The First Step to Dispute Avoidance: Execute the Contract BEFORE Work Commences

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Dating back to Hammurabi’s code in the early fourth millennium B.C., continuing through the development of the U.S. Constitution, and still present in today’s professional culture, a dominant theme has arisen: before any process involving participation of multiple individuals or entities with differing goals can be successfully administered, a fixed set of rules should be adopted by all participants. The construction industry is no different; before a construction project is designed and construction work commences, the “rules” of the project must be agreed upon. The “rules” guiding the performance and obligations of the players in a construction project are found in the various contracts among the owner, design professionals, contractor and subcontractors.

All too often in the construction industry, the “game” begins before the rules are set; the owner meets with the design professional to discuss the schematic design process, the engineers begin incorporating their work into the architect’s drawings, and the contractor orders long-lead items, lines up his subcontractors, and frequently begins site work excavation, all before a single contract has been executed. Unfortunately, it has become quite common in the industry for owners and contractors, and contractors and subcontractors, to agree orally upon the project price and scope, then start working before many of the remaining important issues are agreed upon and reduced to writing in a formal contract. See, e.g., Carvel Co. v. Spencer Press, Inc., 708 A.2d 1033 (Me. 1998); Roberts & Schaefer Co. v. Hardaway Co., 152 F.3d 1283 (11th Cir. 1998). While the performance of such work may lead to an enforceable oral contract, the risks inherent to all parties in “playing the game” with an unknown set of rules may be significantly reduced by mutual written agreement on issues such as insurance coverage, liability (including indemnification), termination procedures, damages, delays, claims, change order procedures, allocation of risks and responsibilities, warranties, fees and payment procedures (including proper invoicing, retention, timing, schedule of values), dispute resolution mechanisms, risk of loss, and scheduling.

Problems with Unwritten Contracts

Many times, usually on a smaller projects, the parties are content with agreeing on the price and scope through informal discussion. One party promises to pay, and the other promises that it will perform. This type of oral agreement is enforceable as an express oral contract. Lucas v. Constantini, 469 N.E.2d 927 (12th Dist. Clermont County, Ohio 1983). Basic hornbook law states that if there is a meeting of the minds as to an offer, acceptance and consideration, then a contract is formed, whether written or oral. In the absence of a statute stating otherwise, oral agreements in the construction context are enforceable. Some states’ consumer protection statutes may require contractors to provide written construction contracts. Dudley v. Wyler, 647 A.2d 90 (Me. 1994) (applying statute requiring contractor to provide written contract to homeowner). Both parties are content with this oral contract arrangement until problems arise; it is when the parties are at each other’s throats that they begin to understand the importance of reducing the business terms to writing. Given the pace of construction deadlines and pressures, there may well be unavoidable times when work may commence while contract negotiations are yet to be finalized. In those instances, the parties are well-advised to execute a brief “early-start agreement,” which addresses the most important issues. An early start agreement should include: the scope of the work to be completed under the early start agreement, price, payment, insurance, standards for performance of the work, authorization for the contractor to begin the work, an understanding that the agreement does not constitute an award of the entire construction contract, and a date certain by which the parties will either execute the complete contract, terminate their relationship, or amend the early start agreement duration. This preliminary agreement, however, is no substitute for a formal contract.

No party to a construction project benefits from construction work performed prior to contract execution. Owners lose much of their negotiating leverage by permitting construction to commence before obtaining a signed contract. Once construction work starts, most owners are loathe to replace contractors, a fact of which contractors are all too aware. Negotiations occurring after construction begins take a decidedly different flavor than those taking place prior to commencement of the work. Owners lose the ability to obtain the benefit of the bargain for pricing and other key terms such as insurance requirements, change order procedures, Many owners require prior written approval of all change order work. Without a signed contract, an owner may be obligated to pay for change orders and extras which it would not have approved. and dispute resolution procedures. See, e.g., Brooks & Co. General Contractors v. Robinson Contracting, Inc., 257 Va. 240 (1999) (finding that the arbitration clause in the negotiated, but unsigned, AIA contract was not enforceable). Even written agreements to agree later on a guaranteed maximum price means that the owner loses bargaining leverage. Once subcontractors have begun a project, subsequent pricing from those subcontractors may well be inflated by the lack of competition, leading to an unnaturally high guaranteed maximum price. Indeed, owners also risk problems with construction loan lenders, who may threaten to pull the project financing in the absence of a written contract.

Contractors similarly run risks by foregoing written contracts. One major risk is obvious: not being paid or incurring steep legal fees to recover for work performed without a contract. In addition, many business terms in the owner-contractor agreement are “flowed-down” into the contractor-subcontractor agreements. Contractors who begin work without executed contracts with the owner take the chance that their agreements with subcontractors will not be in harmony with the requirements set forth in their subsequently negotiated contracts with owners. Moreover, many contractors rely on subcontractor bids and estimates when preparing their own bids, only to find out that, upon being awarded the project and providing the owner with the names of all trade subcontractors, the subcontractor will not honor its bid and seeks more money to perform the necessary work. See Pavel Enter., Inc. v. A.S. Johnson Co., Inc., 674 A.2d 521 (Md. 1006) (finding that a general contractor was not entitled to enforce a subcontractor’s bid where there had been no detrimental reliance or contractual relationship formed despite the subcontractor’s knowledge that the owner had relied upon the subcontractor’s bid in submitting its own bid).

Key Terms for the Written Contract

Prudent owners, contractors and design professionals will nevertheless put the full scope of their agreement in writing. Reducing the agreement to writing should clarify the parties’ respective understanding of the business terms. As the understanding is written down, one or both of the parties may identify issues not previously addressed, and they may also identify differences which were not apparent during their negotiations. Putting the agreement in writing also helps preserve the parties’ understanding. Once a disagreement arises, memories of conversations may become biased, conveniently forgotten, or altered regarding issues that should have been reduced to writing. A written contract executed prior to performing work will greatly assist in avoiding disagreements and misinterpretations based on hazy and selective memories, as well as changed circumstances. Moreover, a properly prepared construction contract should aid in the administration of the project. A thoroughly written and well thought out construction contract anticipates the various types of issues that may arise on the project. An oral agreement may provide mutuality on the basic scope and price of work, but does not provide the rules that will govern the completion of the project within the budget and schedule. Without adequately addressing the rules prior to work on the project, the parties will be hard-pressed to resolve even basic day-to-day project procedures without delaying the project and increasing costs to both the contractor and the owner. Some important terms, and their relevance to the various parties to a construction contract, are set forth below.

The Contract Amount- The contract sum or guaranteed maximum price, as well as general conditions costs and categories, should be agreed upon prior to performance of any work on the project. From the owner’s point of view, the contract should also address allocation of “subcontractor buy-out savings,” or the difference between subcontractors’ bids and the actual amount of the contractor-subcontractor contract after negotiation. The savings realized from the contractor-subcontractor negotiations may be shared between the owner and contractor or, in some cases, used as a basis for reducing the guaranteed maximum price. If the construction documents are not complete prior to commencement of the work, the contract should clearly provide for the method by which the parties will arrive at the actual cost (usually by a written modification to the contract). As set forth above, this approach may still result in an inflated guaranteed maximum price due to the contractor’s and subcontractors’ awareness of the lack of competition. Alternatives and unit prices, if applicable, should be set forth in the contract along with their effect on the contract price. Failure to agree upon pricing prior to performance of work can subject an owner to receipt of invoices greater than anticipated, while the contractor may find that the owner refuses to pay the full requested amount. Such problems must be avoided if the project is to be completed on time and within the budget.

Scope of Work- An improper, or nonexistent, description of the scope of work is all too often a precursor to disputes. For the owner, the concern is that all work required for a properly completed project is described in the contract documents and included in the contractor’s obligations. The contractor, however, is concerned that there are no surprises are inserted in the contract documents which were not included in his bid or evaluation of the project. Also, the contractor should be concerned with responsibility for coordination between the contractor’s work and the work of others, some of whom may be engaged directly by the owner. An oral agreement in which this concept is not addressed is a recipe for disaster. A very specific scope of work, usually drawn from the owner’s request for proposals and the contractor’s proposal, is a key to completion of the project on time and within budget.

Allocation of Risks- In every construction project, problems arise which were unknown to the contracting parties at the beginning of the project, including subsurface conditions, environmental conditions, concealed conditions, force majeure delays, design errors, material and labor shortages, price increases, site security, subcontractor and/or trade defaults. Although the actual nature and presence of each of these conditions is unknown at the time of contracting, it is reasonable to expect that some will arise. Indeed, the parties would be well-served by including provisions addressing these unforeseen issues. The general rule is that the party in the best situation to minimize each particular risk is the party who will bear that risk. Owners feel that the contractor should bear the risk for differing site conditions, errors and inconsistencies in the drawings, and many other delays. Contractors, on the other hand, frequently argue that the risks should be equitably apportioned. Discussion of these principles, and negotiation prior to execution of the contract, is crucial to a harmonious relationship resulting in an on time and within budget project.

Termination- The contract should clearly spell out the parties’ termination rights. Without contract termination provisions, the parties must rely on common law which, generally, permits termination in the event that the other party beaches the contract in a material manner. The contractor is normally provided the right to terminate and/or suspend its work only in the event that the owner fails to pay undisputed amounts after notice and an opportunity to cure. In some cases, the contractor will request the right to suspend its obligations and/or work in the event that that the owner is not diligently pursuing the project. The owner will usually reserve the right to terminate the contractor for either cause or convenience. The distinction in the two lies in the owner’s payments to the contractor. In a termination for cause situation, the owner will look to the contractor for damages incurred in completing the project. In the termination for convenience context, the contractor will want to be paid its entire profit for the project as “lost opportunity” costs. Termination provisions should also include the notion that failure to utilize a party’s termination rights does not equate to a waiver of the right to terminate in the future. The post-termination procedures should also be addressed, including the contractor’s obligation to assign subcontracts to the owner so that the project may be completed.

Payment Provisions and Procedures- The provisions in the contract that determine payment procedures, including retainage and the release thereof, progress and final payments, partial and full mechanics’ lien waivers, invoice documentation requirements, contractor’s schedule of values, payment for materials stored off-site, and payment timing are crucial to dispute avoidance, as nothing may cause acrimony between parties more than a dispute over payment or the lack thereof. Payment calculations and procedures for work performed pursuant to change orders should also be addressed.

Indemnity- Construction contracts typically require the contractor to indemnify the owner for injury to person and property damage on the project arising from the contractor’s work. Many owner’s require broader indemnification. Most states have promulgated anti-indemnification clauses which usually prohibit an owner from requiring the contractor to indemnify the owner for the owner’s sole acts of negligence, and the contractor from requiring indemnification from his subcontractors for the contractor’s sole negligence. Owners may also request that contractors indemnify them for loss of use, although this can become a deal-breaker for some contractors. The agreements usually hinge on the availability of insurance coverage for the requested indemnification. Prudent counsel will review the law applicable in the jurisdiction in which the project is located prior to drafting indemnification provisions.

Completion- The contract should define precisely what is meant by “substantial completion.” This date is much more significant than the date of actual “final completion,” since courts will focus on substantial completion in order to determine the relative rights of the parties in the event of a delay. Many construction contracts place substantial completion as the date upon which the architect issues a certificate of substantial completion. Others tie the date in with obtaining a certificate of occupancy.

Compliance With The Schedule- Timely completion of the project may be the single most important issue to owners. When a completion date is critical, owners will not be satisfied with merely a right to recover damages in the event that the project is delayed. Owners want to have mechanisms in place which will provide them with comfort that the project is proceeding as planned, such as permitting them to monitor the progress of the work and to require the contractor to stay on schedule. Many owners engage a separate construction manager as the owner’s representative to monitor the project on a day-to-day basis, including compliance with the budget and schedule. Owners normally require the contractor to maintain a schedule and update the schedule as the construction project continues. Failure to meet the requirements of the schedule may permit the owner to withhold payment or to require the contractor to accelerate work at no additional cost to the owner in order to rehabilitate the schedule. Alternatively, the owner may have the right to take over some or all of the work or terminate the contract.

These are but a few, but also the most important, clauses in a construction contract which should be agreed upon prior to the performance of any work on the project. Many of these important clauses will not be applicable to a construction project unless the parties agree on them. As a practical matter, such agreement should be reduced to a written contract. No party to a construction contract benefits by a delay in doing so.

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