A Key Battleground: Material Price Escalations and Supply Chain Disruptions

Colm Nelson | Stoel Rives

Material price escalations and supply chain disruptions are hot topics in the industry, with many clients inquiring about their rights and how these risks should be shared. Some have even questioned whether their projects should proceed given the volatility in the market.

For instance, I saw at least one project’s price increase by over $10 million in a matter of months due to the precipitous price increase in lumber. The resulting sticker shock was mitigated somewhat by the recent drop in lumber prices. However, the developer and contractor team were not alone in asking whether the project should proceed and, if so, who carries the risk of future price changes and/or supply chain delays.

Generally speaking, under a standard Guaranteed Maximum Price (GMP) contract, such as the American Institute of Architects’ A102/A201 combination, the contractor is guaranteeing its price against price escalations – i.e., this is a contractor risk. This risk allocation can be adjusted through a variety of methods, including the use of: 1, allowances; 2, contingency; 3, savings bonus; or 4, specifically tailored risk-sharing provisions, addressing both compensation adjustments and/or time adjustments.

How allowances and contingency work in concert, and what those terms mean, differs even among sophisticated contracting parties. For many in the Pacific Northwest, an allowance is merely a placeholder for the expected “Cost of the Work.” If the allowance item costs more than the placeholder, the GMP is increased. If it is less, then the owner should get a deductive change order.

However, industry standard forms like the AIA A201 don’t treat allowances this way and in fact state that “Contractor’s costs for unloading and handling at the site, labor, installation costs, overhead, profit and other expenses contemplated for stated allowance amounts shall be included in the Contract Sum but not in the allowances” – i.e., no increase in the GMP for additional time or labor related to the allowance item.

Under the AIA approach, the contractor would get more, for example, for the price of the door, but wouldn’t be allowed to seek an increase for the time it took to install it. Contingency for some owners and contractors is simply padding to cover additional costs of the work until the GMP ceiling is exhausted. For others, contingency is solely for discrete items, and only to be used upon advance written approval by the owner. Many contractors prefer to list price escalations in materials as an approved use of contingency.

When contract discussions become logjammed over risks that neither party can control, finding an outcome where both the owner’s and contractor’s interests are aligned is sometimes the best way to advance discussions. That often means a sharing of risk to some degree, full transparency by both sides, and even sharing in any savings for effective materials and subcontractor buyouts. Alternatively, if the owner is not willing to share in the risk, which is not uncommon, it should expect the contractor to ask for a higher fee for taking on that risk, or price padding on certain line items.

Supply chain disruptions and resulting delays are treated differently and separately from price escalation risks. Unusual delay in deliveries is generally a basis for a contract time adjustment under most industry-accepted contracts. This is important to contractors because, without the adjustment, they could face liquidated damages or other delay liability.

Who pays for the extended costs resulting from the delays is a more difficult question and not squarely addressed in the AIA A201. Owners feel they are already losing money because of the late delivery (time is money), and contractors question why they should carry the costs.

Historically, given the economic risks to the owner resulting from delay, contractors typically agree to limit their recovery to a time extension and/or expressly negotiate a contingency line item to cover this risk. Also, because contractors are in a better position to control timely subcontractor buyouts and coordination of work among subcontractors, including through the use of float, some argue that contractors should carry this risk. In other words, the party in the best position to control a risk should be the party who bears it.

While not uncommon in other industries, insurance products to cover price escalations in materials are not commonly used in the construction industry. However, sensing the stress in the marketplace due to lumber prices, insurance products are now being offered for those interested in “hedging” risk against future price fluctuations. As we work through the consequential effects of the pandemic on supply chains, it will be interesting to see if the use of these products proliferates through the market. As with bonds, which are rarely used on private projects below $100 million, the cost and ability to timely collect on such products will dictate whether owners and contractors are interested in hedging their bets in this fashion.

You’ve Gotta Fight For Your Right To Get Paid: The Right To Stop Work

Amy Elizabeth Garber and Eric A. Frechtel | Buildsmart

A contractor is halfway through the (timely) completion of a project and the owner’s payment is late. Days, weeks go by, and now the contractor is incurring all the costs of the work without any compensation. It might be tempting to simply walk off the job, but bear in mind that legally speaking, that might constitute the “first breach,” even if the owner is late on payment. Enter: the stop work clause.

The optimal stop work clause clearly provides the contractor the right to suspend its work if the owner fails to pay after a certain amount of time, and then get a time extension for any delays resulting from the suspension. The standard AIA language has it all and can be easily tailored to a contract’s payment mechanisms:

If the Architect does not issue a Certificate for Payment, through no fault of the Contractor, within seven days after receipt of the Contractor’s Application for Payment, or if the Owner does not pay the Contractor within seven days after the date established in the Contract Documents, the amount certified by the Architect or awarded by binding dispute resolution, then the Contractor may, upon seven additional days’ notice to the Owner and Architect, stop the Work until payment of the amount owing has been received. The Contract Time shall be extended appropriately and the Contract Sum shall be increased by the amount of the Contractor’s reasonable costs of shutdown, delay and start-up, plus interest as provided for in the Contract Documents.

Remember, the more details the parties include upfront in the contract, the less there is to argue over later.

Note that there are arguments a contractor can make to justify walking off the job: it was impossible to continue working without payment for labor and materials; the owner’s nonpayment was such an egregious breach that it nullified the contract; or, major subcontractors walked off, too. While some of these may win the day, without clear contract language justifying stopping work, doing so is a gamble.

Contract Drafting Tip: “LEED” Damages and the Waiver of Consequential Damages Clause

David A. Blake | Seyfarth Shaw

Potential Damages

Potential damages arising from the failure to achieve statutory or contractual requirements concerning Leadership in Energy and Environmental Design (LEED) or other green building standards are far ranging and may include: fines, loss of financing or tax incentives, loss of tenants, decreased building value, decreased worker productivity, and increased utility costs.

Direct v. Consequential Damages

Damages are often characterized as direct or consequential. Generally speaking, direct damages are foreseeable and naturally and ordinarily follow the breach, whereas consequential damages are unforeseeable to the breaching party and result from special circumstances. For example, if you were in a car accident, the damage to your car and medical expenses to treat whiplash would be direct damages. If you were on your way to a job interview and lost the job because you missed the interview due to the accident, the lost wages would likely be consequential damages. In our context, a fine arising from the failure to achieve a statutory LEED requirement, such as Silver certification, is probably a direct damage. However, the loss of revenue due to tenants who back out of leases because the building is not LEED certified may be a consequential damage.

Why the Characterization of the Damages Matters

Contracts often contain a mutual waiver of consequential damages provision.  For example, AIA® Document A201™ – 2017, which contains general conditions used for certain AIA construction contracts, states as follows in Section 15.1.7:

§15.1.7 Waiver of Claims for Consequential Damages

The Contractor and Owner waive Claims against each other for consequential damages arising out of or relating to this Contract. This mutual waiver includes

.1 damages incurred by the Owner for rental expenses, for losses of use, income, profit, financing, business and reputation, and for loss of management or employee productivity or of the services of such persons; and

.2 damages incurred by the Contractor for principal office expenses including the compensation of personnel stationed there, for losses of financing, business and reputation, and for loss of profit, except anticipated profit arising directly from the Work.

This mutual waiver is applicable, without limitation, to all consequential damages due to either party’s termination in accordance with Article 14. Nothing contained in this Section 15.1.7 shall be deemed to preclude assessment of liquidated damages, when applicable, in accordance with the requirements of the Contract Documents.

To the extent “LEED” damages constitute consequential damages, this language likely waives the right to recover those damages.

Contractual Options

How you view the waiver of consequential damages provision depends upon who you are. Contractors benefit from the waiver and will not want to change it with respect to LEED damages. On the other hand, developers and owners are the ones who may be unable to recover certain LEED damages due to the waiver, so they may want to change it. The most beneficial change for the developer and owner might be to state LEED damages are excluded from the scope of the waiver. However, the increased risk placed on the contractor may drive a higher fee. A middle ground is to exclude LEED damages from the scope of the waiver, but cap the contractor’s liability for such damages. A more subtle approach a developer or owner may consider is to identify the various types of LEED damages in a section of the contract and state they are foreseeable. This would be used to later argue those damages are not consequential damages because it was agreed they are foreseeable, and therefore they are not within the scope of the waiver of consequential damages clause.       

Final Thoughts

Damages are only relevant if there is liability. Achieving a required level of LEED certification or other green building standard typically involves the duties and responsibilities of several parties, such as owner, designer and contractor. As a result, usually it is not appropriate to state in a contract that the contractor will be liable if the project does not achieve the specified green standard any more than it would be appropriate to state up front that the contractor will be liable if the project is late, because there could be excusable delay. A better approach is to identify the parties’ respective responsibilities for achieving a green building standard and provide that they will only be liable to the extent the standard is not achieved due to their failure to meet their obligations.

Soaring Construction Material Prices: Tips for Reducing Ever-Increasing Costs

Freddy Munoz and Brett Moritz | Peckar & Abramson

The impact of these price increases is being felt across a wide spectrum of projects and is beyond what could have reasonably been expected.

Between the onset of the COVID-19 pandemic in March/April 2020 and mid-May 2021, lumber prices have risen an incredible 308% according to Yahoo News. Steel prices have also risen over 60% according to Trading Economics. These increases, among others, led the Associated General Contractors of America to issue a construction inflation alert, something that the group had not done since 2008. While the reasons for the price increases are too numerous for this article, the question remains: how can construction industry participants minimize the risk of ever-increasing prices?

The impact of these price increases is being felt across a wide spectrum of projects and is beyond what could have reasonably been expected. It is not just owners, contractors, subcontractors, and material suppliers on commercial and civil projects who are feeling the brunt of this price inflation—average consumers are also being affected. As an example, if you recently purchased a house or are in the process of a small renovation project, you have probably been impacted by the rapidly increasing materials costs. But how can the risks associated with the increasing costs be managed effectively to mitigate the risk is the question? This article provides a few recommendations.

  • Read and Re-Read Your Contracts

The first step in analyzing most risks, and particularly those associated with rising material costs, is to look at the document(s) that addresses which party bears that risk. In most situations, it’s the written contract between the affected parties. In the case of an owner and contractor it’s typically the prime contract. However, downstream agreements between the general contractor and subcontractors may also include risk shifting provisions that bear on these issues as well. Often, project personnel responsible for managing these issues may not even be aware of the relevant provisions in the pertinent agreement, in part because materials costs have not risen this quickly in over a decade. Therefore, a careful and thorough review of your contracts should be conducted by personnel with relevant training and experience to determine how the risk of escalating material costs are to be borne by owner, general contractor, Subcontractor, or even the vendors. 

  • Active Cost Monitoring (Project Meetings)

Recommendation number two can be summarized as follows: Be proactive! One of the best ways to handle this unique situation is to ensure that all project participants have the most complete and up-to-date pricing information before decisions are made. While it may sound simple, weekly, or even daily project meetings/conferences can help companies manage the process. Frequent meetings/conferences keep project staff focused on managing this risk by, among other things, keeping in touch with vendors, potentially allowing for opportunities to lock in prices early by buying out the critical material supplies as soon as possible and perhaps most importantly, shortening the decision making process. In situations where vendors and suppliers can or will only keep a quote open for short time periods, it is imperative for responsible project managers and representatives to be able to make decisions quickly with the requisite approvals needed internally. 

  • Preparation of Template Change Orders/Notice Letters

Regardless of the contract provisions at play, it is a good idea for companies to be aware of and plan for the preparation of proposed change orders and notice letters for increased materials costs. Again, it is important to review the relevant contract language, but it’s an equally important to prepare template change orders and letters so they are readily available and easy for the project team to finalize and send out when needed. This is especially important when it comes to notice letters because contracts may require notices be sent within very short timeframes from the discovery of the conditions giving rise to the claim or request for a change order. In those situations, template notice letters can be a life saver for the project team and especially where multiple notices need to be prepared and sent in or around the same time. Oftentimes, these template notices can also be modified and used for other unexpected conditions, including, for example, COVID-19 pandemic related issues.  

  • Negotiate Price Escalation Into Your Contract

Now more than ever before you should make sure that you are addressing price escalation risks in your contracts. Be creative. Consider allowing for price increases between the time the contract is signed and when material orders will generally be placed. This can protect you when material prices increase significantly after the contract is signed but before the materials are actually ordered. The better prepared and more proactive you are, the more likely that other parties will be willing to work with you to find solutions for these increased risks. 

It is highly unlikely that anyone can predict with certainty when materials costs will stabilize, but the more proactive you are in dealing with this situation, the better equipped you will be to deal with its impact. Also, consider that these strategies can be modified and applied to other potentially disruptive events that can unexpectedly impact a project.

Back to (Construction) Work after COVID

Meredith Freeman | Shutts & Bowen

As the nation begins the slow road to recovery following COVID-19 and initiates a return to the workplace, the construction industry – which has proven to be one of the most resilient industries throughout the pandemic – will continue to build momentum and evolve from the lessons learned over the last year.

At the onset of the pandemic, the construction industry and construction workers were quickly deemed ‘essential’ and were largely uninterrupted by lock down and mandatory stay-at-home orders. However, the COVID-19 crisis hit labor-intensive sectors of the construction industry quickly, with outbreaks seriously impacting productivity and presenting a health and safety risk to work crews. These threats to the safety of workers and overall project integrity were further escalated by other problems, including the delay or cancellation of projects, as well as global disruption to the supply chain and massive material shortages. In some ways, construction never stopped, however, the impact from such unprecedented challenges has rippled across the industry.

Low interest rates and dwindling supply in the single-family home market sent demand for new construction through the roof. Amid the ongoing housing boom and subsequent uptick in construction, the industry is plagued with material shortages, price spikes and increased lead times. Proactive companies are finding creative solutions to deal with these issues, seeking to reconnect with people who can help their businesses thrive in a post-COVID economy.

New market dynamics in the post-pandemic environment point to several trends in the construction sector, including:

  • An initial decline in retail/restaurant construction;
  • An increase in warehouse demand;
  • An increase in public construction projects;
  • A mass residential exodus of people from metropolitan areas; and,
  • An increase in companies relocating to new geographies.

As momentum continues to build in the industry, construction companies have engaged in new strategies and operating procedures to rally for long-term success. They have increased their focus on stabilizing and managing supply chains, the adoption of new technologies and efficiencies, off-site and modular construction, cybersecurity measures, adaptive reuse and refurbishment projects for existing structures, as well as implementing pandemic-specific contract clauses to mitigate potential damages. Importantly, proactive construction companies are protecting themselves through legal means to circumvent the unavoidable delays caused by COVID-19’s ripple effects. Key contract terms addressing entitlement to schedule relief, spikes in material costs, contract performance obligations and delay clauses, suspension of work and termination for convenience clauses, among other provisions, allow construction businesses to operate safely in the still volatile marketplace and guard against inflation, long-lead times and continued disruptions in the supply chain.

Most importantly, people in the construction industry are reconnecting and reaffirming the professional relationships that made them successful before the pandemic, including clients, prior joint venture partners, other industry players (i.e. subcontractors, engineers, architects, general contractors, suppliers) and attorneys. These relationships can be critical to supporting existing revenue streams, expanding into new market sectors, and navigating new challenges.  Now is the time to reconnect with these key relationships.