Construction Contracts: Contracts and Risk Transfer

» Articles » Construction Articles » Article

September 18, 2018
Author: Thomas H. Davis, Jr.
Organization: Poyner Spruill LLP

A. Contracts Generally.
The relationship between the Owner and Contractor, or between a Contractor and his Subcontractors and Suppliers, is based upon the law of contracts. A contract can be simply defined as “a promise or set of promises which the law will enforce.” See, Bailey v. Rutjes, 86 N.C. 517 (1882). For a contract to be valid and enforceable, it must include the following elements: (a) at least two parties to the agreement who have the legal capacity to make promises; (b) consideration for the promises; (c) the promises must be legal; and (d) the parties must mutually agree to the terms of the agreement.

Of the four requirements for a legally enforceable contract, the issue of sufficient consideration (payment or compensation for promises) rarely arises as a dispute. One exception relates to contract modifications. If the parties modify an existing contract, the modification must be supported by new or additional consideration (compensation or mutual promises) in order for the modification to become enforceable at law. See, Lee v. Paragon Group Contractors, 78 N.C. App. 334, 337 S.E.2d 134 (1985).

One element which does provide fertile ground for dispute is whether or not the parties mutually agreed upon the terms of the contract. A contract is only enforceable at law if the parties have a “meeting of the minds” on all the essential elements of the proposed agreement. In the case of Croom v. Goldsboro Lumber Company, 182 N.C. 217, 108 S.E. 735 (1921), the Supreme Court stated:

“One of the essential elements of every contract is
mutual of agreement. There must be neither doubt
nor difference between the parties. They must
assent to the same thing in the same sense, and
their minds must be met as to all of the terms. If
any portion of the proposed agreement is not
settled, or no mode agreed upon by which they may
be settled, there is no agreement.”
Id. at 220.

How could the issue of mutual assent arise? Construction contracts, like many other contracts, do not have to be in writing in order to be enforceable. As long as there is a meeting of the minds on essential terms of the contract, an oral contract is enforceable. The problem, however, is that when you have an oral contract, it’s difficult to prove the mutual understanding of the terms of the agreement in the event of a dispute.

Such a situation strongly argues for the concept that all contracts for construction should be in writing. In fact, some construction-related contracts are required by law to be in writing. North Carolina’s “Statute of Frauds” as well as the Uniform Commercial Code have provisions requiring certain agreements be reduced to writing. All contracts to sell or convey land or any interest in or concern in land must be in writing. See, N.C. Gen. Stat. § 22-2. All contracts to answer for the debt or default of another be in writing. As a result, a payment or performance bonds must be in writing in order to be enforceable. See, Roberts & Johnson Lumber Company v. Horton, 234 N.C. 419, 61 S.E.2d 100 (1950).

The Uniform Commercial Code (UCC) requires contracts for the sale of goods with a price of $500.00 or more be reduced to writing. See, N.C. Gen. Stat. § 25-2-201(1). While construction contracts are generally not subject to the UCC since they are for the furnishing of services, the UCC requirement does apply to supply contracts which may be entered into in conjunction with a contract for construction services.

B. Interpretation of Construction Contracts.
In the event of a dispute arising during the performance of work under a construction contract, the courts of North Carolina will apply certain basic rules of interpretation to determine the obligations of the parties to the contract. One of the first rules which will be applied is that of “merger”.

The courts have held the final written construction contract is conclusive as to the terms between the parties, and all preliminary negotiations have been merged into the subsequent written contract. See, Dellinger v. Lamb, 79 N.C. App. 404, 339 S.E.2d 480 (1986). Often referred to as the “parole evidence rule”, any part of a transaction occurring before, or contemporaneously with, a writing recording the transaction are superseded by, and made legally ineffective by, the written agreement.

Next, the courts look at the intent of the parties. The test applied is what a reasonable person in the position of the parties would have thought the contract meant. In order to determine this, the parties’ conduct after the contract has been entered into becomes evidence of the parties’ intent.

See, Thompson-Arthur Paving Company v. Lincoln Battleground Association, 95 N.C. App. 270, 382 S.E.2d 817 (1989).

Perhaps the most important rule in interpreting a contract is that an ambiguity in a written contract is to be determined against the party who drafted the agreement. See, William Muirhead Construction Company v. Housing Authority, 1 N.C. App. 181, 160 S.E.2d 542 (1968). It has been suggested that the courts adopted this rule of construction because the author of the contract is in the best position to guard against any ambiguities.

In the construction arena, a number of “standard” contract form agreements have been developed to which parties simply add or subtract standardized provisions. These forms include those prepared by the
American Institute of Architects (AIA) and the Association of General Contractors (AGC). The use of a “standard form” can be used to argue against the presumption that one of the parties to a contract dispute was the original “drafter”. However, the courts will probably determine the “drafter” to be the party that instituted or created the first draft of the agreement using the standardized form. Standardized forms often have a built-in bias towards one or more parties. For example, the AIA forms, while attempting to be as neutral as possible, have a built-in bias to protect the interests of architects. Likewise, the base documents prepared by the AGC naturally have some bias in favor of contractors.

Another significant rule applied by the courts in addressing disputes between parties over the meaning of the contract is the requirement that specific terms of the agreement supersede general terms. When general terms and specific terms of a contract are in conflict, the courts require the specific terms prevail over the general terms. See, Clement Brothers Company v. N.C. Department of Administration, 57 N.C. App. 497, 291 S.E.2d 908 (1982). A subset of this rule of interpretation applying to “form contracts” specifies that typewritten terms in an agreement will prevail over printed terms in a printed, form contract.

A. Allocation of Risk.
A contract allocates risks between parties for events which may occur during the construction of the project or afterward. Typically, these risks are usually related to time or costs of the project. For the fair allocation of risks, it is necessary that the contract contain a clear set of terms and conditions known and understood by all parties by the time the construction contract is signed and the project begins.

It is important for each of the parties to a contract to understand the scope of the risk which they are undertaking as well as the risks being undertaken by the other parties to the agreement. The most satisfactory way to achieve mutual understanding of the risks is to commit, in the written contract document, how the risk are to be allocated. These risks include not only those directly related to the specific project work but also those which are indirectly related to the project.

The manner in which a construction contract is written, and the manner in which information is exchanged between the parties with respect to project work attend shift risk from one party to another. The type of contract used is a major method of allocating risks. For example, under a cost-type contract, the Owner pays the costs and bares the risk in exchange for the contractor using its best efforts to perform the work. On the other side, a fixed-priced contract, the Contractor is obligated to complete performance for a stated price and runs the risk of overages in costs.

In addition to the risk of price, the contract documents may allocate other various risks and define which party bares those risks and under what condition. Essentially, risks is associated with knowledge, with actual and imputed. One method by which risk and knowledge are allocated is through the process of awarding contract. There are two general methods used: (1) negotiated; and (2) sealed bids. Public entities generally prefer the use of sealed bidding based upon the theory that competition in connection with well-defined specifications, will produce the lowest reasonable price to the work. By contrast, the private sector prefers negotiated contracts which allow for the work description to be less defined that is in the sealed-bid process.

Type of bid, including the type of design specifications used, have a direct effect on the allocation of risk. Generally, specifications contained in the contract may be considered as warranted by the party that prepared those specification. See, United States v. Spearin, 248 U.S. 132 (1918). The basic reason for such a warranty of specifications is the theory that the preparer of the specifications has the most knowledge and, therefore, is in the best position to understand the work and the risks involved.

The type of specifications affects risk allocations. There are generally two types of specifications: (1) design; and (2) performance. Those specifications which contain great detail, such as working drawings required to build a project, are generally referred to as “designs” specifications. These specifications contain detailed design information and prescribe the method of performance. Generally, the design specifications are warranted by the contractual party which prepared them.

Alternatively, there are “performance specifications”. Such specifications are issued by Owners and are only generally define the final product to be produced, leaving all the details of design and construction to the contractor. Such performance specifications leave to the contractor the methods of how to accomplish the work and carry with them the risk of performance. Of course, pure design and pure performance specifications are rare. In most contracts, the parties

B. Risk Transfer
Risk transfer refers to the prospective (future) shifting of the risk of loss in any transaction. It can also be defined as the “downstreaming” of legal liability. Yet another definition refers to risk transfer as the shifting of the financial burden of certain accidental losses which have not yet occurred but which may occur and are assigned to other parties in a contractual relationship.

In transferring risk, one party assumes the financial consequences of certain liabilities of another party by virtue of a contractual obligation and in the event of a specified loss. Risk transfer in the construction industry is generally performed by the adoption of specific terms within a contract between the owner and a general contractor or between the general contractor and the project’s subcontractors. While risk transfer can be aided through the use of appropriate insurance, the procurement of insurance is not the sole methodology of risk transference in construction.

Common risk transfer situations include transfers from lessors to lessees, from owners to contractors, from contractors to subcontractors, or from sellers to buyers. In a typical construction project, liability is downstreamed from the owner to the prime contractor and then from the prime contractor to the various subcontractors on a project.

Transfer or minimizing risk is usually accomplished contractually. As noted in the previous section, a contract is an agreement between two or more parties in which there is an action done by one party and compensation in some form or another by the other party or parties. Verbal agreements are often used in the construction industry. Verbal agreements can serve as valid contracts in many instances. The use of verbal agreements; however, can lead to misunderstandings and make it more difficult to enforce the terms of the oral agreement if there is a breach of the agreement in the future.

There are many benefits to the use of written contracts. A written contract can prevent a disagreement as to what each party is obligated to do under the terms of the agreement. Having the agreement in writing helps ensure everyone understands their duties under the agreement.

Finally, by having a written contract, the parties can obtain valuable information as well as require certain provisions and protections for the purposes of risk transfer.

The typical written construction contract has a number of standard features. The contract will list the contracting parties, their names, physical and mailing addresses and contact personnel. The written contract will specify the project name and scope as well as the project price and any special provisions relating to the project work. There will be paragraphs relating to the timing of construction, warranties required, insurance provisions required, and, importantly, provisions relating to default and indemnification.

Indemnification is an assurance that the party to be protected (the indemnitee) will not have to bear the ultimate legal or financial responsibility for damages and losses caused by certain specified actions of the party providing the indemnification (the indemnitor). Indemnity provisions exist to provide reimbursement by one party to another for injury or damage. If you are a general contractor, you want to have in your contracts with each of your subcontractors, an assurance that the subcontractors will indemnify you, at least to the extent that their actions or inactions cause you harm.

Indemnity, the obligation to reimburse for injury or damage, does not exist at common law. As a result, all indemnity provisions must be included in the contract. By providing an indemnity provision in your contract, should you experience a loss in the future due to the actions or inactions of the indemnitor, the indemnitor will be required to bear the financial responsibility for that loss.

Indemnity provisions in contracts are of three types: (1) broad form; (2) intermediate form; and (3) limited form. The broad form indemnity agreement obligates the indemnitor to reimburse the indemnity for losses that the indemnitor did not cause, even in part, including losses caused solely by the indemnitee. It should be noted that broad form indemnification is unenforceable in the courts of North Carolina.

The intermediate form indemnification is a contract provision that obligates the indemnitor to indemnify the indemnitee for losses that the indemnitor caused only in part, or did not cause at all, excepting only losses caused solely by the indemnitee. The intermediate form is enforceable from the courts of North Carolina. The limited form of indemnity, also known as the comparative negligence form, provides that the indemnitor must compensate the indemnitee in the event of a loss according to the indemnitor’s degree of fault. Under the limited form (comparative negligence form), the indemnitor would indemnify the indemnitee only to the extent of bodily injury or property damage caused directly by the indemnitor. While limited, the comparative negligence form still provides some transfer of risk since North Carolina is a contributory negligence state and, without contractual provisions to the contrary, bars a claimant from any recovery if the claimant is at fault to any degree.

If you wish for the indemnitor to be required to pay for attorney’s fees to defend the indemnitee in any legal action, such a requirement must be part of the written contract between the parties. Specifically, the indemnification portion of the contract must specify that the indemnitor agrees to “defend, indemnify, and hold harmless the contractor and owner . . . from and against any claim, cost, expense or liability (including attorney’s fees) caused by, arising out of . . .” Often, construction contracts include both indemnification agreements and hold harmless agreements. Under a hold harmless agreement, the party assuming the risk agrees not to attempt to recover any portion of the damages from the other contracting party.

Indemnification agreements should not be viewed as an absolute shield against loss. An additional form of protection which is available to the parties is to require that a subcontractor list the general as an additional insured on the subcontractor’s policy of insurance and/or that the owner requires the general contractor to list it as an additional insured on the general contractor’s policy of insurance.

It is very important to remember that if the contract calls for a certificate of insurance, the certificate in and of itself does not function to transfer any risk. Certificates of insurance provide very limited information on the actual coverage provided by an insured. A certificate of insurance does not bind, amend, or guarantee coverage in a policy. A certificate of insurance is a date-sensitive document that only “endeavors” to notify the certificate holder of a change in the status of policyholder. A certificate of insurance can be used as an indication that the certificate holder has been named as an additional insured per the requirements of the written contract, but it is not proof that the party has been so named. It is important for a contractor to verify coverage for independent contractors, blanket contractual liability, coverage for pollution or professional liability and additional insured endorsements.

An additional insured is any person or entity who can make a claim against an insurance policy that was procured and paid for by a different entity. The party paying for the policy is referred to as the “named insured”. You may contractually, in writing, obligate your subcontractors to list you as an additional insured on their insurance policy. Additional insured wording in the insurance contract modifies the definition of “named insured” to include as an insured any person or organization for whom you are performing operations when such persons or organizations have agreed in writing in a contract or an agreement that such person or organization be added as an additional insured on your policy . . .” A copy of the actual endorsement naming the certificate holder as an additional insured should be required and received prior to commencing work. Insurance carriers provide additional insured coverage on two types of forms: blanket; and specific job. The blanket form for an additional insured provides that the insurance company will name the general contractor as an additional insured when required in a written contract and no specific name of job or contractor is required. The specific job form, however, specifies the insurance company will name the general contractor as an additional insured on a job-by-job basis and it must be required by a written contract.

Another tool to transfer risk is the “waiver of subrogation”. Under a waiver, one party relinquishes any rights to make claims against the other for damages that are covered by insurance. For example, if a subcontractor’s employee is injured, and that employee is covered by worker’s compensation, the waiver and the contract will prevent the subcontractor’s insurance company from trying to recover from the general contractor the benefits it is paid for its compensation. General liability and auto policies also allow the insured to waive such transfer of rights and recovery as long as the contract is reached prior to any loss occurring.

In summary, there are 11 steps a Contractor should take to affect risk transfer on any project:
1. Implement a standardized Agreement and/or Purchase Order with the correct risk transfer wording. When in doubt, consult an attorney or insurance agent. Make certain all Agreements are complete, in writing, and do not allow subcontractors or suppliers to commence work or to provide product without all documentation signed and filed.
2. Require signed, written Contracts or Purchase Orders before any work commences.
3. Require the original, signed Certificate of Insurance prior to the beginning of work.
4. Make certain both the General Contractor and the Owner are named as additional insureds on all Certificates of Insurance.
5. Verify each Subcontractor has acceptable limits of insurance.
6. Obtain copies of the actual additional insured endorsements.
7. Make certain insurance coverage of the Subcontractor is primary.
8. Require all Subcontractors to agree not to subcontract to any lower tier subcontractor without verifying the lower tier subcontractor’s insurance.
9. Verify all Contracts down the line contain hold harmless/indemnification, waiver of subrogation and duty to defend the General Contractor and the Owner.
10. Verify all Subcontractors have coverage for blanket contractual liability (usually included in the Standard Commercial General Liability form).
11. Require, in the written contract, all Subcontractors comply with safety policies, programs and OSHA regulations as to the performance of all their work, duties and obligations to maintain a safe working environment.

A. Contract Terms Generally.
“Standard” form contract agreements contain certain standard clauses which should be carefully reviewed by the parties and accepted, modified or deleted as needed. These comment clauses include provisions for express/implied warranties, liquidated damages, delay damages, waiver of consequential damages and dispute resolution processes.

Express warranties generally appear in the form of the contractor’s promise to an owner concerning the quality of work. Usually this is expressed in a written guarantee of a specific duration, commonly one year. There can be other express warranties within the written agreement, but there are also implied warranties created by law which do not have to be written into the contract in order to be valid. North Carolina law implies a warranty by the owner to the contractor that the owner will not hinder or delay the contractor’s performance and that the plans and specifications are accurate for the contractor’s performance of his work. In turn, there is an implied warranty of workmanship on the part of the contractor owed to the owner, together with an implied warranty of habitability with respect to the construction of a residence.

In commercial construction contracts where timing is critical to the owner, liquidated damages clauses are often used to assess monetary damages against the contractor for delay. Liquidated damages must be a reasonable approximation of the owner’s potential, future damages and cannot be in the form of a penalty. Penalties for delay are unenforceable at law.

The owner often attempts to include a “no damages for delay” clause which prohibits a contractor from recovering monetary damages from the owner in the event of owner-caused delays. Under this clause, the only remedy a contractor has for delay is a time extension.

Owners typically include a waiver of consequential damages provision. This provision limits a contractor to recovering only direct damages in the event of an alleged breach of contract.

A well-crafted provision relating to scope of work is important to all parties to a construction agreement. Many disputes which end up in litigation arise out of the question of whether or not work performed by a contractor was outside the scope of the original agreement. Such a dispute can be entirely avoided by a well-crafted and specific description of the scope of work to be completed by the contractor.

B. Specific Terms.
1. Change Clauses. It is probable the contract agreement between the parties will need to be modified to accommodate unexpected events occurring during the performer’s work to accommodate these modifications, “change clauses” need to be incorporated into the contract.

Such a clause address the subject of who can make changes, what can be changed, when changes can be made and how changes are to be made. In addition, the clause should address the consequences of any change, including how the change should be priced and how the change affects the schedule of the work. Included in the change provision, or in a separate provision, the issue of “differing site conditions” needs to be addressed. This can be in conjunction with the clause in the bid documents requiring a site inspection prior to bidding.

2. Delay Clauses. It is not uncommon for work to be completed on a project after the original, specified date for completion. Delay can often be caused by inefficient work created by other, conflicting work on the job. These issues are addressed in clauses dealing with delay and disruption. Delay is a time-based issue and relates only to the enddated contract and over-run of contract work beyond the initial end date.

Usually, the burden is on the contractor to establish that an event cause the end-date performance to be moved out further from the anticipated and contractually called for completion date. Delay clauses should include requirements addressing delay to the project conflict changes to the work, delays in the work or suspension of the work. A delay which causes the end of the contract to be extended but which is excusable relieves the contractor responsibly from for the delay. Excusable delay clauses generally permit adjustments in terms of performance only with no price adjustment for performing the work.

3. Notice Clauses. Construction contracts generally require the contractor to submit written notice to the Owner/Architect within a defined period of time after an event arises causing a change in the project schedule or costs to the contract. Notice requirements are imposed to protect the interest of the owner who may be unaware of the causes on a particular event. Value to provide notice is required in the contract, may result in the waiver of the contract or its rights.

4. Termination Clauses. Termination is the right to terminate a contract for construction for default. Such a right generally arises only when there has been a material or substantial provision of the contract breached or parties felt that the form of material obligation. The rights and liabilities of the parties are controlled by common-law and terms of the contract. There can also be clauses allowing termination for convenience which allows the Owner to terminate the contractor’s work on a project without incurring any liability beyond the value of services provided to the date of termination.

5. Dispute Resolution Clauses. It is not uncommon, especially in current economic times, that disagreements will arise between the Owner and the Contractor with respect to some provision of the contract. Agreement between the parties should specify the rules for Dispute Resolution. When disputes arise during the course of the work, it is too late to discuss and process for resolution-such a process must already be in place. Dispute Resolution clauses, in government contracts, are generally specified by law. In private contracts, the parties are free to craft alternative dispute resolution processes such as arbitration and/or mediation, in addition to litigation. It is also of importance to include a “choice of law” clause in the contract for construction which specifies the law of what jurisdiction we use to interpret the times of the Agreement between the parties. Such a clause can also specify the location of any dispute resolution process. A special note, however, is a North Carolina law which prohibits a requirement that parties resolve the disputes in a form outside of North Carolina if the project is performed in North Carolina. Further, nothing else appearing, North Carolina law will apply to contracts between parties which are performed on projects within the State.

The material appearing in this web site is for informational purposes only and is not legal advice. Transmission of this information is not intended to create, and receipt does not constitute, an attorney-client relationship. The information provided herein is intended only as general information which may or may not reflect the most current developments. Although these materials may be prepared by professionals, they should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.

The opinions or viewpoints expressed herein do not necessarily reflect those of Lorman Education Services. All materials and content were prepared by persons and/or entities other than Lorman Education Services, and said other persons and/or entities are solely responsible for their content.

Any links to other web sites are not intended to be referrals or endorsements of these sites. The links provided are maintained by the respective organizations, and they are solely responsible for the content of their own sites.