Pandemic Creates Cause to Rethink Overlooked Contract Provisions

Zachary Davis | Ahead of Schedule

The last time my byline appeared in this column, we were just a few weeks into the government-ordered lockdown, and I pondered whether construction projects could — or should — continue. In the year since, the construction industry proved adaptable as owners and general and trade contractors worked closely to ensure that work continued while keeping workers safe and complying with the various government-ordered and -recommended practices intended to slow the spread of COVID-19.

While we are still many months from being past the pandemic, we have at least neared the light at the end of the tunnel. Most adults in Oregon are now or will soon be eligible for vaccination, and there are signs of normalcy as kids return to school and the various pandemic-related restrictions that had become the new normal are slowly lifted. As our industry and communities enter this new stage of what is hopefully recovery and resurrection from the pandemic, the time is right to look back at lessons learned over the past 12 months.

Contracting Considerations

Prior to March 2020, I cannot remember spending more than five minutes negotiating force majeure language in a construction or design contract. When advising owners, I often recommended a handful of modifications to the force majeure provisions of the various industry standard forms, which were typically accepted without comment or revision by the other party.

Post-March 2020, the force majeure provision is easily the one that is most closely scrutinized — at least in terms of time and red ink. And for parties negotiating new agreements, the range of solutions has run a broad spectrum as contracting parties have looked for fair — and sometimes creative — ways to allocate the numerous risks that the ever-changing pandemic presented (and still presents).

Of course, for contracts negotiated over the past year, the parties have been in the unique position of negotiating during an ongoing force majeure event — or at least force majeurelike circumstances. Because the pandemic is ongoing, contracting parties should — at least to some degree — be able to account in both price and schedule for the known impacts of the pandemic as of the date of contracting. Thus, the challenge is drafting a provision in the midst of a pandemic that is flexible enough to differentiate between those known risks — e.g., the impacts of existing government orders and restrictions — and the unknown risks — e.g., future government orders strengthening restrictions or imposing new lockdowns due to a surge. While the rule traditionally followed in construction contracting is that the occurrence of a force majeure event gives the contractor the right to additional time — but not necessarily money, many owners have agreed to include a remedy for additional costs as part of pandemic-specific force majeure provisions. On the flip side, many such owners also want the opportunity to share in any savings in the event the work gets less expensive due to, for example, a loosening of government restrictions that comes earlier than anticipated.

But while force majeure has claimed the spotlight, there are other contract clauses that were similarly overlooked pre-pandemic that are proving equally worthy of scrutiny. One such example is the “change in law” provision. Executive orders and agency-level directives may or may not qualify as a “change in law” depending on, among other things, (a) how “law” is defined by the contract (if at all), and (b) whether the contract permits a remedy for all such changes in the law or for just a certain class of changes.

The other challenge is determining how these provisions and remedies interact within the broader context of the contract. For instance, if a new government order that imposes additional social distancing requirements does not meet the contractual definition of a “change in law,” that may not necessarily mean that the impacted party is without a remedy under another provision. Thus, contracting parties may want to include language that, for example, clarifies whether they intend that the “change in law” provision is the exclusive remedy for impacts involving government orders. While that conclusion might be inferable from a holistic reading of the contract, including express language ensures that the parties’ intent is honored.

Managing Impacts and Claims During a Pandemic

The flip side of drafting a contract that allocates risk for unexpected events such as a pandemic is how the parties implement that agreement when those risks arise during performance. For instance, most contracts require an impacted party to provide timely notice to the other party of an event or circumstance that triggers a contractual remedy. While a force majeure provision may excuse performance of certain contract obligations, it is unlikely to excuse notice requirements — even in the event of a global pandemic.

And, of course, the occurrence of a force majeure event is not a blank check for the impacted party and does not provide a remedy or excuse performance for obligations not causally impacted by the event. For instance, a contractor submitting a request for an extension of time due to a force majeure event should expect that the owner will want a critical path analysis showing that the claimed event actually caused a delay and that the delayed activity was in fact on the project’s critical path. In my experience, owners who were initially sympathetic to their contractors at the outset of the pandemic — and thus less inclined to strictly enforce their contracts — are far less willing to overlook shortcomings now that both sides have lived through pandemic conditions for more than a year.

As we emerge from a year of lockdown and conducting business in unprecedented conditions, the events of the past year will leave their mark for generations. The construction industry — like society at large — has learned important lessons that will make it better prepared to face future challenges.

Waiver of Consequential Damages: The Most Important Provision in a Construction Contract

Jeremy P. Brummond | Construction Executive

Construction agreements can be lengthy. They often include terms covering everything from logistics for working on the project site to complicated provisions regarding intellectual property. Many provisions in a construction agreement deal with risk and who is going to pay for damage claims if or when they occur. 

However, not all risk-shifting provisions are equally important. While provisions that impose obligations on the contractor to maintain confidentiality, indemnify for personal injury or property damage, or correct defective work can expose a contractor to substantial damage claims and are thus important, contractors can significantly control the amount of damages the owner can claim by including a well-drafted waiver of “consequential damages” provision in the agreement.  

Because the waiver of consequential damages can significantly control the amount of damages for which a contractor is assuming risk and greatly limit the owner’s ability to recoup many damages, it is arguably the most important provision in a construction contract. Therefore, it is essential for contractors and owners to carefully consider the waiver of consequential damages before entering into any construction agreement.  

WHAT IS A CONSEQUENTIAL DAMAGE?

Generally, when the contactor has breached the construction agreement, the owner will have direct losses (e.g., cost to fix the work) and will have other indirect or consequential losses (e.g., lost revenue incurred during project down time). Whether or not a loss is consequential or direct is determined by state law, and unfortunately, there is no uniform approach among the state cases and statutes. What is a consequential loss to one judge may be a direct loss to another judge evaluating similar facts.  

Because state laws and courts are inconsistent in defining which damages are consequential, parties should consider specifically defining them in the consequential damages waiver. For example, the AIA A201 includes rental expenses, losses of use, income, profit, financing, business and reputation, and loss of management or employee productivity in its definition of an owner’s consequential losses. The ConsensusDocs 200 includes similar language.

HISTORICAL INCLUSION OF WAIVER OF CONSEQUENTIAL DAMAGES 

The types of damages described as “consequential” in many standard agreements such as the AIA and ConsensusDocs (and as defined by courts and state statutes) can be significant. Depending on the type of project, an owner can sustain millions in loss of use damages and lost profits if the contractor is late in delivering performance. Because consequential losses can be so substantial, neither the contractor nor owner wants to absorb the risks associated with those losses.  

For the last 20 years, the most widely used construction general conditions (the AIA A201) have included a broad waiver of consequential damages where the owner waives its right to claim lost profits or loss of use damages caused by the contractor’s failure to perform. Contractors argue the AIA document’s approach is equitable because contractors’ fees are not sufficient enough to allow them to assume the risk of millions in lost owner profits if an unexpected event were to occur and the owner was damaged by delayed or defective contractor work.  On the other hand, owners argue against this provision, noting that if a contractor fails to honor the agreement, the contractor should be responsible for all losses, including direct and consequential damages.  

MODERN TREATMENT – PROPOSED OWNER CARVE-OUTS

Recently, many owners and their counsel have started proposing carve-outs to the waiver of consequential damages during contract negotiation. Owners say they will agree to the waiver of consequential damages, but not in connection with claims asserted against the contractor based on the contractor’s promises to indemnify in the agreement, the contractor’s gross negligence or willful misconduct, the contractor’s failure to pay taxes or liens, or the contractor’s breaches of the provisions relating to intellectual property and confidentiality. Some owners even try to limit the waiver of consequential damages so it does not apply to claims arising from breaches of warranty.  

Contractors evaluating these suggested carve-outs must carefully consider the risk that each will create. In the indemnity provision(s) in a construction agreement, contractors often agree to pay for any losses resulting from their negligence (not necessarily those incurred by third parties and not necessarily only those losses like insured property damage or personal injury losses). A contractor is negligent if it fails to perform its work as well as other similarly situated contractors. If a contractor assumes the risk of any consequential losses (lost profits) arising from any failure of the contractor to perform its work as well as other similar contractors, it is exposing itself to substantial damage claims.  

Again, many owners try to limit the consequential damages waiver so it does not apply to claims arising from gross negligence. The contractor may believe it is fair to agree to unlimited liability for consequential losses for gross negligence claims, but what if the applicable law doesn’t recognize varying degrees of negligence or separate claims for gross negligence from ordinary negligence claims (as in Missouri)? By agreeing to limit the waiver of consequential damages so it doesn’t apply to gross negligence claims, is a contractor living in a state that doesn’t recognize gross negligence claims agreeing to pay consequential damages for any ordinary negligence claim?  

Agreeing to pay consequential damages for a narrow group of claims like those arising out of failure to satisfy liens or pay taxes (and arguably even claims arising from breach of confidentiality or intellectual property agreements) is tolerable because a contractor has more control over whether those claims occur (and the consequential damages flowing from those clams would presumably be less). Contractor delays and mistakes, however, including those leading to accidents or defective work, are more difficult to control. Contractor negligence and defective work (breaches of warranty) can shut down a project and cause significant delays as well as consequential damages. Therefore, a contractor needs to be wary when agreeing to pay consequential damages resulting from gross or ordinary negligence, fault short of willful misconduct, or breaches of its warranty obligations. 

SOLUTIONS AND PROPOSED COMPROMISES  

Because many contractors will not accept broad carve-outs to the waiver of consequential damages, owners, contractors and their counsel have started looking for ways to compromise. In some recent contracts, owners have required contractors to be responsible for consequential damages for any indemnity claim, but have agreed the owner can only recover consequential damages when seeking reimbursement via the indemnity provision for a non-affiliated third party’s consequential damages. While agreeing to be responsible for a third party’s consequential damages can still expose contractors to significant damage claims, this compromise does limit the contractor’s exposure to possible substantial lost profit claims by the owner.  

In other recent contracts, some owners have agreed to broadly waive consequential damages, but not for claims covered by insurance. Contractors can significantly control their risk, of course, by agreeing to limit recoverable consequential damages to those that are otherwise covered by insurance.

Detailed compromises vis-à-vis the waiver of consequential damages are likely to be commonplace in future construction agreements. Contractors and owners’ counsel are becoming increasingly wary of the risks assumed and transferred in the waiver of consequential damages, and have recognized its importance. Indeed, many counselors believe it is the most important provision, requiring a great deal of attention from all parties.  

Reasonableness of Liquidated Damages Determined at Time of Contract (or, You Can’t Look Back Again)

Christopher G. Hill | Construction Law Musings

I’ve discussed the continuing litigation between White Oak Power Constructors v. Mitsubishi Hitachi Power Systems Americas, Inc. previously here at Construction Law Musings because the case was another reminder that your construction contract terms matter and will be interpreted strictly here in the Commonwealth of Virginia.  The prior opinion in this case from the Eastern District of Virginia court the Court considered the applicability of a liquidated damages provision.  In the latest opinion from the Court (PDF) the Court looked at when and how any liquidated damages would be calculated.  In its June 22, 2020 opinion, the Court put the issue as follows:

White Oak’s motion for partial summary judgment presents a narrow issue: whether courts may consider the damages actually sustained by a party as a result of a contract breach when deciding if liquidated damages required by a contract “grossly exceed” a party’s actual damages.

Mitsubishi argued that White Oak could not enforce the liquidated damages provisions of the contract (all of which are laid out in the opinion linked above) because the liquidated damages were not reasonable and “grossly exceeded” the actual damages incurred by White Oak because of project delays allegedly caused by Mitsubishi.  Mitsubishi argued that the Court must look retroactively at the actual damages incurred when determining whether the liquidated damages constituted a penalty.  White Oak argued that the Court should look proactively at what the parties thought damages could be at the time of contracting.  After a thorough review of Virginia law, the Court agreed with White Oak and stated:

[c]ourts applying Virginia law must consider the actual damages contemplated at the time of contract when determining the reasonableness of a liquidated damages provision. Moreover, the fact that courts must focus on the intent of the parties based on the circumstances at the time of contract formation further supports applying the prospective approach. Accordingly, Mitsubishi may not challenge the liquidated damages provision based on the damages White Oak suffered after the alleged delays occurred.

In short, when drafting or reviewing liquidated damages provisions for your construction contracts with the assistance of an experienced Virginia construction lawyer, be sure to have them be “indexed” to the prospective damages the parties reasonably consider to be possible when the contract is made.  You are not likely to win an argument after the fact-based upon the actual damages incurred.

As always, I recommend that you read the entire opinion for yourself and draw your own conclusions.  Also, please let me know with a comment if you have any thoughts on my analysis.

Contract Provisions That Help Manage Risk on Long-Term Projects

Jason Lambert | Construction Executive

Few things can dampen the thrill and promise of a newly closed construction deal than the realization that it could quickly become a losing proposition for the contractor depending on economic and other conditions. In an era of instant information, constantly adjusting markets and political extremes, projects that start under one set of assumptions or conditions can occur or conclude under much different ones. While no one has a crystal ball, there are contractual provisions that can provide clear guidance in the face of many “what ifs” that can arise in construction. 

One of the chief concerns a contractor should have in a project lasting more than a few months is what impact price increases will have on the profitability of the job. On a true cost-plus project, this may be of little concern, but on any project with a limitation on costs or a guaranteed maximum price, contractors should insist on a procedure to revisit the limitation or price if certain conditions change. 

This can be as simple as allowing the contractor to receive an upward adjustment in the price if costs increase by more than a certain percentage. It can be as complicated as requiring multiple new bids and disclosures to the property owner, architect or project manager and allowing approval of new suppliers or subcontractors to limit cost increases to the cheapest increase. The protection—and certainty—to the contractor though, comes from having a process in the contract to address cost increases, whether it is simple or complex. 

In a similar vein, if seeking cost increases is not feasible or preferable, then it may make sense to include a provision that allows the contractor to terminate the contract if costs increase beyond a certain amount or certain percentage. Again, this may require a certain amount of disclosure to property owners or other third-parties to justify termination, but it may be preferable to exit a project at a break-even point or mild profitability rather than take it to conclusion and lose money. This option does not exist though, unless a contract between the parties expressly allows it. 

Shifting away from cost-focused provisions, another unpredictable problem can involve owner-caused delays. Typically, property owners have material selections to make or approve, change orders to authorize and other input to provide on the project. While eliminating delays entirely may be impossible, the best way to address them can be to incentivize timely performance, by, for example, providing for liquidated damages in the event the owner does not meet required deadlines. Another option could be to allow cost increases to be charged if they are the result of delays, and still a third option would be to allow the contractor to make the decision for the owner in the absence of timely input. Again, the specific method of allowing for additional costs or time in response to delays is less critical than having a procedure to do so that eliminate uncertainty from the future.

Another type of delay can arise from third-parties or events external to the project. Contracts commonly alleviate contractors from delays caused by natural disasters, strikes, war, etc., but most do not go the extra step of determining how the risk of those events are to be allocated among the parties or how the contractor is to be reimbursed for the consequences of them. One way to avoid this issue is to provide more specificity, especially in the face of known issues. 

A great example of this is hurricanes. Many projects along the U.S. Gulf Coast and Eastern Seaboard face the threat of hurricanes impacting the project sometime during the summer months, whether a hurricane actually strikes the project or simply strikes a manufacturing facility 100 miles away. Contracts for these projects should include specific hurricane mobilization and demobilization provisions, allocate the costs and delays associated with the same, and allow contractors to seek cost increases if material or subcontractor prices go up due to demand or scarcity. While the hurricane may never impact the project, if it does, the contractor will be able to rely on those provisions to protect its ability to perform the project or terminate it if necessary. 

Finally, contracts should require that contractors, subcontractors and material suppliers exercise their rights under relevant lien laws. This means ensuring the pre-lien notices or any pre-project notices are sent at the beginning of the project, even when things are going well and everyone is performing their contractual obligations timely. This is the only way to ensure that lien and other rights are preserved in the event of any “what ifs” that come to fruition. 

While these are only a few specific types of issues that can arise in the future and can be mitigated through contractual risk allocation, contractors can think through common problems that occur for their business or their region and craft contractual provisions that address what the contractor wants to happen if some foreseeable event in the future. While this may not prevent problems from arising, it certainly will keep those problems from derailing a project or company. 

Pay-When-Paid: What is a Reasonable Amount of Time to Withhold Payments to a Subcontractor?

Brent R. Laman | Smith Currie & Hancock

In an early Rolling Stones classic, Mick Jagger sang, “Ti-i-i-ime is on my side.” The refrain to that hit melody “yes it is” appears to hold true if you are a subcontractor in New York looking to get paid for completed work even while the owner and general contractor duke it out in protracted litigation over amounts you are owed.

A recent New York state decision underscores the unenforceability in that state of the payment risk shifting term commonly known as a “pay-if-paid” clause and adds nuance to the interpretation of payment timing mechanisms referred to as “pay-when-paid” provisions. The project was the construction of four apartment buildings at a total cost of just more than $5,000,000.00. Not quite a year into the project, a payment dispute arose between the owner and general contractor, Plank, LLC. In response, Plank demobilized the site. At that time, Plank owed the electrical subcontractor, A.E. Rosen Electrical Co., Inc., $161,805.49. The owner later paid Rosen $44,527.00, and Rosen pursued its lawsuit against Plank for the remainder.

The subcontract between Rosen and Plank required Plank to make progress payments to Rosen within fifteen days of receiving corresponding payments from the owner. Plank also agreed to make a final payment to Rosen within thirty days of receiving the final payment from the owner. The contract contained the specific stipulation that “[t]he parties acknowledge that this is a ‘pay when paid’ timing mechanism and not a ‘pay if paid’ provision,” likely because New York courts had decided 25 years prior that “pay-if-paid” provisions were void for public policy reasons (more on this below).

Plank raised this contract provision as defense in the lawsuit, arguing simply that it could not be liable for payment to Rosen because it had not yet been paid by the owner. It is worth noting here that by the time the court was asked to consider this defense, more than two years had passed from the date Rosen had completed the work for which payment was demanded. If that argument sounds no different than what would have been argued had the provision been a “pay-if-paid” provision, it is. The result was a ruling from the court highlighting the Empire State’s limitations of the time-based “pay-when-paid” provisions versus the absolute conditional nature of “pay-if-paid” provisions. The court concluded that Plank could not use the contract provision to effectively shift all risk of owner non-payment to Rosen, thereby converting a contractual timing-of-payment mechanism into a conditional “pay-if-paid” provision shifting risk of owner non-payment to the subcontract. Therefore, the provision could only be enforced to the extent the delay in payment was for a reasonable amount of time after the work was complete. To hold otherwise would be to obliterate any difference between the two types of provisions.

If you are building in New York, the question begged by this court’s holding is: what is a reasonable amount of time for a general to withhold payment under a “pay-when-paid” provision when the general has not been paid by the owner? The New York court first looked to a federal case that considered three years to be an unreasonable amount of time, then, without much in the way of explanation, held that the “well over two years” Rosen had waited for payment was an unreasonable amount of time. Of course, there is a lot of ground between what a subcontractor may consider a timely payment, say 30 to 60 days after submission of a payment request, and the “well over two years” at issue in the case. What if it had only been one year or even six months? The court gave no indication as to whether a shorter period of time would have been reasonable.

Perhaps a more useful question to ask is, “What happens when a savvy contract lawyer decides to “draft around” the A.E. Rosen ruling?” For instance, what if the provision said something like “General Contractor (GC) agrees to make payment to Subcontractor (SC) within 15 days of receiving a corresponding payment from Owner. The Parties agree that: (i) in the event of a lawsuit or arbitration between the GC and Owner or (ii) the Owner’s bankruptcy or insolvency, and where the GC has not been paid by the Owner, it is reasonable for GC to wait five years after SC’s work is complete for GC to make payment for that work. The Parties agree that five years is reasonable because neither party is banking on this job to stay solvent or feed their families.” This example may lean toward being silly, but the point is made. Will the New York courts come in and protect the subcontractor from itself by rewriting these provisions, replacing five years with their own ideas of “reasonable,” or will they uphold the sacred freedom to enter into potentially perilous contracts? The importance of being able to draft an enforceable “pay-when-paid” provision is underpinned by the increasing number of states that have passed statutes outright prohibiting or severely limiting “pay-if-paid” provisions.

New York long ago decided that “pay-if-paid” provisions were unenforceable and void as against public policy. The stated legal reason for these decisions was based on close examination of New York’s lien laws with the courts finding that “pay-if-paid” provisions amounted to an impermissible waiver of lien rights. The same is true of California and other states. Of course, courts can often succumb to tortured legal reasoning to arrive at the result they intended from the outset; often knowing where they will land before they figure out how to jump there. A more practical concern, and a reason actually noted in the A.E. Rosen court’s decision, is that suppliers and small contractors on large construction projects need reasonably prompt payment for their work and materials in order for them to remain solvent and stay in business. Of course, the same could be said for many small businesses. On the other hand, the multi-tier, multi-contract nature of a large construction project is unique and has spawned some unique risk-shifting provisions.

Regardless of why, more states have hopped on the bandwagon of prohibiting “pay-if-paid” provisions, primarily through enactment of prompt payment statutes. The following states have statutes that if they do not outright ban “pay-if-paid” provisions, limit (or appear they may limit) their application: North Carolina, South Carolina, Massachusetts, Illinois, Maryland, Missouri, and Wisconsin. Several states have no reported cases dealing with conditional payment provisions and some specifically allow them; however, the takeaway is always to know your state’s law on conditional payment provisions, and, if possible, draft around them in your favor. If your contract is enforced in a state that has banned “pay-if-paid” provisions, careful contract drafting might provide a general contractor with a lengthy period of time to hold onto its money while it tries to negotiate a resolution with the owner as to subcontract funds owed. On the other hand, if you are a subcontractor contracting in one of these states and your subcontract contains a “pay-if-paid” clause, you might consider letting it lay; before taking that course, however, you should consult with counsel on the effect of leaving in such a provision and resulting costs you might incur in attempting to litigate over the enforceability of this risk shifting mechanism. In either event, a thorough vetting and review of the contract before signing it, even if that includes retaining counsel on the front end to review the terms, may be the best way to ensure that enough time is on your side to protect and ensure your payment rights and obligations.  That may, after all, be the best way for you to get the satisfaction you desire.