Five Key Construction Contract Provisions for Contractors and Subcontractors

The importance of the terms of a construction contract in the event of a significant dispute on a construction project cannot be overstated.  Simply put, the terms of the contract can be the difference between successfully navigating a dispute in a manner that still achieves a financially successful project, and a project ending in expensive and protracted litigation at best, or in an absolute financial disaster at worst.  This article highlights five key construction contract provisions that every contractor and subcontractor should pay attention to in order to try to minimize risk and maximize the chances of a successful and profitable project.

1. Indemnification

Indemnification provisions require one party to a contract to assume responsibility for loss or damage incurred by the other party to the contract under certain circumstances.  The party agreeing to accept responsibility is called the indemnitor, and it “indemnifies” and “holds harmless” the indemnitee from the loss or damage.  Contractors and subcontractors should carefully review the indemnity provisions in their contracts, as indemnity provisions are often subject to laws specific to the jurisdiction where the project is located, and indemnity provisions in form contracts like those from the AIA, cannot always be used.

As a general rule, contractors should attempt to limit their indemnity obligation to their own negligence (and that of their subcontractors) and only to their percentage of fault.  Contractors should try to avoid indemnifying an owner for damage or loss caused by the owner’s own negligence, a form of indemnity known as “broad form” indemnity.  Subcontractors should similarly try to avoid taking on such broad form indemnity obligations to contractors.  Contractors and subcontractors should also always review whatever indemnification obligation they agree to take on in the contract with an attorney or insurance professional to make sure that they have appropriate insurance in place to cover the indemnity obligation, as an uninsured indemnity obligation can have a potentially disastrous effect.

2. Liquidated Damages

Contract provisions providing for liquidated damages in a specified amount per day for completion delays are a part of many construction contracts.  Although they generally provide for a contractor to pay daily amounts for every day that project substantial completion is late, properly worded and limited liquidated damages provisions can actually be beneficial to a contractor.  This is because they allow the contractor to know and understand its exposure to delay damages from the beginning of the project, rather than being exposed to potentially unknown and extensive actual damages for delayed completion.

However, in order to be effective, the contractor needs to try to ensure that the provision expressly covers all of the owner’s direct and indirect damages for delay.  The contractor should also try to negotiate a cap or limit on its total exposure for liquidated damages, and to make clear that liquidated damages do not apply to the extent delay is caused by acts or omissions of the owner, or by other entities or events over which the contractor does not have control.   If possible, the contractor should attempt to negotiate a grace period prior to the commencement of liquidated damages.  Also, whatever liquidated damages are agreed to by the prime contractor should be flowed down to subcontractors.

Subcontractors, on the other hand, should try to limit their exposure to liquidated damages to only the portion of the delay for which the subcontractor is actually responsible.  If possible, subcontractors should also try to include a cap or limit on the subcontractor’s total exposure that bears some reasonable proportion to the size of their subcontract.

3. Consequential Damages

Consequential damages are losses or injuries that are not the type that would almost always flow directly and immediately from a breach of a contract, but instead are those that result as a consequence of the breach in a particular case, and they may be recoverable if they can be said to have been within the contemplation of the parties at the time they made the contract.  Typical examples of consequential damages an owner may assert include, among others, lost profits, lost rents, loss of use, damage to reputation, and interest and finance charges.

Because of the unpredictability and potential for significant downside risk for a contractor exposed to consequential damages claims by an owner, a contractor should make every effort to include a mutual consequential damages waiver in the contract.  While the contractor would also be giving up its own ability to potentially recover consequential damages due to a breach by the owner, such as additional financing charges, lost profit on other projects, etc., those types of damages will generally be less than the typical consequential damages an owner is likely to suffer.  Therefore, a contractor is usually better off obtaining a mutual waiver of consequential damages than being exposed to unknown and potentially very large owner consequential damages.  If an owner is unwilling to waive consequential damages, the contractor should at least try to negotiate some type of cap or limit on the amount of consequential damages either party may recover in case of a breach. 

4. Termination for Convenience

Termination for convenience provisions allow an owner or contractor to terminate the construction contract or subcontract for any reason, at any time and without cause.  A termination for convenience can obviously have a significant negative effect on a contractor’s or subcontractor’s finances.  If such a provision cannot be avoided, the contractor should try to ensure that it includes language that ensures that the contractor is paid for work performed prior to termination, including for materials purchased, overhead, profit and general conditions.  The contractor should also try to obtain language in the provision that fairly compensates the contractor for profit and overhead on work not performed due to the owner’s termination for convenience.

Subcontractors should try to limit the contractor’s right to terminate for convenience to only those situations where the owner has terminated the contractor for convenience.  Subcontractors should also try to obtain language providing that they must be compensated for work performed prior to termination, including overhead and profit, and if possible, for profit and overhead on work not performed due to the termination.

5. Claims and Dispute Resolution

Claims and dispute resolution provisions govern the manner in which the parties submit claims and resolve their disputes.  With respect to claim submission, contractors and subcontractors should try to avoid provisions stating that a failure to provide timely notice operates as a waiver of a claim, particularly when coupled with an unreasonably short time in which to provide notice.  If such a provision cannot be avoided, effort should be made to include a provision allowing for an initial simple notice of potential claim within a reasonable time period, followed by additional time period in which to provide a more substantive claim notice to allow additional time to assess the effect of the issue and magnitude of the claim.

With respect to claims that cannot be resolved at the project level, the most common forms of dispute resolution are through litigation in court or by arbitration.  There are various pros and cons to choosing arbitration or litigation as the forum for dispute adjudication.  For example, arbitration may allow for the dispute to be decided by arbitrators that have more experience and understanding of the construction industry than the average judge or jury.  Arbitration may also potentially allow for a quicker and more efficient process to obtain a decision due to more flexibility in the arbitration process and more limited discovery process than in litigation.

However, arbitration decisions are final, with essentially no ability to appeal other than under extremely limited circumstances.  In addition, arbitration filing fees and arbitrator hourly fees can often be very expensive, particularly in large dollar disputes, and arbitration may not always provide a significant time or cost savings over litigation.  These, and other issues, should be carefully considered when negotiating whether disputes will be subject to litigation or arbitration.

If arbitration is the chosen forum, contractors should be sure to flow down the arbitration requirement to subcontractors and to also include language in the provision that would give the arbitrators authority to consolidate disputes so that all necessary parties can be included in the arbitration proceedings.  Contractors and subcontractors should also be sure to include language that would permit them to file a lawsuit if necessary to preserve any mechanic’s lien or payment bond rights notwithstanding the arbitration provisions.  Those litigation proceedings can then be stayed pending the outcome of the arbitration.

Whether arbitration or litigation is chosen, subcontractors should try to ensure that their right to have the contractor pass through subcontractor claims that involve owner acts or omissions is spelled out in the subcontract.  Subcontractors should try to include specifics regarding the contractor’s obligations regarding claim sponsorship, the sharing of costs and expenses, and the distribution of any recovery on such a claim.  Subcontractors should also try to include a requirement that the subcontractor’s pass through claim cannot be settled with the owner without the subcontractor’s prior approval.

Also, whether arbitration or litigation is the agreed forum, contractors and subcontractors should include a prevailing party attorney’s fee provision in the contract.  This is critical to ensure that when successful on a claim, all damages are recoverable, including the attorney’s fees and costs incurred in pursuing the claim.  Otherwise, the costs of litigation or arbitration will not be recoverable and the net value of a successful claim recovery or defense will be reduced.

Conclusion

These are just a few of the key areas that every contractor and subcontractor should pay close attention to when negotiating a construction contract.  There are, of course, many other construction contract provisions besides those discussed here that are also important, and the specific circumstances of a particular project or situation must be taken into account in negotiating any specific contract provision.  Accordingly, an attorney experienced in construction law should be consulted for specific questions and legal advice regarding any particular contract or project.