’t work properly when the owner uses it for other purposes. Does this sound far-fetched? Maybe, but in a lawsuit, a judge and jury with little or no engineering design or construction experience could decide that the owner’s new use of the facility falls within the “suitable for the purposes intended” clause. The contractor would lose the case and need to get out his checkbook. In this instance, the contractor, who did not design the plant, would have been better off deleting the words, “shall be suitable for the purposes intended,” or negotiating a change in the first paragraph of the owner’s proposed warranty clause. A revised version could read similar to the following: Article 28 – Warranty 28 28.1 Contractor warrants that the Work performed by him shall comply with this Contract and its Plans and Specifications, be suitable only for the purpose(s) expressly specified in the design criteria of the Contract, and be free of defects in design, materials, and workmanship.

It’s always best to be specific in contract wording. When the language in a contract is too broad and open to wide interpretation by someone else (owner, arbitrator, judge, or jury), the contractor may end up assuming significant potential financial liability. 210

The revised wording strictly limits the purposes intended as only to those specifically described in the contract’s plans and specifications. This removes the risk of allowing someone else, not associated with the contract, to speculate and determine what the “purposes intended” may mean. Contractors should be careful in agreeing to warranty clauses that have broad, undefined “purposes intended” wording. It’s much better to eliminate the “purposes intended” language or, alternatively, carefully specify what the “purposes intended” are. After all, it is the owner’s project, and he should know what the intended purposes are and be willing to note them in the contract. Also note that in this example no specific time limit applies to the undefined “purposes intended” obligation. The implication of this is that the contractor could find himself in a lawsuit years after the project is successfully finished.

As a final note on the topic, let’s say the contractor in this case had no design responsibility. His scope of work was only material supply and construction. The contractor was to follow the plans and specifications developed by the owner or the owner’s engineer. To agree to the general “purposes intended” language in a warranty clause for which only material supply and construction work was contracted could expose the contractor unfairly to future financial liability for events over which he has absolutely no control or input.

Example 3

The following is another example of a typical warranty clause with an extended time period and several exclusions: Article 28 – Warranty 28.1 Contractor warrants that the Work performed by him shall comply with this Contract and the Plans and Specifications, and that the Work will be free of defects in design, materials, and workmanship. 28.2 The Warranty Period shall be twenty-four (24) months from the date of Mechanical Completion of the Work or twelve (12) months from the date of Start of Operations, whichever occurs first. 28.3 If any defect is found in the Work during the Warranty Period, Contractor shall promptly repair, replace, or otherwise make good the defect and any damage to the Work caused by the defect at his own cost. 28.4 Contractor shall not be responsible for any defect or damage to the Work resulting from: a.) Improper operation or maintenance of the Work by Owner b.) Operation of the Work that is outside the specifications in the Contract 28.5 If Contractor repairs or replaces any part of the Work under this warranty clause, such repair or replacement part shall be subject to the same warranty time period as for the original Work, beginning with the completion date of the repairs or replacements.

This is the type of warranty a contractor might see when there are a number of different contractors working on a large, multi-disciplined project that requires several years or more to complete. Paragraph 28.2 anticipates that the contractor may finish his work and receive his mechanical acceptance certificate prior to the completion of the project and start of operations. The owner’s goal is to have a normal 12-month warranty period be in effect for the contractor’s work while his facility is in operation. He wants the contractor’s warranty period to begin more or less at the start up of the facility. That’s the goal. So the owner requires 211

a 24-­month maximum warranty period from the contractor. This gives the owner a 12-­month “cushion,” or idle time, to get the entire facility built and in operation and still have a 12-­month warranty period in effect for contractor’s work.

An Example

Let’s say the contractor completes his work in 12 months, and the facility is completed and starts up 6 months later. In this situation, the contractor’s 12-­month warranty period begins at the start-­up of the facility per the terms of the warranty clause. The contractor ends up providing a warranty of his work for a total of 18 months (6 months idle time, plus 12 months of operating time). There is some risk here for extended warranty, but maybe not too much. In a different situation, suppose the contractor completes his work and the facility is completed and starts up 18 months later. In this situation, the contractor’s warranty period becomes the maximum of 24 months from the date of the Mechanical Completion (the 18 months of idle time, plus 6 months of operation time). The contractor’s warranty period will expire 6 months after the facility starts to operate because the 24-­month maximum time limit is met. The owner would have liked to have had the contractor’s warranty for his work in place for 12 months of operation of the facility, but he ends up only receiving 6 months of warranty while the facility is operating, due to the 24 months time limit constraint in the warranty clause.

Paragraph 28.3 obligates the contractor to fix any defects in his work found during the warranty period, and at his cost. This is normal. However, the owner has thrown in a twist with the words, “and any damage to the Work caused by the defect.” Although this sounds fair, this type of wording is open to wide interpretation, and, hence, the contractor’s commercial risk can significantly increase. Who’s to judge that any damage occurred and was actually caused by the defect? The owner? The contractor? Some third-­party inspector? As it reads, it looks like the owner gets to make a unilateral decision on whether or not the defect caused additional damage, which isn’t fair to the contractor. In this case, the contractor would be better off eliminating such wording at the contract negotiation stage, or perhaps revising it to something similar to the following: “and any damage to the Work caused by the defect as may be determined by a mutually acceptable third-­party inspection agency.” This achieves what the owner wants in the way of protection for damage to the work caused by defects, but also gives the contractor some measure of protection against unwarranted claims for damage by the owner. 212

Paragraph 28.4 protects the contractor from any actions by the owner that may cause defects or damage to the work. The owner must take responsibility for the operation and maintenance of the facility. If defects or damage to the contractor’s work occur as the result of owner’s improper operation or maintenance, the owner can’t come back to the contractor for repairs under the warranty clause. The paragraph also frees the contractor from the potential financial liability of repairing defects or damage caused by the owner’s improper operation of contractor’s work in the facility. Exclusions like the two shown in paragraph 28.4 should be part of all warranty clauses. Many things can happen to the contractor’s work after he leaves the site. Defects and damage caused by natural events or the owner’s lack of maintenance or improper operation are outside of the contractor’s control, and he should not be responsible under any warranty clause for the consequences of those actions. Finally, paragraph 28.5 states that if the contractor repairs or replaces a defect during the warranty period, he will warranty those repairs or replacements for another 12 months. The 24-­month maximum time limit contained in the warranty clause doesn’t apply in this case.

An Example

Let’s presume that everything goes according to plan. The contractor finishes his work, and the plant starts up 12 months thereafter. The contractor’s warranty on his work is in effect for the 12 full months during the operation of the plant. The 24-­month maximum time period and expiration of the 12-­month warranty period on the work after it starts up occur at the same time. Ten months into the operation of the facility, the owner discovers a defect in the contractor’s work. A main pump begins to malfunction and eventually fails. It doesn’t stop the plant, because the pump has a backup that immediately begins working after the main pump fails. The owner notifies the contractor that the pump failed. The contractor quickly procures a new pump and promptly and safely installs it for him. The provisions of paragraph 28.5 require that any repairs or replacements performed by the contractor be warranted for 12 months. Even though the contractor’s warranty on all the rest of his work expires in 2 more months, the warranty on the new replacement pump he installed will run for an additional 12 months from the date of installation and start-­up of the pump.

This requirement to provide an extension of warranty on repairs and replacements is sometimes called an “evergreen” clause, and should be avoided if possible. 213

The Uniform Commercial Code

What place does a discussion on the Uniform Commercial Code (UCC) have in a chapter on construction contract warranties? The UCC is about 800 pages of rules and regulations regarding the sale of goods. (Goods are considered moveable items for sale.) It is the commercial law in place in all states in the U.S., except Louisiana, as of the date of publication of this book. (Even Louisiana, however, uses most of the UCC regulations.) The UCC does not apply to contracts for construction in general, since what is built is generally considered not moveable. However, because it is virtually impossible to predict how a court of law may rule with respect to what’s considered “moveable”—­and whether or not the UCC applies—­it’s better for contractors to adopt a few simple precautionary modifications or additions to their contracts’ warranty provisions. This precaution is best exemplified by what the UCC considers implied warranties.

Implied Warranty

An implied warranty is a warranty imposed by a state law, like the UCC. It doesn’t necessarily have to be in writing to be in effect; the absence of a written warranty doesn’t necessarily mean that the owner is completely without some form of warranty protection. The two most common types of implied warranties that may be encountered by a contractor are: 1. Implied warranty of merchantability: Goods must function how they are typically intended (ordinary purpose). This may be applicable to some or all of a construction project, in the sense that what is constructed should function as intended. For example, if a contractor builds an office building per an owner’s plans and specifications, the ordinary purpose of this project is a building that provides office space for tenants. In simpler terms, the usual and normal purpose for which this building will be used is as an office building. 2. Implied warranty of fitness for a particular purpose: Goods should perform how the contractor advises the owner they should. This, too, could possibly apply to some or all of a ­construction project. For example, if a contractor builds an office building for an owner and also advises the owner that the b ­ uilding can be used as a discothèque and nightclub, this is a non-­ordinary or particular purpose. In simpler terms, is the building fit to be used for some other purpose than as an office building? So, what’s the big deal? Why is this important? The implied warranties that come out of the UCC are designed to protect consumers against defective goods, like tennis racquets, automobiles, 214

or specialized computer equipment. In theory, this is good for consumers buying merchandise from local retail outlets, but how might this implied warranty theory get applied to construction contracts? As earlier noted, the UCC is designed to apply to moveable goods and, in theory, not to construction projects, which, presumably, construct immoveable goods. But who determines what a “moveable good” is? For example, let’s say a contractor constructs a building that could theoretically, at some later date, be lifted onto beams and moved 2,000 yards to a new location. Is that building considered a “moveable good,” or is still part of a construction project? In another situation, what if a contractor builds a high-­strength steel pressure vessel for an oil refinery that weighs 1,000 tons, is 400 feet tall, and is permanently anchored through a base ring with 100–2-­1/2″ diameter anchor bolts that are all deeply embedded in a concrete foundation. Theoretically, the nuts on the anchor bolts could be loosened and removed, and the 1,000-­ton pressure vessel could be moved to a new location. Is this large, heavy pressure vessel really a “moveable good” or is it, in reality, part of a construction project and not technically “moveable.” Were the structures in either of these two examples intended by their owners to be “moveable goods?” The problem a contractor may have to deal with in situations similar to those noted in the above example is who determines whether or not the structures provided in the construction project are moveable—­and whether the implied warranty laws of the UCC apply. In the event a claim or dispute arises over a warranty, it may go before a panel of arbitrators or a judge in a court case, neither of which may have any experience in the construction business. The outcome of the arbitration or court case is impossible to predict. There is no way to stop creative interpretation of the UCC laws on implied warranties—­or any laws for that matter—­by these groups. If the contractor does not have a written warranty in place that specifically disclaims any implied warranties, then an arbitrator or a court of law may make a decision on what implied warranties the contractor should be responsible for. How can a contractor avoid exposure to the potential financial liability that may arise out of an improper application of an implied warranty? This is easy. First, the contractor must put the details of his warranty in writing in all construction contracts and, secondly, he must conspicuously exclude any sort of implied warranties in the written warranty he provides. The best defense against potential exposure to the financial liability that may arise under any sort of implied warranty is to have a specific, well-­written warranty in the 215

construction contract and that excludes implied warranties of any sort. Contractors should always try their best not to be put in a position that allows others to decide what their warranty should cover. The good news is that the UCC, which provides for implied warranties, also provides contractors a way to exclude them, which is clarified in the following section.

Express Warranties & Conspicuous Exclusion of Implied Warranties A written warranty is called an express warranty. It is important for contractors to provide a specific and well-written warranty for all work. In addition to documenting how to properly take care of defects and placing a time limit on the warranty, as shown in earlier examples in this chapter, it is necessary to conspicuously exclude implied warranties.

Contractors can easily disclaim any implied warranties and all warranties for fitness for a particular purpose and of merchantability. The UCC requires that this disclaimer be done in a conspicuous manner in the contract. An additional paragraph, similar to the following, could be added to the warranty shown earlier as Example 3. 28.6 Owner and Contractor agree that the Warranty contained in this Contract is the only Warranty provided, and there are no other warranties, express or implied. Owner and Contractor further agree that ALL WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE OR OF MERCHANTIBILITY ARE SPECIFICALLY EXCLUDED.

If the contractor had carefully described in writing the sole purpose(s) intended for the work provided in the warranty clause, then the second sentence in the above paragraph is probably unnecessary. If he hadn’t, however, then he may be exposed to an implied warranty and it would be best to add the second sentence of 28.6. The capitalized words and bold print have been added to make the exclusion conspicuous. In the event a contractor is faced with a claim or lawsuit involving an implied warranty on his work, he could point to the capitalized section and present a strong case questioning how the owner could possibly have missed this conspicuous exclusionary language. Actually, the contractor could have capitalized the entire paragraph—even put all of it in bold print—to make it even more obvious that the only warranty provided is the written one contained in the contract. 216

When Is No Warranty Appropriate?

Earlier in this chapter, it was noted that when contractors provide a written warranty for work and abide by its provisions, their reputations can be enhanced. After all, who would want to deal with a contractor who was unwilling to warranty his work? The following is an example of a project where providing a warranty, however, may expose the contractor to potential significant financial liability.

An Example

The owner of a 25-­year-­old chemical manufacturing plant needs some extensive repairs and modifications performed on the plant’s existing process vessels and surrounding process piping and structural supports. The owner specifies in the construction contract the amount and type of repairs and modifications required. The process vessels produce specialty chemicals. The owner agrees to shut the plant down and make the area safe for the contractor to do the required work. The contractual terms and conditions proposed by the owner ­contain a requirement for a full one-­year warranty for design, materials, and workmanship.

Why would the contractor not consider providing a warranty for the repair work for this chemical manufacturing plant? Consider this situation: Six months after the contractor completes the repairs and ­modifications, a catastrophic explosion takes place at the chemical manufacturing plant in one of the process vessels that the contractor repaired. Not much is left of the plant except rubble and scrap. Several people are severely injured, and there is significant damage to adjacent properties of other companies. The owner faces significant financial liability and will be looking for someone to blame and help share the costs. After all, it could not have been the owner’s operating fault that this catastrophic accident occurred! In reviewing contracts for recent work at the plant, the owner finds the contractor’s contract for repairs and modifications to the process vessel that exploded and sees that he has a valid one-­year warranty for design, materials, and workmanship still in effect. The owner now files a lawsuit alleging that the repairs and ­modifications made by the contractor were defective in design, materials, and workmanship. His lawsuit notes that the work performed is still under warranty. He claims that the catastrophic failure of the process vessel was due to defects in the contractor’s 217

work. The lawsuit, of course, seeks significant monetary damages from contractor. When the contractor first considered bidding on the repair work, he should have given more consideration to the fact that the facility was 25 years old, and that providing repairs to it was risky enough, let alone providing the owner with a broad warranty typically only used for new projects. This is an example of a project in which the contractor must consider not providing any sort of warranty. However, it’s important to not simply leave out the warranty clause (remember the issues of implied warranties) altogether.

Example 1 –Warranty Exclusion

Instead, contractors should include a clause specifically disclaiming any sort of warranty. Wording similar to the following could be used: Article 28 – Warranty 28.1 Owner takes full and complete responsibility for the adequacy of all Work specified in this Contract, and Owner further agrees and understands that Contractor will only use ordinary skill in performing the Work specified by Owner. 28.2 With respect to all Work performed by Contractor, Owner agrees and understands that CONTRACTOR MAKES NO WARRANTY OF FITNESS FOR A PARTICULAR PURPOSE OR OF MERCHANTABILITY OR ANY OTHER WARRANTY, EXPRESS OR IMPLIED.

In a catastrophic situation as described in the earlier example, it’s likely the owner will still take the contractor and anyone else he can find to court claiming negligence, poor workmanship, etc. The contractor in this instance would at least have a strong defense because the exclusion of warranty was very conspicuously noted in the contract with the owner. Note that the example used was extreme and should not be construed to mean that all repairs and modifications to existing facilities should exclude a warranty. The decision about whether or not to provide a warranty—or to provide one with limited coverage—is a risk management issue that should be determined based on the nature of the work. What is meant to be emphasized here is that if a contractor is unwilling to provide a warranty for his work, whatever the circumstances might be, he needs to do so in writing and in a conspicuous manner.

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Extended Duration Warranties

While there probably is no absolute correct duration of a warranty for a construction project, one year is a typical time period. It gives the owner plenty of time to make sure the contractor did the work correctly. In warranty Example 3, discussed earlier in this chapter, paragraph 28.2 stated: 28.2 The warranty period shall be twenty-four (24) months from the date of Mechanical Completion of the Work or twelve (12) months from the date of Start of Operations, whichever occurs first.

This would be considered an extended duration warranty if the contractor’s normal warranty for his work was only one year. Assume that the contractor finishes his work on time (receives the Mechanical Completion certificate), and his completed work sits idle for one year while the rest of the owner’s project is being completed by other contractors. The facility starts up (Start of Operations), and his work remains under warranty for another year. His warranty is then in effect for a full 24 months. Again, this is an issue of risk assessment for the contractor. What additional risk does he accept by providing what could end up becoming a two-year warranty, even though for one of the years his completed work sits idle? The risk of a defect being discovered is certainly more likely once the contractor’s work is in operation, beginning after the Start of Operations. Perhaps the contractor needs to provide some sort of physical protection to his completed work for the potential one-year idle period. Or perhaps he must put some limiting provisions in the warranty clause to provide for any additional risk he believes he will incur by agreeing to a longer warranty period. At any rate, there’s a strong likelihood that agreeing to provide an extended warranty may create additional costs for the contractor. Let’s say that the contractor is in the business of designing and building high-rise office buildings. The owner’s contract has the following warranty clause in the contract’s terms and conditions: Article 28 – Warranty 28.1 Contractor warrants that the Work performed by him shall comply with this Contract and its Plans and Specifications, and that the Work will be free of defects in design, materials, and workmanship. 28.2 The warranty period shall be 60 months and shall commence upon the date of issuance of the Certificate of Occupancy. 28.3 Any defect found in the Work within the warranty period shall be promptly replaced or repaired by Contractor at no cost to Owner.

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On first review, this appears to be a standard warranty, except that it runs for five years—­60 months—­from the date of the Certificate of Occupancy (usually issued by state or local government building authorities stating all required permits are complete and the building has been properly inspected and is ready for occupancy). The contractor’s normal warranty duration period is one year. He may choose to allow up to a three-­year warranty duration period from time to time on some of his residential building work, but five years for a commercial building is too long. Why would an owner request an unusually long warranty duration period? It may be that the competitive environment in the building construction business is such that he can get away with requiring this length of warranty. Maybe the owner feels he can use the extended warranty period to get some free maintenance out of the contractor. It should be clear that extended duration periods for warranties can significantly increase the risk a contractor takes on a project. Listed below are some options the contractor should consider when faced with accepting or negotiating an extended duration warranty: • Add money to the price to fund a reserve for taking care of legitimate warranty work that may occur during the extended duration period of the warranty. • Talk to an insurance broker about buying insurance to cover costs that may be incurred for warranty work that occurs after a three-­year period. • Add limiting provisions to the warranty to escape from warranty claims by the owner that are in actuality maintenance work the owner would normally perform. • Pass on the longer warranty provisions to any subcontractors or material and equipment suppliers. • Negotiate with the owner for a warranty duration period that is shorter than what was requested; it doesn’t hurt to ask the owner for less than what he wants. • Require the owner to pay for any requested site visits to address warranty issues and to validate that the contractor’s work is still in as-­new condition and no warranty work is required. Warranties with extended duration periods over and above what the contractor normally offers, or what is standard in the industry for different classes of work, can represent a significant risk to the contractor. It will always pay dividends to the contractor to make sure his warranty obligations expire in a time period that makes sense for the type of work performed. 220

Limiting Provisions in Warranties

An owner is free to put in a warranty claim to the contractor at any time during the warranty duration period. However, the owner shouldn’t be able to make a warranty claim against the contractor’s work for certain conditions, such as corrosion that occurs naturally on parts and equipment. Therefore, it’s important that the contractor place certain appropriate limiting provisions in his warranty to avoid inappropriate claims. The following are examples of some common limiting provisions: • Corrosion, however caused, of materials and equipment. • Abrasion by wind and sand, or similar material, of equipment and materials. • Chemical attack of materials and equipment. • Electrolytic attack of materials and equipment. • Damage caused by third parties. • Improper use and operation of the work by the owner. • Improper or lack of maintenance of the work by the owner. • Equipment and materials provided by the owner and installed by the contractor. (The contractor should be responsible only for workmanship related to the installation.) • An exclusion for the owner’s normal and expected maintenance work on materials and equipment. • Exclusion for normal wear and tear. (See sample warranty Article 33 later in this chapter on how a contractor could consider including these limiting provisions.)

Pass-­Through Warranties

Many projects call for equipment made by specialty manufacturers. This specialized equipment will normally have a manufacturer’s standard written warranty, for a specific duration period, and may contain limiting provisions on the equipment’s use. This is normal. Owners certainly understand that specially manufactured equipment supplied and installed by the contractor as part of his work to complete the project may have warranties that are different from the warranty in the construction contract. However, the owner will still expect that the contractor take care of any warranty claims related to any equipment supplied by a specialty manufacturer in accordance with the warranty terms in the construction contract. The major risk to the contractor is if the standard warranty supplied by the manufacturer of the specialized equipment is significantly different than the terms of the warranty in the contractor’s construction contract with the owner. A good example of this is where the manufacturer of the specialized equipment only offers 221

a warranty for one year, yet the contractor agrees to a longer duration with the owner. In this event, the contractor could be exposed to the financial liability associated with a warranty claim on the specialized equipment after its manufacturer’s warranty expires. One option is to insert a clause in the warranty to the owner that “passes through” the warranty of specialized equipment manufacturers. When the contractor purchases specialized manufactured equipment for a project, the manufacturer of that equipment will have his own written warranty for the equipment. The contractor receives that warranty and provides it to the owner as part of the package of final contract documents. In this fashion, the contractor “passes through” the manufacturer’s warranty for the specialized equipment to the owner. The owner may accept pass-­ through warranties, but is well within his rights to reject them and insist that the contractor honor the warranty contained in the contract. In this situation, the contractor needs to assess the associated risks. In the event the owner specifies a particular type or manufacturer of specialized equipment, then the contractor is on much stronger negotiating grounds to insist that the owner accept the manufacturer’s warranty on a pass-­through basis. However, a note of caution on pass-­through warranties is in order. Often a manufacturer’s warranty excludes all field installation or repair costs. The manufacturer will replace the defective equipment, but the contractor will have to re-­install the replacement equipment. This could be expensive for contractor!

Latent Defects & Warranty

A latent defect is one that is hidden and may not be discovered for a number of years after the owner’s construction project is complete. If the contractor’s warranty period for the project was one year, and the hidden, or latent, defect was found three years later, then there, arguably, would be no warranty coverage available for the owner to fix or replace the defect. However, the owner may be able to file a product liability claim against the contractor in an attempt to remedy this latent defect. Contractors should check with their insurance agents to see if they can obtain general, ongoing, product liability insurance to cover the liability that may arise under claims for latent defects in their construction projects.

Good and Workmanlike Manner?

Take a look at Warranty Example 1. Subparagraph 28.1 reads as follows: 222

28.1 Contractor warrants that all Work performed by him shall comply with the terms of this Contract and all of its Plans and Specifications, and that all Work performed by Contractor will be free of defects in design, materials, and workmanship.

Often times, the last word in the last line of the paragraph— workmanship—is replaced as follows: . . .in design, materials and shall be performed in a good and workmanlike manner. What does “good and workmanlike manner” mean? This is, of course, one of those terms that is open to interpretation. The Owner may have one definition and the Contractor may have a different interpretation. Such term typically means that the Contractor is warranting that the craft labor employed on the project are skilled, well trained, and experienced in the trades they perform. There is probably not a lot of undue risk in this “good and workmanlike manner” language; it is common in many construction contracts and readily accepted by Contractors. However, it is good to know what it means.

When Does a Warranty Start?

Take a look at Warranty Example 1. Subparagraph 28.2 reads as follows: 28.2 The warranty period shall be 12 months and shall commence upon the date of Owner’s issuance of the Mechanical Completion Certificate to Contractor for his work.

Typically, a Contractor would notify the Owner, in writing, that the Contractor’s work on the project has been fully completed and requests the Owner issue the Mechanical Completion Certificate. How long should the Contractor wait for the Mechanical Completion Certificate to be issued? Three days? One week? One month? Remember, the warranty period begins upon the date of the Mechanical Completion Certificate. If the Owner delays issuing the Mechanical Completion Certificate for say, 30 days, the Owner gets an extra month on the warranty: 13 months instead of the contractually agreed upon term of 12 months. Maybe longer if the Owner further delays issuing the Mechanical Completion Certificate. 223

In order to prevent this delay from occurring, the following wording, or similar, can be added to the Subparagraph 28.2 above. (Addition in bold) 28.2 The warranty period shall be 12 months and shall commence upon the date of Owner’s issuance of the Mechanical Completion Certificate to Contractor for his work. In the event the issuance of the Mechanical Completion Certificate is delayed by Owner, the Mechanical Completion Certificate of the project shall be deemed issued 14 days after the date the Contractor provided the request to the Owner.

In this way the term of the warranty is started without further delays by the Owner. Contractor bargained for a 12-month warranty, nothing more.

A Sample Warranty

Contractors want to assure the owner that their workmanship is sound and that they will fix any defects in the work found during the period of the warranty. Although this assurance may seem simple and straightforward, the concepts of warranty and the issues surrounding it can be complex. Warranty duration, implied warranties lurking out there under state law, warranties of fitness for an intended purpose and merchantability, limiting provisions, pass-through warranties, and defects or maintenance issues all must be understood and considered as part of the commercial risk assessment process the contractor goes through for any warranty provided for a project. Article 33 is a sample warranty addressing the main issues discussed in this chapter and that a contractor may consider using as a starting point or warranty guide.

Conclusion

Warranties are expected by owners for work performed by a contractor, and contractors who promptly fix or repair defects in accordance with the terms of their warranty enhance their reputations as a good contractors. However, implied warranties, warranties that have significantly extended time periods, or those that require the contractor to do the owner’s normal maintenance work create a high level of commercial risk and potential financial liability for any contractor. Warranties, like any other commercial term in a construction contract, are negotiable. Contractors should always take the time to negotiate with the owner an acceptable warranty prior to signing the contract.

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Article 33 – Warranty 33.1 Contractor warrants that the Work performed by him shall comply with this Contract and its Plans and Specifications, and that the Work will be free of defects in design, materials, and workmanship. 33.2 The warranty period shall be 12 months and shall commence upon the date of Owner’s written acceptance of Contractor’s Work. 33.3 Any defect found in the Work within the warranty period shall be promptly replaced or repaired by Contractor at no cost to Owner. 33.4 This warranty shall not apply to the following: a.) Corrosion, however caused, of materials and equipment b.) Abrasion by wind and sand, or similar material, of materials and equipment c.) Chemical attack of materials and equipment d.) Electrolytic attack of materials and equipment e.) Damage caused by third parties f.) Improper use and operation of the Work by Owner g.) Improper maintenance of the Work by Owner h.) Owner’s normal and expected maintenance work on materials and equipment 33.5 Contractor will only be responsible for the workmanship required to install any equipment procured by Owner for installation by Contractor. 33.6 All manufacturers’ warranties on equipment specified by Owner by brand or manufacturer shall be passed though to Owner and be in lieu of this warranty. Contractor will only be responsible for the workmanship required to install such equipment. 33.7 Owner and Contractor agree that the Warranty contained in this Contract is the only Warranty provided and there are no other warranties, express or implied. Owner and Contractor further agree that ALL WARRANTIES OF FITNESS FOR A PARTICULAR PURPOSE OR OF MERCHANTIBILITY ARE SPECIFICALLY EXCLUDED.

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Chapter

13

Termination & Suspension Good plans of both owners and contractors sometimes go awry. Unforeseen events or financial difficulties may crop up for both owners and contractors. In some cases, owners may be faced with terminating or suspending a project due to the contractor’s inability or difficulty completing the job, or the contractor encounters serious financial difficulties on the project and can’t complete it. Sometimes owners run into financial difficulties, too, and have to terminate or suspend their project. In other cases, owners may terminate the contract for their own convenience without an apparent legitimate reason. This chapter will cover the three following contractual considerations: 1. Termination for cause 2. Termination for convenience 3. Suspension

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Termination for Cause

Termination for cause, also referred to as termination for default, or simply, cancellation, may occur when: • The contractor becomes bankrupt or otherwise gets into serious financial difficulties. • The contractor is unable to perform the work in accordance with the terms of the contract. • The contractor does not execute the work in a timely fashion. A termination for cause clause in a construction contract provides an enforceable exit mechanism for the owner when the contractor fails, financially or otherwise. These clauses tend to be broadly worded, giving the owner wide latitude in terminating the construction contract and providing him with a variety of actions against the contractor. Contractors need to read these clauses carefully and understand the risk associated with a contract termination. Following is an example of a typical termination for cause clause: Article 18 – Termination for Cause 18.1 Should Contractor fi le for bankruptcy or be adjudged bankrupt, or should he make a general assignment for the benefit of his creditors, or if a receiver should be appointed for Contractor, or if he should fail to supply enough skilled workers or equipment or materials, or fail to make sufficient progress, or if he should abandon the Work or unreasonably delay its progress or completion, or persistently disregard the law, ordinances, or the instructions of Owner, or otherwise be guilty of a substantial violation of any provisions of the Contract documents, then Owner may terminate this Contract by giving Contractor written notice. 18.2 After giving written notice of termination under this article to Contractor, Owner may take possession of the premises and the Work, all materials for the Work, all tools and equipment and all temporary construction that was used in connection with the Work, and Owner may finish the Work by whatever method he may choose at the expense of Contractor. 18.3 After giving written notice of termination under this article, Contractor shall not be entitled to receive any further payment until Work is completed. 18.4 If Owner’s costs of completing Work, including any court and legal fees, exceed any amount due to Contractor, then Contractor shall pay the difference to Owner. 18.5 If Contractor fails to pay Owner the amount due as noted in paragraph 18.4 above within 15 days after written notice to do so, then Owner shall have the right to sell the whole or any part of Contractor’s materials, tools, plant, equipment, and temporary structures.

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The ability to terminate for cause provides protection for the owner from the consequences of having a contractor go bankrupt or severely failing to perform the work.

Termination for Convenience

Such a termination for cause clause in a construction contract provides the owner with a broad menu of justifiable reasons to terminate the contract with the contractor. Most, if not all, owners will be very reluctant to negotiate any substantial changes to a termination for cause article that will diminish any of their rights to legitimately terminate the contract. A termination for cause article is one of those clauses in a construction contract that the contractor is likely going to have to live with. For contractors with good financial standing and the ability to perform the work and meet the schedule, a termination for cause article should represent little risk. Terminating a contract for the owner’s convenience, simply put, is unfair to contractors, yet such clauses often appear in construction contracts. These broadly worded clauses allow the owner to terminate the contract with no more justification than waking up on the wrong side of the bed one morning and deciding he just doesn’t want to do the project, and therefore will terminate the contract for his convenience. These clauses should more properly be named “termination for owner’s convenience only,” as they certainly aren’t for the convenience of the contractor. Most termination for convenience clauses allow the contractor to recover all costs for the work he has done up to the time of termination. Recovery of some of the contractor’s overhead markup and profit may also be provided for. Proving the costs associated with the physical work actually performed is not too difficult, but the contractor’s administrative, overhead, lost work opportunities, loss of use of experienced personnel, business interruption, and other similar, hard- to- prove, intangible types of costs will be difficult or impossible to recover from the owner. Unless he negotiates some changes in his favor to an owner’s termination for convenience clause, there is little chance for a contractor to fully recover all of his costs and his legitimate markups for overhead and profit when an owner exercises his rights under such a clause.

Example 1

Following is an example of a typical termination for convenience clause.

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Article 19 – Termination for Convenience 19.1 Upon written notice to Contractor, Owner may, without cause, terminate all or any part of this Contract. Upon receipt of the notice, Contractor shall immediately stop work and stop the placing of orders for materials, equipment, and supplies in connection with the performance of the terminated Work. 19.2 Contractor shall make all reasonable efforts to secure cancellation of existing orders and subcontracts upon terms and conditions that are satisfactory to Owner. 19.3 After termination, Contractor shall perform only such work as may be necessary to preserve and protect Work already in progress and shall continue to complete any Work not terminated. Contractor shall protect all materials and equipment on the site, or in transit to the site, that are associated with the terminated Work. 19.4 Should Owner elect to terminate this Contract for convenience under this article, the settlement of all claims of Contractor shall be made as follows: 19.4.1 Owner shall reimburse Contractor for all reasonable costs incurred after the date of termination for protecting Owner’s property. 19.4.2 Owner shall reimburse Contractor for the proportion of his Contract Price for Work actually completed and accepted by Owner. In no event shall Contractor’s total reimbursement exceed the Contract Price.

This termination for convenience clause allows the owner to terminate the construction contract for any reason, without penalty or any amount of prior notice, and provides for paying the contractor only for the work he has completed that has been officially accepted by the owner. On a complex construction project, it may be difficult to accurately determine the total value of the contractor’s job site and home office effort at the time of the termination. The owner will likely insist on a lot of documentation to justify costs and will try his best to minimize what he has to pay the contractor. How does a contractor place a cost on having one of his best field superintendents out of work due to the termination for convenience, especially when the superintendent could have been valuable on another, perhaps more profitable, project? What happens if the project completion is measured at 30% and the contractor’s expenditure to date is actually 40%? Will getting 30% of the price as allowed in the termination for convenience cover the contractor’s costs, markups, and profit on all the work actually completed? Probably not.

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An improvement, at least from the contractor’s standpoint, would have been to negotiate some changes to subclause 19.4 in the sample termination for convenience clause similar to the following: 19.4.1 Owner shall reimburse Contractor for all his direct and indirect costs, plus 30% markup for overhead and profit, that occur after the date of termination, and including all those direct and indirect costs that are incurred for protecting Owner’s property. 19.4.2 Owner shall reimburse Contractor for the proportion of his Contract Price that represents the actual amount of the Work Contractor has completed under the Contract, plus all outstanding approved and unapproved extras and additions. In no event shall Contractor’s total reimbursement exceed the Contract Price, plus the value of all approved and unapproved extras and additions. 19.4.3 Owner shall reimburse Contractor for all his direct and indirect demobilization costs and expenses, plus 30% markup for overhead and profit. 19.4.4 In addition to the above noted reimbursements, Owner shall pay Contractor termination fees within 30 days of termination in accordance with the following table: Days from Award of Contract

Termination Fee Percent of Contract Price

0 thru 60 days

10%

61 thru 120 days

15%

121 thru 180 days

20%

181 days or later

25%

19.4.5 It is agreed and understood that Contractor will not provide any Warranty at all, express or implied, on any of Contractor’s completed and uncompleted work.

Let’s take a look at what the suggested modifications to subclause 19.4 of this termination for convenience clause mean to the contractor. Paragraph 19.4.1 – The word “reasonable” was removed. What’s reasonable to the owner may not be—and is not likely to be— reasonable to the contractor. A percentage markup was added to the contractor’s direct costs for overhead and profit; contractors should not be in the charity business. Paragraph 19.4.2 – The value of all extras and additions was added. Otherwise, contractor may not have a chance to recover them. Paragraph 19.4.3 – This is a new paragraph. The contractor should be reimbursed for demobilization costs plus a percentage markup for overhead and profit.

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Paragraph 19.4.4 – This new paragraph adds a termination fee for the owner having the luxury to terminate the contract solely for his convenience. This clause can help sort out the risky owner from the serious and committed owner. An owner’s unwillingness to add this consideration should raise a red flag. This termination fee schedule could also be worded as a liquidated damages clause in favor of the contractor. Paragraph 19.4.5 – This new paragraph aims to make it understood by the owner that he will not have any sort of warranty on the completed or uncompleted work performed by the contractor. The noted changes are just examples of what a contractor might edit in a termination for convenience clause if he is uncomfortable with the owner or the project. Such changes lower the contractor’s overall commercial risk. It’s vital that the contractor assess his own particular risks and make necessary changes, if any, to the language in the contract. After the contract is signed, it’s too late to change the language to something more acceptable. For substantial and financially strong owners with good track records of completed projects, the contractor may be at little risk accepting a broadly worded termination for convenience clause. Such a clause may be part of the owner’s standard boilerplate in his company’s construction contract documents. In a situation like this, a progressive owner may even agree to remove the termination for convenience clause in its entirety if requested by the contractor. In those situations where the contractor has no experience with an owner, the owner is new to the business, or if there are other valid concerns, it will be worth the contractor’s effort to renegotiate the termination for convenience language to something more acceptable—­protecting him both financially and contractually.

Suspension

Construction contracts will likely have some type of suspension of work clause, which allows the owner to suspend work on the project for some period of time and then resume, or even cancel, the project. These clauses rarely, if ever, provide any specific reasons for suspension other than of the owner’s discretion or convenience. Suspension clauses that don’t have a maximum time limit for the suspension, or that don’t address how to reimburse the contractor for his associated costs, are fraught with danger for the contractor.

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Contractors are more likely to be faced with a project suspension than a termination for cause or convenience. Therefore, extra attention must be paid to make sure that the language of a suspension clause allows for the contractor to be treated fairly and to be paid for related costs he incurs.

Example 1

Here’s one example of a typical suspension clause: Article 20 – Suspension 20.1 Owner may, by written notice to Contractor, suspend the performance of the Work to be performed under this Contract. Upon receipt of the notice, Contractor shall: a.) Immediately discontinue work; b.) Place no further orders or subcontracts for materials, services, and equipment; c.) Make every effort to obtain suspension upon terms satisfactory to Owner of all orders and subcontracts; d.) Protect and maintain the suspended Work; and, e.) Take all other steps necessary to minimize costs associated with the suspension. 20.2 Upon receipt of a notice to resume the suspended Work, Contractor shall immediately resume performance of the Work under this Contract, and submit to Owner for reimbursement any reasonable costs incurred by Contractor due to the suspension.

At first glance, this suspension clause doesn’t look too bad, and the owner even agrees to cover the contractor’s costs incurred during the suspension. If the suspension is for 30 days or less, maybe the contractor can live with this. But what happens if the suspension is for one year? Or two years? In an extended suspension, the contractor doesn’t have the right per subparagraph 20.2 to get even his “reasonable” costs back until the project starts up again. What happens if the project never starts up again? Hopefully there is a fair contract cancellation mechanism in the owner’s construction contract’s terms and conditions that will allow the contractor to be fairly reimbursed for his efforts during the suspension and subsequent cancellation. To better protect his interests, the contractor can consider negotiating changes in this Suspension clause similar to the following:

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Article 20 – Suspension (continued) 20.2 Upon receipt of a notice to resume the suspended work, Contractor shall immediately resume performance of the Work under this Contract. Every 30  days during the suspension period Contractor shall submit to Owner for reimbursement all costs incurred by Contractor due to the suspension, plus 30% to cover Contractor’s overhead and profit. 20.3 In the event the suspension exceeds 180 days, Contractor may terminate the Contract by notifying Owner in writing. In this event, Owner shall, in addition to the reimbursements in article 20.2, reimburse Contractor for all costs incurred to completely demobilize from the job site plus 30% to cover Contractor’s overhead and profit, and also release any retention withheld from any of Contractor’s payments. 20.4 In the event Contractor exercises his right to cancel under article 20.3, it is understood and agreed by Owner that there are no warranties provided, express or implied, on the work performed by Contractor under this Contract. 20.5 In the event Contractor exercises his right to cancel under article 20.3, it is understood and agreed by Owner that any performance guaranties or bonds provided to Owner by Contractor are null and void as of the date of the notice of termination by Contractor.

So what do these changes do for the contractor? Paragraph 20.2 is revised to allow the contractor to bill the owner for his costs incurred during the suspension period, plus a percentage markup for overhead and profit. These additional costs on account of the suspension are no different than the normal costs of actually performing the work, and should be paid for on some timely and periodic basis similar to the contractor’s normal terms of payment. As noted above, 30% uplift on costs for O&P is fair. Paragraph 20.3 is a new paragraph that allows the contractor to terminate the contract if the suspension extends beyond 180 days and bill the owner for his demobilization costs, plus a percentage markup for overhead and profit. Paragraph 20.4, also a new paragraph, nullifies any warranty on work performed if the contract is terminated. It’s risky to be exposed to warranty claims from the owner on an uncompleted and unaccepted project. Paragraph 20.5 nullifies any guaranties or on-demand bonds the contractor was required to provide to the owner as a condition of the contract. The proposed changes illustrate some of the considerations a contractor might be faced with during a suspension. A lengthy suspension, or one that ends in a cancellation of the contract, can subject the contractor to a complex mix of cost and commercial 234

considerations. It’s always best to address these ramifications early in the negotiation of the contract’s commercial terms and conditions. Some owners recognize that it makes sense to include a time limit in a suspension clause, after which the contract is cancelled in some orderly fashion. This is a realistic approach. If an extended suspension is necessary, for whatever reasons, and the owner then decides to continue, the owner should terminate the contract and be willing to renegotiate fairly with the contractor to restructure, reprice, and reschedule the contract in the new time frame.

Example 2

Here’s a second example of a typical owner’s Suspension clause containing a time limit, which could also benefit from some editing to make more fair. Article 20 – Suspension 20.1 Owner may at any time suspend performance of all or part of the Work by giving written notice to Contractor. 20.2 The suspension may continue for a period of not longer than six (6) calendar months after the date of suspension. If at the end of the six-month period, Owner has not resumed the Work, the portion of the Work that was suspended shall be deemed to be terminated. 20.3 Owner shall compensate Contractor in accordance with the provisions of the Changes clause for the following costs incurred during the suspension period: a.) Safeguarding the Work and the materials and equipment in transit or at the job site; b.) Keeping personnel, subcontractors, and rented equipment on the job site necessary to maintain the Work; and c.) Other reasonable and unavoidable costs of Contractor that result directly from the suspension.

Although the contract terminates after a six-month suspension, nothing is stopping the owner from renegotiating the contract with the contractor if the owner decides to continue with the project. This time limit also gives the contractor some leverage with the owner to renegotiate the contract if the owner wants to continue. This is fair, because over a six-month period, the contractor’s pricing considerations may change dramatically due to labor and material supply restrictions, cost increases, weather considerations, and the like. This final example of a suspension clause would be improved by adding additional language similar to that suggested in the first example that: 235

1. Allows the contractor to bill on a periodic basis for his suspension-­related costs and add some amount of markup for his overhead and profit. 2. Allows the contractor to recover all his demobilization costs from the job site, plus some amount of markup for his overhead and profit. 3. Makes a positive and clear statement that no warranties, express or implied, apply to any of the terminated work. 4. Adds an agreement that the contractor’s performance guaranties and on-­demand bonds are null and void as of the date of termination.

Cancellation

Cancellation of a contract is just another term for what comes from a termination for cause or convenience, or perhaps at the end of an extended project suspension. Sometimes there will be a clause in a construction contract that is titled “Cancellation.” It will likely be a termination for cause or termination for convenience clause; the author of the contract may feel that cancellation doesn’t sound as bad as termination.

Conclusion

Deciding on whether to take issue with termination and suspension clauses is a part of the contractor’s commercial risk management process. With an owner who is financially strong and has a good track record of developing and completing projects, perhaps the contractor can live with the original language in these clauses, since termination or suspension with the particular owner is not likely. On the other hand, if the contractor is uncertain of the owner’s finances and project track record, he may want to negotiate changes to the termination and suspension clauses to protect his commercial interests. Keep in mind these points: • Renegotiating termination for cause clauses is tricky and often unsuccessful. In fact, if a contractor attempts to change the wording, the owner may get suspicious of his capabilities or financial strength. There is often no getting around a termination for cause clause in a construction contract, as it provides the owner a legal avenue to terminate a contract. It also provides some protection against the potential for contractor bankruptcy and from the contractor’s failure to perform. • A termination for convenience clause that has no financial protection for the contractor is simply unfair. Termination for convenience clauses should be carefully reviewed by the

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contractor and changes negotiated to protect his ability to recover costs and markups, and to limit his exposure to other commercial risks, such as warranties on unfinished work and inappropriate calls on guaranties and bonds. Termination for convenience should not come for free. If the owner wants the privilege of having this type of clause in the construction contract, he should be willing to pay for it. Contractors should strongly consider including a termination fee schedule in these clauses. Suspension of the work on a contract is not an uncommon event in the construction business. Legitimate work suspensions that are limited in time are inconvenient events for both owner and contractor. However, limited duration suspensions can probably be managed by the contractor without unnecessarily exposing him to significant extra costs or disruption to the schedule. Lengthy suspensions can disrupt a contractor’s organization and impact his productivity. He may have to demobilize from the site, but still leave a small team there to protect the work and manage shutdown of other subcontractors and suppliers. The owner may continue to hold any retention withheld from the contractor’s progress payments, and this could affect the contractor’s cash flow and profitability. There is also the risk that the contractor’s team may not be available when the project is restarted. Costs for bringing back subcontractors will increase. Labor and material costs may escalate substantially during the lengthy suspension. The owner will want to minimize, to the greatest extent possible, the costs associated with the suspension. But contractors need to consider all of their costs related to a lengthy suspension. Contractors should be entitled to an overhead recovery and a profit on the costs they incur during a suspension. All suspension-­related costs incurred by a contractor are no different than project-­related costs and should have a percentage uplift added to them for overhead and profit recovery. Contractors should carefully review how they will be paid for all costs incurred during a suspension. Payment of costs incurred during a suspension should be made on some regular, periodic basis, and not at the end of the suspension. The owner may be out of money, out of business, or both, at the end of a lengthy suspension.

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• The duration of the suspension should be limited to an established maximum amount of time. After this time elapses, the contractor may elect to terminate or renegotiate the contract. If the contractor terminates, he needs commercial language in the Suspension clause that eliminates or otherwise limits his warranty obligations for completed and uncompleted work. • Contractors need commercial language that makes any guaranties or on-­demand bonds furnished to the owner null and void in the event that the owner terminates or suspends the contract.

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Chapter

14

Force Majeure

Literally translated, force majeure means “major force,” and refers to an event that cannot be anticipated. In construction, these events can have an effect on a contractor’s exposure to liquidated damages, delays, and change clauses. A force majeure clause in a construction contract attempts to define those events that may be considered “acts of God,” such as natural disasters, unanticipated government mandates, civil disturbances, and so forth, that would give the contractor or owner legitimate reasons to delay the project, cease work, or cancel the contract without penalty.

Negotiating Clauses

Force majeure clauses are often overlooked or taken too lightly in contract negotiations. Depending on the type of construction work performed and its location, leaving out this clause, or agreeing to a poorly worded one, can be a big mistake for a contractor. Depending on where, geographically, in the world a contractor is working and on the type of project he is building, a variety of different events could take place that would be considered force Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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majeure. Following are three examples of construction situations that would have different force majeure event considerations. 1. A building contractor constructing a small commercial building in the middle of an open field in the central United States during the summer may feel the only force majeure risks that he needs to address in his contract with the owner are tornados and lightning strikes, and he may not feel that those risks are very high. 2. A marine contractor laying an undersea pipeline in an area of the ocean prone to hurricanes, typhoons, or cyclones may have an entirely different appreciation of the risk involved, and will want to make sure the force majeure clause in his contract with the owner addresses these events and what he may do (cease work, pull up anchor, and get to a safe harbor) in the event one of these dangerous storms comes his way. 3. An international contractor who is building a new power plant in an unstable foreign country with a war going on just across that country’s border may want to make sure he has a comprehensive force majeure clause in his contract with the owner that covers, among other events, war, rebellion, expropriation, confiscation, and civil disturbances. When negotiating or reviewing force majeure clauses, contractors need to consider two important issues: 1. What natural or man-­made events are considered force majeure? The contractor should make this determination based on discussions with the owner and include them in the final force majeure clause in the contract. If there’s a chance force majeure events may occur, owners typically have just as much interest in accurately defining what they are and how they’ll be handled. 2. What courses of action are available to the contractor and the owner if a force majeure event occurs during the construction of a project?

Sample Contract Language

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Example 1

The following is an example of a simple force majeure clause that is open to wide interpretation. The downside of ambiguous wording is that the owner and contractor may not see eye-­to-­eye on what is considered a force majeure event because none are named or specified. The owner could, theoretically, use such a clause to suspend or delay payments to the contractor for work already performed.

Article 36 – Force Majeure 36.1 Owner and Contractor shall not be liable to each other for any failure to perform any term or condition of the Contract if such performance has been delayed, interfered with, or otherwise prevented by any event that is beyond the control of the party concerned and was not reasonably foreseeable and was attributable to such event.

If the contractor is convinced that the particular project he is bidding on has little risk of a force majeure event occurring, then a clause like the one above is probably acceptable and does not expose him to any objectionable commercial risk. However, if he’s bidding on a project where there is a likelihood of extreme weather, for example, then it’s best to itemize weather-related force majeure events in the clause. Example 1 has another drawback—it doesn’t describe what options are available to the contractor and owner in the event a force majeure event creates a lengthy delay or extra costs for the contractor. Suggestions for added contract language to cover these contingencies are noted in the next example.

Example 2 Article 36 – Force Majeure 36.1 Force Majeure means the occurrence of an event that is unforeseen, insurmountable, and outside the control of and without fault or negligence of Owner or Contractor, and that causes Owner or Contractor to be unable to comply totally or partially with their respective obligations under the Contract. 36.2 Force Majeure events include Acts of God, such as an epidemic, tidal wave, lightning, earthquake, or named hurricane; hostilities, acts of war, riots, civil or military disturbances; national, regional, and professional strikes; and acts of any government or government authority. Force Majeure does not include the bankruptcy or insolvency of Owner or Contractor.

The above is a fairly typical force majeure clause. Depending on the location of the construction project, the contractor may decide to add additional events to the list to be safe, or may find it satisfactory as it is. (Refer to the list of descriptions taken from actual contracts of force majeure events at the end of this chapter.) What the clause in Example 2 does not do is specify what the owner and contractor agree to do in the event that the contract is delayed or cancelled due to a force majeure event. This is important, especially for the contractor, as he could otherwise be trapped into unnecessarily keeping the project in a standby or suspended mode, all 241

the while generating costs that he might not be able to recover because there is no specific provision in the contract for reimbursement. Faced with the force majeure clause shown in Example 2, the contractor might consider adding several new paragraphs that would read similar to the following: 36.3 In the event that Force Majeure causes the Work to be stopped for a period of time up to 120 days, and prior to restarting the Work, Owner shall make adjustments to Contractor’s price and schedule to reflect any changes as a result of such Force Majeure. 36.4 If Owner and Contractor cannot agree on the changes, then Contractor may terminate the Contract. Owner will pay Contractor for the Work completed effective as of the date of the Force Majeure event that stopped the Work. 36.5 Owner shall reimburse all of Contractor’s costs and expenses required to maintain and protect the Work after the occurrence of the Force Majeure event up to time of the restarting or terminating of the Contract. 36.6 In the event that the Work is stopped for a period of time longer than 120  days, then either Owner or Contractor may terminate the Contract, and Owner will pay Contractor for the Work performed effective as of the date of the Force Majeure, and for Contractor’s costs and expenses to maintain and protect the work after the occurrence of the Force Majeure event up to the time of the termination of the Contract.

For those construction contracts that contain a liquidated damages clause for failure to meet the contract schedule, it is important that any force majeure clause provides for immediate cancellation or renegotiation of the liquidated damages clause. 242

Contractors need to make sure that a force majeure clause provides a way to terminate the contract if the delay is prolonged. This is usually a designated maximum time limit after the occurrence of the event. Also, the contractor should be entitled to recover all costs necessary to maintain or protect the work—or repair or reconstruct work that was damaged or destroyed by the force majeure event. Contractors may decide they can forego overhead and profit on costs incurred on account of a force majeure event, but at least they should get their costs and expenses reimbursed by the owner. Many force majeure clauses do not provide compensation for the contractor for his costs incurred to maintain or protect the project after an event. The reasoning seems to be that both the owner and contractor are somehow affected equally by the event, and both should bear their own burden, since no one could have accurately predicted the catastrophe. While this may be a compelling argument used by an owner, the contractor has only one shot at making a profit on the project. If the owner has to pay the contractor something extra to cover the contractor’s costs and expenses that arise out of a force majeure

event, that’s fair, because at least the owner will have a chance to recover those additional costs from the ongoing operations of his completed project. It may take the owner a little longer to recover those extra costs from the profits of his operation, but at least he has the chance to do so. Contractors do not have that luxury. The following is a list of events excerpted from actual force majeure clauses found in construction contracts to illustrate the variety of different examples of actual contract language. 1 . Acts of God or the public enemy 2. Expropriation or confiscation 3. War 4. Rebellion 5. Civil disturbances 6. Riots 7. Floods or unusually severe weather that could not have been anticipated 8. Fires 9. Explosions 10. Earthquakes 11. Tidal waves 12. Lightning 13. Named hurricane or typhoon 14. Epidemic 15. Hostilities or acts of war, whether declared or not 16. Orders, restraints, or prohibitions by any governmental authority 17. Civil commotions 18. Strikes, lockouts, or other concerted acts of workers 19. Sabotage 20. Denial of the use of railway, port, airport shipping services, or other means of public transportation 21. Adverse weather 22. Warlike operations 23. Invasion 24. Act of foreign enemy and civil war 25. Revolution 26. Mutiny

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27. Usurpation of civil or military government authority 28. Conspiracy 29. Terrorist acts 30. Confiscation, nationalization, mobilization, commandeering, or requisition by or under the order of any government authority or ruler 31. Embargo 32. Import restriction 33. Port congestion 34. Shipwreck 35. Shortage or restriction of power supply 36. Epidemics, quarantine, and the plague 37. Landslide 38. Volcanic activity 39. Tidal waves or tsunamis 40. Typhoon or cyclone 41. Hurricane 42. Nuclear events 43. Pressure waves 44. Named hurricane as designated by the U.S. National Weather Service in Coral Gables, Florida. 45. Unreasonable delay in unloading ships and clearing customs 46. Unusually severe weather 47. Failure of the Owner to provide funds

Conclusion

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The occurrence of a force majeure event that will interrupt or terminate a construction project is impossible to plan for or predict. There should be language in the construction contract terms and conditions that lists such possible events—to the extent they can be named—and what should happen if one occurs. There should also be a mechanism for restart or termination of the contract and some fair provisions for the contractor to recover costs associated with, or arising out of, the event.

Chapter

15

Other Contract Clauses Construction contracts can be lengthy, as owners often have all types of commercial and other issues that they want to address contractually with the contractor. Construction contracts rarely, if ever, reduce in length, even during the negotiating phase. Rather, they seem to grow longer as owners find new and creative commercial issues that they want to contractually address. This chapter will review some of the most commonly used additional clauses that may appear in construction contracts—­those that may present elevated risk for the contractor, including: • Site conditions • Use of completed portions of the work • Patent indemnity • Secrecy and confidentiality agreements • Owner’s right to inspect • Independent contractors • Assignment (transfer of rights and obligations) Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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• • • • • • •

Acceptance procedures and the punch list Advance waiver of liens Final waivers Audit rights Severability Venue and applicable law Changes in law

At the end of the chapter, we’ll examine a few additional obscure ones.

Site Conditions

A site conditions clause usually requires the contractor to inspect and understand the grade level and above-­ground job site conditions prior to the start of any construction activities. It can, however, have the potential to be an expensive risk transfer clause for the contractor in a fixed price contract. Often, there will be a clause in the contract regarding which party—­ the owner or the contractor—­will accept responsibility for the physical job site conditions, including subsurface conditions. Owners expect the contractor to have visited and inspected the job site and to make provisions in the estimate for any improvements necessary to prepare the site for construction. These may include: • Building temporary access roads to the site and/or temporary marine jetties • Providing temporary storage, staging, offloading, and work areas • Clearing brush and leveling high areas • Filling in low-­lying areas on the site to keep them free of standing water As long as the contractor has access to the site prior to bidding, he can examine, measure, and estimate what needs to be done at grade level or above ground to the site to properly prepare it for construction. Sometimes a site conditions clause in the contract will specifically require the contractor to do this type of preliminary work as a part of the project. What can be extremely risky for the contractor, however, is a site conditions clause that transfers to the contractor the potential financial risk that may arise from unpredictable behavior or unknown composition of the site’s subsurface soil conditions. Listed below are examples of subsurface conditions that, when left undiscovered, can create problems for contractors: • Rock • High water levels

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• Buried toxic waste materials • Soft organic or clay-­like materials unsuitable for foundations • Cavities such as limestone caves, old tunnels, etc. An attempt to better define subsurface conditions is typically made by performing a soils investigation. A soils investigation is typically performed by a specialized geotechnical company, who will likely have a separate contract with the owner to take soil borings at the site, analyze them, and produce a written geotechnical report, often called a soils report. This report may include recommendations for the design of the project’s foundations or other below grade construction activities. Some typical observations and recommendations contained in a geotechnical report would be: • A description of the site’s subsurface soils composition, developed from a series of individual soil borings taken at the site (e.g., sand, rock, gravel, organic materials, clay, etc.). • An indication of how deep the water table, if any, resides below site grade level. • Recommendations on the ability of the soil to carry different types of loads imposed by the project’s structures. • Recommendations for the use of an allowable soil bearing pressure to be used in conjunction with the design of concrete spread footing or similar types of foundations for the project’s structures. • Recommendations on the amount of potential subsidence (settlement) of the soils that may occur over time due to the loads imposed by the project’s structures. • Recommendations for the type and size of piles to be used with the design of pile type foundations, and a depth below grade level to which they should be driven to carry their design load. Contractors should recognize that the prediction of subsurface soil behavior is not an exact science. Also, assuming the underlying soil composition is uniform across a large project site can be risky if only a few soil borings are taken and analyzed. All geotechnical reports will typically contain a disclaimer by the geotechnical company who prepared the report stating that the recommendations, predictions, and design considerations are best estimates that should be used with some degree of discretion by the owner. In the event the geotechnical report is found to be in error, the report will include a limitation of the geotechnical company’s financial liability to the owner to some maximum monetary amount. This value will be representative of the 247

value of their contract to perform the soils investigation, prepare the subsequent report, and, if required, provide recommendations for foundation design and expected subsidence of the soil. If the geotechnical company that performed the soils investigation states that the findings and conclusions contained in their geotechnical report are a “best estimate,” or they won’t guaranty the absolute accuracy of their findings, then the contractor needs to take note of this and more carefully consider the risks involved. Here are some examples of the risks that may arise from unknown or undiscovered site conditions: 1. A soils report recommends that steel pipe pilings designed to each carry 100 tons are to be used for the project’s foundations. These pilings are to be driven to a depth of 50 feet below grade level. The soils report predicts that at the 50-­foot depth, the piles will encounter enough resistance to further driving to support their design load of 100 tons. The contractor is required to drive 200 piles, and bases his firm price estimate on the soils report’s recommendations for length. During the piling operations, it turns out that the contractor has to drive 100 of the piles to a depth of 65 feet to develop enough resistance to further driving to support the design loads. Who pays for the extra 1,500 feet of piles the contractor has to supply and install? 2. A soils report for a very large site contains a dozen random soils borings to investigate the subsurface conditions. Analysis of the individual borings reveals mainly sand and compacted gravel extending to a depth of 20 feet below grade. The project requires a significant amount of site excavation. The contractor establishes his firm price estimate based on using motorized earth-­moving equipment to excavate. During excavation of the site, the contractor encounters a large amount of rock that requires blasting to remove. The random borings missed the rock. Who pays for the significant extra costs and safety considerations necessary to blast out the rock? 3. A soils report recommends that an allowable soil bearing pressure of 2,500 psf should be used for the design of all concrete foundations for the project structures. Using this 2,500 psf loading, the soils report predicts that a ¼" subsidence (settlement) of the soil is to be expected over time. The contractor designs all the project’s concrete foundations based on the soils report design criteria and predicted soils subsidence. After the project is complete and during the warranty period the owner notices several of the project structures have settled about 2". 248

This settlement is causing cracks in the structure and foundations, and creating problems with piping attached to the structures. Who pays to correct these problems? In the above examples, the contractor based his firm-price estimates on the recommendations, observations, and predictions contained in the geotechnical report prepared by another company and supplied to him by the owner. He did nothing to protect himself from the risk of additional costs in the event that the findings of the report turned out to be incorrect. Is this situation just too bad for the contractor? Is it time for him to get out his checkbook to pay for necessary repairs, changes, or modifications? Yes, possibly, though this situation could have been avoided through the contractor negotiating changes to the contractual language covering site conditions. The following are two examples of clauses that expose the contractor to additional costs and loss of time in the schedule because of differing site conditions.

Example 1 Article 45 – Site Conditions 45.1 Contractor agrees that he has carefully examined the Work site and is familiar with all conditions affecting the Work and has prepared his pricing accordingly. No additional compensation or time extension shall be allowed in the event these site conditions differ from those expected by Contractor.

Example 2 Article 45 – Site Conditions 45.1 Owner has provided to Contractor, as part of the bid documents, a site and soils report prepared by Owner’s geotechnical consultant containing the data on the hydrological and subsurface conditions at the Work site and recommendations for the design of required foundations. Contractor shall be responsible for interpreting all the data and recommendations in the report and shall include in his pricing any contingencies he feels are necessary.

The second example is particularly risky in that it exposes the contractor to extra costs that may arise out of using the geotechnical report’s recommendations for the design of the project foundations. The contractor may, as the first example implies and the second requires, add a contingency to his pricing to accommodate any extra costs he feels may arise from unknown subsurface conditions or from 249

Contractors need to always remember that it’s the owner’s soil, not the contractor’s, and the owner is ultimately responsible for its makeup and behavior.

the consequences of foundation design recommendations that turn out to be incorrect. How should the contractor calculate and add a contingency when he may not have any idea of unusual subsurface conditions or whether the foundation design recommendations are correct? These types of clauses transfer the potential financial risk associated with unknown subsurface conditions and incorrect foundation design recommendations to the contractor. Often the owner has years of experience with his property, whereas the contractor may have little, if any, experience with the job site beyond a visual inspection and whatever random testing is provided in a geotechnical report. Who should bear the risk of subsurface surprises? Certainly this risk should not be borne by the contractor.

Example 3

In situations where the contractor has valid concerns about the site subsurface conditions and/or the foundation design recommendations provided by third parties, he could consider negotiating additional wording similar to the following for the above examples: Article 45 – Site Conditions

The owner must retain full responsibility for the project site’s composition, condition, behavior under load, and, especially, the subsurface conditions.

45.2 Contractor has based the fixed price strictly upon the soils boring data and foundation design recommendations contained in the geotechnical report provided with the bid documents. In the event that the subsurface conditions differ from the subsurface conditions described in the soils boring (e.g., rock instead of loose excavation, buried barrels of toxic waste, underground caverns), or there is subsidence of the soils beyond that recommended by the geotechnical reports foundation design criteria, then all additional costs and time to accommodate differing site subsurface conditions, or to repair, replace, or rectify foundations and attached structures due to subsidence of the soils greater than that recommended in the soils report shall be for the account of Owner.

If piling is also required for the project foundation, wording similar to the following could be added: 45.3 Contractor has based the fixed price for the piling required on the recommendations and lengths stated in the geotechnical report provided with the bid documents. In the event that final piling lengths differ from those stated in the geotechnical report, then the following deductions or additions to the Contract price will apply: a.) $50.00 per foot deduction for piles driven to less than the depth stated in the geotechnical report, and; b.) $100.00 per foot addition for piles driven to more than the depth stated in the geotechnical report.

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Geotechnical companies will attempt to limit their financial liability in their contract with the owner so they are not exposed to any extra costs an owner or contractor may incur on account of the reports recommendations, observations, and predictions being incorrect. However, geotechnical companies get paid by the owner for all the work they perform at the job site. Why shouldn’t the contractor get paid for all the work he ultimately has to perform there? The ultimate responsibility for using the recommendations, observations, and predictions of the geotechnical company rests with the owner. Since the value of the geotechnical company’s contract for soils investigation and recommendations will likely be very small compared to the potential costs associated with repairing foundations, extra costs for pilings, or excavation of undisclosed rock, the owner would like to pass on the potential financial responsibility for these and similar site related risks to the contractor by a risk transfer site conditions clause. Another tactic the contractor can use is to strongly encourage the owner to provide a more comprehensive site soils boring investigation. For example, taking 30 soil borings on a large site where extensive excavation is required, rather than 10, is inexpensive insurance for the owner. Having as much data as possible about the site’s subsurface conditions will always give the contractor better information on which to base his firm price estimate and lessen his concern about adding excessive site related contingency to his pricing.

Use of Completed Portions of the Work

Often a construction contract will contain a clause giving the owner the right to use portions of a project prior to its overall completion. Although the contractor would likely want to accommodate the owner in his request, there are risks associated with agreeing to allow this to occur. These include: • Warranty issues associated with early use. • Safety issues associated with the owner’s employees using a portion of the work while construction is ongoing. • Owner access and egress through the construction site. • Extra costs to secure the part of the work being used by the owner from the rest of the construction site. • Delays to the overall project schedule that may ensue through the owner’s use of completed portions of the work.

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While a contractor should try his best to accommodate the owner’s request to use completed portions of the work, it should not be at the added expense or increased risk of the contractor.

The following is a typical clause allowing the owner to use a portion of the work. Article 47 – Use of Completed Work 47.1 Owner shall have the right to use any portion of the Work before full completion of the Work. Such partial use shall not in any way be construed as Owner’s acceptance of the Work.

If the contractor has concern about the risks and costs of allowing the owner to use portions of the work prior to overall project completion, he could add wording to this example clause similar to the following to protect himself: 47.2 In the event that Owner takes over and uses any portion of the Work before full completion of all the Work, Owner agrees to reimburse Contractor for all expenses, plus a markup for overhead and profit, that Contractor may incur in association with any early takeover. 47.3 Owner agrees to accept the portion of the Work taken over early as complete, and further agrees that Contractor’s warranty on the portion of the Work taken over early by Owner shall commence upon the date of the early takeover. 47.4 Owner and Contractor shall mutually agree upon a safety plan regarding Owner’s early takeover and use of a portion of the Work prior to the full completion of the Work.

These three additional subclauses address the consequences and risks associated with early takeover, specifying how additional costs, warranty, and safety will be handled. Contractors should also check with their insurance companies to see if there are any additional insurance coverage concerns to be considered. This is important so that the contractor doesn’t lose any protection afforded by his project-related insurance policies.

Patent Indemnity

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A patent indemnity clause in a construction contract is designed to protect the owner from the potential financial liability that may arise out of the contractor’s infringement of a patent that exists on processes or equipment incorporated into the owner’s project.

A typical patent indemnity clause follows. Article 48 – Patent Indemnity 48.1 Contractor shall pay all license fees and royalties that may be required to perform the Work, and shall indemnify, hold harmless, and defend Owner from all lawsuits or claims arising out of the infringement of any patent rights that may be related to the Work. 48.2 If any part of the Work is determined to be an infringement of any patent, Contractor shall, at his own expense, and with Owner’s approval: 48.2.1 Secure for Owner’s benefit the right to use the Work that has been determined to be an infringement of a patent; or 48.2.2 Replace any part of the Work with equal non-patent infringing work; or 48.2.3 Modify any part of the Work to make it equal and non-patent infringing.

Since the patent indemnity as written is unlimited in potential financial exposure to the contractor, it’s a good idea to place some maximum financial limit by negotiating additional wording similar to the following: 48.3 Contractor’s liability in the aggregate under the provisions of this Article 48 shall not exceed (insert an appropriate monetary value) less a depreciation allowance for the part of the work that was determined to be an infringement of a patent.

Secrecy & Confidentiality Clauses & Agreements

Owners who build projects using their own proprietary technical information, processes, and/or highly specialized equipment will likely require the contractor to agree to a secrecy or confidentiality clause in the contract, or to a completely separate secrecy agreement. These obligate the contractor to safeguard the information received from the owner, maintain its confidentiality, and not release any of it to the public or to other third parties without the written consent of the owner. Often, the owner will require a contractor to sign a separate secrecy or confidentiality agreement prior to, and as a condition of, receiving the bid documents. A typical confidentiality clause in a construction contract follows.

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Article 49 – Confidentiality 49.1 All information provided to Contractor by Owner in connection with the Work shall remain the property of Owner, shall remain confidential, and shall not be copied or used in any way except in connection with the performance of the Work by Contractor and his employees. 49.2 Contractor shall not disclose any information provided by Owner in connection with the Work to the public or any third parties without the written consent of Owner. 49.3 In the event Owner authorizes disclosure of information to a subcontractor, material supplier, or equipment supplier of Contractor, then such subcontractor, material supplier, or equipment supplier shall also be bound by the confidentiality requirements of this Article 49. 49.4 Information that is determined to be in the public domain, or information that is developed independently by Contractor, shall not be subject to the confidentiality requirements of this Article 49. 49.5 Information required to be disclosed by law (i.e., by a court order) shall not be subject to the confidentiality requirements of this Article 49.

One risk the contractor takes in accepting the above, Article 49, is that there is no expiration of the confidentiality requirements. It can be argued that the provisions of this clause could be enforced long after the contractor completes the project. An unintentional release of information years after the completion of the project could potentially expose the contractor to a claim for breach of contract and to unnecessary potential financial liability because of that breach. If the contractor is uncomfortable with the risk of having the potential exposure to a never-ending secrecy agreement, he can negotiate time-limiting wording similar to the following: 49.6 The provisions of this Article 49 shall expire five years (or some other time period) from the date of completion of the Work (or some other fixed date in the future).

Sometimes an owner will require the contractor to sign a separate secrecy agreement prior to receiving the set of bidding documents for the project. Figure 15.1 is an example of a separate secrecy agreement that addresses the bidding and construction phases in the event the contractor is successful in winning the work. (Note the fixed expiration date.)

Owner’s Right to Inspect 254

In most construction projects, the owner will hire inspectors to inspect the contractor’s work to make sure that it conforms to applicable codes, standards, and requirements of the construction

Figure 15.1 Sample Secrecy Agreement contract. This inspection process is typical on a project. The owner has the right to nominate inspectors to act on his behalf; these inspectors may be employees of the owner or hired third-party inspectors. The following is a typical example of an inspection clause. Article 50 – Inspection by Owner 50.1 Owner’s inspectors shall have unlimited access at all times to all portions of the Work in progress. Contractor shall not cover any portion of the Work until Owner has completed his inspection of such Work. 50.2 Owner’s inspection of Contractor’s Work shall not relieve Contractor of his contractual obligations to perform the Work in accordance with the Contract.

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On first inspection, Article 50 may seem somewhat harsh or one-sided, but actually the wording in this clause is common to construction contracts and is generally considered to be fair. Owners have the right to inspect the work done by their hired contractors. Competent and qualified inspectors on a construction project can be a big help to the contractor. They can help resolve questions about the work they are inspecting in a timely manner or help find defects or improperly installed work. It’s always better to have one of the owner’s inspectors find a problem and help solve it during the construction of the project than the owner finding the problem after the project is complete, when the contractor would have to return to the site to fix it. The risk to the contractor is that the inspectors hired by the owner may not be competent and/or qualified or arrive at the job site in timely fashion to perform their inspections. The owner, of course, has the right to nominate his own inspectors, and if the contractor takes issue with the owner’s selection, this can create a problem. The best way for the contractor to resolve any concerns regarding the owner’s inspectors is to address them early. Owners are, for the most part, interested in having qualified and competent people working for them. The contractor has a right to expect qualified and competent inspectors to be assigned to his work. Life is easier for everyone when this is the case! Therefore, if the contractor is concerned with the owner’s choice of inspectors, he might negotiate wording in the contract similar to the following: 50.3 Owner agrees to provide qualified and competent inspectors to inspect in a timely manner the Work performed by the Contractor. Owner will provide to Contractor prior to the commencement of construction activities the names and qualifications of all his inspectors assigned to the Work.

If a contractor can get the owner to agree to provide “qualified and competent” inspectors, and is allowed access early on to the list of the inspectors and what their experience and qualifications are, then he may be able to raise any issues he may have privately with the owner. Sometimes this is the best way to effect a change in the contractor’s favor. Note that the additional paragraph doesn’t convey any rights of selection or rejection of inspectors to the contractor. (Owners would likely object to allowing contractors to do this.) 256

Independent Contractors

Some construction contracts may include a clause specifying that the contractor is an independent contractor. There are two issues involved with independent contractor status: 1. The Internal Revenue Service (IRS) makes a distinction for taxing purposes between an “independent contractor” and several different types of employees. Employees are those individuals who work for an owner (or contractor) and who are generally under their direct control and direction. By law, the owner and contractor have to withhold or pay certain types of taxes on behalf of or from their employees, such as Social Security, federal and state tax withholdings, and state and local unemployment and Workers’ Compensation taxes. Employees may also be entitled to certain benefits in connection with their employment status with the owner or contractor, such as vacation pay, retirement plan contributions, health benefits, and educational benefits, to name a few. 2. There is a legal definition of the term “independent contractor.” The following definition from Barron’s Law Dictionary is helpful: One who makes an agreement with another to do a piece of work, retaining in himself control of the means, method and manner of producing the result to be accomplished, neither party having the right to terminate the contract at will. When an owner contracts with a contractor who is by the terms of the construction contract an independent contractor, he hires him to produce a specific result and, in theory, does not exercise any direct control over the contractor or provide any direction of the work being performed by the contractor. The owner doesn’t have to pay the above noted taxes and benefits that he normally would for someone classified as an employee. The IRS notes and recognizes this distinction and has a series of tests it makes to determine if someone is an employee or an independent contractor. (See IRS publication 1779 “Independent Contractor or Employee” for more information.) Here’s an example of an independent contractor clause that may be found in a construction contract: Article 51 – Independent Contractor 51.1 Contractor shall be deemed to be an Independent Contractor, and not an employee, servant, or agent of Owner, and all personnel furnished by Contractor shall be deemed to be employees and personnel of Contractor and not of Owner.

If a contractor is specified by the construction contract to be an independent contractor, the owner may be able to avoid certain types 257

of claims associated with injuries to persons or property caused by the independent contractor. While the owner may be responsible for injuries or property damage caused by his own employees, who are under his control and direction, an independent contractor and his employees are not considered employees of the owner. A final note on the issue is that neither the independent contractor nor the owner has the authority to terminate the contract at will, according to part of the Barron’s Law Dictionary legal definition (on the previous page). If this part of the definition really applies, then it would seem to void any unfair termination for convenience clauses that may be included in a construction contract. This would be a good deal for independent contractors. If being specified as an independent contractor would tend to make a termination for convenience (owner’s convenience, that is) unenforceable, that would be a good deal for a contactor. This is just a thought to keep in mind when negotiating commercial terms and conditions with an owner.

Assignment

An assignment is a written agreement that transfers all or some of one party’s rights and/or obligations in a contract to a third party. The distinction between the assignment of rights and the assignment of obligations is an important one to understand. For example, when an owner secures outside financing for a construction project, the financial organization would typically require him to assign his rights in the construction contract to it as a condition of the agreement. In the event the owner becomes bankrupt, the financial organization now would have all the owner’s rights in the construction contract transferred to it by the terms of the assignment clause in the financing agreement, and likely through a similar or parallel assignment clause in the construction contract. However, it is likely that the owner didn’t assign to the financial organization any of his obligations in the construction contract. This is a key issue for contractors to be aware of with assignments made by the owner. The assignment will likely transfer only the owner’s rights, but none of his obligations. For example, one of the key obligations in the construction contract is for the owner to pay the contractor for the work performed. In the example above, the financing organization acquires all the rights (including the right to enforce the liquidated damages provisions in the contract against the contractor) by the assignment agreement, but none of the obligations (such as payment to the contractor for work performed). It is important for a contractor to fully understand the possible consequences of the

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owner assigning some or all of his rights and perhaps none of his obligations of the construction contract to some third party. Most construction contracts will include a clause that prohibits a contractor from assigning any of his own rights and obligations in the construction contract to a third party. The following is an example of a simple assignment clause that requires the contractor to obtain written permission from the owner to assign the contract to someone else.

Example 1 Article 51 – Assignment 51.1 Contractor shall not assign the Contract without the prior written consent of Owner.

Example 2 If the contractor has the right to approve the owner’s assignment of the contract, then he should review it and understand how it might affect his work. If the contractor has valid concerns or issues arising from the owner’s assignment, he at least has some leverage to revise the contract.

The following is another example of an assignment clause that prohibits the contractor from assigning the contract, but allows the owner to assign the construction contract, with the sole obligation of notifying the contractor that he has done so. Article 51 – Assignment 51.1 Contractor shall not be entitled to assign in whole or in part any of its rights and obligations under the Contract without the prior written consent of Owner. 51.2 Owner may assign any or all of its rights and/or obligations under the Contract subject only to prior notification in writing to Contractor.

Example 3

The following example is more fair to both parties. Article 51 – Assignment 51.1 Owner shall not assign any of his rights or obligations in the Contract without the prior written consent of Contractor. 51.2 Contractor shall not assign any of his rights or obligations in the Contract without the prior written consent of Owner. 51.3 Owner and Contractor have the right to review any proposed assignment agreement.

Clauses that provide for the mutual agreement to the assignment of rights and obligations are the best way to go. Each party may have legitimate reasons for an assignment. As noted earlier, some owners 259

may be required to assign their construction contracts for a project to their lenders in order to meet financing requirements. This is acceptable, but the contractor should understand how that assignment affects him and his work.

Acceptance & the Punch List

All construction contracts should contain a clause that describes the acceptance process that applies to the contractor’s work—­and how and when the owner will provide written acceptance of that work. This process concludes by providing documents and defining some dates that are important to the contractor: • The start date of the contractual warranty period. • The document used to trigger final payment and/or the release of retained monies. • The ending date of any outstanding payment and performance guaranties, on-­demand bonds, or standby letters of credit. • The start date for any required warranty period on-­demand bond or guaranty, general performance-­on-­demand bond or guaranty, or standby letter of credit. • The document provided by the owner signifying the work is complete, tested, and ready for use. • The ending date of the work, as it may be used for the determination and imposition of any liquidated damages that may apply due to contractor’s late performance. • The ending date of the work, as it may be used for the determination and award of any bonus available due to contractor’s early completion. The documents provided by the owner that signify his acceptance of the contractor’s work are called by a variety of names, including: • Certificate of mechanical completion or acceptance • Certificate of final acceptance • Certificate of occupancy • Certificate of taking over • Certificate of operational acceptance • Certificate of practical completion If not specifically defined in the contract by any of the above terms, the acceptance clause may simply state that acceptance of the contractor’s work will be provided in writing by the owner. Another issue that arises in the acceptance process is the issue of a punch list. This is a list of final minor items of work that need to be completed by the contractor, but do not interfere with the completion

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notice given by the owner. Typically, the contractor will receive the completion notice, along with the punch list and a specified time in which to complete the outstanding items. The minor tasks included on the punch list do not affect the takeover and use of the work by the owner and should not be used by the owner to delay or stop the acceptance process of the project. Typical punch list items might include: • Touch-up painting or minor repairs • Minor site restoration, repair, or cleanup • Minor repairs or adjustments that don’t hinder the operation, performance, or use of the completed work The contractor is normally given some amount of time (such as 30 days) to complete punch list items. Meanwhile, the acceptance process should continue to completion without delay.

Example 1

Following is an example of a typical acceptance clause that gives the owner 30 days to review the contractor’s work and issue a certificate of completion. The only problem with a clause like this one is that it gives the owner the right to keeping looping through the 30 days’ acceptance period if he does not like the way in which the contractor resolved uncompleted work issues. Acceptance by the owner with the use of this clause could go on for a period of time well in excess of 30 days. Article 54 – Acceptance 54.1 Contractor shall provide Owner with written notice that the Work is complete. Owner shall have 30 days after receipt of notice to determine if the Work is complete. 54.2 If the Work is complete, Owner shall notify Contractor in writing that the Work has been completed to his satisfaction and shall issue a Certificate of Acceptance to Contractor. 54.3 If the Work is not complete, Owner shall notify Contractor in writing of the uncompleted or defective portions and Contractor shall correct them at Contractor’s expense. 54.4 The procedure in this Article 54 shall be repeated until the Work is completed and Contractor receives the Certificate of Acceptance from Owner. 54.5 Contractor’s Warranty Period shall commence upon the date of the Certificate of Acceptance.

Example 2

The second example is a bit more favorable to the contractor. The contractor agrees to take care of all deficiencies (the punch list) within 30 days from the time he finishes the work. Even if the owner 261

does not start the facility within 90 days of the contractor’s notice of practical completion, the contractor automatically gets the final completion notice. This clause puts a time limit on the acceptance process. Article 54 – Acceptance 54.1 Owner shall provide Contractor with a Certificate of Practical Completion upon completion of the Work, which will list all deficiencies discovered in the Work. 54.2 Contractor shall rectify all deficiencies listed in the Certificate of Practical Completion within 30 days after issue. 54.3 If Owner does not begin operating the Work within 90 days from the date of the Certificate of Practical Completion for reasons other than those arising out of defects or delays in the Work, then Owner shall issue Contractor a Certificate of Final Completion. 54.4 Contractor’s Warranty Period shall commence upon the date of the Certificate of Final Completion.

A well-thought-out acceptance process that defines how the owner will accept the project, clarifies a punch list that will not delay acceptance, and places a time limit on the owner’s acceptance is valuable for both the owner and the contractor.

One issue associated with the acceptance process is delay (intentional or unintentional) by the owner in granting formal acceptance. For example, it’s not too difficult to understand what might drive an owner’s delay in accepting the work if the contractor is eligible to receive a $10,000 per day bonus for early completion! If the contractor feels that a delay of acceptance might be a risk, he can negotiate additional wording that places a time limit on the owner in the acceptance clause similar to the following: 54.5 Contractor shall notify Owner in writing that the Work has been completed and is ready for Owner’s acceptance. Within three weeks after the date of the notification, Owner shall advise Contractor in writing of any deficiencies in the Work. In the event Owner does not advise Contractor of any deficiencies in the Work within the noted three-week period, then the Work shall be deemed to be accepted by Owner.

A clear acceptance process will make it easier for the contractor to close out the project, establish the beginning of his warranty period, receive final payments, lessen exposure to liquidated damages, and cancel project-related on-demand bonds and surety obligations.

Advance & Partial Waiver of Liens 262

As a matter of good contracting, contractors should not waive any of their rights, legal or otherwise, in advance as a condition of the construction contract. Many contracts have unfair clauses in them that obligate the contractor to waive certain rights he has for the

duration of the contract and perhaps even afterwards. This prevents a contractor from exercising those certain rights that are normally available to him under the laws of the state he is working in. Think of it this way: why would a contractor waive in advance—at the time he signs the contract—his right to be paid on time? One of the most typical applications of the owner requesting an advance waiver of rights is in regard to the contractor’s right to file a mechanic’s lien against the owner’s property. If the owner does not pay the contractor for the work he has performed or the materials he supplied, the contractor may file a mechanic’s lien against the owner’s property. There are mechanic’s lien laws favorable to contractors in place in all states, which contractors can use to force owners to pay them for work they have performed or materials they have supplied (and the owner has not paid for). A mechanic’s lien on the owner’s property places a legal encumbrance on the property and may prevent the owner from securing financing for his project—or prevent him from selling the property without first discharging the lien. The right to file such a lien is valuable to keep in the contract in the event the owner refuses to or cannot pay the contractor for the work he has performed.

Example 1

The following is an example of an unfair clause (subclause 56.2 in particular) in which the owner wants the contractor to waive in advance his mechanic’s lien rights: Article 56 – Liens 56.1 Contractor shall promptly pay for all subcontractor services, labor, equipment, or materials provided by Contractor in connection with the performance of the Work. 56.2 Contractor hereby waives all rights to fi le any mechanic’s lien and/or all other similar liens for the payment of services, labor, equipment, or materials furnished by Contractor in connection with the performance of the Work against Owner’s premises or property. 56.3 Owner shall not make final payment to Contractor until the Contractor has delivered to Owner a final release of liens in a form acceptable to Owner.

With respect to mechanic’s liens and waivers of rights, there are two issues at work: 1. The owner expects the contractor to fully and timely pay all subcontractors and material suppliers who do work for the contractor on the owner’s project. 263

The contractor expects to be paid by the owner for his efforts and in accordance with the terms of the contract. If the owner refuses to pay him or becomes bankrupt, the contractor wants some way to get the money that’s owed him. Filing a mechanic’s lien against the owner’s project is one method. It is also a good reason not to waive in advance— at the time of signing the contract—any right to file a lien.

2. The contractor expects the owner to fully and timely pay him for the work he has performed. The owner has a legitimate right to expect the contractor to pay subcontractors and material suppliers. Since the owner is paying only the contractor, he wants some protection in the event the contractor does not pay his subcontractors and material suppliers. If the contractor does not pay them, they have the right to file a lien against the owner’s property. An owner doesn’t want to be in the position of paying the contractor for work and then having to pay a subcontractor for the same work because the contractor didn’t pay the subcontractor or material supplier in the first place. All 50 states in the U.S. have mechanic’s lien laws. Each has specific filing and notification requirements, and the contractor will ultimately have to file a lawsuit to foreclose against the owner’s property to force a sale of the property and be paid from the proceeds. The filing of a lien can also put pressure on the owner to resolve the payment issue. It’s not simple, nor is it easy, and it’s not a guaranteed payment process, but filing a mechanic’s or similar lien against an owner is something that the contractor does not want to waive his right to use. Lien laws can be complex, and the failure to provide timely notices may invalidate any lien rights the contractor negotiated into the contract. Each state has slightly different requirements, so it’s important to understand them before signing a contract. If the owner has borrowed money to build his project, lenders tend to be unhappy about having outstanding liens against the project they have lent their money to build. A mechanic’s lien in this instance provides the contractor with some leverage to get paid. Owners requesting an advance waiver of a contractor’s lien rights are often willing to allow the contractor to provide partial waivers of liens as the work progresses.

An Example

A contractor has a $1,000,000 contract to build a building. With the first progress invoice for $100,000, the contractor provides the owner with an executed waiver of liens for the value of the work performed and paid for under the invoice. With each subsequent invoice, the contractor provides similar waivers of liens for the value of the work performed under those invoices. At the conclusion of the project, the owner has received waivers of liens amounting to the full value of his project; this procedure meets the needs of most owners.

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When faced with an advance waiver of liens clause in a construction contract like the one noted above in Article 56, revised wording similar to the following could be negotiated: Article 56 – Liens 56.1

Keep as is.

56.2 Delete this subparagraph. 56.3 Reword: With each payment invoice, Contractor shall, as a condition of being paid, submit a waiver of any and all liens for the payment of services, labor, materials, and equipment supplied in connection with all the work performed under the invoice, and such waiver shall become effective only upon receipt of full payment of Contractor’s payment invoice.

In this manner, the owner receives the protection from liens that he wants, and the contractor also preserves his right to file a lien against the owner’s property in the event he does not receive timely payment from the owner.

Final Waiver of Liens

Requiring a contractor to provide a final waiver of liens as a condition of receiving his final payment or release of retention money is fairly typical. A final waiver of liens is like a partial waiver of liens, but covers the entire value of the project. Although this chapter has already addressed advance and partial waivers of liens, it can’t be emphasized enough that the contractor must make sure that any final waiver document contained in the owner’s construction contract is actually a final waiver of liens, and not something more. Any time an owner provides his own waiver forms in a construction contract, they need to be carefully reviewed. This caution is important because these final waivers that the owner would want the contractor to sign often have to be executed and filed as a condition of receiving any final payments. The right time to make any revisions to owner-generated final waiver documents is at the negotiation phase of the contract. Figures 15.2 and 15.3 are examples of two final waiver documents. Figure 15.2 is an example of an unfair owner-generated form that must be executed by the contractor as a condition of receiving final payment for the work performed. Typically, this form would have to be signed by the contractor and submitted along with his final payment invoice. No signed final waiver means no final payment. Blackmail? Perhaps. Not only does this owner-supplied form provide a final release of liens (which is okay and normal), but as stated in item #2, it: “Fully releases and discharges Owner against all liens, 265

Figure 15.2 Final Waiver Example claims, demands, and causes of action of every kind and nature arising directly or indirectly out of the performance of the Work.” In addition, item #5 states that with respect to any liens, claims, or demands, “Contractor will indemnify and hold harmless Owner from and against any such payments, all costs of defense and all other costs incurred in connection therewith.” In signing such a form, the contractor takes a significant risk by waiving his rights to any claims or demands he may have against the owner. Such claims or demands may be separate issues and not have anything to do with a lien. Also, the contractor agrees to indemnify the owner, for an unlimited 266

Figure 15.3 Final Waiver Example amount of money, against any payments he may have for claims or demands and, in addition, the contractor agrees to pay for the defense of the owner in such cases. What has happened here is that the owner has made the provision of providing an unlimited indemnity a condition of receiving final payment. Such a form should be tossed in the garbage can at the beginning of the contract negotiations! As an example of the havoc a final waiver like that shown in Figure 15.2 can create, let’s say the owner damages a piece of the contractor’s construction equipment during the course of the construction. The contractor files a claim with the owner for the cost of repairing the equipment. The owner stonewalls resolution and the claim is outstanding at the end of the job. The contractor signs the final waiver and gets his final payment—­but that’s it. In signing the final waiver form, it’s likely that the contractor would be prevented from resolving his claim on the damaged equipment, since he waived his right to do so. He could also get stuck paying any legal bills the owner may incur to defend against the contractor’s claim for the damaged equipment. Always read and understand any owner-­supplied documents like final waivers. 267

Figure 15.3 is another example of an owner-generated form to be used with the contractor’s invoice for final payment. This is an example of a fair final waiver of liens form to be supplied by the contractor with his final payment invoice. No other waivers of rights or claims or the provisions of indemnities—like those shown in Figure 15.2—are required of the contractor as a condition of receiving his final payment.

Audit Rights

Sometimes an owner will want the contractor to allow him to audit the contractor’s accounts related to the owner’s construction project. On a cost reimbursable contract where the owner is paying the contractor based on direct costs incurred, and agreed-on markups on those costs, then allowing the owner to audit the project’s accounts is appropriate. However, on a fixed price contract, and especially where the contractor has bid in competition with others, the owner really has no business being allowed to audit the contractor’s accounts related to the project. If such audit rights are so important to the owner, then he should strongly consider doing his project on a cost-reimbursable basis where he can have access to the details of the costs incurred by the contractor. On a fixed price contract, audit rights would only likely be granted for those changes to the scope of work which would be performed on some type of cost-reimbursable basis. The following is a typical audit rights clause in a construction contract: Article 57 – Audit Rights 57.1 Contractor shall keep all accounts and records in conjunction with the performance of the Work for a period of three years from completion of the Work. 57.2 Owner shall have the right to examine and copy such accounts and records with advance notice to Contractor.

For a cost-reimbursable type of construction contract, this clause is probably acceptable to use. However, if it appears in a fixed-price contract, the contractor may want to consider negotiating additional wording similar to the following: 57.3 This Article 57 is not applicable to any fixed price construction contracts. It is only applicable to cost reimbursable types of construction contracts and to any extras and additions to fixed price contracts that are paid for on a cost reimbursable basis.

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Severability or Validity Clauses

Almost all construction contracts will contain a severability or validity clause, which can be a benefit to a contractor who understands the nuances of negotiating construction contracts. Basically, such a clause says that if one or more of the clauses in a construction contract ends up being ruled unenforceable or invalid (most likely as a result of some kind of court ruling), then the remaining clauses will continue to be in full force and effect. This has the effect of severing the unenforceable or invalid clause from the construction contract. The risk here is that the contractor who is not careful might lose his hard-negotiated limitation of liability and exclusion of consequential damages. Take the instance of a contractor who negotiates a limitation of his liability and includes this limiting language within the contract’s indemnity clause. Since the limitation of liability is not a separate clause, it is possible the contractor could lose it if a court ruled that the indemnity clause was unenforceable or invalid, and struck (severed) the entire clause from the contract. The same holds true if the contractor had successfully negotiated an exclusion of consequential damages and included it within the indemnity clause. If the indemnity clause is, for some reason, ruled unenforceable, the contractor will likely lose his protection from any consequential damages that may arise against him. This is a serious risk! It is worth noting that incorporating an exclusion of consequential damages clause within an indemnity clause could be ruled to apply to the indemnity only, and not across the board, as desired by the contractor. This is why it’s important to have a separate limitation of liability clause and a separate exclusion of consequential damages clause, along with a separate indemnity clause. If this is done, then if the indemnity gets severed from the contract, the contractor doesn’t lose the protection of the limitation of liability and/or the exclusion of consequential damages clauses. The following is an example of a typical severability clause. Article 58 – Severability 58.1 If one or more of the provisions of the Contract should become invalid or unenforceable, the validity of the Contract and of all the other provisions of the Contract shall not be affected.

If such a clause is not in a construction contract, the contractor may want to negotiate with the owner for its inclusion.

Venue & Applicable Law

Most construction contracts contain a clause that reads similar to the following example:

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Article 59 – Applicable Law This Contract shall be construed in accordance with and shall be governed by the laws of the State of Florida.

Changes in the law that have a cost effect on the owner’s project are the responsibility of the owner, not the contractor.

This type of clause is commonly used to set out the agreement between the owner and contractor that, in the event of a lawsuit, both agree to the legal jurisdiction (venue) and the laws of a named state (applicable law). Each state may have slightly different laws that apply to construction contracts. The contract law considerations in one state may tend to favor the owner and not the contractor on certain matters, such as with regard to indemnity agreements. A good example of this is when the contractor is involved with a construction contract in Florida where there is anti-indemnification legislation in place that provides some measure of protection for the contractor, and agrees to an applicable law clause in the contract that says the laws of the state of Alabama apply. The contractor is at risk in this situation; Alabama, as of the time of writing of this book, has no anti-indemnity state statute in place. Also, if the contractor in this example is working in Florida, he may have to go to Alabama to pursue a legal solution to a claim or dispute. Applicable law is, arguably, not one of the riskiest contract clauses a contractor has to worry about, but with respect to those states that don’t have anti-indemnity legislation in place, it could be.

Florida Civil Code Chapter 47 Venue 47.025 Actions against contractors.—Any venue provision in a contract for improvement to real property which requires legal action involving a resident contractor, subcontractor, sub-subcontractor, or materialman, as defined in 1part I of chapter 713, to be brought outside this state is void as a matter of public policy. To the extent that the venue provision in the contract is void under this section, any legal action arising out of that contract shall be brought only in this state in the county where the defendant resides, where the cause of action accrued, or where the property in litigation is located, unless, after the dispute arises, the parties stipulate to another venue.

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Texas Business & Commercial Code Annotated §272.001 If a contract [that is principally for the construction or repair of an improvement to real property located in this state] contains a provision making the contract or any conflict arising under the contract subject to another state’s law, litigation in the courts of another state, or arbitration in another state, that provision is voidable by the party obligated by the contract to perform the construction or repair.

Venue and Choice of Law State Statutes

The following 26 states have enacted legislation, so called home court rules, for construction projects requiring claims and disputes arising from construction projects in that state to be ruled by the laws of that state. Arizona Florida Kansas Montana New Mexico Ohio Pennsylvania Tennessee Virginia

California Illinois Louisiana Nevada New York Oklahoma Rhode Island Texas Wisconsin

Connecticut Indiana Minnesota Nebraska North Carolina Oregon South Carolina Utah

These statutes can be amended and new state statutes added so an online search for “venue and choice of law” can update the above chart.

Contractual Rendition?

Here’s one example of a popular current day definition of rendition: “the practice of sending a foreign criminal or terrorist suspect covertly to be interrogated in a country with less rigorous regulations for the humane treatment of prisoners.” Let’s say you have a construction contract that contains a broad-form or intermediate form indemnity and the venue and state law clause in

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the construction contract require that all claims and disputes arising out of the contract shall be adjudicated in the State of Alabama and under the laws of the State of Alabama. Absent a venue and state law “home court rule” statute in the state in which the construction project is performed, the contractor would then have to get on his horse and go to Alabama to defend or otherwise resolve the claim under the laws, or lack thereof, of Alabama. Alabama currently does not have an anti-indemnity statute on the books. This is called “contractual rendition.” Being forced to go to another state to be tortured by the lack of anti-indemnity legislation in that state. Always check the venue and state law legislation in place for the state in which you are performing a construction contract.

Changes in the Law

If the laws of a state change during the course of a construction contract, the contractor’s costs may be adversely affected. For example, a change in state environmental laws may require the contractor to immediately adopt certain environmental protection measures that he had not included in his original estimate. Contractors can gain protection from costs associated with such law changes by adding a new paragraph (or separate clause) to the applicable law clause with wording similar to the following in 59.2: Article 59 – Applicable Law 59.1 This Contract shall be construed in accordance with and shall be governed by the laws of the State of Florida. 59.2 Any new laws, codes, or regulations or modifications of existing laws, codes, or regulations which take effect after the signing date of this Contract shall be a basis for adjustment of the Contract Price and Schedule.

The owner may argue that this is just a risk that the contractor has to accept. No, it isn’t. The contractor has just one shot at making a profit on a construction project. The owner at least has the ongoing profitmaking capability of his newly completed project to recover the additional costs of changes in the law.

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Some Interesting Clauses to Close

And finally, a couple of interesting clauses extracted from actual construction contracts worth commenting on: Article 60 – Consultation and Advice 60.1 In addition to its other obligations in the Contract, Contractor shall, when requested, and without additional compensation, consult with and advise Owner on any question or technical matter which may arise in connection with the Work.

If a contractor ever wondered what it would cost to train the entire group of young new engineers and junior project managers on an owner’s staff, he can agree to this clause. And one of the better ones: Article 70 – Don’t Bother George! 70.1 Contractor shall not bother, feed, poke, prod, or in any way disturb or aggravate George during the course of the site construction.

It turns out that George is a fondly thought-of 8-½ foot alligator who makes his comfortable home in and around a golf course pond adjacent to the site where a new structure is to be erected. Finally, someone with a sense of humor contributes to a construction contract!

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Chapter

16

A Construction Contractor’s Contract Checklist It has been said that a checklist creates laziness on the part of the user. Fill out the checklist and if the results look okay for whatever the checklist analyses, proceed and don’t do any further analysis. Performing a thorough analysis of the commercial risks associated with a construction contract for a project requires some skill and the ability to understand and evaluate the proposed commercial terms and conditions in order to best protect the assets of the company. Each construction project will always have a different mix of commercial risks associated with the project contract’s commercial terms and conditions. There is no such thing as a standard construction project. There is also no such thing as standard commercial terms and conditions for a construction project. As such, it is difficult to develop an all-­ encompassing and comprehensive checklist that would be appropriate for each and every construction project and set of commercial terms and conditions. Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Having a thorough knowledge of the typical risks associated with commercial terms and conditions and having the ability to independently understand and analyze these risks for each contract are the best ways to lower your commercial risk. Having said all that, a checklist is simply one tool to use in the contract analysis process. If it is used with some circumspection, it will at least highlight some of the most common or typical commercial risks associated with a construction contract. As long as a checklist is used in conjunction with independent evaluation and analysis of the commercial terms by the reviewer, then the risk review process can be performed more efficiently. One final point: use your own knowledge and skill—­or the knowledge and skills of others—­to thoroughly understand and evaluate the risks associated with each of the construction contract’s commercial terms and conditions. After you sign the contract, it is too late to change those risky commercial oversights! Here is a checklist of 11 important and commonly encountered contracting issues all earlier discussed in this book, along with 54 clarifying notes, to consider using as part of a comprehensive contract evaluation and analysis process: Contract Clause

Issue to Review

Scope of Work

Thoroughly written?

 1

Battery limits defined?

 2

Interfaces defined?

 3

Exceptions defined?

 4

Work by others defined?

 5

Positive cash flow?

 6

Down payment/early payment?

 7

Retention?

 8

Paid when paid/paid if paid?

 9

More than 30 days terms?

10

Terms of Payment

Schedule

Letter of Intent

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OK?

Not OK? See Note

Electronic transfer of funds?

11

Set offs?

12

Adequate time for scope of work?

13

Realistic if liquidated damages?

14

Contingency (float) in schedule?

15

Who owns the “float”?

16

“Commitment” only?

17

Defined scope and payment?

18

Contract Clause

Issue to Review

Insurance (General Liability)

Realistic amounts?

19

Additional insured status?

20

Contractual liability?

21

OCP allowed?

22

Completed operations?

23

Care, custody, and control?

24

Broad form?

25

Intermediate form?

26

Limited form?

27

Knock for knock?

28

Who’s covered?

29

Financial limits?

30

Location limits?

31

Time limits?

32

Anti-­indemnity legislation?

33

Venue/Applicable law?

34

Time only?

35

Time and money?

36

Process to get change defined?

37

Payment for changes?

38

Contract rates for changes?

39

Negotiate first required?

40

Executive solutions required

41

Mediation required?

42

Arbitration required?

43

Litigation?

44

On-­demand bond?

45

Surety bond?

46

Standby letter of credit?

47

Parent company guarantee

48

Direct/Actual?

49

Liquidated?

50

Consequential?

51

Start time defined?

52

Duration defined?

53

Exclusions defined?

54

Indemnity

Changes

Disputes

Assurances of Performance

Damages

Warranty

OK?

Not OK? See Note

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Notes 1. Make sure the scope of work is comprehensive and very thoroughly written. Most claims and disputes arise out of poorly written scopes of work.   2. The battery limits define the outside limit of perimeter of your work. This is where your work ends and someone else’s begins.   3. At your battery limits—­the interface between your work and someone else’s—­define what your scope is at that interface. For example: who hooks up the piping from your work to another contractor’s work.   4. Clearly define what work is not included in your scope. For example: construction permits and local environmental permits.   5. Make sure you specifically define work that you expect to be performed by others. For example: owner is providing scaffolding services for all contractors on the jobsite.   6. Analyze the proposed terms of payment. Make sure the proposed terms yield a positive cash flow. If they don’t, negotiate terms that do.   7. Always try to negotiate a down payment or an early payment. An early payment may be made on something such as submission of bills of materials or unpriced POs for contract materials. Invoice for the breakout value of materials. Be creative.   8. Always try to eliminate retention. In lieu of retention, negotiate providing a warranty bond along with invoice for final payment. Clients like to claim that retention assures the warranty obligations, as does a warranty bond.   9. If you agree to be paid when paid or paid if paid terms, make sure you establish some maximum time that your invoice can be outstanding. Better yet, negotiate more favorable terms. Your client has the money to pay you on time and in accordance with your preferred terms. 10. You do not have to agree to payment terms beyond 30 days. Try to negotiate 15-­day terms by electronic transfer of funds. 11. Learn how to establish electronic transfer of funds for payment of your invoices. 12. A set-­off contractually allows your client to subtract money from your invoices for money, he claims you owe them for a different project. Do not ever agree to set-­offs. 13. Make sure there is adequate time in your schedule to properly and safely perform the work. 14. If there are liquidated damages in the contract, it is even more important that there is adequate time in your schedule to perform the work. 15. Make sure there is at least some contingency time in your schedule as unforeseen delays are common. 16. Do not ever agree to give your client ownership of your contingency time in the schedule. Contingency time is commonly called “float.” It is yours; keep it. 17. A letter of intent that only expresses a “commitment” to award you the project, subject to some final unresolved issues or terms and conditions is nice, but it is not a contract. 18. A vastly improved letter of intent expresses the commitment to award and also defines scope of work to perform, like engineering and procurement of materials, plus the commitment to pay for this scope prior to a final contract being signed.

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Notes 19. Is the amount of General Liability insurance, or its follow on Completed Operations insurance, appropriate for the work? A requirement for $10,000,000 of GL and CO insurance for a $250,000 job is not appropriate. GL insurance is in effect during the course of your project and ends when you leave the jobsite. See note 23 below for Completed Operations insurance. 20. If you agree to name your client as an additional insured of your GL policy, he has full access to the coverage and limits of the policy at no cost to him, including the insurer’s obligation to provide and pay for legal defense of a claim. A claim by your client as additional insured could ruin your ability to secure GL insurance or significantly increase your premiums. Try hard not to agree to add your client as an additional insured. Your client can buy his own insurance to meet his own needs. Insurance is an asset; protect it! 21. Contractual liability is likely a component part of your GL insurance policy. It covers the obligations you agree to in an indemnity clause in the construction contract. Make sure your agent or broker carefully explains contractual liability coverage to you and the issues that arise when you also agree to name your client as an additional insured on your GL policy. 22. An Owners and Contractors Protective liability insurance policy—­an OCP—­covers an Owner against the vicarious liability arising out of so-­called third party over claims, most typically in relation to workers compensation cases. This is a completely acceptable substitute for naming your client as an additional insured on your GL policy. You purchase the OCP for client and you can include the charge in your contract price. 23. Completed Operations insurance is a separate GL policy that begins once you have completed your work and left the jobsite. Make sure you know how long the client wants the CO insurance in place, one to three years is normal. Also, try not to add your client as an additional insured to this CO insurance. Same comment as note 20 above. Remember, insurance is an asset; protect it! 24. If you accept equipment procured by your client for your installation, make sure your GL policy provides for this as “Care, Custody and Control.” This is typically a component part of your GL policy, but check, just in case. 25. A broad form indemnity makes you responsible for the financial liability arising out of claims for bodily injury, including death, and property damage caused by any degree of negligence of your client, including his sole negligence. You also would have to pay your client’s legal defense costs. This is a contractual landmine. Don’t agree to it! If you have to agree, make sure you negotiate a financial limitation of liability as a separate clause in your contract. See note 30 below. 26. An intermediate form indemnity is the same as a broad form indemnity, except it excludes claims for bodily injury, including death, and property damage arising out of the client’s sole negligence. A client could be 99% negligent for a claim and you would be responsible for the resulting financial liability. You also would have to pay your client’s legal defense costs. Don’t agree to it! If you have to agree, make sure you negotiate a financial limitation of liability as a separate clause in your contract. See note 30 below.

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Notes 27. A  limited form indemnity makes you and you client responsible for the financial liability arising out of claims for bodily injury, including death, and property damage but only to the extent of your negligence and your client’s. This is the type of indemnity you always try to negotiate into all your construction contracts. 28. A so-­called Knock-­for-­Knock indemnity obligates you and your client to be responsible for the financial liability arising out of bodily injury, including death, and property damage of their own employees and property, regardless of the degree of negligence one or the other party may have regarding the claim. Just beware that a Knock-­for-­Knock indemnity may run afoul of state anti-­indemnity laws. See note 33 below. 29. Try not to cover more than your client and his employees in the indemnities you negotiate. “Agents, representatives, subsidiaries” and other third parties are dangerous, unsafe, additions. 30. If you have to agree to a broad-­or intermediate form indemnity, try to negotiate a financial limitation of your liability as a separate clause in the contract, preferable one that would fall within the limits of your insurance program. 31. Any indemnity you agree to in a contract should be limited to covering claims occurring only during the on-­site performance of your work, nowhere else, and at no other time before or after you are on the site. 32. Any indemnity should be limited to covering claims occurring only during the time you are physically present on the jobsite. 33. A number of progressive states have statutes—­laws—­in place that make broad-­and intermediate form indemnities “against public policy and therefore void and unenforceable.” Some of these statutes also disallow providing of additional insured status to cover indemnity obligations. Legislation that only outlaws broad form indemnities is completely worthless since intermediate form indemnities may still be enforced. Some states have no such laws. Some states have common law decisions in place to void broad-­ and intermediate form indemnities. Knowledge of these statutes and common law considerations are very powerful negotiating tools for a contractor. Your contracts pro or attorney can keep you abreast of these laws. 34. A hidden land mine in contracts is a venue and choice of law clause. Clever clients like to insert a clause that obligates the parties to resolve claims or litigate in states, other than the state in which the project is located, that have no effective anti-­indemnity legislation in place. Make sure you understand the consequences of working in one state, but subject to the laws of another state. Also, some states have statutes in place that require parties to claim to resolve the claim in the state in which the project is located. This is another powerful negotiating tool which your contracts pro or attorney can advise. 35. Changes clauses that only allow time only should never be agreed to. Are you a charity? 36. All changes clauses should be negotiated to include for both time and money. 37. Make sure the changes clause has a well-­defined and fair process to have change reviewed.

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Notes 38. P  ayment for changes should be 100%. They were not part of the original contract where other payment terms were agreed to. 39. Strongly consider adding an addendum to all construction contracts that includes for unit rates for engineering, labor, materials, subcontracts, equipment rental, etc. to use when changes arise. 40. A dispute clause should require the parties to first try to negotiate a resolution. 41. A dispute clause should require the parties to nominate an executive of each party to meet and try to resolve the dispute in the event negotiations fail. 42. A dispute clause should require the parties to use mediation in the event negotiation or executive resolution fail. 43. Arbitration is a very poor dispute resolution process. It is really not much different from litigation and can drag on forever and cost a lot more than litigation. A clause that requires the parties to always go to arbitration is meant only to intimidate the contractor from pursing a claim. If you have to use arbitration, make sure the arbitrator(s) have some long-­term practical construction experience and are not just retired judges or lawyers who just read words. 44. Do not ever agree to a dispute clause that requires the parties to resolve by going to court without at least trying to resolve by negotiating, executive resolution, or mediation. 45. An on-­demand bond—­likely issued by a bank—­is not an assurance of performance nor is it a guaranty. As the name implies, a client can go to the bank and cash the bond simply by stating the contractor failed to perform. On-­demand bonds are dangerous and are used in many occasions by clients to pressure the contractor not to pursue legitimate claims. 46. A surety bond is an assurance of performance and a guaranty. Always use if a “bond” is required. 47. A stand by letter of credit is nothing more than the on-­demand described in note 45. 48. A parent company guaranty is as the name implies as assurance of performance by the contractor’s parent company. 49. You are responsible for actual damages caused by your construction activities. However, the actual damages must be proven, typically in a court case. 50. Liquidated damages in a contract create an adversarial relationship between the contractor and the Owner or his General Contractor, or both. LDs should bear some reasonable estimate to how much the Owner or his GC are actually damaged by the contractor’s late or other performance-­ related issues. LD clauses should always have a financial cap. 51. Always negotiate a separate clause in the contract excluding consequential damages. It is not sufficient to be silent on consequential damages in a contract. 52. Make sure the warranty period begins with some well-­defined completion occurrence, excluding punch list items. 53. Make sure the warranty period is well defined. For example: 18 months from contractor’s scope of work completion, or 12 months from project start up, whichever occurs first. 54. Make sure your warranty clearly provides for exclusions like corrosion, improper maintenance, etc.

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Chapter

17

International Contracting So far, this book has focused on how construction companies can better negotiate construction contracts for work performed for private companies in the United States. However, many U.S. construction companies work in foreign countries—­or would be interested in doing so. Some U.S. construction companies may have one or more divisions or subsidiaries located in other countries to pursue new work and execute projects. Others may be interested in expanding their business by seeking new construction opportunities in overseas locations. Although the contracting process for a project in the U.S. can at times be complex, at least the parties involved speak the same language, use the same monetary system, have a mature legal system to work with, and live within a stable economic and political environment. And, for the most part, a contractor building a project in California can talk to the owner in New York during the business day and not worry much about time zone differences of up to 14 hours.

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Often contractors working in foreign locations are overheard saying, “That’s how we work and contract in the U.S., so it ought to be the way it’s done in this country.” While there are many similarities between construction contracts in the U.S. and those of other countries, there are many important differences to consider, too. Contracting and commercial risk issues can change dramatically when working abroad. U.S. contractors considering doing construction work in another country must understand the various risks involved, and the different and unusual situations that may arise. This will improve the chances of success. This chapter will present an overview of some of the most common risks and considerations a contractor will be exposed to. In international contracting, it pays to do your homework—­a lot of homework. When in doubt, ask for help! This chapter will cover the following topics: • International contracts • • • • • • • • • • • • • • •

International Contracts

284

The U.S. Foreign Corrupt Practices Act (FCPA) Letters of credit Split contracts Political, religious, and economic risks Overseas Political Investment Corporation (OPIC) Legal systems Local employees, partners, and agents Offshore companies Currency risks, devaluation, and payment in foreign currency Applicable law Joint ventures and joint operations Import and export considerations Understanding INCOTERMS The Export‐­Import Bank of the United States (Ex‐­Im Bank) Assistance from the U.S. government

An international construction contract, in its basic form, is not much different from what a contractor would expect to see for similar work in the United States. Since English is the world’s business language, it’s likely that an owner who requires worldwide sourcing for his construction project will write the inquiry documents and contract in English. Often, owners hire U.S. companies with international experience to project manage the work. These companies will likely use a contracting format they are comfortable with, typically the same used on their U.S.‐­based construction contracts.

In fact, many of the commercial clauses in an international construction contract will be similar to, if not exactly the same as, those in a U.S. contract. Contractors can expect to see clauses covering scope of work, terms of payment, insurance, indemnity, termination and suspension, dispute resolution, force majeure, and others that may read just like their commercial counterparts in a U.S. construction project contract. The risk of accepting clauses as written in an international contract for construction work in a foreign country, however, may be greater. For example, the terms of payment a contractor may be willing to accept from an owner in the U.S. in a construction contract may not be acceptable, or even workable, in a complex international contract with an owner who is new and unknown to the contractor.

The U.S. Foreign Corrupt Practices Act

The U.S. Foreign Corrupt Practices Act (FCPA) is a U.S. law that addresses a problem most are not comfortable discussing: bribery of foreign government officials by U.S. business people (or any business people or business subject to U.S. laws) in an effort to gain assistance in securing new, or keeping existing, business. It is important to be aware of the reality of bribery in foreign countries, and the penalties to pay if one is convicted of bribing, even indirectly, a foreign government official. Enacted in 1977 (with several amendments since), the FCPA prohibits payments to foreign government officials for the purpose of inducing them to assist a company in obtaining new business or keeping existing business. There are also record‐­keeping provisions of the FCPA that need to be followed, requiring that all accounting entries be clearly defined. (Vaguely‐­defined entries may be used to conceal bribes.) These requirements are enforced by the U.S. Securities and Exchange Commission and the U.S. Department of Justice. Many U.S. companies operating in a foreign location have local agents or representatives to assist them in their business activities in the country—­a normal and useful international business practice. However, if it can be proven that the local agent or representative used the money paid to him by the U.S. company to bribe a government official, then the U.S. company may be subject to prosecution under the provisions of the FCPA. This is an example of the indirect consequence of bribing a foreign official. Agreements with local agents or representatives in a foreign country need to be in writing. The U.S. company hiring the local agent or representative also must perform a due diligence review of the agent’s or representative’s business activities to determine if he is reputable 285

and qualified. A thorough analysis of what constitutes appropriate due diligence for a foreign agent or representative is well beyond the scope of this chapter and would certainly vary greatly country to country. “Due diligence” just means taking a careful, closer, in‐­depth, look at the business and background of a candidate agent or representative. The results of the due diligence process should be documented and made part of the U.S. company’s internal business records. The written agreement with a local agent or representative should also contain a clause prohibiting bribery of foreign officials and include a specific reference to the provisions of the U.S. FCPA. (See the section later on in this chapter entitled “Local Employees, Partners, & Agents” for additional information on due diligence and agreements.) While bribing a foreign government official is illegal under the provisions of the FCPA—­and often under the laws of the official’s own country—­certain facilitating payments made to expedite performance of what the FCPA calls “routine governmental actions” may be allowed. Facilitating payments might include the costs to obtain licenses, process government papers like visas, provide police protection, load or unload cargo, and schedule inspections. (A slang term for facilitating payments is simply “grease,” or “grease money.”) Contractors must make sure they understand what constitutes a facilitating payment under the provisions of the FCPA. Consult legal counsel experienced in FCPA matters or the U.S. Department of Justice if in doubt. U.S. companies interested in doing construction business in foreign countries can obtain more detailed information on the FCPA from the Office of the Chief Counsel for International Commerce, located at the U.S. Department of Commerce in Washington, D.C., as well as from the Department of Justice in Washington, D.C. As a final note, in some countries, it may be the long‐­standing business custom to provide gifts to local businessmen and perhaps even local government officials. A U.S. company doing business in foreign countries should consider having some sort of written policy on gift‐­giving that does not run afoul of the U.S. FCPA. The best bet is to check with legal counsel experienced in FCPA matters.

Letters of Credit

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An essential part of doing international business involves understanding how to use a documentary letter of credit to receive payment for work performed. This is typically referred to as a letter of credit, or just “L/C” for short. L/Cs used for international payment transactions should be irrevocable. Once the L/C is in place, it should not be revoked by the organization who put the L/C in place, typically the owner.

An Example

A contractor has a contract to build a new, small power plant in Thailand. The contractor is responsible for engineering, material supply, ocean transport of materials from the United States to Thailand, and the onshore construction and start‐­up of the power plant. The combined value of the engineering, material supply, and ocean transport to Thailand is US$8,000,000. The value of the onshore construction and start‐­up in Thailand is US$3,000,000. The terms of payment in the contract require the full price of the engineering, material supply, and ocean transport to Thailand to be paid in full under an irrevocable L/C provided by the owner. The contract also requires the L/C to be provided by a bank acceptable to the contractor—­and on terms acceptable to the contractor. The contractor advises the owner that Chase Manhattan Bank’s Bangkok branch is acceptable to him for use in providing the L/C. The owner arranges for Chase to provide the L/C either by directly depositing the US$8,000,000 in the bank, establishing a line of credit for that amount, or providing for the transfer of the amount from the owner’s regular bank, the Bank of Thailand. The commercial terms of the L/C provided to the contractor by Chase Manhattan Bank require the following: 1. Payment of the full US$8,000,000 will be made by Chase Manhattan Bank in cash to the contractor upon presentation of shipping documents evidencing that all the materials required by the contract have been placed aboard the ship going to Thailand. Partial shipments and payments are allowed. 2. Payment of the US$8,000,000 will be made by any of the Chase Manhattan Bank’s offices in the United States. 3. Insurance documents are to be provided showing that the materials being shipped are properly valued and insured. 4. Loading of the materials aboard the ship going to Thailand must take place on or before a certain date. Otherwise, the L/C can’t be cashed without revising the terms. Once the contractor finishes the engineering, procures all the materials, packs them for ocean shipment, and loads them on the ship bound for Thailand, he assembles all the documents pertaining to the shipment and the evidence of insurance coverage and goes to the bank. At one of the local U.S. offices of Chase Manhattan Bank, the contractor presents his documents as required under the terms of the L/C. The bank reviews the documents and, if they are in order, pays the contractor the US$8,000,000 or a partial payment for a partial shipment. The bank’s only obligation is to review the documents 287

required by the L/C and presented to them. Banks pay on ­presentation of proper documents, hence the term documentary letter of credit. Using L/Cs to pay for the supply of goods and services provided from outside the country in which the project is being built is common on international construction contracts. This is one of the most common uses of an L/C. L/Cs are also a good practice with owners whose ability to pay may be in doubt, or who have no past payment record with the contractor. They can also be structured to pay for onshore construction activities in the foreign country, if necessary. While L/Cs can be complex in their documentary requirements and other conditions, they allow a contractor to be paid by a reputable third party—­a bank—­in a simple and timely manner upon presentation of the proper documents. Contractors interested in working in a foreign location should talk with their banker about the benefits of using L/Cs for some or all of their contract payments from the owner. One last comment on L/Cs: it’s hard to find much better payment terms than payment in cash in U.S. dollars under an irrevocable letter of credit.

Split Contracts: Onshore & Offshore Contracts

In the previous example for the project in Thailand, the U.S. contractor had in place two separate contracts from the owner—­one worth $8,000,000 for engineering, materials, and ocean transport of those materials to Thailand, and another for $3,000,000 to perform construction and start‐­up. The separate contract to supply the engineering, project materials, and ocean transport of materials is referred to as an offshore contract. The contract to construct and start up the project in Thailand is called an onshore contract. Considered together, they are called split contracts. The following are some benefits of split contracts: • The offshore contract can be denominated in the contractor’s preferred currency. • The offshore contract can be paid by a letter of credit, thereby virtually eliminating the risk of nonpayment for the value of the goods and services provided from outside the foreign country where the actual construction takes place. • Certain U.S. corporate administrative and overhead costs and markups associated with the value of the onshore construction work can be legitimately shifted to an offshore contract, thereby eliminating the risk of non‐­recovery of these costs and markups.

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• The value of the offshore contract may be, and probably will be, exempt from taxes, fees, stamp duties on contract value, and the like, which can be imposed by the foreign country on the value of the onshore contract. • There may be certain U.S. tax advantages available to the contractor to have the offshore contract awarded to a subsidiary of his company that is incorporated outside the United States in a country other than where the actual construction will occur. • The onshore contract can be denominated in the contractor’s or owner’s preferred currency, or it can be denominated in the currency of the foreign country in which the construction occurs. A competitive advantage may be gained by denominating the onshore contract in the currency of the foreign country. It’s also advisable for the contractor to have the owner contract with two different entities. For the offshore portion of the contract, the owner could contract with the contractor’s U.S. organization or one of the contractor’s U.S. subsidiaries, or a foreign subsidiary of the contractor, if there is one. For the onshore portion of the contract, the owner would contract with a different subsidiary of the contractor, possibly a new company, partnership, or joint venture the contractor had established in the foreign country. Setting up to work with split contracts requires some expertise. It’s worth the time and effort to seek the advice of an experienced company that can provide accounting, tax, and legal guidance in this form of contracting and the establishment and use of offshore subsidiaries.

Political, Religious, & Economic Risks

Is it safe to work in a foreign country? Is it possible to do well there? The correct answer to both is maybe, and quite possibly yes, if you do your homework. Foreign countries with stable political, religious, legal, and economic institutions tend to better attract new and continuous capital investment and foreign lending, which can translate into construction opportunities for a U.S. contractor. This doesn’t mean that the risk of performing construction work in a foreign country is small, or similar to the risk of working in the U.S. It does mean, however, that a contractor needs to be prepared, understand the various risks, and account for them when pricing any construction work and in developing business plans for work in a foreign country. Prior to working in a foreign country, it’s best to do some homework on what it takes to do business in that country and what kind of physical and commercial risks the contractor might expect to 289

encounter. Most foreign countries have U.S. embassies with commercial and economic officers on staff who can provide information about doing business in that particular country. Many foreign countries also have a branch of the American Chamber of Commerce, or “AmCham” for short. The U.S. Commercial Service, part of the U.S. Department of Commerce, has offices all over the world, staffed with commercial officers whose job it is to assist U.S. companies interested in doing business abroad. (See the section later in this chapter on “Getting Some Help from the U.S. Government.”)

Overseas Private Investment Corporation (OPIC)

Contractors with serious concerns regarding the political and economic risks associated with working in a foreign country can explore the option of procuring political insurance, either on their own or through the U.S. government’s Overseas Private Investment Corporation (OPIC). Headquartered in Washington, D.C., OPIC can provide insurance coverage, project finance, and investment funds to U.S. companies expanding into approved foreign countries. As of the writing of this book, OPIC works with 140 approved countries. For a fee, OPIC offers U.S. contractors performing construction work in foreign countries and U.S. companies exporting U.S. goods insurance to protect against: 1. The wrongful calling of bid, performance, or advance payment guaranties, custom bonds, and other guaranties. 2. Loss of physical assets and bank accounts due to confiscation or political violence and inconvertibility of proceeds from the sale of equipment used at a site. 3. Losses due to certain breaches of contract by foreign buyers related to the contract’s dispute resolution procedures. Detailed information is available at the OPIC website (http://www. opic.gov). For broader insurance coverage than that offered by OPIC, contact a business insurance broker.

Legal Systems in Foreign Countries

If there is a need to legally enforce some aspect of the contract with the owner in a foreign country, the contractor may have to utilize that country’s legal system. It is always a good idea to have a thorough understanding of the workings of the local legal system. What looks good on paper may not be so good in reality. It’s also important to understand all the legal requirements of working in a foreign country and establishing a company there. Many foreign countries have well‐­developed legal systems that can assist a foreign contractor in resolving construction contracting issues and in properly establishing a local operating company or joint venture. It’s always best to develop a relationship with an experienced local law

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firm prior to establishing a local company or joint venture and prior to negotiating and signing contracts in a foreign country.

Local Employees, Partners, & Agents

Doing construction work in a foreign country requires local assistance and knowledge. Trying to do business without local help will likely result in failure. It may be, too, that having a local partner is a legal requirement in order for a U.S. company to do business in a particular country. Even though English may be widely used in other countries, having employees who speak the local language can help resolve or head off a lot of unnecessary problems. Being able to effectively communicate with local government officials, customs officers, immigration officials for visas, the police, tax officials, bankers, accountants, subcontractors, suppliers and vendors, and the like is important to the success of a contractor’s efforts in a foreign country. Having a local partner or agent is another matter, however. Typically, a U.S. contractor would have some sort of written agreement with a local business partner or a local agent. Partners and agents can provide valuable assistance to a U.S. contractor working in the country, but once the association is made, it may be very difficult and time‐consuming to terminate the relationship.

Partners and agents in foreign countries can provide valuable assistance in securing work and assisting with resolving day‐to‐day problems. However, their selection should be carefully thought‐out, as the U.S. contractor is likely establishing a long‐term relationship.

Generally, a local partner would likely have an ownership interest, along with the U.S. contractor, in the local company established. The local partner would provide assistance to the U.S. contractor in securing work in the country and would receive a share of the profits of the local company. A local agent would, for a fee, simply represent the U.S. contractor’s interests in the country, provide assistance with a specific project, or provide assistance with local business or technical matters. When selecting partners or agents, here are three tips to keep in mind: 1. The U.S. contractor should take as much time as he feels necessary on deciding who should be his local partner(s) or agent(s). Often, there are time constraints placed on a contractor by his own company in the U.S. when he travels to a foreign county. In the long run, a second or third trip to the foreign country may result in a much better selection of a local partner or agent. 2. The U.S. contractor should perform a due diligence review of the local partner or agent and on his business interests. 3. Any agreement with a new local partner or agent should be in writing and carefully define responsibilities and the system for payment of services rendered, as well as address the requirements of the U.S. Foreign Corrupt Practices Act. 291

Once a partner or agent is selected, the written partnership or agency agreement should have a section on the applicability of the U.S. FCPA. This can provide some measure of protection from any indirect exposure to bribery of foreign government officials.

Offshore Companies

For a U.S. contractor, an offshore company is simply a company he establishes in a country outside the United States. It does not necessarily have to be located—­and probably shouldn’t be located—­in the country in which the contractor wants to do foreign construction work. It also doesn’t have to have a name that sounds anything like the contractor’s parent company. For example, a U.S. contractor who is planning a construction project in Thailand may establish a separate company in Thailand to do that construction work; this is his onshore company. The U.S. contractor may also establish a separate company in the British Virgin Islands, for example, to supply materials and other services in support of the project in Thailand; this is his offshore company. There may be U.S. and foreign tax advantages available to the contractor’s U.S. parent company and to its foreign subsidiaries in the use of an offshore company. Certain foreign countries provide favorable tax treatment of profits, so prior to establishing an offshore company, the U.S. contractor needs to understand the tax laws of the countries in which he wants to establish an offshore company. An offshore company is particularly useful when a U.S. contractor is doing construction work in a foreign country, and the contract requires the supply of materials and/or services from outside the foreign country. Material supply and other services can be contracted through the U.S. contractor’s offshore company. (This is the concept of split contracts that was covered earlier in this chapter.)

An Example

American Civil Engineering and Construction Company (ACECC), a U.S. company, secures a construction contract from Indian Power Company in India. The contract in India is awarded to ACECC’s Indian subsidiary company, India Civil Engineering and Construction Company (ICECC). The contract requires the supply of certain specialty materials from outside of India. ACECC has an offshore company, Material Supply Company, Inc., organized in Tortola, British Virgin Islands. ICECC’s proposal for work states that the materials supplied from outside of India will be supplied by a separate contract to a nominated material supplier, Material Supply Company, Inc. If the owner, India Power Company, has a concern about the use of this “unknown”

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company, ICECC is willing to provide a parent company guaranty covering the performance of Material Supply Company, Inc. Material Supply Company, Inc. is to be paid in U.S. dollars by an irrevocable letter of credit from a bank acceptable to ACECC. Material Supply Company, Inc. may choose to procure the required materials as it sees fit, including buying the materials from ACECC, its parent company. Figure 17.1 shows how this contract might be constructed.

Figure 17.1 Typical Onshore/Offshore Contract Structure A benefit of having an offshore company like Material Supply Company, Inc. in this example is that the offshore company’s separate contract can have payments made to it in U.S. dollars through an irrevocable letter of credit. Receiving payment in a strong, international, and readily convertible currency, like U.S. dollars, can be important where there may exist significant currency convertibility or devaluation risks involved in taking payment in local currency.

Currency Risks

A major risk for U.S. contractors working in foreign countries is agreeing to accept full or partial payment for the contract in the local currency. After receipt of the local currency payment, the contractor 293

may then find out that there are restrictions to converting the local currency to U.S. dollars or transferring the funds out of the country. This can make it difficult or impossible to convert the local currency to U.S. dollars and repatriate any foreign earned profits, or pay direct costs accrued outside the country and collect any overhead costs associated with the contractor’s U.S. operations. Understanding the strengths or weaknesses of foreign currency and the currency exchange controls in effect is important. Knowledge of the currency controls in existence in a foreign country can help U.S. contractors decide on alternate contracting methods, negotiating to receive payments from the foreign owner in U.S. dollars, or deciding not to bid on a contract where only local currency will be used for payment. Some foreign currencies may not be readily converted into U.S. dollars, or there may be severe restrictions on how much can be legally converted at any one time. What can happen is that the U.S. contractor can end up being stuck with a lot of foreign currency and no ability to convert it to U.S. dollars—­and limited ability to use all of it to pay for the costs associated with his foreign operations. One bright spot is that it is not uncommon for foreign construction contracts to be denominated in U.S. dollars, or partially in combination with U.S. dollars and the local currency. Often, a major construction project in a foreign country will be financed by another country (or group of countries), and U.S. dollars or other readily convertible international currencies will be used for payment. Another major risk is the devaluation (loss of value) of a local currency with respect to the U.S. dollar, referred to as exchange risk. Sometimes, for a variety of political and economic reasons, the value of a local currency with respect to other foreign currencies declines. Devaluation means that it takes more of the local currency to purchase U.S. dollars than it did at an earlier point in time. For a U.S. contractor, this means he will receive fewer U.S. dollars for the local currency, which can be costly when working in a foreign country.

An Example

A U.S. contractor was awarded a construction contract valued at the local currency, baht, 250,000,000 in Thailand in early 1998. At that time, the baht, was B25 to US$1. This conversion rate had been steady for 20 years or more. Therefore, it did not appear to be too risky in taking a construction contract in Thailand denominated in Thai baht. The value of the contract could be collected, and any baht amount not used in Thailand could be converted to U.S. dollars—­and the U.S. dollars sent to countries outside of Thailand without any undue restrictions.

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At the then‐­steady conversion rate of B25 to US$1, the value of the construction contract for the contractor was US$10,000,000. The contractor had a lot of additional costs, both outside of and within Thailand. The contractor didn’t concern himself with the risk of the Thai baht losing value against the U.S. dollar. Then, in early 1998, the Asian financial crisis hit. The Thai baht, like many other Asian currencies, lost a significant amount of its value against the U.S. dollar. It devalued quickly from B25 to US$1 to between B40 and B50 to the dollar. Therefore, the U.S. contractor saw the dollar value of his onshore construction project in Thailand devalue by almost 50%, as his project was now worth about US$5,000,000. Needless to say, the contractor’s ability to pay his U.S. dollar denominated costs by converting Thai baht progress payments into U.S. dollars was destroyed. This extreme example would be a disaster for a U.S. contractor who had an enforceable, fixed price, baht‐­denominated construction contract in Thailand with no contractual provisions to protect from such a significant devaluation of the local currency. Perhaps he could claim such an extreme devaluation was a force majeure event. Good luck. A more typical example of foreign currency exchange risk would be a devaluation of the foreign currency in the 5% to 10% range. This could be enough to wipe out any profit on a job. However, there is a way for U.S. contractors to protect themselves from this type of currency devaluation. For a fee, contractors can purchase from a bank a forward exchange contract, or a foreign currency option, described below. 1. Forward exchange contract: The buyer (U.S. contractor) has the obligation to sell a certain amount of foreign currency at or within a certain time to the bank who sold him the forward exchange contract at a fixed exchange rate. 2. Foreign currency option: The buyer (U.S. contractor) has the right, but not the obligation, to sell a certain amount of foreign currency at or within a certain fixed time period to the bank who sold him the foreign currency option at a fixed exchange rate. Both serve as “insurance policies” against the risk of incurring financial loss when converting a foreign currency into U.S. dollars.

An Example

A U.S. contractor working in a foreign country takes a contract denominated in Japanese yen. The construction project is financed through a branch of the Japanese Government called JBIC, the 295

Japan Bank of International Cooperation, and all construction contracts on the project are denominated in yen. The U.S. contractor is awarded a construction contract in the foreign country valued at ¥750,000,000, or the equivalent of approximately US$6,500,000 at the prevailing exchange rate of ¥115 to US$1. The U.S. contractor expects to receive the equivalent of $6,500,000 after converting his yen payments to U.S. dollars. He needs to collect this amount to make a profit on the construction contract. The U.S. contractor intends to convert all his yen progress payments into U.S. dollars, assuming the rate is ¥115 to US$1. However, he wants to protect himself against a possible devaluation of the yen against the dollar, so he contacts his banker and arranges to buy a series of forward exchange contracts (or foreign currency options) for Japanese yen. The timing of these forward exchange contracts coincides with his expected receipt of progress payments over the life of the project, and assures him he will be able to sell the Japanese yen to the bank for the fixed conversion rate of ¥115 to US$1. These forward exchange contracts provide a guaranty to the contractor that he can exchange the yen he receives as progress payments into dollars at the rate he expects. In other words, for a fee, the bank takes the risk of a future devaluation of a certain amount of Japanese yen currency. If, during the open periods of the forward currency exchange rate contracts, the yen devalues to ¥130 to US$1, the contractor is protected from the exchange loss, as he has a contract with his bank to sell them the Japanese yen for ¥115 to US$1. If the contractor receives a progress payment of ¥150,000,000, and the yen had devalued to ¥130 to US$1, he is protected. If he had to convert the same yen payment at the prevailing rate at time of receipt at ¥130 to US$1, he would have received only $1,150,000, or an exchange loss of $150,000. Where forward exchange contracts are available for selected currencies, they are an effective means of lowering the risk of foreign currency exchange losses. Contractors should talk to their banks and consider purchasing such options at the estimating stage of the contract so that the costs can be included in the price. Another sometimes successful way of protecting against the risk of exchange loss on a foreign construction project is to negotiate with the owner a fixed or variable exchange rate to apply to each local currency progress invoice. The local currency invoice would be converted into U.S. dollars at the agreed‐­on rate and paid to the contractor. 296

Applicable Law

Construction contracts for work in a foreign country will almost always contain a clause specifying which country’s law will apply to the contract. This sounds odd. Why wouldn’t the contract laws of the country in which the project is being built automatically apply? Just because a construction contract takes place in Brazil doesn’t necessarily mean that the laws applicable to contracts in Brazil will apply to the contract in the event of a lawsuit, dispute, arbitration proceeding, or some other form of alternative dispute resolution. It is not uncommon for an owner in a foreign country to contract with a large international company to perform a major construction project and act as the project manager. This international company will have the skills, as well as the financial and staffing resources, to engineer, build, and project manage the work. The international company will likely subcontract much of the work rather than self‐perform it, and will award subcontracts for various portions to a combination of local and foreign companies. In this fashion, the owner of a major construction project in a foreign country is able to have access to worldwide sourcing of capabilities and specialized materials and equipment. The international company serving as project manager for the work will likely have a preference for the laws of one country. A major U.S.‐based international engineering and construction company that is acting as project manager for an owner in Brazil may have a clause in its standard construction contract form that states U.S. laws will apply. The following is a simple example of an applicable law clause as it may appear in an international contract. Article 41 – Applicable Law 41.1 This Contract shall be governed and interpreted under the laws of the United States of America.

In the above example, even though the contract is being executed in Brazil, U.S. law would apply to the administration of the construction contract. The clause could have just as well stated: “. . .under the laws of Brazil.” Below is an example of a better way to define which law applies. Article 41 – Applicable Law 41.1 This Contract shall be governed and interpreted under the laws of Brazil that are in effect at the time of signing this Contract. Any new laws, codes, or regulations different from those noted in this Contract shall be the basis for an adjustment in the Contract Price and Contract Schedule.

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This clause is much better, as it allows the U.S. contractor to be compensated for the effects of changes in local laws, regulations, and codes—an important issue when working in a foreign country (as well as in the United States, for that matter). Following is another example of an applicable law clause that addresses how the parties to the contract will use the laws of England to interpret the contract, and how they will resort to arbitration to resolve disputes. Clauses similar to this one are typically considered fair to contractors and owners. Article 41 – Applicable Law 41.1 This Contract shall be governed and interpreted in accordance with the laws of England. 41.2 Any dispute arising out of or in connection with the Contractor or the provisions of the Contract which cannot be amicably settled shall be submitted to arbitration under the auspices of the International Chamber of Commerce. 41.3 Any arbitration shall be conducted in London, England. The language of the arbitration shall be English.

Under the provisions of this clause, the laws of England related to contracts would apply. If the parties to the contract decided to go to arbitration to settle the dispute, they would both have to go to London for the proceedings. Why go through all of this extra commercial language on applicable law if the foreign country in which the project is being built has a legal system and also has the ability to conduct formal arbitration proceedings?

For U.S. contractors, there’s nothing wrong with trying to negotiate a change in the applicable law clause in a foreign construction contract to make the laws of the United States apply.

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There are two prevailing reasons for including this type of applicable law language: 1. To make it more difficult for a contractor or subcontractor to initiate legal or arbitral proceedings against the owner or the owner’s project manager. 2. To protect the interests of the contractor or the subcontractor and the owner’s project manager from legal and arbitral systems in the country in which the work is being performed that may be prone to or subject to corruption, political influence, lack of experience, or all three. Contractors should always take the time to understand the consequences of agreeing to be subject to the local legal system, or the legal system of a country other than that in which the project is being built.

Joint Ventures

A joint venture is an organization established by two or more companies joining together to provide resources, share management responsibilities, and share any resulting profit or losses. For a U.S. construction company doing business in a foreign country, a joint venture is a way to formally team up with another company—­U.S.‐­based or foreign—­to build a project. Each company in the joint venture will have a certain scope of work to perform, and each will bring their own expertise, as well as financial and management resources, to the project. The joint venture company established in a foreign country will likely be subject to all the business and taxation laws of that country. It will also likely be treated as a separate business entity for taxation purposes. Typically, a formal joint venture agreement would be drawn up detailing the scope of work each party will perform and what management and other responsibilities each will undertake through the course of the project. This agreement will also outline how any profit and losses of the completed project will be shared. It should also mandate that both parties abide by the provisions of the U.S. Foreign Corrupt Practices Act. Project and contractual responsibilities with respect to the owner will likely be shared in some form of a joint and several basis by both of the companies who make up the joint venture. Joint and several means that all parties (joint) in a joint venture are responsible for the project; in the event one of the parties fails to perform, the other party or parties (several) in the joint venture would still be fully responsible for the project. An owner may insist that the parties in the joint venture each accept some degree of joint and several responsibilities, in the event one or more is in breach of the contract or becomes bankrupt, insolvent, or otherwise fails to perform. Also, there may be tax laws specifically for joint ventures in foreign countries, so it’s necessary to check with an experienced accounting firm and law firm in the country in which the joint venture will operate. A joint venture is a good way to combine the skills and expertise of several companies to secure work in a foreign country. Having a capable and experienced local joint venture partner with a strong financial base from the country in which the work is to be performed can be a real asset in securing work in a foreign country.

Joint Operations

A joint operation is similar to a joint venture in the sense that two or more companies join forces to work together to build a specific project in a foreign country. However, each party to the joint operation is responsible for independently estimating and performing its own scope of work, and will receive any profit or accept any loss 299

that may result from its own operations. Unlike a joint venture, profit and losses resulting from the project are not pooled together and then split between the parties. The basic idea of a joint operation is not to form a separate taxable entity in the foreign county. Each party to the joint operation would be responsible for the tax considerations that may arise from the profit or loss on his own scope of work on the project. A joint operation can be established by what is called a Memorandum of Understanding, or MOU, which outlines the responsibilities of each of the parties, including scope of work and joint or joint and several responsibilities with respect to the project and contractual obligations with the owner. A joint operation may be formed with companies of significantly unequal resources and skills. There may be good reasons (such as political), for a U.S. construction company to consider having some formal working arrangement with a local company for a specific project. Just because a local company doesn’t have significant financial or people resources or doesn’t have much experience in managing projects, this shouldn’t automatically exclude the local company from developing a working relationship with a U.S. contractor. The company may, for instance, have excellent personal contacts within the local business or political community that can greatly assist the U.S. contractor in his work. There may also be benefits to advertising that the U.S. contractor has a working relationship, through the joint operation for the project, with a local company. For example, a politically well‐­connected local company would likely be able to facilitate the U.S. contractor gaining opportunities for additional profitable projects in the foreign country. With a joint operation, the U.S. construction company may find that the owner will insist that the U.S. company take full responsibility for completing the project, and will not agree to a joint and several responsibility relationship with the local company.

Import & Export Considerations

A U.S. contractor may find that he has a complex mix of local regulations—­and associated costs—­to deal with when bringing materials, supplies, personnel, and construction equipment into a foreign country, and when removing construction equipment out of the country at the conclusion of the project. If the contractor needs to import materials for the project, there may be duties applied to their stated value, and the materials may be held up at the docks after they have been off‐­loaded until all import duties are paid in full. In some cases, imported materials may be duty‐­free, particularly if the construction project is being built for the local government or one of its agencies. Sometimes, private foreign construction projects

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may have duty‐­free status for imported materials, especially those that are not available in the foreign country. In these cases, properly filled out paperwork must be supplied to the country’s customs officials in order for the materials to be released from customs at port of import. Specialized construction equipment is often required on a construction site. If the site is remote, or the equipment is not available in the foreign country, it’s not uncommon for the contractor to be required by the local government to bring the specialized equipment in under an on‐­demand performance bond. The U.S. contractor would have to buy the bond from a local bank in order to import the equipment into the country. The contractor would likely also have to agree not to sell the equipment in the country, and further agree to export the equipment out of the country at the end of the project. If the contractor fails to meet these restrictions and conditions, then the bond that was supplied by him would be cashed in by the government. If the contractor does not sell the equipment in the country and exports the equipment out of the country at the end of the project, then the bond is void. The bond is the local government’s assurance of performance that the contractor will not sell the equipment in the country and that he will export it at the conclusion of the project. It’s important to note that some materials and supplies that a U.S. contractor might prefer to import may be subject to high import duties, since similar materials and supplies may be available in the country—­a practice designed to protect local industries. There may even be a prohibition on the import of certain materials and supplies if they are readily available locally in the foreign country. On foreign projects that have been granted duty‐­free status, all imported materials will have to be described on what is sometimes referred to as a Master List. This is a listing of duty‐­free materials for the project and is provided by the owner for use by the foreign country’s customs officers at the port or ports of import. The imported materials described on the shipping manifest must match the materials described on the Master List. Accuracy is critical. However, too much detail can lead to delays as custom officers try to match each and every item on the Master List with each item on the shipping manifest. It’s best to keep descriptions simple and as broadly worded as possible. When dealing with imported materials, supplies, and equipment, it’s absolutely essential to employ a local shipping agent or freight forwarder who can assist a U.S. contractor in meeting all the local 301

import rules and regulations. Having critical material and equipment tied up at the docks due to incorrectly prepared paperwork, or because import fees and duties aren’t paid on time, can cause significant delays in a foreign construction project. Local shipping agents or freight forwards are also likely to have good personal relationships with the local customs officials, which can help speed up the process of getting imported materials, supplies, and equipment through the customs process and onward to the construction job site. U.S. contractors should be sure to include a clause in the contract that clearly defines the tax status of the project and who is responsible—owner or contractor—for directly paying any duties and fees on imported materials and supplies for the project. A typical clause for payment of duties and fees on imported materials might look like the following: Article 51 – Duties and Fees on Imported Materials 51.1 Contractor shall be fully responsible for the timely payment of all applicable duties and fees in effect at the time of signing of this Contract on all materials supplied from outside of the Country and imported into the Country. 51.2 Owner shall reimburse Contractor at cost for the value of any increases in duties and fees on imported materials that arise after the date of the signing of this Contract.

This clause states that the contractor has included in his price for the project all duties and fees assessed on the value of any materials imported into the country. The clause also provides for the owner to pay any increases in duties and fees on imported materials that become effective after the date of the signing of the contract. On any foreign project that enjoys tax‐ or duty‐free status, it’s also important to state that status in the construction contract and to also have the clause provide for the owner paying any duties and fees on imported materials in the event the project loses its tax‐ or duty‐free status.

Understanding INCOTERMS

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INCOTERMS, an abbreviation for “International Commercial Terms,” are a set of international rules first established in 1936 for the interpretation of commonly used shipping terms. Full descriptions of all INCOTERMS are published by the International Chamber of Commerce. Of particular importance to a U.S. contractor working in a foreign country is the use of those INCOTERMS that are related to the shipment of goods from one international location to another

international location. INCOTERMS describe the duties and responsibilities of buyers and sellers for the shipment of goods. As such, each different INCOTERM that describes a required shipping process will have a different set of duties, responsibilities, risks, and costs for both the owner and contractor. There are 13 INCOTERMS commonly used for shipping goods. They are: EXW (Ex‐­Works) 1. FAS (Free Alongside Ship) 2. FOB (Free on Board) 3. FCA (Free Carrier) 4. CFR (Cost and Freight) 5. CIF (Cost Insurance and Freight) 6. CPT (Carriage Paid To) 7. CIP (Carriage and Insurance Paid To) 8. DES (Delivered Ex‐­Ship) 9. DEQ (Delivered Ex‐­Quay) 10. DAF (Delivered at Frontier) 11. DDU (Delivered Duty Unpaid) 12. DDP (Delivered Duty Paid) Each of the above 13 terms would typically have a named location attached to it to designate where the goods are going, for example: FOB, port of export, Baltimore, Maryland. In this example, “port of export, Baltimore, Maryland” is the named location of destination of the goods. The contractor’s shipping responsibilities, cost, and commercial risk can increase significantly as the shipping of project materials becomes more complex going from EXW (Ex‐­Works, named location), which will likely be the least expensive and least risky, to DDP (Delivered Duty Paid, named location), which will likely be the most expensive and most risky. The best way to explain the use of these terms is through examples. Let’s say a U.S. contractor procures from a supplier in the United States, the materials for a major construction project near Cairo, Egypt. 1. EXW (Ex‐­Works): In this example, the contractor states in his proposal to the Egyptian owner that all materials for the project will be procured and shipped “EXW (Ex‐­Works), Contractor’s Warehouse, Baltimore, Maryland.” What this shipping term means is that the contractor is responsible for the costs to supply project materials, including any delivery costs, only to the back door of his warehouse in Baltimore, Maryland. 303

Understanding INCOTERMS used in the shipment of project materials to a foreign job site is an essential part of international contracting. A good freight forwarding agent is an asset to a U.S. contractor when international shipment of goods is required.

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The Egyptian owner, or another party retained by the owner, would be responsible for all the costs and logistics of getting the materials from the Ex‐Works location—the contractor’s warehouse in Baltimore, Maryland—to the project job site location in Egypt. This shipping option is the least expensive and least difficult and risky one for the contactor. 2. CIF (Cost, Insurance, & Freight): In this example, the contractor states in his proposal to the Egyptian owner that all materials for the project will be procured and shipped “CIF, Port of Import, Alexandria, Egypt.” What this shipping term means is that the contractor is responsible for the costs to supply project materials and deliver the materials to the port of import at Alexandria, Egypt. In this instance, the contractor pays for all costs to pack the goods for ocean shipment, take them to the port of export (Baltimore, MD), arrange for ocean shipment to the port of import, Alexandria, Egypt, get the materials loaded on the ship, and insure the goods during the ocean shipment to Egypt. Once the ship arrives at Alexandria, the contractor’s shipping responsibilities are fulfilled. The client receives the goods and is responsible for all further efforts and costs to get the materials to the job site near Cairo. This is a normal shipping responsibility of an international contractor and does not typically carry any unusual risk. As a typical method of international shipping, costs are well known. 3. DDP (Delivered Duty Paid): In this example, the contractor states in his proposal to the Egyptian owner that all materials for the project will be procured and shipped “DDP, Job Site, Cairo, Egypt.” What this shipping term means is that the contractor is responsible for the cost to supply project materials and deliver them to the owner’s job site located outside of Cairo, Egypt. These costs will include all U.S. inland freight, ocean shipment, insurance, and foreign country inland shipping costs to the project job site, plus all imposed duties and fees on imported materials. The U.S. contractor is responsible for all the costs and logistics of getting the materials from wherever he gets them in the United States to the project job site location near Cairo, Egypt. This shipping responsibility is the most costly and risky, and the contractor would have to fully understand how to properly undertake and estimate this delivery effort. INCOTERMS are copyrighted by the International Chamber of Commerce. Detailed descriptions of INCOTERMS can be purchased through their online bookstore at http://www.iccwbo.org

The Export‐­ Import Bank of the United States

The Export‐­Import Bank of the United States (Ex‐­Im bank) is an agency of the U.S. government that provides lending and insurance services to U.S. exporters of goods and services. The Ex‐­Im Bank provides guaranties for commercial loans to U.S. exporters of U.S. manufactured goods and also provides direct loans to international buyers of U.S. goods and services. Foreign owners of construction projects can seek some or most of their project financing requirements through the Ex‐­Im Bank. As a condition of receiving the Ex‐­Im Bank‐­supported project financing, the owner of the foreign project must agree to use the financing provided to procure from U.S. companies some portion of the goods and services needed for the project. The portion of the project financing that must be allocated to U.S. companies is expressed as a percentage of the amount of financing provided. Typically, when project financing is provided to a foreign owner by the Ex‐­Im Bank, a minimum of 50% of the amount must be used to procure U.S. goods and services; in some instances, this percentage amount can be higher. Having the financing of a foreign construction project provided only by the Ex‐­Im Bank can create a competitive edge for a U.S. construction company. However, the U.S. contractor competing on a foreign construction project needs to understand that Ex‐­Im Bank financing competes with similar institutions from other countries. The U.S. is not the only country providing government support services to its own providers and exporters of goods and services. For example, similar government financing support is provided by countries in Europe and by Japan. Consequently, a U.S. contractor competing for a foreign project needs to try to determine how the project will be financed. Just because the owner is considering applying for Ex‐­Im Bank financing support doesn’t mean he will receive it, or that it will be competitive against other foreign lending institutions. It would be indeed unfortunate if a U.S. contractor based his pricing and plan to secure a foreign construction project on the basis that Ex‐­Im Bank financing support would be provided, and then the Ex‐­Im Bank financing offer was not competitive with other financing packages. The Ex‐­Im Bank also provides insurance for U.S. exporters of U.S. goods. This insurance can cover situations such as buyer nonpayment and political risk, like war. For more information on the Export‐­ Import Bank and the services it provides, see their website at http:// www.exim.gov

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Where to Get Some Help— Ask the U.S. Government

Nothing will ever beat doing a lot of homework before embarking on bidding on a foreign construction project. Assuming the effort to build the project will be just like doing work in the United States is a formula for failure. The best advice is to get some help! The following are some excellent initial sources of information on doing business in a foreign country: 1. The U.S. Embassy and/or U.S. Consulates located in the foreign country 2. The U.S. Commercial Service Office located in the foreign country 3. The American Chamber of Commerce office located in the foreign country Falling under the jurisdiction of the U.S. Department of State, the U.S. Embassy and/or U.S. Consulate in a foreign country is typically staffed with economic officers, who can provide contractors with information on visas and work permits, as well as the business, political, and legal climate in the country. It can also assist with dealing with the local government offices and contacting other U.S. businesses working there. For U.S. Embassy information on a particular country, visit http://usembassy.state.gov

The American Chamber of Commerce in a foreign country can provide excellent references to legal, accounting, and other professional services that may be required by a U.S. contractor.

The U.S. Commercial Service Office, which falls under the jurisdiction of the U.S. Department of Commerce, promotes U.S. goods and services in foreign countries and assists U.S. businesses who want to work or invest there. It may have offices in the local U.S. Embassy compound, or may have its own separate office elsewhere in the country. For contact information on U.S. Commercial Services, visit http://www.buyusa.gov In many countries where there is a significant U.S. business presence, it’s likely that an American Chamber of Commerce Abroad organization, commonly called an “AmCham” will be active. It is an organization made up of U.S. businesses and their representatives working and living in the country. The American Chamber of Commerce Abroad is an independent organization affiliated with the U.S. Chamber of Commerce in Washington, D.C., that works closely with the U.S. Embassy and the U.S. Commercial Service regarding U.S. business interests in the country, but it is not part of any U.S. Government agency. The American Chamber of Commerce in a foreign country is an excellent place to meet other U.S. businessmen to get a first‐hand overview of doing business in that country. There are currently 104 AmChams in 91 countries. To find contact information for an American Chamber of Commerce office in an international location, go to http://www.uschamber.org/ international/directory. This site also provides useful contact

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information for all the U.S. Embassy and Consulate locations in foreign countries.

Lastly, Use the Right Paper Size!

If a U.S. contractor is going to do business in a foreign country, he must learn to use A4 sized paper for communications and sales and marketing efforts. The A4 designation refers to the metric size of the paper, which is 210 mm wide and 297 mm long. Converted to English dimensions, A4 paper is 8.27″ wide and 11.69″ long. Most foreign countries use A4 sized paper, which is a little longer and a little narrower than the 8‐­1/2″ by 11″ paper typically used in the United States. Using A4 size paper for international proposals, international marketing and promotional materials, and general international communications adds a nice touch to a contractor’s approach to his foreign clients. It’s also a small, but important, acknowledgement by the contractor that he understands that doing work in a foreign country is not like doing work in the U.S. A4 size paper is available at many office supply companies in the U.S.

Conclusion

Performing construction projects and doing business in foreign countries is different than in the United States. To believe that it is the same is a certain formula for failure. However, for the contractor who is prepared to take the time necessary to carefully do his homework on how to conduct business in a foreign country, there will be plenty of opportunities for good projects—­and making a good profit on them.

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Chapter

18

What’s It Take to Do Business in Southeast Asia? The first step in being successful in Southeast Asia is NOT assuming that business is done just like it is in the US! You are a US businessman and you want to take a look at doing business in Southeast Asia. To many Americans, hearing the term “Southeast Asia” brings back old memories of the US military involvement in Vietnam in the 1960s and 1970s. Times have changed. So has Southeast Asia. Today, Southeast Asia, a diverse mix of countries, peoples, cultures, religions, and politics, offers many good opportunities for US businesses interested in working or investing there. US companies working in Southeast Asia range from newcomers to the region to companies that have been working in Southeast Asia for over 100 years. The countries of Southeast Asia are Myanmar (formerly Burma), Thailand, Laos, Cambodia, Vietnam, Malaysia, Singapore, Brunei, Indonesia, and the Philippines. These ten countries are the members Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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of an organization called ASEAN. ASEAN, established in 1967, is the acronym for the Association of South East Asian Nations. ASEAN promotes the mutual interests and solidarity of the ten member countries. Thailand, Malaysia, Singapore, Brunei, and the Philippines offer reasonably stable political, legal, banking and business environments (especially Singapore). Indonesia is trying to implement positive changes in their legal, banking, and business environments. Laos, Cambodia, Vietnam and Myanmar are somewhat less developed and have much less certain legal, banking, political, and business environments. The ASEAN countries are rich in natural resources and people resources with a regional population of 667,000,000 or about 9% of the world’s population, and a combined GDP of USD $3 trillion. All of the ASEAN countries are interested in foreign investment and can provide varying degrees of tax and financial incentives to foreign companies willing to invest in their country’s economic improvement. A work force of college and university educated people, skilled labor, and unskilled labor, with diverse language abilities, is readily available at very competitive rates. What does it take for a US company to do business in Southeast Asia? Here are some things to think about:

Patience Is Golden

The most important element of doing business in Southeast Asia is patience. You will need plenty of it. Things just don’t happen as quickly or efficiently as you might like. If you are used to closing deals in one or two meetings back home, you may have to have two, three, four, five, or more meetings to achieve the same result in Southeast Asia. Everything takes more time to do in Southeast Asia. With nearly all business communication taking place instantly or very quickly via email, be aware that it is an Asian tendency not to respond to emails if they do not have a response to your questions or enquiry. Therefore, you can expect it may take two to five days or more to receive a response. In order to ensure that your efforts do progress, always give whomever you are communicating with a target date for their reply to move the process along.

Walk the Talk 310

English is widely spoken and used in all the countries, especially in the business communities and you will be able to conduct most of your business in English.

However, it will always be a plus for you to be able to speak a little of the local language as in greetings, thank you, and good bye. Take the time to learn how to say a few phrases in the local language: “Good morning,” “How are you?,” “Nice to meet you,” and “My name is . . . .” Even if you do not say these greetings very well, your foreign counterparts will be pleased that you at least made an attempt. It breaks the ice when meeting people for the first time. However, be prepared for misunderstandings to occur as English will be the second language of the people you are dealing with and their skill levels in the use of English will vary. Be patient, speak slowly (or slower), clearly, quietly, and avoid the use of complicated sentences and slang. The written communication of your Asian counterpart may not be perfect, so therefore it is wise to be neither judgmental nor correct their written capabilities. It would be more productive to respond in simple written English.

Time and Money

Be prepared to spend time and money developing and establishing your business. Just because you arrive in one of the countries with the world’s best widget in your pocket doesn’t guarantee you instant success. It will require time and money to develop your local business support services, arrange for and receive necessary local government permits, promote your products, and meet your local business contacts and prospective clients. The same holds true if all you are looking to do is to develop a local supplier for export of goods or services back to your country.

Get Some Help

Actually, get some local help. Forget about trying to be superman and doing it all on your own, or you’ll take an early and frustrated exit from the country without results. Having a local associate, agent, or employee is a good idea. You will need someone to provide assistance to you as you work your way through the local business, political, legal, and cultural system. It really helps, too, to have a local associate who speaks the language and can help get you from point A to point B in a hot, jam-­packed city, or find a remote site way out in the countryside. If you intend to establish a company in one of the ASEAN countries, you should contact a local accounting and legal firm to advise you on rules and regulations your new company would have to follow. A number of US accounting and legal firms have subsidiaries in the ASEAN countries. 311

Having a local business partner can make sense, but may not be absolutely necessary. Do not rush into signing up the first company or individual that claims he or she can open up all the local back doors to businesses and politicians. Remember, do your due diligence and investigate a potential partner through the resident country’s trade association or embassy in your home country. They may or may not be able to assist you but often can give you further direction. Once you agree to take on a partner, you have that individual for better or worse, for a long time. Your new partner may be “politically in” today, and “politically out” tomorrow. Careful is the watchword here. Take your time, as you can always bring in a more permanent partner or investor at a later date.

The US Foreign Corrupt Practices Act

All US businesses and their foreign subsidiaries are subject to the US Foreign Corrupt Practices Act (FCPA). The FCPA makes it a crime to bribe local government officials in order to obtain new business or keep existing business. This act applies as well to any bribery of local government officials by the local employees or partners of a US subsidiary. If you intend to have a local partner or company, then perform a thorough written due diligence report on that individual(s) or company and keep a copy of it. Any written agreement between your US company and your partner’s local company or individual(s) must contain a clause incorporating by reference the provisions of the FCPA as may from time to time be amended. The FCPA allows for what are called “facilitating payments.” The US Justice Department can provide clarifying information on facilitating payments. Details of the FCPA can be found at http://www.justice.gov/ criminal-­fraud/foreigh-­corrupt-­practices-­act

Culture Shock

The countries of Southeast Asia have many cultures, customs, no-­ no’s, and religious practices. Just because you finally figure out how you can comfortably work with the folks in Singapore does not automatically mean you can apply the same formula to the folks in Indonesia or Thailand! You will find there are many similarities in working with the people and respecting the cultures in each of the Southeast Asian countries. You will find there are many differences, too, and this is where having 312

a good local associate is very valuable. He can keep you out of cultural trouble. Here are some examples of social behavior to observe: In Thailand, do not say anything bad about or make fun of the King or Queen, or you could end up in trouble with the law. In Malaysia, if a man and his wife are introduced to you as Datuk and Datin, that’s not their first names; those are conferred titles. In Indonesia, the largest Muslim country in the world (274,000,000 population), it would be in very poor taste to offer pork to your local guests. In Burma, do not pat the little kids on the head. They are Buddhists, and they believe the head to be the highest and most revered part of the body. In Singapore, Lee Hsien Loong is the Prime Minister; his last name (surname) is Lee, not Loon. Hsien and Loon are his Chinese given names. Chinese people place their last name first when introducing themselves. You would address him as Mr. Lee, not Mr. Loong. In doing business in Southeast Asia, it is important to understand the social and religious customs and practices of the people in the different countries. It is not too hard to learn about these customs and practices and follow them in your everyday dealings with the local people. Knowing and applying these social and religious customs and practices will certainly help you be successful in your business activities as it will be observed as a sign of respect. Many western business people come to Southeast Asia without any cultural awareness. This is viewed negatively by the local people. Generally, people from this region are familiar with the United States due to the regular coverage of US news, politics, economics in their national newspapers, and TV news. Popular American TV and reality shows, books, and magazines are also widely available. Advent of the internet and search engines with specific domain and translations capabilities allows for easy research of US news and vice versa.

Center for Strategic and International Studies

If you would like to do business with Southeast Asia whether you want to break into the market to sell a product or service via distributors, establish operations, search for a joint venture or outsource to third-­party contract manufacturing, an organization that you should be aware of is The Center for Strategic & International Studies, which is a think tank based in Washington D.C., website: http://csis.org/programs/southeast-­ asia-­program 313

Specifically, the CSIS Southeast Asian Program is the premier forum for sustained high-­level policy dialogue focusing on Southeast Asia and the US business interest in the region. Subscribe to its newsletter as it is an excellent source of information to understand US government initiatives are for the region, which directly relates to present and future opportunities for US businesses.

Trans Pacific Partnership (TPP)

Have you heard of the Trans Pacific Partnership (TTP) also known as the Trans Pacific Strategic Economic Partnership Agreement? It is a multilateral free-­trade agreement that aims to further liberalize the economies of the Asia-­Pacific region. The original agreement between the countries of Brunei, Chile, New Zealand, and Singapore was signed on June 3, 2005, and entered into force on May 28, 2006. Five additional countries—­Australia, Malaysia, Peru, Japan, United States, were later added. The US withdraw from the agreement during the term of President Donald Trump. The objective of the original agreement was to eliminate ninety percent of all tariffs between member countries by January 1, 2006, and reduce all trade tariffs to zero by the year 2015. It is a comprehensive agreement covering all the main pillars of a free trade agreement, including trade in goods, rules of origin, trade remedies, sanitary and phytosanitary measures, technical barriers to trade, trade in services, intellectual property, government procurement, and competition policy. TPP advised that the value of 2011 US trade with its SEA members is as follows: Vietnam: US$20 Billion Malaysia: US$37 Billion Singapore: US$46 Billion The US has had a bilateral Free Trade Agreement (FTA) with Singapore since 2004, which secured a US presence in Southeast Asia and provided a standard of free trade that encourages a high level of liberalization. Bilateral economic and trade cooperation between the United States and this dynamic region is reaching new levels.

Backdoor to China and India 314

US companies remain focused on doing business with China and India. However, more experienced business persons are realizing the value that the long-­term relationships the countries in ASEAN have with China and India. Nowadays many of the ASEAN countries have

extensive trade links to China and India. US companies that choose to do business via Southeast Asia are benefitting from such established linkages and trade agreements between the ASEAN countries and China and India.

Have You Done Your Homework?

There are many resources available to the US business person interested in learning more about doing business in Southeast Asia. Economic Officers resident at the US Embassy in each of the countries can help provide country-­specific business information. For a listing of US embassies in Southeast Asian countries, see http:/ www.usembassy.gov/ The US Commercial Service, a division of the US Department of Commerce, also provides resident Commercial Counselors to help provide country-­specific business information. The main role of the US Commercial Service is to promote the sales of US goods and services to foreign countries. For a listing of US Commercial Service offices in Southeast Asian countries, see http:/ trade.gov/US-­commercial-­service The US Commercial Service may charge a fee for certain of the services it provides. These Commercial Counselors and Economic Officers are excellent sources of information on the ins and outs of doing business in the country. All the ASEAN countries have an active American Chamber of Commerce organization. This is an organization consisting of US and local business persons who are living and working in the specific country. Each chamber offers varying services; some are also able to organize meetings for companies interested in doing business in the country. These meetings are excellent opportunities to learn about doing business in the country from American and foreign companies actually working there; however, there are associated charges for such services. For a listing of US Chambers of Commerce abroad, see http://www.uschamber.com/international-­affairs

Modern Business Environment in ASEAN

The modern-­day business environment in ASEAN is challenging. It is also dynamic, high growth, and very opportunistic at this time as it is poised for growth. It is a region that should be approached realistically and systematically. Prior to any action advice should be sought from a reliable source preferably upon recommendation. Attempt to fully understand what you will be facing, such as significant time 315

differences that can make communication challenging, more public holidays than in the United States and prepare to visit the region a few times if you do not have any representation. Don’t try to change the system or the business culture because as a foreigner you must fit in with their culture to be successful, not the other way around.

SPECIAL SECTION—­The Socialist Republic of Vietnam (Vietnam)

The Vietnamese economy is at the heart of the fast-­growing Southeast Asia region and is one of Asia’s great success stories. Vietnam’s economy has grown rapidly since the country opened its economy in the 1980s. This country with a population of about 97 million has posted economic growth of about 7%. Vietnam has also prospered by choosing to open itself more broadly to the outside world, joining the World Trade Organization (WTO) in 2007 and normalizing trade relations with the United States. These steps have helped to ensure that the economy is consistently ranked as one of the region’s most attractive destinations for foreign investors. Vietnam has also expanded its exports of manufactured goods, especially products such as textiles and footwear. The liberalization of services created opportunities for rapid expansion across a range of sectors including retail and transportation. The nation also boosted its tourism infrastructure and experienced a surge of interest in residential and commercial real estate. Vietnam’s exports of commodities such as rice and coffee have also grown briskly. Industrial production is growing about 9% annually. As Vietnam continues economic development by liberalizing its economy and strengthening its growth policies and infrastructure, it is becoming a more attractive option to US companies seeking alternative trade and investment to China. In February 1994, the United States lifted its trade embargo against Vietnam and restored full diplomatic relations in July 1995. In December 2001, the two countries signed a bilateral trade agreement. The United States and Vietnam still have differences on issues such as human rights, but even so they have started talking about negotiating a “strategic partnership.” The US–Vietnam Road Map proved to be an invaluable mechanism as the two sides addressed subsequent trade issues that surfaced due to the fact that Vietnam is a communist country governed by socialist laws. It provided the United States with an opportunity to spell out exactly what it was looking for and gave the Vietnamese clarity and confidence about what they would get in exchange for specific steps they took. As Washington and Hanoi normalized relations, more overseas Vietnamese returned to Vietnam bringing investment and

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technical skills, which helped Vietnam develop as it liberalized its economy and opened up to foreign investors. The population of Vietnam is large enough to make it second most populous country in the Southeast Asia (behind Indonesia), seventh in the Asia-­Pacific region, and the 12th most populous in the world list. One should also notice that the ratio of literate persons is high in Vietnam and the majority of the population is young. However, doing business in Vietnam, like most foreign countries, can still be challenging and any business person should perform adequate due diligence on local businesses it intends to do business with, whether it is for import or export. Having local representation on the ground may allow business transactions to progress in a short time period than via telephone and email. Remember in Asia people still like to meet and greet the people they are going to do business with, shake their hands, or share a meal, not to say that business cannot be facilitated via the internet and multimedia communication. It may take longer than you expected. As mentioned previously, patience is king when doing business in Southeast Asia. If you are interested in purchasing goods manufactured in Vietnam or are attempting to expand your business into this country, contact the US Chamber of Commerce in Hanoi or Ho Chi Minh City (formerly Saigon), as well as a Vietnamese chamber of commerce or business organization in the United States. These organizations are a good starting point and can advise or give you direction on initial steps to take. Attending business briefings and country presentations on doing business with Vietnam that are held in the United States is another way to begin networking with people, organizations, and companies that specialize in business with Vietnam.

Resources for Business in Southeast Asia

There are also many internet websites with information on the countries in Southeast Asia. Check out the following websites: • The CIA World Factbook provides general information on all the countries in the world. You can also find contact information for US embassies in the countries. Go to this website and click on “The World Factbook” under Library and Reference. See: http://cia.gov/the-­world-­factbook • The US-­ASEAN Business Council, Inc. provides excellent business-­related information on the Southeast Asian countries and on US businesses working there. This site is devoted to promoting US business interests in the ASEAN countries. See: http://us-­asean.org 317

• The website maintained by ASEAN and is an excellent source of business, political, social, and economic information on all the ASEAN countries. See: http://asean.org • The US Small Business Administration provides a number of services for US importers and exporters. See: http://sba.gov/ content/expoprt-­assistance • SCORE can provide free business counseling service for US business persons interested in international trade. SCORE has 365 offices in the United States. To find an office near you, see: http://www.score.org Doing business in Southeast Asia will be challenging and often frustrating for a business person who is unprepared. However, for the business person who has patience and does his homework well, the opportunities and rewards are there.

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Chapter

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Some Final Thoughts on Negotiating Contracts It’s time to lighten things up a bit after the previous chapters’ serious discussion of contract terms and conditions, commercial risk, and negotiating. The fact is, the process of negotiating better terms and conditions in a construction contract can be a frustrating and mentally tiring effort, but it absolutely needs to be understood by anyone in the construction contracting business. This chapter contains some important final points about contracting and negotiating based on the author’s experience. They may be helpful in negotiating efforts to achieve more favorable terms and conditions and to reduce the commercial risk you accept in the contract. At the very least, they will give you something to think—­and perhaps laugh—­about. After all, it’s important to maintain a sense of humor about some of the events that occur during negotiations on a construction contract. Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Why Negotiate?

Obviously, every single term or condition in an owner’s proposed construction contract will not have to be negotiated. A careful review of all the different physical and commercial risks involved in any one construction project and its proposed contract will point the way to those that need attention. Negotiating better terms and conditions protects the assets of your company, plain and simple.

The Concept of Standard Terms & Conditions

“You want to negotiate these terms and conditions?” says the owner’s contracts manager. “Son, just listen up here for a moment. You need to understand that these are our standard terms and conditions.” How about getting a nickel for every time a contractor has heard this? He could comfortably retire from the contracting business and not have to negotiate terms and conditions anymore! A Basic Contracting Rule: There is no such thing as “standard terms and conditions.” Each and every construction project is different—­physically and in terms of commercial risk. If there were such a thing as a “standard construction project,” then one could perhaps successfully argue that there was the need for such a thing as “standard terms and conditions.” If an owner tells you that you cannot change the proposed commercial terms and conditions contained in the bidding documents, he is putting up his company’s first obstacle. Those so-­called standard terms and conditions are typically carefully designed to protect the commercial interests of the owner—­not the contractor.

An Example

During the course of commercial negotiations with a contractor for a large construction project, the owner’s commercial manager said to the contractor, “I don’t understand why you object to so many of our terms. It took us two years of working with our lawyers to come up with this set of terms and conditions. We really worked hard within our company to develop what we believe are fair terms.” “Did you ever take the time to get some feedback from one of your better contractors on what they thought of your terms during the two years that it took you to develop them?” replied the contractor. “Well, no,” said the owner’s commercial manager. “Our lawyers told us all contractors would accept them.” It’s not too hard to understand why negotiations for terms and conditions on this construction project were likely to become long and difficult.

The above is not an unusual example. Many owners develop standard terms and conditions for their construction projects without any 320

input whatsoever from the people who they will have to rely on to successfully complete the project—the contractors. The way to circumvent this obstacle of an owner’s standard terms and conditions is with proper planning, determination, and effort. First of all, expect to be told that the owner’s standard terms and conditions are chiseled in stone and nothing short of an act of God will change them. This, of course, is nonsense. If your offer for the project is competitive in price and schedule, or your company has something unique to offer, you have a very good chance of getting consideration from the owner on modifying contract conditions to better meet your company’s commercial needs and interests. The process of negotiating better commercial terms and conditions begins with addressing the issue of revised terms and conditions in your proposal to the owner. Sending along your company’s own preferred set of terms and conditions is one way of starting the negotiation process. However, it may result in an “it’s too difficult to deal with these guys” attitude from the owner. The owner is not likely going to, carte blanche, accept 100% of any contractor’s preferred terms and conditions. Sending along your own set of terms and conditions also rejects the owner’s standard terms and conditions, which usually creates a larger barrier to achieving agreement on a set of mutually acceptable terms and conditions.

If your proposal for the work is competitive, you are likely to get a chance to negotiate changes to an owner’s standard terms and conditions.

A more professional way to begin the negotiating process is to carefully review the owner’s proposed terms and conditions and decide on what additions, deletions, and modifications you would like—then include these specific clarifications in a separate section of your written proposal for the work. By doing it this way, you’re indicating to the owner that you can live with some or most of his pet terms and conditions, but there are a few that need revision. Don’t be deterred when an owner suggests that it is just too hard to change his standard terms and conditions, as there is no space on the document to write in the changes the contractor wants. This is just another obstacle put in front of the contractor. A separate letter (which can be used as an addendum to the contract) containing the revised terms, signed by the owner and the contractor, and incorporated into the final contract by specific reference, is a perfectly acceptable way of revising the owner’s standard terms and conditions. Some owners state in their bid documents: No exceptions to Owner’s standard terms and conditions will be accepted. Contractor risks being disqualified from the bidding if exceptions are taken.

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The easiest solution to this obstacle is not to take any exceptions and state so. Simply include a separate section in your proposal entitled “Clarifications” that provides for revising the owner’s standard terms and conditions to be more favorable to your company. A clarification is technically not an exception, and if your proposal for the work is competitive, you will get a chance to negotiate. For example, you could clarify in your proposal that the above clause should be modified to read: No exceptions to Owner’s standard terms and conditions will be accepted, unless done so in writing.

Remember, it first takes a competitive offer just to get in the door in order to have the opportunity to negotiate better terms and conditions than those proposed by the owner.

Risk Transfer Item 1: Get Rid of the Indemnity Clause!

Don’t forget that as a contractor, you always have the option to tell the owner that you don’t see the need to have an indemnity in the terms and conditions, and you want to completely delete the owner’s proposed indemnity clause. Remember that it is likely that the only reason an indemnity clause is in the contract is to transfer the owner’s liability for claims associated with personal injury, property damage, and defense costs associated with those claims that arise out of his negligence. Explain that you believe both the owner and the contractor should be responsible for the consequences of their own actions and behavior, and so there is no need to have any commercial language in the contract that inappropriately shifts any of one party’s risk to the other party. The owner’s commercial representatives or lawyers who are involved in the contract negotiations may give you an incredulous look. After all, eliminating the indemnity clause, which is often considered the Holy Grail of the owner’s terms and conditions, seems just too much to ask for. The discomfort that comes from this request is always amazing. After all, an indemnity clause in the owner’s terms and conditions is designed to shift the potential financial liability for the owner’s negligent acts to you, the contractor. The owner would like very much to have that risk shift made. Better you pay than he for the consequences of his negligence. But, having said all of this, sometimes an owner’s progressive commercial representative or lawyer will say, “OK, let’s see if we can make that work,” and you negotiate a way to eliminate the indemnity. If an owner can be comfortable with accepting the consequences of his own acts, then there is no need for an indemnity. Purchasing his

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own insurance policy and working closely with the contractor on an effective job site safety program is the best way for an owner to protect himself from the risks he wants to transfer in an indemnity clause.

Risk Transfer Item 2: Don’t Provide Additional Insured Status

Remember that granting additional insured status to the owner on your Commercial General Liability (CGL) policy gives the owner full access to the benefits of that policy—­and he doesn’t have to pay anything to get it! You are responsible for paying the policy deductible for an accident caused by the owner, and the policy may likely cover the owner even if the accident is the result of his sole (100%) negligence. In addition, recall that if the owner makes a claim against your CGL as an additional insured, your experience rating will likely change for the worse, and your future premiums for insurance may increase or, in the worst case, your insurance company won’t renew your policy. The acceptable alternative to granting additional insured status is to provide the owner with an Owners’ and Contractors’ Protective (OCP) policy or a separate, project-­specific General Liability policy on which he is the named insured. The owner pays for the premium for these types of insurance policies, pays the deductible on any claims, and, if there is a claim, his experience rating will likely suffer, rather than yours.

Risk Transfer Clauses, Insurance, & Safety

Risk transfer to contractors (and subcontractors) for the negligence of the owner, his project manager, his general contractor, or any others is simply out of date and needs to be eliminated. The two most important risk transfer clauses a contractor will have to negotiate with the owner are indemnity and additional insured status, as described above. Risk transfer to contractors is a paradigm in the world of construction contracting. Owners should not be allowed to hide behind the terms and conditions of their construction contracts when it comes to accepting responsibility for their actions and behaviors. Insurance companies are established to accept risk transfer and the potential financial liabilities. This is their business, and they are paid premiums to accept risk and pay claims that may arise out of that risk. Owners need to embrace, and pay for, the benefit of hiring safe contractors who have demonstrated a commitment to excellence and safety on the job site. The elimination of injury to persons or damage to property through safe work practices and programs needs to be a primary concern of both the owner and the contractor. 323

How to Say No without Aggravating the Owner

Sometimes during the course of contract negotiations, the owner may be asking for too much in the way of risky commercial terms and conditions, and your only alternative is to say no. Following is a suggested resolution:

An Example

During negotiations for a large construction contract with the commercial representatives of a major Japanese engineering, procurement, and construction (EPC) company, the contractor asked to change some of the proposed commercial terms and conditions of the contract. After much discussion in Japanese, the commercial representatives of the Japanese EPC company switched back to English and said that they could accept most of what was requested. However, on one of the requested changes, they simply said, “Please withdraw your request for this change.” Later, it occurred to the contractor that he basically had been told “no” on that one issue; asking him to “please withdraw your request” was just a nice way of saying, “no, we can’t accept what you want to do.”

The next time the owner asks you to warranty your work for, say, five years (instead of the one year you normally offer), you can carefully explain why your company is unable to do that, and then politely ask the owner to “please withdraw the request.” If that doesn’t work, you can simply revert to more direct negotiating terms and say, “no.”

The Worst Contracting Word: “Reasonable”

Observant readers have probably noticed that up to this point in the book, the word “reasonable” has generally not been used, except in a few sample contract clauses. In many instances, such as in the cost of changes to an owner, what is completely reasonable to the owner may be completely unreasonable to the contractor. The word “reasonable” calls for a subjective assessment—­precisely the reason it appears so often in an owner’s construction contract. The owner gets to define it as may suit his own interests. Some examples of the use of “reasonable” from contracts: • “In the reasonable opinion of Owner. . .” • “Owner will approve all reasonable changes to the contract price and schedule.” • “All requests by Owner for the addition of reasonably small amounts of extra work will be performed at no charge by Contractor.” • “All work that may be reasonably inferred from the Plans and Specifications will be performed by Contractor.”

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• “Contractor shall follow all reasonable directions provided by Owner.” Again, what is reasonable to the owner may not be reasonable to the contractor—and end up costing the contractor a lot of money. Unfortunately, it will be tough to eliminate all references to “reasonable” in an owner’s construction contract. Contractors should select the most important clauses and negotiate substituting the word “reasonable” with more specific wording that is less susceptible to broad, one-sided, interpretation of how to resolve the issue.

The Best Contracting Word: “Notwithstanding”

The word “notwithstanding” is a great word to know how to use in negotiating construction contracts. It simply means “despite anything to the contrary,” or, as is often the case in the construction industry, “it doesn’t matter what was said, here is what we really mean.” For example, let’s say a contractor is faced with the following indemnity clause in the owner’s standard terms and conditions proposed for use in a construction contract: Article 20 – Indemnity 20.1 Contractor shall indemnify and hold Owner harmless from all financial liability, including all legal costs, that may arise out of any and all claims or demands that occur on the job site prior to Contractor’s arrival at the job site, during Contractor’s work at the job site, and forever after Contractor leaves the job site, regardless of how caused, and including those claims and demands arising from any amount of negligent behavior or acts of Owner.

Most will agree that this looks like a fairly normal indemnification clause where, as a reward for getting the work, the contractor gets to be financially responsible for everything that may happen on the site, including anything caused by the owner’s negligent acts or behavior. During contract negotiations, the owner is not interested in changing his pre-printed and standard indemnity terms and conditions. However, he agrees, by way of an addendum to the contract, to add a second paragraph to Article 20, that was proposed by the contractor and that reads as follows: 20.2 Notwithstanding anything to the contrary in the above Article 20, subparagraph 20.1, Contractor agrees to indemnify Owner only to the extent of Contractor’s negligence for claims and demands for injury to persons, including death, and damage to property occurring only during the on-site construction of Contractor’s Work and only while Contractor is physically present on the job site.

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The phrase “notwithstanding anything to the contrary” in the above paragraph basically means that whatever has been stated in the preceding clause (owner’s unfair indemnity requirement in subparagraph 20.1) is made null and void, and that the indemnity the owner and contractor really agree to is as stated in this new paragraph 20.2. The new indemnity in paragraph 20.2 makes the contractor responsible for claims and demands that are attributable only to the extent of his own negligence and that occur only while he is physically present and working on the site. The new paragraph eliminates the requirement to pay for the owner’s legal defense costs, as well. If you are having trouble revising or rewriting any unacceptable or unnecessary paragraphs in the owner’s proposed contract, then consider using a new paragraph beginning with, “notwithstanding anything to the contrary in the above paragraph(s),” and then followed by what you actually want to agree to, including deleting any offending clauses. Any “notwithstanding” clauses that need to be agreed on can also be put in a separate letter (or addendum), signed by both the owner and the contractor and incorporated into the final contract. (This way the owner won’t have to mess up or rewrite his standard terms and conditions pages in the contract.)

Win-­Win & Lose-­Lose in Contract Negotiations—­ Fairy Tales?

These two concepts are fairy tales. They simply don’t exist except in the minds of people who have ever had to negotiate a construction contract or its commercial terms and conditions, or resolve a claim or dispute. Win-­win implies that both parties to the negotiations win something and go away happy or satisfied, while lose-­lose implies that both parties lose something and go away unhappy or dissatisfied. The better question to ask is whether the negotiations, claim, or dispute can be considered resolved, or if it is unresolved. A good negotiator tries his best to resolve matters. The final resolution arrived at between the contractor and owner may have varying degrees of the so-­called win-­win or lose-­lose concepts involved, but the contract negotiation, claim, or dispute is resolved, and both parties can get on with completing the project. The matter is now in the rearview mirror. An unresolved matter is just that. The owner and contractor have failed to resolve whatever it is they are negotiating—­a contract, a claim, or a dispute. After entering into negotiations for a contract, if both parties can’t agree on commercial terms, then no contract is

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arrived at, and both parties go their own way—hardly a win-win situation. Some might call it a lose-lose situation, but in fact, this is not necessarily so for the contractor. If the indemnity clause and additional insured requirements wanted by the owner were too risky for the contractor to accept, and the owner was unwilling to negotiate better terms, then the contractor has won (or at least avoided losing) by not entering into the contract. How can the loss of what appears to be a good construction contract be good for the contractor? Sometimes a contract is just not worth accepting. If the proposed commercial terms and conditions are totally unacceptable and present too much commercial risk for the contractor, then he stops the negotiations and goes on to other work. It may turn out to be one of the better decisions the contractor has made.

Is There a Price for Bad Commercial Terms & Conditions?

Terms of Payment

Someday, you may see—or you may have already seen—the following commercial terms in an owner’s proposed construction contract: Contractor’s base bid price is to be in accordance with the terms and conditions in the bidding documents. Any exceptions or deviations must be accompanied by an appropriate adjustment in Contractor’s price.

Some owners try to require (although it’s more likely just to be a negotiating obstacle on their part) that a contractor put a cost in his price to cover certain terms and conditions that the contractor doesn’t like. Some commercial terms can’t be priced by a contractor. For example, how would you price an owner’s preferred indemnity, or liquidated damages clause, which, if enforced, could ultimately put your construction company into bankruptcy? Some commercial terms are so unfair that they can’t be priced. It’s always better to try to negotiate more favorable commercial terms that are less risky to the contractor. As the contractor from Toledo quoted in the introduction to this book said, “There is no price for bad terms.” There are three simple rules to improve terms of payment and cash flow: 1. Always negotiate a downpayment or some form of advance payment. 2. Insist on being paid on time. 3. Don’t agree to retention money being withheld. Remember the three rules of business: 1. have cash, 2. have cash, 3. have cash. Getting and keeping cash for your construction efforts is a good way to stay in business. 327

Some Tips on Successful Negotiating

• Be prepared: know your subject matter and the facts and details. • Think ahead: what commercial terms and conditions are most important to the owner, and what strategies and tactics will you have to employ to get him to change them? • Be knowledgeable: understand the issues involved with construction contract terms and conditions; have options and alternatives to present. • Listen carefully and attentively to what the owner says during negotiations. Try to understand, even if you don’t agree. • Be patient: the negotiations may take more than an hour, a day, or a week. • Negotiations are just that; as things proceed, you may find that you have to take back something you agreed to earlier, depending on how things go. • Find a back door: having a good working relationship with one of the owner’s senior or influential people not associated with the contract, claim, or dispute negotiations can be valuable. • Try not to negotiate too much over the telephone; it is unlikely each party will fully understand what the other said. All negotiations need to be put in writing. Document all phone conversations in writing and then fax or email confirmation. • Stay positive during the negotiations. Look for solutions, not roadblocks. • Explain your concerns and positions; if they are well thought out and well-­founded, reasonable owners will listen. • Try to avoid “nickel and diming” of your claim by the owner; look for a global settlement, not a series of small settlements. • Develop thick skin.

Three First (and Final) Suggestions

If you remember anything from this book, remember these three points: 1. Read and understand everything in the construction contract. 2. Protect the assets of your company by negotiating better commercial terms and conditions with the goal of reducing commercial risk and the associated exposure to potential financial liability. 3. Put all your agreements in writing! No excuses granted! And, don’t forget to work safely!

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Resources Resources for Contractors Doing Business in the U.S.

American Concrete Institute (ACI) http://www.concrete.org American Council of Engineering Companies (ACEC) http://www.acec.org American Institute of Architects (AIA) http://www.aia.org American Society of Civil Engineers (ASCE) http://www.asce.org American Society of Heating, Refrigerating, and Air-­Conditioning Engineers (ASHRAE) http://www.ashrae.org American Subcontractors Association Inc. (ASA) http://www.asaonline.com Associated Builders and Contractors (ABC) http://www.abc.org Associated General Contractors of America (AGC) http://www.agc.org Construction Specifications Institute (CSI) http://www.csinet.org

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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Design-­Build Institute of America (DBIA) http://www.dbia.org Engineers Joint Contract Documents Committee (EJCDC) http://www.ejcdc.org Insurance Services Office Inc. (ISO) http://www.iso.com Mason Contractors Association of America http://www.masoncontractors.org Mechanical Contractors Association of America http://www.mcaa.org National Electrical Contractors Association (NECA) http://www.necanet.org National Society of Professional Engineers (NSPE) http://www.nspe.com National Utility Contractors Association (NUCA) http://www.nuca.com Sheet Metal & Air Conditioning Contractors’ National Association (SMACNA) http://www.smacna.org U.S. Department of the Treasury http://www.ustreas.gov U.S. Treasury, for Surety Bonds http://www.fms.treas.gov/c570/ Export-­Import Bank of the United States (Ex-­Im Bank) http://www.exim.gov International Chamber of Commerce http://www.iccwbo.org INCOTERMS http://www.iccbooksusa.com International Federation of Consulting Engineers (FIDIC) http://www.fidic.org Office of Chief Counsel of International Commerce http://www.ogc.doc.gov/intl_comm_home.html Overseas Private Investment Corporation http://www.opic.gov/ U.S. Chambers of Commerce Abroad (AmChams) http://www.uschamber.org/international/directory/default

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U.S. Commercial Service (division of the U.S. Department of Commerce’s International Trade Administration) http://trade.gov/cs/ U.S. Department of Commerce http://www.commerce.gov/index.html U.S. Department of Justice http://www.usdoj.gov U.S. Embassies and Consulates in Foreign Countries http://www.usembassy.state.gov

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Glossary Terms are defined in this glossary as they apply to a typical construction or construction-­related contract between an owner and a contractor. acceptance  The process by which an owner documents approval of the satisfactory completion of a project. acceptance certificate  A dated and signed document issued to a contractor by an owner certifying that all the work of a construction project is complete and in accordance with all provisions of the contract. actual damages  Damages that can be assessed against an owner or contractor if either or both fail to perform their respective responsibilities and obligations as contained in the construction contract. Actual damages are considered economic (monetary) damages that can be clearly determined and proven, typically awarded by a court as the result of a lawsuit brought by one of the parties to the construction contract. additional insured  A person or a company (typically the owner) other than the named insured (typically the contractor) who is added to an insurance policy and who may be able to receive some or all of the coverage provided by the policy. advance payment  A partial payment to a contractor made shortly after the contract is signed. Similar to a downpayment.

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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advance payment bond  The generic term for the assurance of performance provided by a contractor to an owner that any money advanced to the contractor will be properly used to pay for project costs. Sometimes called a downpayment bond. advance waiver of liens  A waiver of all of the contractor’s rights to file mechanic’s or materialsmen’s liens against the owner for nonpayment for work performed. Such advance waiver may be a condition of the owner’s contract. aggregate limit  The maximum amount an insurance policy will pay for the sum of all personal injury and property damage claims that may arise during the term of the policy as the result of multiple occurrences. Legal defense costs may be excluded from this limit. Alternative Dispute Resolution (ADR)  A confidential method of settling a dispute without going to court, typically negotiation, mediation, or arbitration. applicable law  A typical clause in a construction contract that defines the laws of a particular state or country that will apply to the legal resolution of any issues that arise out of the contract. arbitration  The process by which parties (e.g., the owner and the contractor) agree to submit their disputes to the determination of a third, impartial party (referred to as the arbitrator, or as an arbitration panel), rather than pursue their claims in court. Parties may agree in advance to binding or nonbinding arbitration of disputes, typically stated in a clause in the contract. Binding arbitration: both parties agree ahead of time to abide by the arbitrator’s decisions. Nonbinding arbitration: neither contractor nor owner has to accept the decisions of the arbitrator. articles  Also referred to as clauses, these separate and numbered paragraphs within a construction contract state the rights, duties, responsibilities, and obligations of the parties (e.g., the owner and the contractor) to the contract. assignment  A written agreement that transfers all or some of the owner’s or contractor’s rights and/or obligations in a contract to a third party. automobile insurance  Coverage for claims for injury to persons and damage to property, and defense of those claims, caused by the contractor’s owned or leased automobiles. Typically provided on an occurrence basis. bid bond  An assurance of performance provided by the contractor that he will enter into a contract with the owner within a specified period of time. May be in the form of an on-­demand bond or a guaranty provided by a surety company. boilerplate  Standard, formulaic text often used in documents such as contract agreements. bond  The generic term for an assurance of performance for some or all of the contractor’s obligations in a construction contract. It may be in the form of an on-­demand bond, a guaranty provided by a surety company, a standby letter of credit, or a parent company guaranty.

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bonding capacity  The maximum dollar limit a surety company will place on the total, or aggregate, amount of the value of all the performance guaranties that a contractor can have outstanding at any one time for all projects he is working on. Also refers to the maximum dollar limit a bank will place on the total, or aggregate, amount of the value of all the on-­ demand bonds or standby letters of credit that a contractor can have outstanding at any one time. breach of contract  The failure of an owner or a contractor, without a legitimate reason, to perform some contractually agreed-­on obligation in accordance with the terms of the contract. builder’s risk insurance  A specialized form of property insurance that provides coverage for loss or damage to the work that occurs during the time it is under construction. Can be purchased by either the owner or the contractor. business interruption insurance  An insurance policy that protects a contractor from the financial consequences of certain risks when there are, for example, lengthy delays in a construction project he is working on. It may provide payment for key employees on salary when work cannot be performed and may also cover the extra expense of obtaining rental equipment if the contractor’s equipment has been damaged. care, custody, and control  A term used when a contractor receives a piece of equipment purchased by the owner for later installation in the construction project by the contractor. Once the contractor takes possession of the owner’s purchased equipment, it is considered to be in the contractor’s “care, custody, and control.” cash flow  The amount of cash a company or construction project generates, or fails to generate, over a specific period of time. clauses  See articles. combined fixed price and reimbursable contract  A contract that combines the elements of a fixed price contract and a cost reimbursable contract. It is used for contracts where some portions of the work are well-­defined, and other portions are not. See fixed price contract and cost reimbursable contract. combined single limit  The maximum amount an insurance policy will pay for combined injury to persons and property damage. Commercial General Liability insurance  Commonly called CGL, this type of insurance provides coverage for claims involving personal injury, including death, and property damage. Legal defense of such claims is also generally covered. commercial letter of credit  A payment instrument, typically issued by a bank, that will pay out a certain amount of money within a fixed time period upon presentation of all the documents specified in the body of the letter of credit. Used mainly for the payment of sales of goods, such as the

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supply of specialty materials from a foreign location for a construction project. Banks expect to pay out the proceeds of the commercial letter of credit. See standby letter of credit. commercial risk  A type of risk that arises out of the commercial terms and conditions contained in a construction contract. Typical examples are: indemnity, granting additional insured status, and liquidated damages for not meeting the contract schedule. commercial terms and conditions  The clauses in a construction contract that contain all the rights, duties, responsibilities, and obligations of each party (e.g., the owner and the contractor) to a construction contract. completed operations insurance  Provides coverage for claims for injuries to persons, including death, or damage to property that may arise after all operations under the contract have been completed by the contractor, or otherwise abandoned by the contractor, or after the work has been put to its intended use by the owner. Legal defense of such claims is also generally covered. Completed operations insurance does not generally apply to damage caused by third parties to the completed work itself or to legitimate warranty claims. completion schedule  The time period stated in the contract within which the contractor is obligated to complete the construction project. consequential damages  Damages that occur indirectly from, or as a consequence of, an accident or the contractor’s or owner’s failure to perform. For example, if a job site explosion causes damage to a private house a mile away, the damage would likely be considered consequential. Such damages are usually rectified by a monetary award. constructive change  A change allowed to the contractor for the consequences of an owner failing to perform certain obligations in a contract, where such failure causes extra cost and schedule for the contractor. Examples include over-­inspection by the owner, the owner’s failure to grant legitimate schedule extensions, or the owner’s failure to coordinate other contractors and subcontractors on the job site. contract  A written agreement that clearly defines the rights, duties, responsibilities, and obligations of each included party, is legally enforceable, dated, and signed by an authorized representative of each party (e.g., the owner and the contractor). contractor-­provided wrap-­up insurance  An insurance policy purchased by contractors to cover all the subcontractors working on a project (often solving the problem of some subcontractors having trouble getting or maintaining liability and property insurance). contractual liability insurance  Insurance that provides the contractor with coverage for financial liability that arises out of certain commercial terms and conditions in a construction contract. It typically covers the contractor only for the financial liability for claims for personal injury, death of persons, and property damage, including legal defense of those claims,

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that he may be exposed to through the risk transfer obligations found in an owner’s construction contract indemnity agreement. contributory negligence  When the negligent actions of the owner and contractor both contribute in part to causing an accident or creating some failure to perform. cost-­only type of change clauses  Change clauses in a contract that allow the contractor to recover only the costs involved in a change to the scope of work but don’t allow the contractor the ability to change his completion schedule. cost plus fee contract  A contract that provides for payment of all direct, documented engineering, material supply, and construction costs associated with the completion of the work, plus a fee for services to cover the contractor’s overhead and profit. cost reimbursable contract  A contract that provides for payment of all direct, documented engineering, material supply, and construction costs associated with the completion of the work, plus fixed markups applied to those direct costs for the contractor’s overhead and profit. cross-­liability clause  A contractual obligation that requires an insurance company to protect each insured company separately in the same manner as if a separate insurance policy were in place for each company. Also called a severability of interest clause. default  See breach of contract or failure to perform. defect liability period  A contracting term for the warranty period. It refers to the period of time that begins when the work performed by the contractor is final and accepted by the owner and ends at some fixed later date. During this period of time, the contractor is obligated to fix or repair any defects found in the work he performed. defined terms  Terms defined at the beginning of a contract document and used frequently throughout the contract, such as scope of work, owner, or contractor, that are either partially or fully capitalized. devaluation  Loss of comparative value of one country’s currency with respect to the value of another country’s currency. disputes resolution clause  A clause included in a contract that clearly outlines a process for resolving disputes between the owner and the contractor. downpayment  A partial payment of the construction project’s contract price made by an owner to a contractor immediately at the beginning of the contract. downpayment bond  See advance payment bond. drawings  Graphic illustrations depicting the dimensions, design, details, and location of a project. Generally including plans, elevations, details, diagrams, schedules, and sections.

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employer’s liability insurance  Provides coverage for employers against claims made by employees that arise out of injuries or certain diseases sustained in the course of their employment that are outside of the coverage provided by the employer’s Workers’ Compensation insurance. Often called Coverage B. endorsement  A supplement or addition to an insurance policy that clarifies, modifies, includes, or excludes coverage for certain types of risks. exchange risk  The risk of the change in value of one country’s currency with respect to the value of another country’s currency. express warranty  A written warranty. facilitating payments  Payments that may be allowed under the provisions of the U.S. Foreign Corrupt Practices Act (FCPA) to be made to foreign government officials to, for example, expedite routine governmental actions, such as processing visas, providing police protection, or loading or unloading cargo. failure to perform  When an owner or contractor, or both, does not perform each and all of his respective obligations in the construction contract. final waiver of liens  A document prepared and executed by the contractor at the conclusion of the project stating that all subcontractors and material suppliers have been paid in full and that no mechanic’s or materialsmen’s liens will be filed against the owner. Typically required to be filed with the owner as a condition of receiving the contractor’s final payment or release of retention for the work he performed. fixed price contract  A type of contract in which the contractor agrees to construct a project for an established price, agreed-­on in advance. float  An amount of additional time, or contingency, in a contractor’s fixed completion schedule that is over and above what he believes is actually needed to finish the project. force majeure  An unexpected or unanticipated event that, if it occurs, can provide the owner or contractor, or both, a legitimate reason to delay the project, cease work, or cancel the contract without penalty. A force majeure clause in a construction contract attempts to define those events. Such events may be, for example, natural disasters deemed “acts of God,” unanticipated government mandates, civil disturbances, and so forth. Foreign Corrupt Practices Act (FCPA)  A U.S. law that prohibits payments to foreign government officials for the purpose of inducing them to assist a company in obtaining new business or keeping existing business. foreign currency option  The buyer (contractor) has the right, but not the obligation, to sell a certain amount of foreign currency at a fixed exchange rate at or within a certain fixed time period to the bank that sold him the foreign currency option.

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forward exchange contract  The buyer (contractor) has the obligation to sell a certain amount of foreign currency at a fixed exchange rate at, or within, a certain time to the bank that sold him the forward exchange contract. general terms and conditions  Contract commercial terms and conditions covering general needs or issues involved in a particular construction project. guaranteed maximum price contract  A contract for construction, wherein the contractor’s price is most likely stated as a combination of accountable cost plus a fee, with a promise provided by the contractor that the final contract price will be limited to a specific maximum amount. guaranty  A contract between three parties: a surety (or contractor’s parent company), owner, and contractor. The surety (or contractor’s parent company) guarantees the performance of the contractor’s contractual obligations as stated in the construction contract for the benefit of the owner. implied warranty  A nonwritten warranty, such as an implied warranty of merchantability or implied warranty of fitness for a particular purpose, that is imposed by law and legally enforceable. imputed liability  See vicarious liability. INCOTERMS  A set of international rules first established in 1936 for the interpretation of commonly used shipping terms. Full descriptions of all INCOTERMS are published by the International Chamber of Commerce. indemnification  An obligation assumed by contract or imposed by law on one party to protect another against the financial liability arising from stated risks. indemnity, broad form  A type of indemnity where the contractor agrees to be responsible for the financial liability that arises from claims for personal injury, death of persons, and property damage, including legal defense of those claims, that are the result of any amount of the owner’s negligence, including his sole negligence. indemnity, intermediate form  A type of indemnity where the contractor agrees to be responsible for the financial liability that arises from claims for personal injury, death of persons, and property damage, including legal defense of those claims, that are the result of any amount of the owner’s negligence, but excluding only those claims that arise out of the owner’s sole negligence. indemnity, knock-­for-­knock  A type of indemnity that establishes that a contractor and an owner agree to be responsible for claims associated with personal injury and property damage for their own employees and property, regardless of how caused and regardless of the other party’s negligence.

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indemnity, limited form  A type of indemnity where the contractor agrees to be responsible for the financial liability that arises from claims for personal injury, death of persons, and property damage, including legal defense of those claims, that are the result only to the extent of the contractor’s negligence. indemnity, patent  A type of indemnity where the contractor agrees to be solely responsible for resolving claims arising out of utilizing equipment or processes on an owner’s project that infringe on existing patents. indemnity clause  A contractual obligation by which the contractor agrees to be responsible for certain risks and the associated financial liabilities that arise out of claims attributable to some or all of the owner’s negligence. independent contractor  A contractor who, under written contract, provides services to an owner but is not considered an employee of the owner for tax or other legal reasons. The independent contractor controls the means, method, and manner of producing the result to be accomplished. inquiry  See request for proposal (RFP). insured contract  That part of a construction contract (typically the indemnity clause) in which the contractor assumes the tort liability of the owner for claims involving injury to persons, death of persons, and property damage. See tort liability. ISO endorsements  Standardized language for endorsements to insurance policies written by the Insurance Services Office Inc. job site  The entire area, or part of the area, within the defined boundaries of a project. joint and several  All parties (joint) in a joint venture are responsible for the project. In the event one of the parties fails to perform, the other party or parties (several) in the joint venture would still be fully responsible for the project. joint operation  Two or more companies working together to build a specific project, where each company is responsible for independently estimating and performing its own scope of work, and each company will receive its proportionate share of any profit or loss that may result from its own operations. joint venture  An organization established by two or more companies joining together to provide resources, share management responsibilities, and share any resulting profit or losses. latent defect  A defect that would not be revealed under reasonably careful observation. legally enforceable contract  A contract that holds up under the law because it has been negotiated without any coercion, has something of

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value for both parties, has nothing illegal in it, and has been signed by representatives of the owner and the contractor who have the authority to commit the resources of their companies. liability  The obligation to pay money. liquidated damages (LDs)  A monetary amount specified in a construction contract to cover estimated damages incurred by the owner as a result of the contractor’s failure to perform. Typically applies when the contractor fails to complete the work within the time frame set forth in the contract, or a production process provided by the contractor fails to conform to the contract’s design specifications. litigation  The time-­consuming, expensive, and adversarial process by which contractor and owner hire lawyers and submit their disputes to the jurisdiction and procedures of federal or state courts for an indeterminate resolution that then becomes public knowledge. master list  A list of a construction project’s duty-­free materials provided by an owner for use by the foreign country’s customs officers at the port or ports of import. material breach of contract  A failure to perform a contractual obligation, where the failure is extremely serious and damaging to one or both parties. materialsmen’s lien  If an owner or contractor does not pay a material supplier for materials supplied, the material supplier can place a lien against the owner’s property that may hinder or prevent the owner from securing financing for his project or selling the property without first discharging the lien. mechanic’s lien  If an owner does not pay a contractor or subcontractor for work performed, the contractor or subcontractor can place a lien against the owner’s property that may hinder or prevent the owner from securing financing for his project or selling the property without first discharging the lien. mediation  The simplest, least expensive, and most straightforward form of ADR, where a neutral professional mediator, who likely has significant construction experience, is hired by mutual agreement of the contractor and the owner to resolve a contract dispute. Mediation is a confidential dispute resolution process. memorandum of understanding (MOU)  Used to establish a joint operation by outlining the duties and responsibilities of each of the parties, including scope of work and joint or joint and several responsibilities with respect to the project and contractual obligations with the owner. milestone  A specific, predetermined measurement of the completion of a project typically used for progress payment purposes. named insured  The owner of the insurance policy, most often the contractor. The named insured pays the policy premium and any deductible on a claim.

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negative cash flow  On a construction project, when the periodic payments a contractor receives from an owner for the performance of the contract’s construction work amount to less than what he will pay out during the same period for expenses associated with the work. (The amount of money coming in is less than the amount going out.) neutral cash flow  On a construction project, when the periodic payments a contractor receives from an owner for the performance of the contract’s construction work equal what he will pay out during the same period for expenses associated with the work. (The amount of money coming in equals the amount going out.) This is virtually impossible to achieve. occurrence limit  The maximum amount an insurance policy will pay for all injury to persons, property damage, and medical expenses that arise as the result of a single occurrence. offer  A written proposal or bid form prepared by the contractor to perform the work required by the owner. offer and acceptance  The term used to test whether a contract has been arrived at or not—­basically successful contract negotiations between the owner and the contractor. offshore contract  A contract between a company in one country and a company in another country. Typically used in conjunction with an onshore contract. on-­demand bond  A monetary form of contractor performance assurance, typically provided by a bank, where the bond is payable to the owner simply on his demand, and usually without the owner having to provide the bank any evidence or details of the contractor’s failure to perform. onshore contract  A contract between two companies in the same country. Typically used in conjunction with an offshore contract. order of precedence  A clause in a construction contract that specifies the order in which contract documents and contractor’s proposal or other submissions will apply in the event a dispute or claim arises over similar or conflicting terms. owner-­provided wrap-­up insurance  Also called an Owner-­Controlled Insurance Program (OCIP), it provides coverage for owners of large construction projects and for the many different engineers, main contractors, subcontractors, inspectors, suppliers, and others working on the job site. owner’s and contractor’s protective liability (OCP)  An insurance policy purchased and provided by a contractor for the exclusive benefit of an owner that covers the owner for claims against him for personal injury and property damage incurred by third parties, as well as any associated legal defense costs, that arise out of the contractor’s operations on the construction job site. The owner is the named insured on an OCP.

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paid if paid  If the main contractor receives payment from the owner for his work that includes the subcontractor’s work, then and only then will the main contractor pay the subcontractor. paid when paid  When the contractor receives payment from the owner for work that includes the subcontractor’s work, then the main contractor will pay the subcontractor. penal sum  The technical term used to designate the maximum amount of money a surety bond will pay the owner in the event the contractor fails to perform and the surety has to take over his contractual obligations. performance bond  A generic term for an assurance of performance provided to the owner by the contractor. It may take the form of an on-­ demand bond, a performance guaranty from a surety, a standby letter of credit, or a parent company guaranty. The performance bond is used to provide the owner some measure of assurance that the contractor will complete the construction project in accordance with the provisions of the contract. performance guaranty, parent company  A written risk transfer contract between three parties: a contractor, an owner, and the parent company of the contractor. The parent company guarantees the performance of the contractor’s obligations in the construction contract with the owner. In the event the contractor fails to perform, the parent company will step in and finish the contractor’s work. performance guaranty, surety  A written risk transfer contract between three parties: a contractor, an owner, and a separate company, called a surety. The surety guarantees the performance of the contractor’s obligations in the construction contract with the owner. In the event the contractor fails to perform, the surety company will step in and finish the contractor’s work, or pay the owner some money up to the amount of the guaranty’s penal sum. performance incentive  A feature of a contract whereby the contractor can earn extra money for certain types of exemplary performance, such as a safety bonus for having no lost-­time accidents on a construction project during the full course of construction. periodic progress payment  A measurement of how much of a construction project has been completed over some fixed time period, such as one month. At the end of the specified time period, the contractor bills the owner for the value of the work performed. personal injury  When a person is injured, regardless of how caused. Includes death of persons and sometimes certain diseases. physical risk  The risk of personal injury or property damage that is ever present due to the working conditions on construction job sites that can create safety hazards. Working at heights, unprotected excavations, overhead power lines, movement of heavy equipment, demolition activities,

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asbestos remediation, and blasting are examples of physical risk activities that may create safety issues and may injure persons or damage property. plans  The two-­dimensional overview of the design, location, and dimensions of a project. positive cash flow  When the periodic payments a contractor receives from the owner for the performance of the contract’s construction work amount to greater than what he will pay out during the same period for expenses associated with the work. (The amount of money coming in is greater than the amount going out.) preamble  The opening paragraph(s) of a contract used to specifically identify the parties to a contract. premium  The fee charged for an insurance policy. principal  As used in relation to construction contracts, when a contractor secures a performance guaranty from a surety company, the contractor is considered the “principal” on the guaranty. professional liability insurance  Also called errors and omissions insurance, provides coverage for the insured professional’s liability for claims, and legal defense of those claims, for damages sustained by others that arise as a result of negligent acts, errors, or omissions in the performance of their professional services. property damage  When property is damaged or destroyed. proposal  A complete signed bid to perform construction work (or a designated portion) for a stipulated price. The proposal is submitted to the owner by the contractor in accordance with the inquiry or request for proposal. punch list  A final list of minor work items remaining to be performed by the contractor to fully complete the project, prepared by an owner or his representative and confirmed by the contractor. Typically a punch list does not stop the owner from issuing the contractor some form of final completion notice. punitive damages  Damages that may be imposed as punishment by a court for fraud or misfeasance, or for grossly negligent, intentional, reckless, malicious, or willful types of behavior. request for proposal (RFP)  A set of documents, plans, and specifications prepared by the owner or his engineer or project manager that is given to contractors and that forms the basis of the contractor’s bid—­proposal—­for the project. Often called an inquiry. retention  A percentage of the value of each payment invoice from a contractor that is withheld by the owner until the end of the project. The retention is typically held until all terms of the contract have been fulfilled. rider  See endorsement.

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scope of work  An accurate, detailed, and concise description of the work to be performed by the contractor, the owner, and third parties in a construction contract. scope of work matrix  A document that contains a line-­by-­line description of all of the work items included in a construction contract, and specifies who is responsible for performing each of them—­the contractor, the owner, or others. scoping drawings  Contract drawings that are marked up to indicate for a contractor what is “in scope” for his scope of work and what is not. secrecy agreement  An agreement signed by the contractor that obligates him to keep certain information about the owner’s project or process confidential. Typically applies to most of the contractor’s material suppliers and subcontractors working on the project. self-­insure  An insured’s decision to take on a larger deductible than would otherwise be included in an insurance policy. This approach is used by contractors to lower the premiums they pay for insurance. self-­insured retention (SIR)  Basically the same as to self-­insure (above), but the insured in this case may take on the functions normally provided by an insurance company such as directly paying claims. set-­offs  Money that the owner can deduct from a contractor’s payments for parts of the contractor’s work that the owner performs, or money related to claims or disputes on other projects a contractor performed for the owner. Amounts for set-­offs should always be agreed to in writing by both parties. severability clause  Also called a validity clause, this states that if one or more of the clauses in a construction contract is ruled to be unenforceable or invalid, the remaining clauses will continue to be in full force and effect. site conditions clause  A contract clause that typically requires the contractor to, at a minimum, inspect and understand the grade level and above-­ground job site conditions prior to the start of any construction activities. The clause may also obligate the contractor to take full responsibility for the site’s subsurface conditions. soils investigation  An investigation of the job site surface and subsurface conditions typically prepared by a specialized engineering company. It describes and reports on the conditions in detail and may provide recommendations for the design of foundations and the possible maximum subsidence of the soil when the site foundations are under load. special terms and conditions  Contract commercial terms and conditions covering any special needs or issues involved in a particular construction project. These will typically supersede any similar or like terms found in the contract’s general terms and conditions. specifications  Documents that define the qualitative requirements for products, materials, and workmanship on which the contract for construction is based.

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split contracts  A term typically used in international contracts to note the existence of both an offshore contract and an onshore contract for the same construction project. stacking  The practice of adding together—­stacking—­the maximum amount of money available from an insurance policy to the maximum amount of money available under an indemnity agreement to use in paying a claim. standby letter of credit  A payment instrument that can be used by owners as an assurance of the contractor’s performance, typically issued by a bank, that will pay out a certain amount of money within a fixed time period upon presentation of documents specified in the body of the letter. In the event the contractor fails to perform, the owner can cash the standby letter of credit, subject to the presentation of any documents required. See commercial letter of credit. subrogation  The legal process by which one party (e.g., an insurance company) can recover money it paid out for a claim submitted by its policyholder (e.g., the contractor) from the negligent party who was responsible for causing the claim (e.g., the owner). surety company  A company that specializes in providing guaranties of performance for contractors. In the event the contractor fails to perform on a contract, the surety company will step in and finish the project for the owner, or pay the owner up to the maximum stated monetary value of the guaranty. suspension of work clause  A contractual right that allows an owner to suspend work on a construction project for some period of time and then resume, or even cancel, the project. target price contracts  A contract where a contractor and owner agree on a certain fixed, lump-­sum price, the target price, and then the contractor tries to execute the contract at or below that price. The contractor typically shares all his estimated project costs, markups, and expected profit with the owner. termination for cause clause  A contractual right that provides an enforceable exit mechanism for the owner when the contractor fails to perform, financially or otherwise. termination for convenience clause  A contractual right that allows the owner to terminate the contract at his convenience with little or no justification. third parties  All persons or organizations that are not signatory to the construction contract between the owner and the contractor. time is of the essence  A term used in contracts to imply that it is very important to finish an obligation, typically the contractor’s completion schedule, as agreed on in the contract.

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tort  A civil wrong. Typically on a construction site a tort (civil wrong) is an incident or act arising out of the negligence of the owner and/or contractor that damages property or injures a person or persons. tort liability  The financial liability that arises from a negligent act that causes harm to persons or property. Such financial liability is usually determined in court. transport insurance  Insurance coverage for loss or damages to materials and equipment while they are being transported from one place to another. travel accident insurance  Insurance coverage for the contractor’s employees while they are traveling on company business. umbrella or excess liability insurance  Insurance that provides additional liability coverage for the Comprehensive General Liability and automobile policies in the event the occurrence or aggregate limits are exceeded on these policies. unilateral change clauses  Change clauses in a contract that allow the owner to direct the contractor to perform a change with the sorting out of cost and schedule changes to take place at some later date. unit rate contract  A construction contract in which the contractor’s payment is based on a mix of varying unit rates for all the different elements of the work performed. vicarious liability  The liability that arises where one person (an employer or an owner) is deemed responsible for the actions of another (an employee or a contractor). Also known as imputed liability. waiver of subrogation  A waiver by one party (the contractor) of another party’s (the contractor’s insurance company who paid a claim on his behalf ) right to recover the amount of the claim from the party whose negligence caused the claim (the owner). See subrogation. warranty  A contract between two companies—­the contractor and owner. The contractor warrants that the work he performed for the owner is free of defects, and if any defects are found within a certain time period, he will repair or replace them. Workers’ Compensation insurance  Insurance covering the liability of an employer to employees for claims, compensation, and other benefits required by statutory Workers’ Compensation laws with respect to injury, sickness, disease, or death arising from their employment. Often called Coverage A in a contract.

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Index A

acceptance, 246, 260–262 certificate of, 31 acts of God, See force majeure actual damages, 193–196 additional insured, 113, 120–134, 323 administrative terms, xxiv advance payment bond, 85–87 advance waiver of liens, 246, 262–265 aggregate limit, insurance, 114 Alternative Dispute Resolution (ADR), 186–188, 191 American Arbitration Association, 190 American Chamber of Commerce (AmCham), 290, 306–307 American Institute of Architects (AIA), 11 anti‐indemnity legislation, 144–149 applicable law, 246, 269–272 in international contracting, 284–285, 297 arbitration, 187–188, 190, 191, 215

articles, definition of, 25 assignment, 245, 258–260 Associated General Contractors of America (AGC), 11 assurances of performance, 69–101 advance payment bond, 85–87 bonds, 70–73 downpayment bond, 85 guaranties, 70–72 on‐demand bond, 73, 75–76, 84, 85, 87, 89, 93–99, 101 parent company guaranties, 97–98 performance bonds, 91–93 performance guaranties, 91–93 standby letter of credit, 73, 76–78, 101, 260 step‐down values, 95–97 subcontractor payment guaranties and bonds, 88–91 supplier payment guaranties and bonds, 88–91 true performance guaranty, 73–75 warranty guaranties, 93–95

Understanding and Negotiating Construction Contracts: A Contractor’s and Subcontractor’s Guide to Protecting Company Assets, Second Edition. Kit Werremeyer. © 2023 John Wiley & Sons, Inc. Published 2023 by John Wiley & Sons, Inc.

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attachments, to contract, 26–27 audit of contractor’s work records, 18 rights to, 246, 268 automobile insurance, 108

B

bankruptcy, 72 bid bond, 82–85 bid documents, 2, 20 bid review, 20 binding arbitration, 188 boilerplate language, in contracts, 12, 117 bonding capacity, 80, 86, 96 bonding limits, 99–101 bonds, 70–73, 173 breach of contract, 7, 72, 194 broad form blanket contractual coverage, 138 Builder’s Risk insurance, 108–109 Business Interruption insurance, 111

C

cancellation, 228, 236 See also termination captive insurance, 112 care, custody, and control, insurance, 116–117 cash flow, 42–43, 97 calculating, 43–44 negative, 42, 51 neutral, 42 positive, 42, 51 certificate of mechanic completion, 209, 213, 219, 260 certificate of occupancy, 58, 220 changes clause, 169–181, 199, 204 claims, 38, 120–131 claims made vs. occurrence, insurance, 105–106 clauses, definition of, 25 codes and standards, 3, 27

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combined fixed price and reimbursable contracts, 18–19 combined single‐limit, insurance, 114 Commercial General Liability insurance, 104, 106–107, 115, 120–123, 126–128, 130–132, 134, 138–140, 323 commercial letter of credit, 77 commercial obligation, 72 commercial terms and conditions, xxi, 9, 25–26 administrative, xxiv financial liability, xxiv negotiating, xxv, xxvi common law, xxiii Completed Operations insurance, 109, 130 endorsements, 130 completed portions of work, use of, 245, 251 completion schedule, See schedule conditions, of contract, xxi confidentiality agreements, 245, 253–254 consequential damages, 193, 195, 204–206 consideration/something of value, 5, 9 construction equipment, 31 contingency, 18, 62, 250 contract bonds, 73 contract completion, 10 contract language, sample, xxvii contracts breach of, 7, 72, 194 conditions of, xxi consideration, 5 definition, 1 design‐bid‐build, 22 design‐build, 22 example of, 8–9 government, xxii international, xxii, 284–285 language in, 10–11

myths, 11–12 negotiations, 12–13, 320–328 parties involved, 2–3, 5 private, xxii proposal for, 4–5 signatory parties, 5 starting point, 3–4 steps in, 1–2 types and forms of, 15–32 contracting, process, xxv Contractor‐Provided Wrap‐up insurance, 110 contractor selection, 20 Contractual Liability insurance, 107–108, 157–162 contributory form, 124 cost plus fee contracts, 15, 20–21 cost reimbursable contract, 269 cross‐liability, 117 currency, 293–296

D

damages, 193–206 actual, 193–196 consequential, 193, 204–206 liquidated, xxiii, 23, 171, 193, 197–204, 206, 242 punitive, 193 subcontractors and, 203 deductible, insurance, 113 default, 72 defect liability period, 31 definitions, contracting, 30–32 delays, xxvi, 66–68, 203–204 design‐bid‐build contracts, 22 design‐build contracts, 22 design engineering, 20 devaluation, 295 directives, owners’, 171 disputes, 38, 174, 186, 189–191 resolutions to, 183–192 downpayment, 327 downpayment bond, 85 Dun & Bradstreet®, 44 duty‐free status, 300, 301

E

Employer’s Liability insurance, 108 Engineering, Procurement, and Construction (EPC) ­contractor, 199 Engineers Joint Contract Documents Committee (EJCDC), 11 environmental protection groups, 2 equipment and material procurement, 20 evidence of insurance certificate, 140 excess, coverage on additional insured insurance policy, 126–127 exchange risk, currency, 294 experience rating, insurance, 113 Export‐Import Bank of the United States (Ex‐Im Bank), 284, 305 exports, 300–302 express warranties, 216 extended duration warranties, 219–220

F

failure to perform, 7, 72, 194, 195 fast‐track projects, 20 final waiver form, 27 final waiver of liens, 13, 246, 265–268 financial liabilities, xxi, xxiii, xxiv fitness for a particular purpose, implied warranty of, 214, 218 fixed price contract, 16, 268 fixed schedule contract, 16 float, 62–63 force majeure, xxiii, 239–244 Foreign Corrupt PracticesAct (FCPA), 284–286, 291, 292, 312 foreign currency option, 295

G

grace periods, damage clauses and, 202 guaranteed maximum price contract, 15 guaranties, 69–75, 208

I

implied warranty, 214–216 conspicuous exclusion of, 216 imports, 300–302 indemnity, xxvi, 141–167, 322–323, 325–327 and additional insured status, 157–162 and claims, 161–162 and contractual liability insurance, 157–162 definitions, 142–143 examples of, 150–157 and fairness, 143 and insurance, 142 knock‐for‐knock, 165–166 legislation for, 144–149 negotiating, 162–166 patent, 245, 252–253 transferring the owner’s risks to contractors, 143 independent contractors, 125, 245, 257–258 insolvency, 72 inspection, owner’s right, 245, 254–256 insurance, xxvi, 9, 103–140, 323 additional insured, 113, 120–134, 157–161 aggregate limit, 114 automobile, 9, 108, 136 broker, 104 Builder’s Risk, 108–109, 136 Business Interruption, 111 captive insurance, 112 care, custody, and control, 116–117 claims made vs. occurrence, 105 combined single‐limit, 114

Commercial General Liability, 107, 115, 120–123, 125, 127, 128, 130–132, 134, 138–140, 162, 323 Completed Operations, 109, 130 Contractor‐Provided Wrap‐up, 110 Contractual Liability, 107–108 Coverage B, 108–109 cross‐liability, 117 deductible, 105, 113, 115 definition of, 105 Employer’s Liability, 108 evidence of insurance certificate, 119 experience rating, 113 General Liability, 9 manuscript endorsements, 118, 130 named insured, 112 notification provisions, 119 occurrence limit, 114 Owner‐Provided Wrap‐up, 110 Owner’s and Contractor’s Protective Liability, 110–111 perils, 104 premium, 105, 115 primary and non‐contributory, 117 Professional Liability/Errors and Omissions, 109 reviewing details of, 2 riders and endorsements, 117 sample clause, 134–140 self‐insured retention (SIR), 113–114 special requirements for, 27 specialty insurance, 111–112 stacking, 118–119 subcontractor default insurance (SDI), 112 terrorism insurance, 111 transport insurance, 109 types of, 106–112 umbrella/excess liability, 111 vicarious liability, 122

351

insurance (cont’d ) waiver of subrogation, 114–116 Workers’ Compensation, 9, 108, 136, 257 Insurance Services Organization, Inc. (ISO), 128–130 endorsements, 118, 130 interest accumulated, 51 negative, 51 positive, 51 rates, 44–45 Internal Revenue Service (IRS), 257 International Commercial Terms (INCOTERMS), 284, 302–304 international contracting, xxii, 283–307 International Federation of Consulting Engineers (FIDIC), 11

J

joint operations, 284, 300 joint ventures, 284, 299

K

knock‐for‐knock indemnity, 165–166

L

labor unions, 66 latent defect, 222 law, applicable, 246, 269–272 changes in, 246, 272 common, xxiii international, 284, 297 legal systems, foreign, 284, 290–291 legally enforceable contract, 6 letters of credit, 73, 76–78, 101, 260, 284, 286–288 liabilities, financial, xxiii, xxiv lien, 88 mechanic’s, 12, 262–264 waiver of, 12, 246, 262–268

352

limit of liability, 81 line of credit, 44 liquidated damages, xxiii, 23, 171, 193, 196–204, 206, 242 litigation, as a dispute resolution option, 188

M

manuscript endorsements, 118 markups, 16, 17, 21 master list, 301 material breach of contract, 7 materials delivery of, 46 lead‐time for, 48 mechanic’s lien, 12, 263–264 mechanical completion certificate, 209, 212, 219, 260 mediation, as dispute resolution, 187 Memorandum of Understanding (MOU), 300 merchantability, implied warranty of, 214, 218 milestone payments, 45–59 mobilization, 48, 49 myths, of contracting, 11

N

named insured, 112 negligence, 114 negotiating, final thoughts on, 319–328 negotiation, as dispute resolution, 186–187 nonbinding arbitration, 187 Notice to Proceed, 92 notification provisions, insurance, 119

O

obligations, assignment of, 258–259 obligee, 81 obligor, 81 occurrence limit, insurance, 114 offer and acceptance, 3, 4

offer, 4, 9 offshore companies, 292–293 offshore contracts, 288–289 on‐demand bond, 73, 75, 84, 86 onshore contracts, 288–289 order of precedence, 23, 27–30 OSHA safety inspector, 2 overhead, 17, 20 Overseas Private Investment Corporation (OPIC), 284, 290 Owner’s and Contractor’s Protective Liability insurance, 110–111 Owner‐Provided Wrap‐up insurance, 110

P

partial waiver of liens, 262–265 pass‐through warranties, 221–222 patent indemnity, 245, 252–253 payment, xxv advance, 48–49 cash flow, 42–44 downpayment, 48–49, 327 electronic funds transfer (EFT), 48 example of, 58–59 for changes, 172 interest rates, 44–45 milestone payments, 45–59 “paid if paid,” 55–57 “paid when paid,” 55–57 periodic progress payments, 45–59 retention, 50–51, 57, 180, 327 set‐offs, 54 terms of, 8, 41–59, 327 payment bond, xxiii, 28 penal sum, 81, 84 performance, assurances of, 69–101 advance payment bond, 85, 86 bonds, 70–73 downpayment bond, 85 guaranties, 70–72

on‐demand bond, 73, 75–76, 84, 85, 87, 89, 93–99, 101, 180, 260 parent company guaranties, 97–99 performance bonds, 27, 91–93, 172 performance guaranties, 91–93 standby letter of credit, 73, 76–79, 101, 260 step‐down values, 95–97 subcontractor payment guaranties and bonds, 88–91 supplier payment guaranties and bonds, 88–91 true performance guaranty, 73–75 warranty guaranties, 93–95 performance bonds, 27, 91–93, 172 performance guaranties, 70, 73, 260 performance incentive contracts, 16, 22–23 performance, late, xxiii periodic progress payments, 45–59 plans, 2, 3, 26 preamble, 23–25 premises and operations, 138 premium, insurance, 105 pricing, of work, xxv, 8 primary, coverage on additional insured insurance policy, 126–127 principal, 81 products and completed operations coverage, 138 Professional Liability/Errors and Omissions insurance, 109 profit, 16, 17, 21 progress payments, xxiii project management staff, 20 project manager, 2 proposal, 1, 28 punch list, 246, 260–262 punitive damages, 193

R

recitals, 24–25 reimbursable type contracts, 16–18 cost plus, 16–18 unit rate, 16–17 request for proposal (RFP), 1, 3, 5, 8, 38 retention, 50–51, 58, 180, 327 riders and endorsements, insurance, 117–118 rights, assignment of, 258–259 risk commercial, xxii–xxiii, xxiv, 2, 25, 104 of conditions to contract, xxi and insurance, 105 management, 194 perils, 104 physical, 105 third parties and, 2 transfer clause, xxvi, 3

S

safety, 2, 27, 251, 323 contractor incentive for, 22–23 schedule, xxv, xxvi, 3, 9, 19, 20, 26, 61–68 changes in, 179, 180 contractor incentive for, 22–23 float, 62–64 time is of the essence, 64–66 scope of work, xxv, 2, 3, 8, 19, 21, 25, 26, 33–40, 185 changes to, 169, 170, 178–179 matrix, 37–39 scoping drawings, 39–40 secrecy agreements, 245, 253–254 self‐insure, 127 self‐insured retention (SIR), 113 severability, 246, 269 signature block, 23, 27 site conditions, xxiii, 245–251 site visit, 2 soils investigation, 246–248 special terms and conditions, 23, 26–28

specialty insurance, 111–112 specifications, 2, 3, 26 split contracts, 284, 288–289 stacking, insurance, 118–119 standby letter of credit, 73, 76–78, 101, 260 subcontractor default insurance (SDI), 112 subcontractor payment guaranties and bonds, 88–91 subcontractors, 23, 174, 175 damages and, 202–203 selecting, 2 supplier payment guaranties and bonds, 88–90 suppliers, selecting, 2 surety, 73, 80–81, 172, 173, 180, 208 suspension, of a contract, 227–238

T

target price contract, 15, 21–22 termination for cause, 228–229, 236 of contract, 227–238 for convenience, 229–232, 236–237 terms and conditions, of contract, xxi standard, 320–322 terms of payment, 41–59, 327 terrorism insurance, 111 third‐party over action, 123 time is of the essence, 64–66 transport insurance, 109 true performance guaranty, 73–75

U

umbrella/excess liability, 111 underground explosion and collapse (XCU) coverage, 138 Uniform Commercial Code (UCC), 214–216

353

V

validity clauses, 269 vicarious liability, 122

W

waiver of liens, 246 advance, 262–265 final, 265–268

354

waiver of subrogation, 114–116 warranties, 74, 207–225, 251, 260 clauses, 208–213 express, 216 extended duration, 219–220 guaranties, 93–95 implied, 214–216

obligations, 82 pass‐through, 221–222 period, 92 work, xxiii weather, effects of, 21, 66 Workers’ Compensation, 9, 108, 136, 257

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