PALO ALTO, CA-In the world of real estate development, one of the most significant and often undervalued agreements is the contract between the owner/developer and the general contractor. Drafting and negotiating construction contracts for commercial and/or large scale construction projects is, in its simplest form, an exercise in risk management. Each side jockeys for position on where and how to allocate risk; while, at the same time, managing those risks through a variety of mitigation techniques.
A construction contract should clearly and unambiguously lay out not only the tangible terms such as the scope of work, the project delivery methodology, the project schedule, the project budget, the payment terms and the insurance coverage, but it also must address various foreseeable and unforeseeable risks that may arise either during the course of construction or after the project is complete. In an effort to streamline negotiations and reduce initial fees and costs, various organizations have developed form contracts including, but not limited to, the American Institute of Architects, the Associated General Contractors of America, ConsensusDOCS, the Engineers Joint Construction Documents Committee and the Associated Owners & Developers. While these forms are regularly used under the pretext of being fair and equitable consensus documents, it is critical to remember that the drafting organizations prepare the forms from the perspective of their own constituents. For this reason, regardless of whether the parties use a form or sui generis contract, the documents must be modified and tailored to each particular project in an effort to allocate risk to the party who is in the best position to control or manage the same. In some instances this may be the owner/developer and in others it may be the contractor. What is most important to remember is that, when it comes to construction, one size does not fit all.
A comprehensive discussion of all the risks that should be addressed in a construction contract is beyond the scope of this short article; however, a few of the more heavily negotiated provisions in the current marketplace are summarized below.
1. Change Orders: It is difficult at the outset of a project to definitively establish a total scope of work, budget and schedule. Change orders allow flexibility for the inevitable changes that arise during construction. When the parties agree on a modification to the contract's terms, it is documented as a written change order. When the parties do not agree, it is critical for the contract to expressly identify which party is obligated to carry the risk.
2. Concealed or Differing Site Conditions: One of the most significant risks in the construction process is not knowing what will be encountered below grade or within the structure of an existing building. When negotiating the contract, the parties must decide whether the owner/developer, the contractor or both should carry these unknown risks and to what extent. Failing to properly allocate and mitigate such risks will, in most instances, result in a dispute that can easily derail a project.
3. Project Delays: Construction projects regularly experience delays. Some are caused by weather, others by shortages in supplies or by the failure of the contractor or owner to satisfy obligations under the contract. To mitigate these risks, most projects utilize a critical path schedule. If a delay impacts the critical path, a milestone or the date of completion (substantial or final), the contract must dictate when a delay is excusable and/or compensable.
4. Indemnification: Indemnification affords one party protection against claims that may arise as a result of an act or omission by the other party. Significant time is spent negotiating the scope of an indemnity clause (including defense and hold harmless obligations) and the applicable carve-outs (including willful misconduct or degrees of negligence by the indemnitee). Carefully crafted indemnification language is essential to properly mitigating construction risks.
5. Consequential Damages: Contractors seek to mitigate unforeseen risks by limiting their liability to only the owner/developer's actual damages. Such provisions can include liability caps and waivers of consequential damages (i.e., indirect and economic damages). Owners/developers on the other side want to preserve their ability to recover such damages (i.e., lost profits, overhead, interest and rent), and the negotiated resolution is typically somewhere in the middle with a narrowly defined waiver and broad and expansive carve-outs.
Whether owner/developer or contractor, it is always in the best interest of the parties to spend the time, energy and resources at the outset to fully negotiate the terms of a comprehensive agreement.
Michael C. Polentz is Co-Chair of the Real Estate & Land Use Practice Group at Manatt, Phelps & Phillips LLP, located in the Palo Alto office. The views expressed in this column are the author's own.
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