Managing Contractual Risk in U.S. Construction Projects to Increase Profitability: Beyond the Incentives

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Managing Contractual Risk in U.S. Construction Projects to Increase Profitability: Beyond the Incentives

By Christopher M. Caputo*

 

Bringing manufacturing jobs to the United States is a goal that is often discussed at every level of government and politics. There is little doubt that the United States is seeking to attract foreign based investment – particularly in manufacturing – and state and local governments are competing to attract factories that will ultimately house highly paid American workers. For a foreign inbound company, the choices can be daunting and seemingly every state or region touts itself as having the best trained workforce or the most well-developed logistics network. The site selection business is booming, fueled by inbound companies with a wealth of options but sometimes very little experience in siting a factory in the United States.

 

States compete over inbound prospects not only by touting their perceived advantages, but also by offering various financial incentives to the foreign company. The cash value of the incentive packages is often statutory and is based on the level of planned capital investment anticipated by the company as well as the number of permanent jobs to be created over a period of time.

 

While incentives may be subject to statutory formulas and restrictions, they nevertheless need to be negotiated, preferably before a location decision is announced. However, incentives sometimes seem to receive a disproportionate share of a company's attention at a project's inception. Employment and wage decisions, proximity to upstream clients and downstream vendors, supply chain redundancy and facility and equipment design can be more significant drivers of risk and profitability than the one-time sugar rush of a cash grant (which may only be marginally more lucrative than the next best offer). Moreover, the success or failure of the construction project can easily have a greater impact on the facility's initial profitability than the outcome of an incentive negotiation. For this reason, an inbound business must pay careful attention to the project delivery system and the contracts governing its relationships with its designers, contractors and equipment suppliers. In many cases, critical risk-shifting decisions embodied in the construction and design contracts will have outsized ramifications for the financial success or failure of the project.

 

A substantial industrial project will involve a large number of parties, whether they be contractors, design professionals, or other consultants with specific knowledge in the industrial or fabrication process that will take place when the project is complete. It is up to the company developing the project to decide the manner in which the contracts with each of these entities will be organized. In the United States, there are certain contract forms and project delivery systems that are predominately used. Of course, the contract forms and delivery systems ought to be highly customized to meet the specific needs of the company developing the project and to comply with the local requirements imposed by the governmental authorities where the facility is to be located.

 

In brief, the typical project delivery systems used in the United States are as follows:

 

Design-bid-build – This is the traditional method of causing a facility to be designed and constructed. Under this system, the owner causes the facility to be designed by its architect and engineers of various disciplines. (The engineers may be directly retained by the owner or hired as consultants by the architect.) Once the project design is sufficient that potential contractors can reliably submit bids for the work, the design documents will be circulated and contractor bids collected and analyzed. Once the successful bidder is selected, a contract for the construction of the facility will be entered between the facility owner and the contractor.

 

Construction manager – In this method, a construction manager and architect and engineers are each retained while the facility is being designed. The construction manager participates in the design process and, if the process works correctly, cost savings are achieved because the construction manager is able to advise on constructability and alternative methods of meeting the design criteria and other project requirements before commencing construction. After the design phase, the construction manager may continue to assist the facility owner in a mere advisory role or will undertake to actually construct the facility as the general contractor. If the construction manager serves as the general contractor during the construction phase, it is said to be construction manager "at risk."

 

Design/build – Under the design/build delivery system, the same entity will contract with the facility owner to both serve as the architect and the contractor for the project. This system has the advantage of certain cost savings for design work and, if there is any defective element of the project or completion of the facility delayed, the owner can look to one single entity to compensate it for any loss (avoiding the common dispute between architect and contractor as to who is at fault) for any such delays or defects. Design/build projects are often built on a "fast track" basis, meaning that construction begins before the project design is complete.

 

Each of these project delivery systems has advantages and disadvantages, few of which are mentioned here but all of which must be carefully considered prior to selecting one. There are various commonly used contract forms readily available in the United States for each such arrangement, including forms prepared by the American Institute of Architects (AIA), Associated General Contractors (AGC) and the Design/Build Institute of America (DBIA), among others. Certain organizations have developed collaborative contract models, such as integrated project delivery, whereby the facility owner and its design and construction teams will share the benefits of particularly efficient project completion and the potential liability for project delays or defects; in such an arrangement, the parties may give up rights that they may have otherwise possessed to pursue recovery against each other in court.

 

No matter which project delivery method or contract is selected, no project is identical to another and every facility owner's needs will be different. Accordingly, the forms discussed above should be construed to be conceptual guides around which the rights, responsibilities, and expectations of a company constructing a facility in the United States should be construed. When making such a significant investment, however, no facility owner should be constrained by the language of any given form. In particular, owners should be purposeful in negotiating the various types of provisions set forth below. Proper negotiation on these risk-shifting factors will mitigate risk, increase leverage and, quite possibly, impact the ultimate cost of construction by millions of dollars.

 

1.    Statutory Requirements

 

The design and construction teams performing work in the development of a facility must be registered (in the case of the design team) and licensed (in the case of the construction team) prior to performing work on the facility. Construction licensing is a matter of state law and a contractor must be licensed in the state in which the facility is located. Different states have different requirements. Owners are advised to request evidence of appropriate registration and licensure prior to entering into any contracts. Even if the lack of appropriate registration or licensure is not the fault of the owner, a construction project can be shut down and its completion delayed because unlicensed entities are working on the site. This delay ultimately hurts the otherwise blameless owner, whose revenue stream is dependent on prompt completion and operation of the facility. The risk of performance of work by an unlicensed subcontractor should therefore always be placed on the contractor that retains them.

 

2.     Retainage/Prompt Pay Acts

 

Typically, a construction contract allows the project owner to deduct certain amounts from each payment made to the contractor until the project is complete. The deduction is known as "retainage" and is available to the owner to complete or correct the contractor's work if the contractor fails or refuses to do so. Once the project is complete, the owner will release any accrued retainage to the contractor. However, care should be taken in the negotiation of a construction contract to ensure that the owner has the maximum leverage possible to induce the contractor to complete the project, particularly in the manufacturing context in which the final phase will likely relate to the commissioning and start-up of the plant equipment needed to make the facility productive.

 

A project owner's ability to deduct retainage from payments to a contractor is not unlimited. Each state treats an owner's right to retainage somewhat differently and there are typically statutory limits, which may vary from state to state, on the amount of retainage that can be withheld from a contractor's progress payments. Additionally, state statutes may impose requirements on what an owner can do with funds that have been returned from a contractor (for example, some require that retainage be placed in a separate, interest bearing bank account) or as to when retainage must be released to the contractor. Accordingly, while retainage provisions should be negotiated with the contractor, it is very important to consult the statutes of the state in which the project is located in order to ensure that the negotiated retainage provisions are enforceable.

 

Beyond retainage restrictions, states typically enact and enforce "Prompt Pay" statutes that require a contractor to be paid within a certain period of time after its applications for payment. The extent to which the parties may contract around these requirements varies from jurisdiction to jurisdiction. Any industrial owner should pay very careful attention to compliance with these statutes, but should also negotiate all potential provisions to entitle it to withhold sufficient payment to protect it in the event of uncompleted or defective work after substantial completion, particularly where the contractor is responsible for commissioning of plant equipment. In many cases, an owner may be able to negotiate favorable payment terms and rights to withhold additional sums at the end of the project, exclusive of retainage, to protect its interests and reduce the risk of the contractor leaving the project before it is in proper working order.  These rights should be specifically set forth in the precise language of the written contract because some Prompt Pay statutes do allow owners to withhold additional sums as long as such withholding does not otherwise violate the contract.

 

3.    Warranty of Design-Related Information

 

In any project, the owner will possess certain design-related information. In a design/build job, the owner will provide design criteria for the design/builder for use in a project. In a design/bid/build job, the contractor will be furnished with a design provided  by an architect or engineer that has been retained by the owner. Only in rarest of occasions does an owner actually design a project.

 

Under the Spearin Doctrine, a party who is responsible for furnishing completed designs warrants the adequacy of the designs and the other party "will not be responsible for the consequences of defects in the plans and specifications." United States v. Spearin, 248 U.S. 132, 136 (1918). A contractor cannot recover under the Spearin Doctrine if it could have known the design or specifications were defective by undertaking its general duty to visit the site, check the plans and inform itself of the requirements of the work. More broadly, however, there is always negotiation over the extent to which an owner warrants any design information. This is particularly the case where a foreign owner selects to replicate the design of its existing facility in its home country. Inbound companies should be counseled to retain a qualified U.S. engineer to validate any existing design and to conform it to U.S. requirements. To the extent possible, companies should also resist warranting design information that they provide, particularly to design/builders. If an owner does not disclaim warranties of design information, to the extent that a contractor incurs extra costs as the result of unforeseen design issues, the owner will be required to pay the contractor those costs.

 

4.    No-Damage-for-Delay Clauses

 

A contractor performing work on an industrial facility may well incur costs simply by being mobilized and will be damaged by delays in the completion of the project. Owners often include a "no-damage-for-delay" clause in their contract whereby the owner attempts to avoid liability to pay the contractor extra money stemming from a delay in construction, causing the contractor to suffer damages. These clauses often provide that in the event of a delay, the contractor is entitled to a time extension only, but no monetary compensation.

 

Because of their harsh effects, the courts and legislatures of some states have proved hesitant to give effect to the clauses. States have therefore created exceptions under which no-damage-for-delay clauses will not block recovery of damages. These exceptions may include delays caused by the fraud, bad faith, active interference, or gross negligence on the part of the owner. Similarly, no damage for delay clauses have been held unenforceable where a contractor has successfully argued that the type of duration of the delay that was encountered on the project was beyond the scope of what was contemplated by the parties when negotiating the contract. In any event, while no damage for delay clauses are often enforceable, courts are likely to strictly construe no-damage-for-delay clauses and will interpret any ambiguity against the party seeking to benefit from their provisions.

 

5.     Liquidated Damages

 

Facility owners are typically understandably anxious to commence production on time and any delay in project completion will cause the owner to suffer financial loss. Accordingly, owners often include a "liquidated damages clause," which is a contractual provision that determines in advance the measure of damages to which the owner will be entitled if the contractor fails to complete the project on time. Liquidated damages clauses are typically enforceable unless they are found to be a penalty, in which case they are unenforceable. One way in which contracting parties avoid future inquiry as to the enforceability of liquidated damages clauses is to incorporate a representation whereby the parties agree that the liquidated damages  set by the contract are reasonable and not a penalty.

 

Because penalty provisions are generally found to be against public policy, in order for a liquidated damages clause to be valid and enforceable as opposed to a void penalty clause, the following factors must be satisfied:

 

(1)

the injury caused by breach must be difficult or impossible to accurately estimate;

(2)

the parties must intend to provide for the damages rather than for a penalty; and

(3)

the sum stipulated must be a reasonable pre-breach estimate of the probable loss.

 

Courts in the United States typically respect the intent of contracting parties and, as a general rule, enforce contracts as written. If it is clear that a property owner drafted a liquidated damage provision as a penalty, a court may refuse to enforce the provision. However, "when courts find a bona fide attempt to estimate potential damages, they generally enforce the liquidated damages provision even if actual damages are absent or less than the stipulated amount." R. Cushman et al., Construction Disputes: Representing the Contractor, at p. 624 (3rd ed. 2001).

  

Those not experienced in construction in the United States may be inclined to wonder why liquidated damage provisions are such a commonly used vehicle to manage construction risk. While every party will have its own motivations for insisting on or agreeing to a liquidated damage provision, there are certain broad reasons why the provisions may be advisable. For a facility owner, the liquidated damage provision secures a predetermined amount of "pain" that a contractor will suffer if it fails to complete the contract in time. The owner can then proceed with its project knowing that it has a degree of leverage over the contractor to finish the project on time without having to worry about the cumbersome task of proving its actual damages that were caused by the delay in project completion.

  

While the amount of actual damages may be very significant, the cost and uncertainty of proving such damages may be daunting. However, because liquidated damages replace an owner's actual damages for project delay, an owner must be very careful not to underestimate its damages in an effort to appear "fair." If there is a liquidated damages provision in a contract, the owner will not be able to recover its actual damages associated with the delay in the project completion. As such, an owner's first consideration should be whether it would be adequately compensated by the agreed liquidated damages amount.

  

                   6.     Consequential Damages and Waivers

 

The standard AIA forms contain a mutual waiver of consequential damages. The fact that such damages are worded in the standard form imputes a perception that the mutual waiver is "fair." A project owner should reject this perception.

  

The notion of a "consequential" damage is a difficult one for courts and attorneys to fully and definitively explain. In the construction context, direct damage might be the cost to correct or complete certain work, but consequential damages might be a decline in production, the need to outsource parts or product, and the resulting loss of income or profit. There are legitimate and quantifiable risks. For a contractor to suffer a consequential damage as the result of an owner's breach of a construction contract, it will likely be required to prove some lost opportunity to perform a different job (and that the job would have been profitable). Such recovery would be unlikely. Because an owner is therefore more likely to incur demonstrable consequential damages associated with a disruption in its manufacturing operations, the right to claim consequential damages is likely more valuable to an owner than to a contractor and should not be waived by an owner as freely as a contractor might.

  

Construction contracts in the United States are lengthy documents, sometimes well over a hundred pages long. While not every term or condition will be truly impactful, the risk-shifting provisions mentioned above may prove to be fundamental to the success or failure of a project. Consequently, negotiating these terms carefully and thoughtfully is an important element of planning and protecting an investment in the United States. 


 * Christopher M. Caputo is a shareholder in the Nashville and Memphis offices of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC, where he practices construction law and litigation and leads the Firm's Tennessee construction practice. He can be reached at ccaputo@bakerdonelson.com.

 

photo
Memphis, TN 
Monday, September 25, 2017
Contracts / Agency