A Guide To Construction Contract Clauses
Posted by: Mark Albright on Fri, Sep 07, 2012Share this post
I. INTRODUCTION: THE FORM CONSTRUCTION CONTRACT
The American Institute of Architects has them. Landlords have them. Oil companies have them. Banks have them. What are they? They are the standard form contracts and agreements so common in the construction industry.
Many people will accept the unacceptable if it is in a standard form agreement, perhaps assuming that because language is “merely boilerplate” it has no significant consequences, or that unforeseen consequences may result from attempts to change the tried and true; However, just because language is contained within a standard form contract does not mean that it has any special distinction, or that it will best serve the interests of one’s client. In order to best serve the client, an attorney reviewing a form contract should be aware of where the standard form contract came from, which origination’s name is on the form, and who the agreement is designed to protect, at whose risk.
Attorneys representing owners should be especially cautious when using standard form contracts, such as those cited herein from the A.I.A. (American Institute of Architects) or the EJCDC (Engineers joint Contract Documents Committee), or the AGC, (Associated General
Contractors), or Construction Management Association. Such contracts are drafted specifically to shift the design and construction risks from the architect or engineer, or the contractor to the owner/ developer or to the general contractor. See generally, Thomas J. Maloney, Comment: Flirting with Disaster: the A.I.A. Owner-Architect Agreement Shifts the Risk of Loss to Owners, 36 Loy. L. Rev. (1990). As one commentator has stated, owners should draft their own documents or modify existing form documents since, “the non-professional owner has neither a united lobbying voice nor standard form contracts to protect his interests.” Note, Allocation of Risk in the Construction Industry: The Non-Professional Owner and His Construction Manager, 46 Law & Contemp. Probs. 145, 147 (1983); See also, Richard M. Shapiro, The 1987 AIA A201 General Conditions: An Owner’s View, 24 Real Prop. Prob. & Tr. J. 523 (1990) (A.I.A. forms are oriented “primarily toward the interests of architects and secondarily towards those of contractors.”)
Even when an attorney represents the interests of a party, such as an architect, whose national professional organization ostensibly prepared the form, the attorney must still ensure that the language of the form meets the needs of his or her client. Individual clients practicing a profession on whose behalf a form was ostensibly created will not always agree with the language contained therein, or find the language helpful to their personal circumstances. This is illustrated by the modifications which are continually made to Form contracts at the behest of members of the professional organizations involved, or as the result of surveys of the members.
In order to assist in meeting the challenges of drafting and reviewing construction contracts, this article examines one of the most common and significant clauses contained in AIA and EJCDC construction form contracts; the differing site conditions, or changed conditions clause, and also examine other clauses and provisions which relate to the problem of site conditions in a manner beneficial to the owner, rather than the contractor, as well as examining damages issues relating to differing site conditions, demonstrating the importance of the risk allocation undertaken by clauses dealing with the potential for differing site conditions. This discussion is preceded by a brief review of some of the clauses which may be implied by law if not addressed by the parties in their contract. The following also examines certain other clauses which owners may wish to consider utilizing when preparing their own standard form contacts. Finally, one of the commonly disputed clauses within subcontract agreements, the contingency payment clause, is examined, as an example of one of the issues which arises in the context of that contractual relationship
This article addresses the purpose of each examined clause, discussing on whose behalf the clause has been generated, as well as the treatment such clauses have received in the Courts. While there are obviously many significant construction contract clauses which are not discussed in this article, or which are touched upon only briefly herein, it is hoped that this overview will illustrate for the practitioner some of the issues that arise in evaluating construction contracts, including risk allocation or avoidance in the industry, and will direct the practitioner to common sources which may be helpful when studying clauses not directly discussed herein.
II. CONTRACT CLAUSES IMPLIED BY LAW
In addition to standard form contract provisions, attorneys and contractors should be aware of implied provisions which will be held to govern the contract if litigated in their jurisdiction. Construction work is complex and courts frequently find it appropriate to imply covenants that cannon be found within the four corners of the agreement. Courts are especially likely to imply covenants to protect consumers.
For example, courts will often imply on the contractor or subcontractor a duty to perform services in a workman-like manner. Pioneer Enters, Inc., v. Edens, 345 N.W.2d 16 (Neb 1984). A Texas court said “ we think there was a implied contract here that the house to be constructed would be constructed on a foundation to be sufficient to sustain the character of the house to be built.” Phillips v. Wick 288 S.W.2d 899 (Tex. Ct. App. 1956). In a 1975 Alaska case, Lewis v
Anchorage Asphalt Paving 535 P.2d 1188 (Alaska 1975), the contract with a paving subcontractor provided for new streets and repaving of three old streets. The owner wanted to use hot mix asphalt. The subcontractor performed according to the requirements of the contract with disastrous results. Portions of the street settled, causing roller coaster effects, pot holes, etc. The court held that the contractor could not blind itself and ignore the probability that a suitable result could not be obtained by placing hot mix asphalt pavement on the roads. The court noted that the subcontractor had an implied affirmative duty to warn the owner. It was the subcontractor, not the owner, a trailer court owner, who had the requisite expertise. Contractors who are bound to follow plans are required to use their expertise and notify the owner of architect of reasonably discoverable defects.
Other cases hold that there is an implied duty on the part of owners to cooperate with contractors so as to enable both parties to carry out the objectives of the contract. One such essentially implied obligation in every construction contract is that the owner will supply the contractor with a site on which the contracted structure may be erected. Statler Manufacturing, Inc., v. Brown, 691 S. W. 2d 445 (Mo. 1985). Additionally, an owner has an obligation to cooperate with the contractor and not to interfere with, hinder or delay performance of the contractor. R.C. Tolman Constr. Co., v. Myton Water Ass’n, 563 P.2d 780 (Utah 1977). When the contract documents do not provide otherwise, there is an implied covenant that the owner will provide whatever easements, permits or whatever documents are necessary for the construction to proceed in an orderly manner. Coas, Inc., v. Kennedy ENGRS., 136 Cal. Rptr. 890 (1977). The implied covenants of cooperation also apply between subcontractors and prime contractors. If a contract is silent as to the period of time for performance, then a reasonable time will be implied. RA Weaver & Assoc. v Haas & Hanie Corp., 663 F.2d 168 (D. Cir. 1980).
Contractors should also be aware of the contents of documents that are incorporated by reference into a contract such as drawings, specifications, general conditions, special conditions, etc.
III. DIFFERING SITE CONDITIONS CLAUSES
For many years, most of the commonly used standard form contracts have contained differing site conditions or changed conditions clauses. These types of clauses shift the risk of unforeseen site conditions from the contractor to the owner.
A. Changed Site Conditions at Common Law
Under general common law rules, a contractor bears the risk that performance of his contract will be more costly that he thought when he made his bid. The court in Eastern Tunneling Corp., v. Southgate Sanitation Dist., 487 F. Supp. 109 (D. Colo. 1979) States this rule as follows:
It is conceded that, under the common law rule, the contractor who undertakes an entire contract for erecting a building is presumed, in absence of an express provision to the contrary, to have assumed the risk of unforeseen contingencies arising during the course of the work, unless performance is rendered impossible by an act of God, the law or the other party.
See also, United States v. Spearin, 248 U.S. 132, 136 (1918) (When a party “agrees . . . for a fixed sum, a thing possible to be performed, he will not be excused or become entitled to additional compensation, because unforeseen difficulties are encountered.”); The Restatement (Second) of Contracts § 467 (“Facts existing when a bargain is made or occurring thereafter making performance of a promise more difficult or expensive than the parties anticipated do not prevent a duty from arising or discharge a duty that has arisen.”)
There are a number of exceptions to the general common law rule, such as: impossibility, City of Littleton v. Employers Fire Ins. Co., 453 P.2d 810 (Colo. 1969) (impossibility of performance was a defense to action by city against contractor for breach of contract, unless contractor knew or had reason to know at the time of executing contract for construction of two five million gallon water tanks that it would be impossible to construct the tanks as specified); mutual or unilateral mistake, Ray D. Lowder, Inc. v. North Carolina State Highway Commission, 217 S.E.2d 682, 696 (N.C. Ct. App. 1975) (when the parties to a contract “labor under a mutual mistake as to vital facts, the contract, in the interest of fairness, should be flexible enough to permit an equitable adjustment.”); Architects and Contractors Estimating Service, Inc. v. Smith, 211 Cal. Rptr. 45 (Ct. App. 1985) (a contractor’s contract may be nullified by mistake of fact, whether mutual or unilateral, where mistake is due to the fault of other party who knew or had reason to know of mistake); unjust enrichment, Cannon Builders, Inc. v. Rice, 888 P.2d 790, 797 (Idaho Ct. App. 1995) (“unjust enrichment doctrine, also referred to as quasi-contract, contract implied in law or restitution, allows recovery where the defendant has received a benefit from the plaintiff that would be inequitable for the defendant to retain without compensating the plaintiff for the value of the benefit.”); Hash v. R.J. Sundling & Sons, Inc., 436 P.2d 83, 86 (Mont. 1967) (contractor entitled to additional compensation for unanticipated conditions if such unanticipated conditions “vary substantially from anticipated conditions reasonably foreseeable by the parties.”); commercial impracticability, Conam Alaska v. Bell Lavalin, Inc., 842 P.2d 148 (Alaska 1992) (jury finding of commercial impracticability excusing subcontractors non-performance); fraud or negligent misrepresentation of pertinent facts, Jim’s Excavating Service, Inc., v. HKM Associates, 878 P.2d 248 (Mont. 1994) (upholding verdict in favor of contractor who brought action against project engineer for extra work and delay damages caused by engineer’s negligent design and holding that third party contractor may successfully recover for purely economic loss against project engineer or architect when said design professional knew or should have known the particular Plaintiff was at risk in relying on information supplied); breach of plans warranty, Fairbanks Northstar Borough v. Kandik Construction, Inc., 795 P.2d 793 (Alaska 1990) (held contractor may bring suit for breach of warranty of plans and specifications so long as contractor “acting reasonably” was “misled” by inaccurate plans to its detriment.) vacated in part on other grounds, 823 P.2d 632 (Alaska 1991).
B. Standard Differing Site or Changed Conditions Clauses
In order to avoid reliance on one of the foregoing exceptions to overcome the potentially harsh common law rule, most standard form construction contracts now contain a clause allowing the contractor to obtain an equitable adjustment for changed, differing, or unanticipated site conditions. As discussed above, these clauses tend to be written to favor the party whose professional association drafted the contract, and should, therefore, be used with caution when representing the interest of another party. (Note, for example, how the AIA form calls upon the owner and the contractor to use the architect to investigate and arbitrate disputes, whereas, the Engineer’s form gives the engineer this right.
Examples of some standard “differing site conditions” clauses are set forth as follows:
1. American Institute of Architects Document A201 § 4.3.6 (1987 ed.):
4.3.6 Claims for Concealed or Unknown Conditions. If conditions are encountered at the site which are (1) subsurface or otherwise concealed physical conditions which differ materially from those indicated in the Contract Documents or (2) unknown physical conditions of an unusual nature, which differ materially from those ordinarily found to exist or generally recognized as inherent in construction activities of the character provided for in the Contract Documents, then notice by the observing party shall be given to the other party promptly before conditions are disturbed and in no event later than 21 days after first observance of the conditions. The Architect will promptly investigate such conditions and, if they differ materially and cause an increase or decrease in the Contractor’s costs of, or time required for, performance of any part of the Work, will recommend an equitable adjustment in the Contract Sum or Contract Time, or both. If the Architect determines that the conditions at the site are not materially different from those indicated in the Contract Documents and that no change in the Terms of the Contract is justified, the Architect shall so notify the Owner and Contractor in writing, stating the reasons. Claims by either party in opposition to such determination must be made within 21 days after the Architect has given notice of the decision. If the Owner and Contractor cannot agree on an adjustment in the Contract Sum or Contract Time, the adjustment shall be referred to the Architect for initial determination, subject to arbitration proceedings.
2. The Engineers Joint Contract Documents Committee, Document No. 1910-8,§ 4.3 (1978 ed.):
CONTRACTOR shall promptly notify OWNER and ENGINEER in writing of any subsurface or latent physical conditions at the site or in an existing structure differing materially from those indicated o r referred to in the Contract Documents. ENGINEER will promptly review those conditions and advise OWNER in writing if further investigation or tests are necessary. Promptly thereafter, OWNER shall obtain the necessary additional investigations and tests and furnish copies to ENGINEER and CONTRACTOR. If ENGINEER finds that the results of such investigations or tests indicate that there are subsurface or latent physical conditions which differ materially from those intended in the Contract Documents, and which could not reasonably have been anticipated by CONTRACTOR, a Change Order shall be issued incorporating the necessary revisions.
Interestingly, more recent versions of the EJCDC form contract substantially track the language of the AIA form shown above.
3. Federal Acquisition Regulations, 48 C.F.R.§ 52.236-2 (1984)
(a) The Contractor shall promptly, and before the conditions are disturbed, give a written notice to the Contracting Officer of (1) subsurface or latent physical conditions at the site which differ materially from those indicated in this contract, or (2) unknown physical conditions at the site, of an unusual nature, which differ materially from those ordinarily encountered and generally recognized as inhering in work of the character provided for in the contract.
(b) The Contracting Officer shall investigate the site conditions promptly after receiving the notice. If the conditions do materially so differ and cause an increase or decrease in the Contractor’s cost of, or the time required for, performing any part of the work under this contract, whether or not changed as a result of the conditions, an equitable adjustment shall be made under this clause and the contract modified in writing accordingly.
(c) No request by the Contractor for an equitable adjustment to the contract under this clause shall be allowed, unless the Contractor had given the written notice required; provided, that the time prescribed in (a) above for giving written notice may be extended by the Contracting Officer.
4. The Construction Management Association of America, Inc., CMAA Document No. A3
4.20.4 If the Contractor believes that:
22.214.171.124 Any factual data on which the Contractor is entitled to reply is inaccurate; or
126.96.36.199 Any existing surface or subsurface condition encountered at or contiguous to the site differs materially from that indicated or referred to in the Contract Documents, the Contractor shall, after becoming aware thereof and before performing any Work in connection therewith, except in an emergency as permitted by Paragraph 9.1.3, promptly notify the Construction Manager in writing about the differences.
4.20.5 The Construction Manager shall review the pertinent conditions and, in consultation with the Design Professional, determine the necessity of additional investigations, explorations or tests with respect thereto, and advise the Owner in writing about the inaccuracy or difference. If the Construction Manager, in consultation with the Design Professional, determines that an existing surface or subsurface condition, facility or structure is materially different from that indicated or referred to in the contract Documents, or that there exists a surface or subsurface condition at or contiguous to the site, of which t he Contractor could not reasonably have been expected to have been aware, or to have been entitled to rely upon, the Construction Manager and Design Professional shall determine the extent to which the Contract Documents should be modified. The Contractor may be entitled to a change in the contract price or time in accordance with the provisions of Article 11. The Contractor shall be responsible for the safety and protection of such condition, as provided in Article 9.
C. Purpose of Differing Site Conditions Clauses
As previously stated, at common law the contractor was responsible for changed or differing site conditions. Hence, the contractor had to include in his bid or contract price: (i) the cost of investigating conditions, a time-consuming and expensive practice which raised the price of the bid, or (ii) a high continency factor to protect against the potential cost and expenses which might be incurred if unforeseen site conditions were encountered during the performances of the contract. The differing site condition clause was based on the concept that the owner (particularly public owners or large corporations) would remove the risk of unknown conditions from the contractor and thereby obtain lower bid prices, but suffer the uncertainty of not knowing from the outset the ultimate cost of the project. As stated by the court in Foster Construction C.A. & Williams Bros. Co. v. United States, 435 F.2d 873, 887 (Ct. Cl. 1970):
The purpose of the changed conditions clause is this to take at least some of the gamble on subsurface conditions out of bidding. Bidders need not weigh the cost and ease of making their own borings against the risk of encountering an adverse subsurface condition, and they need not consider how large a contingency should be added to the bid to cover the risk. They will have no windfalls and no disaster. The Government benefits from more accurate bidding, without Inflation for risks which may not eventuate. It pays for difficult subsurface work only when it is encountered and was not indicated in the logs.See also, Iacobelli Const, Inc. v. County of Monroe, 32 F.3d 19 (2d. Cir. 1994) (the purpose of the differing site conditions clause is to reduce speculative contingency costs in bids and reduce “inflated bidding.”).
D. INTERPRETATION OF DIFFERING SITE CONDITIONS CLAUSES
Differing site conditions have been categorized as either “Type I” or Type II”differing conditions. This distinction arises out of the way differing site conditions were defined in the federal differing site conditions clause (Federal Acquisition Regulations 48 C.F.R. 52.236-2(a), supra) and the distinction between the two categories has been widely adopted in both the federal and state courts.
1. Type I
Type I differing site conditions, such as those described in 48 C.F.R. 52.236-2(a)(1), supra, concern whether the site condition differs materially from a representation indicated in the contract itself. See, e.g., Servidone Construction Corp. v. United States, 19 Cl. Ct. 346, 360 (1990) A’ffd 931 F.2d 860 (Fed. Cir. 1991). To prevail in a Type I claim, the contractor must prove, by a preponderance of the evidence, “that the conditions indicated in the contract differ[ed] materially from those in encountered during performance.” John Massman Contracting Co. v. United States, 23 Cl. Ct. 24, 30 (1991) (citing P.J. Maffei Bldg. Wrecking Corp. v. United States, 732 F.2d 913, 916 (Fed. Cir. 1984)). The actual differing site conditions encountered need not be expressly or specifically indicated in the contract; it is sufficient that the “contract contain reasonable plain or positive indications that conditions would be different from what the contractor actually encountered.” Id. Determining whether the contract document contains any “indications” of a site condition is a question of law which the court determines according to the standard of a reasonably prudent contractor. Weeks Dredging & Contracting, Inc. v. United States 13 Cl. Ct. 193, 218 (1987). aff’d, 861 F.2d 728 (D.C. Cir. 1988). The core issue in a Type I claim is “whether the contractor could reasonably have anticipated the condition encountered from a knowledgeable interpretation of the contract documents, his inspection of the site, and his general experience as a contractor.” Erickson-Shaver Contacting Corp. v. United States, 9 Cl. Ct. 302, 304 (1985). A Type I claim further requires the contractor to prove the following six elements:
(i) the contract documents must have affirmatively indicated or represented the subsurface conditions which form the basis of the plaintiff’s claim; (ii) the contractor must have acted as a reasonably prudent contractor in interpreting the contract documents; (iii) the contractor must have reasonably relied on the indications of subsurface conditions in the contract; (iv) the subsurface conditions actually encountered, within the contract site area, must have different materially from the subsurface conditions indicated in the same contract area; (v) the actual subsurface conditions encountered must have been reasonably unforeseeable; and (vi) the contractor’s claimed excess costs must be shown to be solely attributable to the materially different subsurface conditions within the contract site.
Youngdale & Sons Constr. Co., Inc. v. United States, 27 Fed. Cl. 516, 528 (1993), (citing Weeks, 13 Cl. Ct. at 218).
Two of the most critical and decisive factors in any type I analysis include the definition of what constitutes “contract documents” and the “indicated or represented” conditions in those contract documents. The term “contract documents” includes not only bidding documents, i.e., invitation for bids, drawings, specifications and other documents actually given to the contractor, but also documents and other materials or test results referred to in the contract documents and made available for inspection. A.S. McGaughan Co., Inc. v. United States, 24 Cl. Ct. 659, 666 (1991), aff’d 980 F.2d 744 (1992).
The failure of the contractor to inspect and analyze documents and test results for “indicated” conditions may defeat a contractor’s type I claim. Id. Furthermore, a contractor must be extremely cautious in its interpretation of the indicated conditions. The indicated conditions are not required to be stated with specificity and detail in terms of amounts and exact location.
A contractor will not recover for Type I changed conditions if the indications in the contract are inherently unreliable. If the indications are incomplete, irreverent to the site, or otherwise so deficient that a reasonably prudent contractor would not rely on them, recovery by the contractor will be denied, except perhaps in cases where no other conflicting information is available to the contractor. See, e.g., Clark v. United States, 5 Cl. Ct. 447 (1984), aff’d, 770 F.2d 180 (Fed. Cir. 1985).
2. Type II
A Type II claim, such as those described in 48 C.F.R. 52.236-2(a)(2), supra, arises where the differing site conditions is an unknown physical condition a the site, of an unusual nature, which differs materially from those ordinarily anticipated and perceived in common construction projects. Spirit Leveling Contractors, 19 Cl. Ct. 84 (1989). A claimant seeking to establish a Type II claim is confronted with a relatively heavy burden of proof. Walser v. U.S., 23 Cl. Ct. 591 (1991). The Claimant has a “duty to conduct pre-bid inquiries or reasonable site inspections inasmuch as recovery is available only if the condition is unknown, which means it would not have been revealed upon inquiry or during a reasonable site investigation.” Appeal of Totem Construction Co., 1990 WL 224243, 91-1 BCA 23 ,585, ASBCA No. 35,985 (1990). Type II claims are generally considered more difficult to prove and less frequently alleged than Type A claims. The differences between a Type I and a Type II claim are explained by one commentator as follows:
[The] second type of changed condition, Type II is available to available to a contractor even though the contract is completely silent about the condition, indicated nothing with respect to it. This second type of changed condition does not involve a comparison between contact indications and actual facts, which is precisely why it is more difficult to prove. When the first type of changed conditions a contractor’s proof generally consists of comparing actual physical conditions encountered at the project site with those indicated in the contract. In the second type of changed condition, however, the contractor must compare the actual conditions at the project site with what the contractor could reasonably have anticipated, taking into account those factors which a prudent, experienced bidder customarily uses in making judgments about site conditions, quantity, quality and methods of performing the particular work. (Emphasis added.)
Kenneth M. Cushman, Bruce W. Ficken and Kenneth I. Levine, Contractor’s Rights and Duties: Bid Disputes and Associated Problems, Differing Site Conditions and Site Inspection Clauses, Change Orders, and Contract Technical Defenses, 391 PLI/Real 61 (1993).
To prove a Type II differing site condition a claimant must establish a combination of two of three required elements:
In Order for [a claimant] to prove a Type II differing site condition, a combination of two of three indispensable element must be established, namely, that (I) the physical condition at the site was unknown; or (ii) said condition was unusual and could not be reasonably anticipated by the contractor from his study of the contract documents, his inspection of the site, and his general experience, it any, in the contract area; and (iii) the condition encountered was materially different from those ordinarily encountered and generally recognized in the work of this character. [citations omitted]. In other words, to prevail on this issue, [a claimant] must prove, by a preponderance of the evidence, either elements #1 and #3 or elements #2 and #3.
Youngdale, 27 Fed.Cl. at 537-38.
The courts have often had occasion to interpret the meaning of “unknown conditions” or Type II conditions in cases involving subsurface conditions. One of the key factors in deciding subsurface issues concerns whether the condition encountered is reasonably foreseeable based upon the conditions of the site. See, e.g., Appeal of L.L. Hall Construction Co., 1962 WL 688, 1962 BCA 3590, ASBCA No. 7627 (1962) (contractor not entitled to compensation for see page of underground water into ditch excavation because job site was in a reclaimed swamp area, which fact was visible on inspection); Cf., Appeal of De Weese Construction Co., Inc., 1971 WL 1229, 71-1 BCA 8726, ASBCA No. 14,444 (1971) (contractor established changed condition where the government’s test borings did not indicate subterranean ground water condition which made compaction of the soil difficult.).
In summation, Type II changed conditions are generally thought to be harder to prove than Type I changed conditions. To proved a Type I changed condition, the contractor need only show a material variance between actual conditions and the indications in the contract. The contractor does not have to establish that the conditions were unusual or not usually encountered in the area. As explained by the court in Charles T. Parker Const. Co. v. United States, 433 F.2d 771, 778 (1970):
Under “category two,” in contrast, the Government has elected not to presurvey and represent the subsurface conditions with the result that a claimant must demonstrate that he has encountered something materially different from the “known” and the “usual.” This is necessarily a stiffer test because of the wide variety of materials ordinarily encountered when excavating in the earth’s crust.
E. CONDITIONS OF A RECOVERY AND THE CHANGED CONDITIONS CLAUSE
Before a contractor will be allowed to recover under a changed conditions clause, he will have to prove compliance with all of the notice provisions or other prerequisites to recovery set forth in the contract documents. The standard differing site conditions clause provides for a notice requirement as part of the procedure for dealing with the differing site condition. For example, the A.I.A. clause requires prompt notice and in no event later than 21 days after first observance of the conditions.
As a general rule, the requirement that a contractor give written notice of a claim has one central purpose: to ensure that the owner gains actual knowledge that the costs of his construction project may exceed the funds he previously allocated. The real purposes of written notice, however, may not always be so simply stated, because the owner may need more than knowledge. More important to the owner than knowing he might be sued, is the ability to make decisions in light of the possibility of increased costs. The ability of the owner to make decisions if prompt notice is given and the prejudice the owner may suffer if notice is not given are the two most important reasons for enforcing a notice requirement. Other purposes include the early investigation of the validity of the claim when evidence is still available, and that the memories of witnesses have not faded.
The notice given to the owner should include two items; first, the basis of the claim, and second, the size (dollar amount) of the claim. See generally, Contract Cleaning Maintenance, Inc. v. United States, 811 F.2d 586 (1987). In one case, for example, the court ruled that a letter to the owner did not comply with the notice requirement because it “merely requested a change in the specifications and contained not a hint of a claim.” Central Penn. Indus. v. Commonwealth, Dep’t of Transp., 358 A.2d 445 n.2(1976).
IV. TERMINATION FOR CONVENIENCE CLAUSE
Attorneys representing owners in construction transactions, who are concerned with the potential adverse effects of a changed conditions clause required by the contractor may wish to protect the owner’s interests through a “Termination for Convenience Clause”. As discussed above, the reason for shifting the risk of differing site conditions to the owner is to remove the incentive to contractors to increase their bids to cover every contingency. Otherwise, the contractor would received a windfall if no problems were encountered. Shifting the risk to the owner, however, exposes the owner to claims by the contractor and to potentially unlimited risks. In order to protect the owner, some jurisdictions allow the owner to stop the project and rescind the contract without being liable to the contractor for damages for breach if the project becomes so difficult, dangerous or expensive that the purpose of the project is frustrated or the project is commercially impracticable. See, Restatement (Second) of Contracts, 261-272.
However, most courts are generally reluctant to apply the doctrine of commercial impracticability to excuse performance unless the difficulty or danger involved is so serious that it would be pointless to go forward with the project. The doctrine generally does not apply if a project is merely more expensive than planned. Moreover, an owner typically cannot determine whether a project is commercially impracticable without litigating the issue. If the owner stops the project and in the court’s opinion there was not sufficient cause to do so, the owner will be liable to the contractor for lost profits. Unless the probable cost overrun is very great, this risk is one the owner may not wish to take.
Therefore, in order to protect the owner from cost overruns without relying on the doctrine of impracticability, a Termination for Convenience Clause should be included in the contract, if you are an owner. The clause limits the owner’s liability in the event that the owner for any good faith reason decides to abandon the project. Such clauses could save owners who are unexpectedly confronted with large cost overruns due to differing site conditions. Such clauses have long been used in federal contracts. The A.I.A. does not include such a termination clause in its general conditions. If an owner using the A.I.A. forms wants to have such a clause, it must be added. A suggested termination clause is as follows:
TERMINATION BY THE OWNER FOR CONVENIENCE
The owner may, at any time, terminate the contract for the owner’s convenience and without cause. Upon receipt of written notice from the owner of such termination for the owner’s convenience, the contractor shall (1) cease operations as directed by the owner and the notice[.]
V. SITE INVESTIGATION CLAUSES
Another clause which owners may wish to included in the construction contract is a “Site Investigation” clause. Such a clause can make a contractor’s recovery under a changed condition clause more difficult by, in effect, stopping the contractor from arguing that actual conditions were different than the conditions he anticipated or should have anticipated. A Site Investigation Clause requires the contractor to investigate the site. It should be noted, however, that such a clause does not constitute a complete annulment of any changed conditions clause which exists in the contract. Examples of site investigation clauses follow.
The Construction Management Association of America, Inc., CMAA Document No. A-3 (1990 ed.) offers the following clause:
4.20 Existing Facilities, Structures and Physical Conditions
4.20.1 The Contractor shall have fully acquainted itself with the type and location of the Work and shall be responsible for having carefully examined and inspected any existing facilities and structures and conditions that may affect the Work, including without limitation those relating to and which may affect: the transportation, handling, delivery and storage of materials; the availability of water and electricity; the availability, condition and use of roadways and other access to the Work; weather conditions; the type and location of surface and subsurface conditions; the type and location of surface and subsurface utility lines at the Project site and those adjacent to the Project site; other contracts to be entered into by the Owner relating to the Project that may affect the Work and require coordinating and scheduling efforts by the Contractor; and the type, availability and storage of equipment, materials or supplies for use in performing the Work. The Contractor shall determine and fully acquaint itself with all regulations, codes, ordinances and provisions of law that affect the Work.
4.20.2 Certain information and data is shown or indicated in the Contract Documents with respect to existing surface and subsurface conditions at or contiguous to the site. The Contractor shall determine the sufficiency of the information and shall conduct additional investigations as may be necessary to fully acquaint itself with the existing conditions or facilities at the site.
4.20.3 The Contractor shall be entitled to rely upon the accuracy of the factual data contained in reports of explorations and tests of surface and subsurface conditions at or contiguous to the site that have been used by the Design Professional in preparation of the Contract Documents and that have been furnished to the Contractor.
The Federal Acquisition Regulations (FAR 52.236-3)(1988) provides:
Site Investigation Conditions Affecting the Work
(a) The Contractor acknowledges that it has taken steps reasonably necessary to ascertain the nature and location of the work, and that it has investigated and satisfied itself as to the general and local conditions which can affect the work or its cost, including but not limited to . . . (4) the conformation and conditions of the ground . . . The Contractor also acknowledges that it has satisfied itself as to the character, quality and quantity of surface and subsurface materials or obstacles to be encountered insofar as this information is reasonably ascertainable from inspection of the site, including all exploratory work done by the Government, as well as from the drawings and specifications made a part of this contract.
The Standard Form of Agreement between Owner and Contractor on the Basis of a Stipulated Price, prepared by the Engineers Joint Contract Documents Committee (1990 ed.), provides as follows:
7.2 CONTRACTOR has visited the site and become familiar with and is satisfied as to the general, local and site conditions that may affect cost, progress, performance or furnishings of the Work.
The A.I.A. General Conditions (1987 ed.), also provides as follows:
1.2.2 Execution of the Contract by the Contractor is a representation that the Contractor has visited the site, become familiar with local conditions under which the Work is to be performed, and correlated personal observations with the requirements of the Contract Documents. The degree of protection offered by a site investigation clause will depend upon the nature of the investigation which would have been needed to discover the differing condition. Generally, only a reasonable investigation, or that which a reasonable, experienced and intelligent contractor could perform, is required. Conditions which could only be discovered by a specialized expert conducting technical investigations such as subsurface boring and core samples, will not be required. See, e.g., S. Head Painting Contractor, Inc., 1982 WL 7032 82-1 BCA 15,629, ASBCA No 26,249. (1982); W.G. Thompson, Inc., HUDBCA No. 79-353-C11, 81-2 B.C.A. (CCH) 15,411 (1981); Ray D. Lowder, Inc. v. N.C. State Highway Commission, 217 S.E.2d 682 (N.C. Ct. App.) Cert, denied, 218 S.E.2d 467 (N.C. 1975). In public contracts it is especially likely that a contractor will be strictly bound to investigate of suffer the consequences from the failure to do so, given the equitable consideration involved in safeguarding the government and public from high costs. See, e.g., Branna Construction Corp. v. West Allegheny School Authority, 242 A.2d 244 (Pa. 1968).
VI. LIQUIDATED DAMAGES CLAUSES
Another clause which owners can include in the contract for their protection is a liquidated damages clause. Such a clause will be upheld if reasonable under the circumstances, where damages are difficult to ascertain, and if it does not operate as a penalty. The “party alleging that the liquidated damages assessed are excessive or unreasonable must bear the burden of proving that said damages are inappropriate” Nevertheless, a court is likely to decline to uphold the liquidated damages caused where the owner has not acted reasonably in attempting to mitigate costs to the contractor, or if the owner prevents or delays performance. Id..
VII. EXCULPATORY CLAUSES
Contracts frequently contain broad exculpatory clauses in which the owner disclaims any liability for the accuracy of its plans, specifications, boring and other subsurface data. However, courts normally will not allow such clauses to eliminate the relief provided to the contractor by a differing site conditions clause.
Nevertheless, some courts do take a hard line in upholding and enforcing such disclaimers to protect owners. For example, in Costanza Construction Corp. v. City of Rochester, supra, the court enforced the disclaimers in a public improvement contract for a street, rejecting the contractor’s differing site conditions claim. The drawings for the project estimated twenty (20) cubic yards of rock. The contractor, in fact, removed over 600 cubic yards of rock. The contract contained a disclaimer stating that the City was not responsible for the information about the site and obligated each bidder to perform its own site investigation. The court went so far as to hold that the disclaimer protected the City from nondisclosure of old sewer maps that showed additional rock in the project area. Two justices dissented, arguing that the difference between the estimated 20 yards and actual rock quantities was so great that the contract was no longer viable. The dissenting justices felt that it was unconscionable to hold the contractor to its obligations without and equitable adjustment. The case demonstrates the risk shifting potential of exculpatory clauses, particularly where judges want to protect public funds and public entities.
Courts will not always strictly enforce owner disclaimer clauses or other owner protections when an independent site investigation by the contractor is not feasible. For example, in I.A. Construction Corp. v. Dept of Transportation, 591 A.2d 1146 (Pa. 1991) the contractor entered into a subcontract whereby the subcontractor was to dig a pipe trench. The contractor and subcontractor both relied upon a drawing that was make a part of the contract. The drawing contained no indications of any obstructions. Immediately after commencing excavation, the subcontractor was confronted with a number of obstructions below the surface, including utility lines and large iron pipe. The contractor asserted claims against the Department of Transportation (DOT) and the State Board of Claims ordered DOT to pay damages. The DOT appealed. Based on a site investigation clause in the contract wherein the contractor warranted that he had time to examine the site of the work, the Department of Transportation argued that it made no misrepresentations about subsurface conditions. In rejecting the DOT’s attempt to use the disclaimer language, the court stated that “if the investigation required by the contract could not reasonably have been performed, those provisions cannot be used to deny recovery to a contractor.” This case represents a more reasonable approach to interpreting these disclaimer clauses. By considering not only the express language of the clause but also the realities in the construction industries, the court achieved a more equitable result.
VIII. ALLOCATION OF RISK CLAUSES
In some cases the owner may not be willing to accept the risk of unforeseen site conditions. For example, smaller owners who, unlike a governmental entity or large corporation, may be more interested in a firm price (even if it is high) than in suppressing overall bids on a large number of projects. A one-project owner does not have the consolation that lower bids are being received on all other projects. An owner who is willing to pay for a firm price can insist on a contract clause that shifts all of the risk of cost overruns caused by changed conditions to the contractor. A contractor who agrees to such a clause should be prepared to conduct a thorough site investigation. A contractor should negotiate for enough time to complete the investigation and analyze it before submitting final construction bid prices. Such a clause, to be effective, should protect the owner from claims based on implied warranty, mutual mistake, impossibility, impracticability, or unjust enrichment.
IX. ASSESSMENT OF DAMAGES IN DIFFERING SITE CONDITION CASES
In order to understand the importance of addressing potential differing site conditions in contracts, it is helpful to determine the extent of potential damages if these issues are not adequately addressed in the contract. An excellent source for determining the types of damages which may be available to a contractor seeking recovery on a claim of differing site conditions is the case of Youngdale & Sons Constr. Co., Inc., v. United States, 27 Fed Cl. 516 (1993). In this case, the court held that the Plaintiff contractor had failed to prove either a Type I or a Type II differing site condition as to rock, but had established the existence of a differing site condition with regard to water. After making this determination, the court reviewed “what method of recovery” the Plaintiff was entitled to utilize in calculating its damages. Id. at 540.
A. Total Cost Method: (Total cost less bid price)
The court first discussed the “total cost method’ for calculating the contractor’s damages. The amount of damages recoverable under this method “is roughly equivalent to the total actual costs incurred in performing the contract less the contractor’s bid price.” Id. at 541. The total cost method of damages, however, is highly disfavored by the courts because it assumes “that every penny of the plaintiffs’s costs are reasonable, that the bid was accurately and reasonably computed, and that the plaintiff is not responsible for any increases in costs.” Id. Thus, the total cost method is only utilized “where no other means of accurately computing damages are available” or “in extreme cases where it is difficult or impossible to identify specific increases in cost with the action of the defendant.” Id.
The Youngdale Court explained that as a safeguard against frequent utilization of the total cost method, courts have developed a set of criteria which a plaintiff must establish in order to secure recovery under the Total Cost approach. Basically, in order to utilize the total cost method, a plaintiff must establish the following 4 requirements for Total Cost:
(i) The impracticability of proving actual losses directly; (ii) the reasonableness of its bid; (iii) the reasonableness of its actual costs; and (iv) the lack of responsibility for the added costs.
Id. Moreover, even where these four elements are met. A plaintiff has the burden of proving its damages by a preponderance of the evidence. Id.
B. Modified Total Cost Methods: (Total cost modified for any deficiencies of the 4 requirements for Total Cost)
A second method for determining a contractor’s or plaintiffs’ damages, where any one of the elements required to utilize the total cost method have not been met, is the “modified total cost” method. The modified total Cost method:
This is simply the total cost method modified or adjusted for any deficiencies in the plaintiff’s proof in satisfying the four requirements of [the total cost] method. [citation omitted] In other words, to the extent that the court modifies any of the four prongs of the total cost test, the court has, in actuality, utilized the modified total cost method as opposed to the total cost method. [citation omitted]. The theory behind the modified approach is that, in order to prevent the government from obtaining a windfall stemming from the plaintiff’s inability to satisfy all the elements of the total cost method, the court will modify that test, so that the amount would have been received by the plaintiff under the total cost method is only the starting point from which the court will adjust the plaintiff’s recovery downward to reflect the inability to prove any of the aforementioned four elements.
Id. [citations omitted].
C. The Direct Cost Method
Given the plaintiff’s deficiencies in proof, the Youngdale Court determined that the plaintiff was not entitled to calculate its damages pursuant to either the total cost method or a Modified total cost method. Thus, “the sole viable alternative is the direct cost method.” Id., The Youngdale Court determined the plaintiff’s damages under a “direct cost’ method by simply reviewing the plaintiff’s claim against the government for costs sought for the excess water and rock differing site conditions which the government itself conceded, as verified in an audit report, to have been $210,433.00. The Youngdale Court also added to this amount, other costs which the court felt should be allowable.
D. Other Methods
Other methods of recovery mentioned but not discussed in the Youngdale case include the Productivity Comparison method, the Jury Verdict method, and the Costs Plus method.
The “costs plus” method involves assessing “the costs of extra work proven by the contractor, plus a reasonable profit . . . recoverable in quantum meruit for changes and modifications in the plans agreed to by the parties.” CKP, Inc. v. GRS Construction Co., 821 P.2d 63 (Wash. Ct. App. 1991). A “jury verdict” is not favored, but is allowed where: “(1) there was clear proof that the contractor was injured, (2) there was no more reliable method of computing damages, and (3) the evidence was sufficient to make a fair and reasonable approximation of the damages.” Jack L. Olsen, Inc. v. Espy, 26 F.3d 141 (Fed. Cir. 1994). The “productivity comparison” method “makes a comparison between a normal production period and the impacted production period, which difference is usually expressed as a percentage.” Jack L. Olsen, Inc. supra.
E. Interest on Awards
The Youngdale case also discussed a date upon which interest on a contractor’s damages begins to accrue. Specifically, under 41 USC 611, where the contractor is working for the federal government, interest accrues from “the date the contracting officer receives the claim . . . from the contractor until payment thereof.” Youngdale, 27 Fed. Cl. at 561. To this analysis, the Youngdale Court explained the added requirements that the claims submitted to the contacting officer must “be appropriately certified and quantified to be a proper claim sufficient to activate the running if interest [.]” Id. At 562. Certification means that the claim must be signed by a company official; quantification means that the claim must “demand . . . the payment of money in a sum certain [.]” Id.
X. INDEMNITY CLAUSES
Indemnity agreements are usually a standard feature of “boiler plate” provisions in construction contracts. They are often imposed on the party of inferior bargaining position with owners at the top and subcontractors and suppliers at the bottom. Indemnity agreements are closely related to insurance contracts both in function and in effect.
An example of a common indemnity agreement protecting the owner follows:
Contractor acknowledges that it is an independent Contractor and agrees to indemnify and hold harmless the Owner against loss or threatened loss or expense by reason of the liability or potential liability of the Owner for, or arising out of, any claims for damages, including but not limited to bodily injuries, death, or damage to property due to any act or omission of the Contractor, its employees, or agents arising out of this agreement.
O-C [Owner-Contractor] Clause 6.13(1), from Samuel Frank Schoninger, Drafting Construction Contracts, 151 (Wiley Law 1990).
Interpretation and enforcement of indemnity clauses is complicated by opposing policy concerns. One policy is to enforce contracts according to their terms. Another it to avoid the inequitable enforcement of contracts of adhesion, i.e., standard contracts imposed on a party of weaker bargaining strength. Yet another public policy is to discourage wrongful conduct, and indemnity agreements seem to encourage negligent acts by the indemnitee, since he has nothing to lose.
A. Indemnity Against Own Wrongdoing
Some courts find it reprehensible that a party should seek to be protected from the result of his own negligence. Others see such protection as a form of insurance that is beneficial to commerce. Some courts strictly construe such clauses while others accord them a liberal construction. In some states, the public policy as to the construction of such agreements is controlled by statue. An Illinois statute provides that every covenant in a construction contract to indemnify another person from that person’s own negligence is void as against public policy and is wholly unenforceable. By Minnesota statute, such agreements entered into after 1984 are void.
The Massachusetts Supreme Court gave a liberal interpretation to indemnity clauses in the 1981 decision of Shea v. Bay State Gas, 418 N.E. 597 (Mass. 1981). A liberal interpretation was also accorded to an indemnity clause by the Alaska Supreme Court in CJN Construction v. Chandler Plumbing, 708 P.2d. 60 (Alaska 1985). A worker fell through a hole drilled by the subcontractor and was injured. A subcontract provision required the subcontractor to indemnify the prime contractor from damages incident to the subcontractor’s performance. The court found that a rule of reasonable construction applies to indemnity provisions since they are very common in the construction industry. The court also noted that insurance was available to the subcontractor to cover its potential liability. Also the subcontractor could have passed the cost of this insurance on to the prime contractor.
Some states interpret indemnity agreements to protect against passive but not active negligence. In a 1980 California decision; Armco Steel Corp. v. Roy Cox, Co., 163 Cal. Rpter.330 (Cal. App. 1980) a painting contractor’s employee suffered a fall from a ladder when an employee of the owner activated a large industrial fan. The fan blew air threw the room at 50 mph. The owner sought indemnity under a contract clause with the contractor. Since the owner’s negligence was active, the court found that the owner was not entitled to indemnity by the contractor. Other cases do not allow indemnity for the sole negligence of the indemnitee, the party injured. Bethleham Steel v. Zarnas & Co., 498 A2d. 605 (Md. Ct. App. 1985). It is important to note the importance of timely notice of any claim for indemnity. An indemnitee, when sued, must give prompt notice of the claim to the indemnitor and allow the indemnitor an opportunity to defend the suit. The courts have held that notice is a clear pre-requisite to performance under indemnity clauses. Only with timely notice can a party be in a position to promptly investigate the claim and prepare an adequate defense. Cochrane Roofing and Metal Co., v. Callahan, 472 So. 2d. 1005 (Alabama 1985).
B. Implied Indemnity
The doctrine of Implied Indemnity is also called implied equitable indemnity and common law indemnity. The doctrine is of recent development and is constantly changing. It is usually applied between co-defendants, one of whom, in justice, ought to indemnify the other for liability caused by the idemnitor’s active or primary fault. In some cases the doctrine may be implied based upon the degree of fault. In a 1983 California decision, Valley Circle Estates v. VTN Consol., Inc., 189 Cal. Rptr. 871 (1983), the owners filed an action against a subdivider when their home was damaged by soil subsidence. The subdivider filed a cross claim for equitable indemnity against the engineer who prepared the grading plan. The court found that the obligation of the implied indemnity is a matter of fairness, and to impose on the subdivider, the liability of its engineer, not only would be unfair, but could deter beneficial activities in the construction industry. Application of the doctrine of Implied Indemnity enables a contractor to seek indemnity from the party primarily responsible for the damages suffered by a home buyer. Under the principle of contribution, a joint tortfeasor against whom judgment is entered is entitled to recover proportional shares of the judgment from other tortfeasors whose negligence contributed to the injury and who were also liable to the plaintiff.
XI. NO DAMAGES FOR DELAY CLAUSES
A no damages for delay clause provides that, in the event the contractor is delayed in the performance of the work by any act of the owner or the owner’s agents, then the contractor is entitled to an “extension of time” for the performance of the contract, but not to recover damages for delay from the owner. In other words, the no damages for delay clause provides that a time extension is the contractor’s only remedy and the owner is not liable to the contractor for payment of extra compensation or damages by reason of delay. Such no damages for delay clauses are disfavored, and will be strictly construed to avoid forfeitures. Courts have exercised great ingenuity in formulation exceptions to the strict enforceablilty of the clause.
For example, in Corinno Civetta Construction Corp. v. City of New Youk, 493 N.E. 2d 905 (NY 1986), the New York Court of Appeals gave a detailed analysis of circumstances under which a no damages for delay clause may be enforced. The court held that such clauses are enforceable. However, even when such a clause is in effect, damages may be recovered for (i) delays caused by the owner’s bad faith, or willful, malicious, or grossly negligent conduct (rising to the level of active or willful interference) (ii) delays not contemplated by the terms of the clause, (iii) delays so unreasonable that they constitute an intentional abandonment of the contract, and (iv) delays resulting from the owner’s breach of a fundamental obligation of the contract.
In L.S. Hawley v. Orange County Flood Control District, 27 Cal. Rptr. 478 (1963) the court held that a contractor could recover extra costs caused by the owner’s unreasonable delay and owner’s failure to provide necessary revisions to correct design errors in the plans and specifications (in spite of no damages for delay clauses). Hawley noted that “no damage for delay” clauses will be enforced unless the delay was not contemplated by the parties, was unreasonable in duration, resulted from a breach of contract, or resulted from the owner’s interference with the contractor’s work.
These are the most common and traditional exceptions to a “no damage for delay” clause. Less common, non-traditional exceptions include the “Cardinal Change” rule, holding that a drastic or fundamental change to the contract’s scope constitutes breach of the contract and entitles the contractor to resultant delay damages, and the “First to Breach” rule, under which, if the contractee had breached some other material contact term, he man not be entitled to rely upon the protections of exculpatory language found elsewhere in the contract. These non-traditional rules are discussed in Richard G. Thomas and Fred D. Wilshusen, How to Beat a “No Damage for Delay” Clause, Construction Lawyer, January 1989 at 17.
Whether one relies upon traditional or non-traditional means for overcoming a “no damages for delay” clause, there is no guarantee of success. The clause will be enforced if the plaintiff’s theories are not found to be applicable. See, e. g., Allen-Howe Specialities Corp. v. U.S. Constr., Inc., 611 P.2d 705 (Utah 1980)(upholding award of summary judgment against Electrical subcontractor’s claim for delay damages on hospital renovation project where contract contained a no damages for delay clause and allegations of tortuous misconduct on part of the owner’s assignee did not constitute the type of active interference which would prevent enforcement of the clause); Kalish-Jarcho, Inc. v. City of New York, 488 N.E.2d 413 (N.Y.1986)(requiring contractor to demonstrate that owner’s conduct amounted to gross negligence, not just active interference, before allowing recovery for delays due to no damage for delays clause).
XII. CONTINGENCY PAYMENT CLAUSES IN SUBCONTRACT AGREEMENTS
One of the most contentious and dispute ridden aspects of the subcontract relationship centers upon the question of whether the general contractor or the subcontractor should bear the ultimate risk of the potential failure of the owner to fully pay the prime or general contract amount. The subcontractor’s right to receive payment is sometimes conditioned upon the contractor’s receipt of funds from the owner for subcontractor’s work.. Such a provision, commonly referred to as a “pay when paid” or “pay if paid” clause seeks to condition the contractor’s payment obligation upon its receipt of funds from the owner. Subcontractors, of course, generally object to such clauses as they have no direct contractual relationship with the owner and thus have no ability to evaluate the risk of owner non-payments. In addition, owner nonpayment may reflect a number of factors, such as disputes between the owner and the contractor, which may not involve the subcontractor’s work.
Judicial treatment of conditional payment clauses varies widely in different jurisdictions. Generally, courts are very reluctant to enforce contract terms that result in a forfeiture or the loss of the right to payment for work actually performed by the subcontractor. If the payment language is open to more than one interpretation, the courts’ abhorrence of a forfeiture typically prevails, such that the subcontractor will be held to be entitled to payment. For example, if the payment provision requires the contractor to “promptly” pay its subcontractor upon receipt of monies from the owner, or to make payment within a certain “number of days” after payment is received from the owner, the court is likely to characterize the provision as a “pay when paid” clause, and hold that it governs the timing of the payment, not the obligation to make the payment. Under a “pay when paid” clause, so construed, the contractor retains the risk of owner nonpayment, and is obligated to pay its subcontractors within a reasonable time after the subcontractor has performed its work, regardless of whether payment from the owner has been received.
The leading case interpreting a conditional payment provision I n this manner is Thomas J. Cyer Co. v. Bishop, Int’l Eng’g Co., 303 F.2d 655 (6th Cir. 1962). In this case, the general contractor was building a race track in Kentucky. Dyer was hired to perform mechanical work on the project and was owed over $100,000.00 when the owner went bankrupt. The subcontract provided that “no part of the subcontract shall be due until five days after owner shall have paid contractor therefore.” The court noted that “the solvency of the owner is a credit risk necessarily incurred by the general contractor” whereas a subcontractor “is primarily interested in the solvency of the general contractor with whom he has contracted. He looks to him for payment.” The Dyer approach has been adopted by the Restatement (second) of Contacts, at section 227. Approximately 25 states have adopted this majority rationale, including Arizona, Colorado, Oregon and Washington. Other jurisdictions, such as New York and California have found that condition precedent payment clauses in a subcontract are simply void and unenforceable because they violate the public policy embodied in the mechanics’s lien statues. See Westfair Electric Contractors v. Aetna Casualty and Surety Co., 661 N.E. 2d 967 (NY 1995).
In marked contrast to the foregoing, a minority of courts considering these issues have elected to focus solely on the conditional payment language. If the language conditions the subcontractor’s right to payment upon the contractor’s receipt of funds from the owner, then in these few courts, the subcontractor is not entitled to payment until the contractor is paid. A distinct minority of jurisdiction, including 1. Georgia, 2. Connecticut, 3. Illinois and 4. Tennessee, make absolutely no distinction between “pay when paid” or “pay if paid” subcontract language, In these jurisdictions, even the mildest form of payment language may be sufficient to indicate the parties’ intention that receipt of payment from the owner is an absolute condition precedent to the subcontractor’s entitlement to payment.
Five states have addressed conditional payment provisions by way of statute. 1. North Carolina statutes declare pay if paid and pay when paid clauses unenforceable. 2. Wisconsin adopted this rational in 1992, enacting a statute stating that any provision in a contract pertaining to the improvement of land is void if the provision seeks to make payment to a general contractor or condition to a general contractor’s payment to a subcontractor or a supplier. 3. Illinois and 4. Maryland do not expressly bar such clauses, but instead provide that the subcontractor retains its lien rights, notwithstanding the presence of such a clause. 5. Missouri followed this trend in 1995.
When examining and negotiating construction contract clauses, practitioners must be aware of how different clauses shift and allocate the risks of a construction project between owners, contractors, subcontractors, architects, engineers, and other parties to the construction project. Parties who are fully aware of how the risks of the project are allocated will better able to make informed decisions regarding fair contract prices, and the importance of other steps to protect one’s interest prior to commencement of the construction project.
For example, differing site conditions clauses enable contractors to avoid the potentially harsh common law rule requiring completion of the project at increased cost due to unforeseen conditions, and shift the risk of changed conditions on site to the owner. In response, owners may wish to include contractual provisions requiring site inspections by contractors prior to commencement of the project, or other clauses to protect the owner’s interests. Other potential risks may likewise be allocated between the parties in accordance with their relative positions. For example owners of several potential construction projects, such as large corporations or public entities may prefer to allow contractors an escape clause from the onerous possibilities of changed site conditions in return for generally lower contract prices, where single-project owners may be more interested in a set price for the construction project, even if the price is established at a higher rate to address the risk of changed conditions. Contractors and subcontractors will wish to address who bears the risk of non-payment by the general contractor. Parties with greater bargaining power should be aware that contract provisions which are unduly harsh maybe unenforceable as unreasonable. It the contract is held to be one of adhesion.
In formulating and agreeing upon the contract terms which address these risk allocation questions, attorneys, contractors and owners will often turn to “form contracts” for standard language. When utilizing such forms, attorneys and their clients should ensure that they are keenly aware of how the form contract allocates potential risks (and on whose behalf the contract forms were drafted), the nature and degree of those risks, the degree to which the contract’s clauses will be enforced by the courts, and the manner in which the contract price should be affected by the risk allocation choices made within the contract.
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Note: This article, and any other information you obtain at this website, is not offered as legal advice, nor should it be relied upon as such, nor is it a solicitation for legal services. Only a licensed attorney can advise you with respect to your specific legal needs. We welcome your contacting our firm to discuss such representation. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.