Construction contracts are the framework of every project. They are not just legal documents to govern disputes but essential tools that define the rights, responsibilities, and expectations of all parties involved. These contracts also serve as agreements that allocate risk among the parties involved in the building process. In the fast-paced and often high-stakes environment of construction, having a thorough understanding of the contract can be the blueprint for success. This article highlights five key factors to help you avoid pitfalls in construction contracts.
The Contract Is the Contract
Call me an optimist, but I believe most people have good intentions. However, when it comes to contracts or legally binding agreements, intentions are interpreted solely by the language used in the contract. The only thing that matters are the actual words and terms defined on the pages of the document. This is called the "objective rule of contracts," a widely accepted principle of contract law across the United States. It means that if the language in a contract is clear and straightforward, the interpretation of that document will be based entirely on the actual words used. No external factors, such as the intentions of the parties, previous conversations, emails, or other contextual implications, will be considered.
The objective rule of contracts leads to one of the primary pitfalls of contract review—drawing a conclusion or understanding of something not explicitly stated in the contract. Surprisingly, the people most susceptible to this pitfall are those with the most experience. The issue arises when experienced individuals start looking for what they expect to see in the contract rather than reading the terms as they are specifically defined.
For instance, imagine during the contract review process that the insured or insured's representative does not verify the exact insurance requirements in the contract, assuming they are standard and included. Fast forward a few months, and an incident occurs on the construction site where it is discovered that the contractor did not have the assumed insurance coverage. As a result, the contractor faces unexpected liabilities because the contract did not explicitly require the insurance policies they assumed were in place. This gap in coverage could have been avoided had the insured interpreted the contract as it was written and amended it as needed because the contract is the contract.
Definitions Matter
If the contract is the contract, then it is important to understand the language of a contract. Contract documents are part of a larger universe of files, intricately woven together through time and space. Okay, maybe we aren't tracing a map through history to discover hidden treasure, but contract documents certainly can have an extensive paper trail. Knowing where that trail leads is important. Prime contracts and other documents flow down and are generally incorporated by reference. The purpose of a flow-down provision is to bind the subcontractor to the terms and conditions of the prime contract—the agreement between the general contractor and project owner. Since the contract documents can significantly impact an entire hierarchy of entities, failure to understand their contents could have detrimental effects. This is why definitions matter.
Definitions are the language of contracts, and unless you know the definitions, you don't know your contract. Definitions are simply identified terms listed in a dedicated "definitions" section, which is generally at the beginning of the contract. These terms are often capitalized, making them easy to identify throughout the contract, and a capitalized letter can completely change the meaning of a term. Often, these capitalized terms will refer to another set of documents that flow down into this contract. For example, "… in this agreement" is not the same as "… in this Agreement." One would correctly assume that "agreement" (with a lowercase "a") refers only to the document in hand. However, "Agreement" (with a capital "A") is likely defined as the Subcontract Agreement for work in connection with the project, together with all other contract documents. Understanding these nuances can help prevent misunderstandings.
Another reason that definitions matter is that one of the best ways to revise a contract is to revise the definitions. By carefully updating definitions, you can eliminate ambiguities and ensure that all parties have a clear understanding of key terms. Updating definitions can also streamline the revision process, as changes to definitions can have a cascading effect throughout the entire contract, automatically updating the meaning of terms wherever they appear.
The Tension of Contracts
You don't have to be a construction expert to know that there is a huge difference between what is written in a contract and what actually happens in the field. Contracts are written by lawyers with a focus on precision and thoroughness. They use unambiguous language to avoid being misunderstood. If you are on the receiving end of a contract, this can often leave you feeling as if you're caught between a rock and a hard place. On one hand, you have a legally binding contract to adhere to (the rock), but on the other, you have what happens in the field (the hard place). This concept is probably most evident in change orders.
Change orders are quite common in construction projects and, if not handled properly, could leave the contractor stuck in the middle. Suppose a contractor is working on a large commercial building project. The original contract specifies the use of a particular type of roofing material. Midway through the project, the client requests a change to a more expensive, higher-quality roofing material. The contractor is still bound by the original contract terms, which include specific materials, timelines, and costs. The contractor is caught between adhering to the original contract (the rock) and accommodating the client's request (the hard place). If the contractor proceeds with the change before a change order has been executed, they risk not being compensated for the additional cost and time. However, if they insist on strict adherence to the original contract, they risk damaging their relationship with the client and potentially losing future business. The following are a few suggestions to avoid pitfalls in change orders.
First, most change order provisions will state that a change order must be submitted within a certain number of days following the trigger event. Unfortunately, identifying the exact trigger event can sometimes be challenging. To address this, it can be beneficial to modify the contract language from a definite number of days to a more flexible standard, such as when you "reasonably should have known of the impact." This adjustment allows for a more practical approach and permits greater flexibility in accommodating real-world scenarios.
Next, most contract provisions will require a fully executed change order before work can continue. Typically, the provision will also state that "time is of the essence" and the contractor will be responsible for "damages due to delay." This can create significant pressure on the contractor, especially if there are uncontrollable delays in obtaining the necessary approvals for a change order. To avoid potential conflict and ensure a smooth project progression, it would be best to modify the timing of when work should resume after the signed change order has been received. Additionally, including an automatic extension of the project schedule for the change order wait period can provide a buffer for any delays. This adjustment ensures that the project timeline remains realistic and achievable. It also helps protect the contractor from being unfairly penalized for delays outside their control.
Taking Control of the Contract
Growing up, I learned a valuable lesson: You can't always control what happens to you, but you can control how you react. The same lesson applies when negotiating a construction contract. While you can't always control the demands of the other party, you can control how you respond.
There are multiple responses when it comes to managing risk. The first response is to increase risk. It has been said that with great risk comes great reward. This can be true in many scenarios. Whether in business, finance, or personal decisions, increasing risk can sometimes lead to higher rewards. Unfortunately, this principle does not hold true for construction contracts, where higher risk generally leads to greater loss. Therefore, instead of increasing the risk, another response would be to eliminate it altogether. However, despite our best efforts to change the project scope, alter processes, or implement strict safety measures, it is impossible to eliminate all risk in a project. In the end, we accept a certain level of risk. The goal should be to reduce or transfer as much risk as possible through contract negotiation. A contract is simply a vehicle for allocating risk.
Interpretation and allocation of risk is one of the most frequent disputes that arises after a project is awarded. The easiest way to mitigate this issue is by determining how much risk you are willing to accept and effectively expressing that assumption of risk in the contract. To maintain a reasonable balance of risk, consider the following questions when reviewing the contract: "Who has control of the task or area associated with the risk?," "Who is receiving the benefit, and is the assumed risk proportionate to the benefit?," and "Which party is most capable of dealing with, insuring against, or minimizing the assumed risk?" These questions can help negotiate a fair and equitable contract for both parties.
Ultimately, risk allocation is only effective through specific and explicit contract language. Remember, the objective rule of contracts bases the interpretation solely on the words used in the contract. The more explicit you are in defining your assumption of risk, the better your chances of avoiding unexpected exposure. Unfortunately, you may not be able to remove all of your risk in a contract, but you can determine which exceptions to accept.
A Great Contract Starts with a Great Negotiation
Everything discussed up to this point is only effective if you can communicate with the other side. That's why the foundation of a successful contract lies in the quality of the negotiation process. Effective negotiation seeks to foster an open and collaborative dialogue for all parties involved.
The art of negotiation is to keep the conversation going. This can be accomplished by learning to disagree by agreeing because the moment you disagree, the conversation is over. This is also known as the "Yes, and …" approach, which builds on the statements of the other party rather than opposing them. For instance, if the other party includes a provision in the contract that isn't agreeable, simply crossing it out and sending it back could likely end the negotiations. A more collaborative approach may be to agree to the provision with exceptions, such as "with the exception of …" or "if …" word phrasing. By maintaining a positive and constructive dialogue, you increase the chances of reaching a mutually beneficial agreement.
Another important aspect of effective negotiation is having the confidence to ask questions. A negotiation can be intimidating, especially if the other party is more experienced. However, it's crucial to understand your contract, so if something is unclear, don't hesitate to ask for clarification. Given the inherent complexity of construction projects, misunderstandings or ambiguities in the contract can lead to significant issues down the line, such as delays or disputes. Proactively seeking clarification transfers the responsibility of information back to the owner and ensures all parties have a mutual understanding of the agreement. By asking the question, you may discover that the other party needed clarification as well.
Conclusion
Although this article discusses common challenges, it should be noted that construction contracts do not follow a one-size-fits-all format. Every project has a unique combination of risks, and every contract is a negotiation; the only way to ensure effective allocation and transfer of risk is to pay attention to the details. Executing a carefully drafted contract with clear definitions and terms takes skill but is essential to the effective management of risk on a project.
This article is derived from a presentation titled "Blueprint for Success: Avoiding Pitfalls in Construction Contracts" at the 2024 IRMI Construction Risk Conference.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
Construction contracts are the framework of every project. They are not just legal documents to govern disputes but essential tools that define the rights, responsibilities, and expectations of all parties involved. These contracts also serve as agreements that allocate risk among the parties involved in the building process. In the fast-paced and often high-stakes environment of construction, having a thorough understanding of the contract can be the blueprint for success. This article highlights five key factors to help you avoid pitfalls in construction contracts.
The Contract Is the Contract
Call me an optimist, but I believe most people have good intentions. However, when it comes to contracts or legally binding agreements, intentions are interpreted solely by the language used in the contract. The only thing that matters are the actual words and terms defined on the pages of the document. This is called the "objective rule of contracts," a widely accepted principle of contract law across the United States. It means that if the language in a contract is clear and straightforward, the interpretation of that document will be based entirely on the actual words used. No external factors, such as the intentions of the parties, previous conversations, emails, or other contextual implications, will be considered.
The objective rule of contracts leads to one of the primary pitfalls of contract review—drawing a conclusion or understanding of something not explicitly stated in the contract. Surprisingly, the people most susceptible to this pitfall are those with the most experience. The issue arises when experienced individuals start looking for what they expect to see in the contract rather than reading the terms as they are specifically defined.
For instance, imagine during the contract review process that the insured or insured's representative does not verify the exact insurance requirements in the contract, assuming they are standard and included. Fast forward a few months, and an incident occurs on the construction site where it is discovered that the contractor did not have the assumed insurance coverage. As a result, the contractor faces unexpected liabilities because the contract did not explicitly require the insurance policies they assumed were in place. This gap in coverage could have been avoided had the insured interpreted the contract as it was written and amended it as needed because the contract is the contract.
Definitions Matter
If the contract is the contract, then it is important to understand the language of a contract. Contract documents are part of a larger universe of files, intricately woven together through time and space. Okay, maybe we aren't tracing a map through history to discover hidden treasure, but contract documents certainly can have an extensive paper trail. Knowing where that trail leads is important. Prime contracts and other documents flow down and are generally incorporated by reference. The purpose of a flow-down provision is to bind the subcontractor to the terms and conditions of the prime contract—the agreement between the general contractor and project owner. Since the contract documents can significantly impact an entire hierarchy of entities, failure to understand their contents could have detrimental effects. This is why definitions matter.
Definitions are the language of contracts, and unless you know the definitions, you don't know your contract. Definitions are simply identified terms listed in a dedicated "definitions" section, which is generally at the beginning of the contract. These terms are often capitalized, making them easy to identify throughout the contract, and a capitalized letter can completely change the meaning of a term. Often, these capitalized terms will refer to another set of documents that flow down into this contract. For example, "… in this agreement" is not the same as "… in this Agreement." One would correctly assume that "agreement" (with a lowercase "a") refers only to the document in hand. However, "Agreement" (with a capital "A") is likely defined as the Subcontract Agreement for work in connection with the project, together with all other contract documents. Understanding these nuances can help prevent misunderstandings.
Another reason that definitions matter is that one of the best ways to revise a contract is to revise the definitions. By carefully updating definitions, you can eliminate ambiguities and ensure that all parties have a clear understanding of key terms. Updating definitions can also streamline the revision process, as changes to definitions can have a cascading effect throughout the entire contract, automatically updating the meaning of terms wherever they appear.
The Tension of Contracts
You don't have to be a construction expert to know that there is a huge difference between what is written in a contract and what actually happens in the field. Contracts are written by lawyers with a focus on precision and thoroughness. They use unambiguous language to avoid being misunderstood. If you are on the receiving end of a contract, this can often leave you feeling as if you're caught between a rock and a hard place. On one hand, you have a legally binding contract to adhere to (the rock), but on the other, you have what happens in the field (the hard place). This concept is probably most evident in change orders.
Change orders are quite common in construction projects and, if not handled properly, could leave the contractor stuck in the middle. Suppose a contractor is working on a large commercial building project. The original contract specifies the use of a particular type of roofing material. Midway through the project, the client requests a change to a more expensive, higher-quality roofing material. The contractor is still bound by the original contract terms, which include specific materials, timelines, and costs. The contractor is caught between adhering to the original contract (the rock) and accommodating the client's request (the hard place). If the contractor proceeds with the change before a change order has been executed, they risk not being compensated for the additional cost and time. However, if they insist on strict adherence to the original contract, they risk damaging their relationship with the client and potentially losing future business. The following are a few suggestions to avoid pitfalls in change orders.
First, most change order provisions will state that a change order must be submitted within a certain number of days following the trigger event. Unfortunately, identifying the exact trigger event can sometimes be challenging. To address this, it can be beneficial to modify the contract language from a definite number of days to a more flexible standard, such as when you "reasonably should have known of the impact." This adjustment allows for a more practical approach and permits greater flexibility in accommodating real-world scenarios.
Next, most contract provisions will require a fully executed change order before work can continue. Typically, the provision will also state that "time is of the essence" and the contractor will be responsible for "damages due to delay." This can create significant pressure on the contractor, especially if there are uncontrollable delays in obtaining the necessary approvals for a change order. To avoid potential conflict and ensure a smooth project progression, it would be best to modify the timing of when work should resume after the signed change order has been received. Additionally, including an automatic extension of the project schedule for the change order wait period can provide a buffer for any delays. This adjustment ensures that the project timeline remains realistic and achievable. It also helps protect the contractor from being unfairly penalized for delays outside their control.
Taking Control of the Contract
Growing up, I learned a valuable lesson: You can't always control what happens to you, but you can control how you react. The same lesson applies when negotiating a construction contract. While you can't always control the demands of the other party, you can control how you respond.
There are multiple responses when it comes to managing risk. The first response is to increase risk. It has been said that with great risk comes great reward. This can be true in many scenarios. Whether in business, finance, or personal decisions, increasing risk can sometimes lead to higher rewards. Unfortunately, this principle does not hold true for construction contracts, where higher risk generally leads to greater loss. Therefore, instead of increasing the risk, another response would be to eliminate it altogether. However, despite our best efforts to change the project scope, alter processes, or implement strict safety measures, it is impossible to eliminate all risk in a project. In the end, we accept a certain level of risk. The goal should be to reduce or transfer as much risk as possible through contract negotiation. A contract is simply a vehicle for allocating risk.
Interpretation and allocation of risk is one of the most frequent disputes that arises after a project is awarded. The easiest way to mitigate this issue is by determining how much risk you are willing to accept and effectively expressing that assumption of risk in the contract. To maintain a reasonable balance of risk, consider the following questions when reviewing the contract: "Who has control of the task or area associated with the risk?," "Who is receiving the benefit, and is the assumed risk proportionate to the benefit?," and "Which party is most capable of dealing with, insuring against, or minimizing the assumed risk?" These questions can help negotiate a fair and equitable contract for both parties.
Ultimately, risk allocation is only effective through specific and explicit contract language. Remember, the objective rule of contracts bases the interpretation solely on the words used in the contract. The more explicit you are in defining your assumption of risk, the better your chances of avoiding unexpected exposure. Unfortunately, you may not be able to remove all of your risk in a contract, but you can determine which exceptions to accept.
A Great Contract Starts with a Great Negotiation
Everything discussed up to this point is only effective if you can communicate with the other side. That's why the foundation of a successful contract lies in the quality of the negotiation process. Effective negotiation seeks to foster an open and collaborative dialogue for all parties involved.
The art of negotiation is to keep the conversation going. This can be accomplished by learning to disagree by agreeing because the moment you disagree, the conversation is over. This is also known as the "Yes, and …" approach, which builds on the statements of the other party rather than opposing them. For instance, if the other party includes a provision in the contract that isn't agreeable, simply crossing it out and sending it back could likely end the negotiations. A more collaborative approach may be to agree to the provision with exceptions, such as "with the exception of …" or "if …" word phrasing. By maintaining a positive and constructive dialogue, you increase the chances of reaching a mutually beneficial agreement.
Another important aspect of effective negotiation is having the confidence to ask questions. A negotiation can be intimidating, especially if the other party is more experienced. However, it's crucial to understand your contract, so if something is unclear, don't hesitate to ask for clarification. Given the inherent complexity of construction projects, misunderstandings or ambiguities in the contract can lead to significant issues down the line, such as delays or disputes. Proactively seeking clarification transfers the responsibility of information back to the owner and ensures all parties have a mutual understanding of the agreement. By asking the question, you may discover that the other party needed clarification as well.
Conclusion
Although this article discusses common challenges, it should be noted that construction contracts do not follow a one-size-fits-all format. Every project has a unique combination of risks, and every contract is a negotiation; the only way to ensure effective allocation and transfer of risk is to pay attention to the details. Executing a carefully drafted contract with clear definitions and terms takes skill but is essential to the effective management of risk on a project.
This article is derived from a presentation titled "Blueprint for Success: Avoiding Pitfalls in Construction Contracts" at the 2024 IRMI Construction Risk Conference.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.