Construction Contract Basics
Updated: Mar 6, 2021
A. General Contract
Under a General Contract, typically the project is designed before the owner selects the contractor. An architect and as necessary, including engineers or other design professionals for the site work and the civil, structural, electrical, and mechanical engineering design. In the alternative, an Owner may sign a design/build contract, where all services are provided as a turn-key option and providers do so as subcontractors to the general contractor. In most circumstance the Owner engages an independent project manager for quality control. Depending upon the form of agreement, design build or general contract, all of the work is based upon plans and specifications prepared by the architects, engineers and other design professionals. The devil is in the detail with regard to plans and specifications, and proper preparation of design documents can limit exposure to mistakes, change orders or performance issues.
A Design Build Construction Contract, the Contractor/Developer (Builder) will be responsible for both the design and construction of the improvements. Under a Design Build Agreement, the Owner contracts directly with the Builder, who oversees all aspects of the construction process, beginning with design, letting of subcontracts, insurance, material purchases and labor matters, disbursements and payments, and completion of construction. As the Owner is in direct contract with the Builder, the Owner’s recourse is generally limited to the Builder. Proponents of Design/Build gives significant control of the project to the Builder, which some owners may view as beneficial. Design Build can also allow for flexibility, as in fast track projects, where the design is development concurrently with the commencement of construction, especially with single tenant industrial projects where simple structural design can commence while tenant requirements can be incorporated as the project moves forward. However, fast track leaves pricing and final design open ended, which may be too risky for some. Fast track. Fast Track leaves the Owner vulnerable to pricing for a lump sum price or guaranteed maximum price (see discussions below) at a time when the owner often has the least amount of leverage. To alleviate this concern, most Fast Track projects are design/build. Design Build does have constraints, as exact design details being unknown and uncertainty of final design and development costs may not satisfy the Owner’s use or budget.
C. Project Management.
With any form of construction contract, the Owner should consider engagement of a construction expert to oversee and represent the owner in all phases of the project, including design, construction and post completion consulting. Generally, architect either don’t have the skill or the inclination to oversee the specific trades, or a conflict of interest may arise where a dispute centers around design versus implementation leading to change orders. Project Managers can be serve in an agency capacity, as an advisor without authority over design or implementation of construction, or fully vested, with full responsibility for project compliance, assuming risk if issues arise, and essentially serving as the general contractor. Most owners prefer an independent advisor, that is not subject to conflict of interest in the dual role as both architect and/or contractor.
D. SELECTION METHODS
On a public works project, the governmental entity is usually required to employ competitive bidding. Typically bidding process is supervised by either the Architect or Builder (or both), or perhaps sealed bid process. In either event, the Owner typically will engage the Architect, Contractor and Project Manager, to review the bids. In a design-select-build arrangement, the architect usually prepares the bid or proposal package for the selection of the contractor. In a design/build arrangement, the owner often looks to the Project Manager to prepare the package. Often, the attorney is involved in the process to be sure the terms and conditions are consistent and includes the construction contract preferred by the Owner.
E. CONTRACT PRICE
There are several pricing contract structures available for owners.
1. Lump Sum (Stipulated Sum). A lump sum is a fixed contract price. This is the type of pricing structure usually employed when the contractor is selected by competitive bidding. The contractor agrees to furnish the work for a fixed price, paid upon stages of completion. The General Contractor negotiates his own pricing with the subcontractors, and the Owner is not involved and has no control over selection of subcontractors or suppliers, and or material selection.
2. Unit Prices. Under a Unit Price Contract, the work may be clearly defined, but the pricing is based upon some measurement system, i.e., cost per square foot.
3. Cost-Plus. Typically used, the Cost System prices out the base cost of construction and provides the General Contractor with a percentage or fixed amount above the base cost. Unless the owner intends to give the contractor the equivalent of a blank check, most cost-plus contracts also have some cap or "guaranteed maximum price." The Owner must give careful consideration to the contract terms with each pricing system.
F. Industry / Standardized Form Contracts
There are a number of construction industry trade groups that have attempted to create form contract documents for use on various types of projects.
1. American Institute of Architects (AIA). Many forms used in the industry are available from the American Institute of Architects. They purport to be balanced, but include a bias in favor of architects and contractors. Don’t be fooled by the pre-printed form, nor allow the architect to draft the agreement without modification by legal counsel. The benefit of AIA forms is that they are the default contract used by Architects and Contractors, who are more familiar with their use and terms.
2. Associated General Contractors (AGC). These forms are provided by the largest trade group for general contractors (the Associated General Contractors) and are quite similar to the AIA forms. Not as widely used or accepted, they nevertheless can be used with modifications by the Owner. As with the AIA forms, not surprisingly, the AGC forms have a reputation of favoring general contractors more than the other standardized forms.
3. Engineers Joint Contract Documents Committee (EJCD). Provided by the Engineers Joint Contract Documents Committee are also similar to the AIA forms. These forms are not as widely used or accepted as the AIA or AGC forms, although it is not unusual to see them used on heavily engineered projects such as bridges, manufacturing facilities, and power plants.
4. Custom Legal Forms. Typically designed by legal counsel for the Owner with Owner bias intended.
G. Types of Construction Contract Documents
1. Project Manager. Used when an owner needs professional assistance in the planning, development, and coordination of projects.
2. Architect Agreement. Most, if not all jurisdictions, require building permits and in order to qualify for a building permit, professionals must attest or apply their professional seal and license number to the documents. Consequently the Architect agreement defines the scope of work and responsibilities of the Architect, including design, supervision, review of change orders, dispute resolutions, ownership of plans and specifications, etc.
3. General Conditions. On larger projects, the Owner-Contractor Agreement may include a set of General Conditions which set out in greater detail the rights, responsibilities, and remedies of the parties to the construction contract.
H. STANDARD CLAUSES AND TERMS
Though not exhaustive, below are some key components of any construction contract.
1. Scope of the Work. The scope is as one would assume. It details the services to be performed. Though the goal of the parties is to define with as much certainty at the outset of the role of the various parties and the services to be provided, it often includes language defining inferences to be drawn based upon common sense and custom in the industry.
2. Contract Time. Every contract should state that "time is of the essence" and should impose some reasonable time limitations on the part of the contractor to complete its performance. Deadlines may be imposed at various milestones during design and construction, with the most significant milestone is "substantial completion."
3. Final Completion. Another important milestone is final completion which should also be defined. Final Completion impacts important matters relating to damages as well as tolling of the period for filing of mechanic’s liens, as well as matters of final payment.
4. Damages. In the event of a delay in completion of construction, an owner may recover those damages which are the "natural, probable, and foreseeable consequences" of the contractor's conduct. Typically the parties will negotiate the issue of consequential damages, meaning recovery of speculative lost profits.
5. Contract Sum. A fixed sum contract is as implied and the most simplistic pricing method. However, a Cost Plus Contract, includes pricing risk and may result in pricing inefficiencies with little incentive for the Builder the curtail costs. Often a cap or maximum guaranteed amount is negotiated, as well as consideration of items of work to be completed as part of the General Conditions, rather than possible “double dipping” by the contractors, claiming such item as an expense or cost item above the fixed price. Also consider a "shared savings" clause should be inserted that allows the contractor to recover some additional fee based upon the difference between the final Cost of the Work and the Guaranteed Maximum Price (to the extent that such difference is a savings to the owner). A Guaranteed Maximum Price contract sum should be linked to actual costs based upon professional oversight of the plans and specifications and/or industry standards before settling on the figure.
6. Payment Procedures. Construction Contracts must take into consideration Mechanic’s Liens Laws, and are often dictated by bank loan documents mandating payments be disbursed through a title company construction escrow, with certifications on completion and performance, and issuance of title insurance over each payment installment to protect both the owner and the lender. The Owner and Contractor are required to provide Sworn Statements in which there is a Schedule of Values in which the entire Contract Sum is allocated among the various portions of the Work. It is recommended that the Schedule of Values be agreed upon during the contract negotiations, and periodically reviewed to be certain allocations of payment are not exceeded to line items under the schedule of values. Most contracts also include a hold-back (typical 10%) to address defects and non-performance matters, and include a punchlist review and approval process. Hold-backs can be based upon a percentage of each payment, plus a percentage of the contract value.
7. Subcontracting. Key to the Construction Contract is obtaining some balance on the subcontract matters. Among the concerns are assignment of subcontracts upon default by the Contractor to assure the Owner can deal directly with the subcontractor. Also, standards should be set for selection of subs, including competitive bidding and ability to object to a subcontractor.
8. Change Orders. There must be a detailed procedure for allowing for changes to the Scope of Work, as well as determining whether a matter is an “extra” requiring a change as well as an adjustment for any reduced scope of work. The process should also address defects in plans and workmanship, or site conditions mandating change, in an effort to alleviate or effectively manage disputes.
9. Delay Damages. The contract documents must address delay, whether breach in performance or a force majeure (act of god) event, including more recent issues like pandemic, riots, supply shortages, labor disputes and strikes, etc.
10. Warranty. It is standard construction practice that the contractor agrees to correct work for a period of one year from the date of substantial completion.
11. Insurance and Indemnification. The contract should impose specific insurance requirements on the contractor. Insurance coverages that should be furnished in a typical construction project include: comprehensive general liability (CGL) (broad form coverage); builder's risk, in an amount of the Contract Price; business automobile liability; workers' compensation/employer's liability; and professional liability covering any professional services. While some coverages (particularly, builder's risk) can be purchased either by the owner or the contractor, the contract should make it very clear who is responsible for providing the policy. The policies should name the parties as Additional Insured’s as well as provide for subrogation to determine which policy is primary. An indemnity clause provides that the Builder indemnifies the owner from an injury caused by the contractor or one of its subcontractors. The breadth and scope of the indemnity is often negotiated, and possibly include legal fee and court cost reimbursements.
12. Surety Bonds. Are typically required under public works/government contracts and large development projects. Otherwise, performance bonds are a matter of negotiation and impact the contract cost. Bonds will cost from 1% to 5% of the Contract Sum (or Guaranteed Maximum Price), depending upon the contractor's track record with the surety and the size of the bond.
13. Termination. As with most contracts, construction contracts typically have termination clauses that set out the grounds and procedures for parties to terminate the contract, with some grace and cure period, and outside performance date. Often Builders may recover “substantial performance” costs, so the contract should be specific as to completion standards and limits on profit. Upon Owner termination, rights should include recovery of damages, access to the site and all materials and equipment and assumption of subcontracts.
14. Dispute Resolution. Arbitration is a common method of resolving construction disputes, because construction matters can be so complex. Most construction contract forms provide for mandatory, binding arbitration, usually per Rules of the American Arbitration Association (AAA). Most clauses also include provisions allowing for local discovery and procedure so neither party can manipulate the process and with limited appeal rights.
Robert K. Feldman
Attorney at Law