Today’s builder must be as expert at managing its contractual risk as it is at managing a safety program. Many large and small contractors, once considered outstanding builders, are out of business today. Some of the contractors may have even been good financial managers. However, what many of these contractors did not do well was contracting and contractual risk management.
How can the contractor create a company-wide appreciation for contractual risk management? This article will attempt to answer that question.
A Working Definition of a Contract
A contract is a binding agreement between two or more parties where consideration, usually cost plus a fee or a lump sum bid amount, is given in exchange for certain performance guarantees involving a well-defined scope of work. In theory, the contract represents a “meeting of the minds” of the contracting parties, with respect to each party’s responsibilities, obligations, and assumed risks. (This is not a legal definition.) Traditionally, contractual risk has been allocated to the party that has control over the risk. For example, in a construction contract, the contractor has control over safety conditions and, therefore, appropriately accepts responsibility for worker safety risks. Everyone understands this risk and agrees to the allocation of the risk to the contractor.
In recent years, however, this equitable approach to risk allocation has, in large part, been ignored. True, the contractor is still responsible for worker safety, but often the contractor is also contractually responsible for many risks over which it has little or no control. Today, it is not unusual for a contract to unfairly allocate risk to the contractor for differing site conditions, delay, even design deficiencies and timely payment.
Inequitable Allocation of Risk
The contractor commonly has no control over site and locational conditions since the owner usually selects the site. With respect to delay, contracts today, more often than not, contain “no damage for delay” clauses that waive the contractor’s rights to compensation, regardless of the cause of the delay. The owner can suspend work on the contract and, many times, the only adjustment the contractor is contractually entitled to is an extension of time. This kind of clause can, and often does, impose a serious unplanned financial burden on the contractor. “Pay if paid” clauses shift the risk of payment away from the owner (if financing is not guaranteed) or from the general contractor (when found in a subcontract) down to the party performing the work.
A “pay if paid” clause should only be agreed to under certain circumstances. If this clause appears in a contract between the owner and the general contractor, and refers to release of the funds by a financial institution, the contractor must be aware of the requirements of that particular financial institution for release of funds. How available is additional financing if costs escalate through no fault of the contractor? If a “pay if paid” clause appears in a subcontract, the subcontractor must have access to the financial information of the owner before assumption of payment risk is reasonable for the subcontractor.
There are several ways a contractor can minimize its exposure to inequitable allocations of risk. Once the proposed contract has been reviewed, and the “killer” risk allocation clauses have been identified, the contractor can attempt to negotiate these clauses out of the contract. For public works contracts, negotiation is usually not available to the contractor – “If you want the work, sign the contract!” However, many “killer” clauses are not enforceable on public works projects. “No damage for delay” clauses, for example, may or may not be enforceable, depending on locality. (The contractor should contact an attorney in the local project area to determine the enforceability of certain clauses in that area, before the contract is signed.)
For large scale, lump sum private projects, again, contract negotiation is often not an option. In this case, by agreeing to the contract as it stands, a contractor may waive its rights to compensation for costs associated with risks that would normally, and appropriately, be allocated to the other party. As long as the contractor is aware of the “killer” clauses contained in the proposed contract, it can make an informed business decision to:
(a.) execute the contract and accept these risks,
(b.) walk away, or
(c.) execute the contract and manage the assumed risks.
This is contractual risk management. It should be as common as safety loss control – both prevent losses. For Part II of this Article, be sure to read next month’s issue of the ConstructionRisk.com Report. It will include specific examples of Killer Clauses and practical tools for managing them.
Reproduced with permission from CFMA Building Profits, the official publication of the Construction Financial Management Association, Princeton, NJ (http://www.cfma.org)
About the Author: Pamela Tittes is a Principal at Kellogg, LLC. During her 30 years of professional experience, Ms. Tittes has worn many hats, including engineer, owner, contractor, and consultant. Prior to joining Kellogg, Ms. Tittes was the President of Tittes Construction Consulting, LLC (TCCLLC), a company specializing in disputes avoidance and resolution. Before TCCLLC, Ms. Tittes was a Vice President at Aon Risk Services, Inc, providing disputes avoidance and resolution services to Aon’s construction clients. Ms. Tittes came to Aon from Kajima Engineering and Construction, Inc., where she was Corporate Manager of Contract Administration. Ms. Tittes is a graduate of the Colorado School of Mines, with a BS in Metallurgical Engineering, and a MS in Mineral Economics. She is also a Bioenvironmental Engineering Officer in the Colorado Air National Guard.
ConstructionRisk.com Report, Vol. 4, No. 5 (May 2002)