FEATURE ARTICLE, AUGUST 2005

CREATING A SOLID CONSTRUCTION CONTRACT
Owners should pay attention to 10 key issues.
Bruce Merwin

Construction contracting offers a very unique business atmosphere that runs nearly counter to normal business intuition. Not only is the occupation fraught with high competition and risk, but also the nature of the business usually involves conflicting objectives with property owner clients.

Contractors have addressed some of those concerns by using contract forms, such as the American Institute of Architects (AIA) forms, that tilt in their favor. Property owners, then, need to be fully cognizant of certain issues when entering into a construction contract.

When selecting a contractor, the property owner should become comfortable with the contractor’s background, capabilities and requirements. The owner and the contractor each will be served better if the contract informs each party what it must do and to what it is entitled; anticipates likely problems and resolves them in a way that reflects the proper allocation of risk and responsibility; includes well-drafted drawings and specifications; reflects the reality of contract administration; outlines what is required of the owner and contractor to obtain advances out of the owner’s loan and contract, respectively; informs each party of its rights if the other party does not perform; and provides a procedure for resolving disputes.

Once the contractor’s proposal has been approved by the owner, preparation of the contract should include a reflection of the architect’s role in construction administration; a review of the contractor’s proposal and/or bid documents to determine the scope, qualifications and business terms of the project; and a review of loan documents to incorporate the lender’s requirements.

Generally, the owner’s counsel will revise the contract submitted by the contractor on an AIA or other industry form to incorporate the owner’s requirements. The contract will address many issues; however, the following issues generally are considered the most important.

Description of Work. Describing the work accurately and comprehensively cannot be underestimated. Work should be performable by contractor in accordance with the drawings and specifications as well as what is reasonably inferable therefrom to produce the intended results. The contract must provide a method of resolving conflicts or ambiguities within the contract documents. While change orders are inevitable, a comprehensive description of the work can help avoid surprises and disputes.

Change Orders. The contract should accommodate the owner’s changes by specifying the procedure for determining additive and deductive costs, including the contractor’s fee, and by requiring the contractor to perform the change before a final agreement is reached on cost, at least up to a specified amount.

Retainage. While 10 percent statutory retainage affords the owner maximum protection against lien claims in Texas, the amount of retainage is an economic issue to a contractor and is subject to negotiation. The owner seeks to protect itself against lien claims and to provide an incentive for the contractor to complete the work. If the contractor is providing a payment bond, retainage is not so important. Whatever reduction in retainage is negotiated, the owner should hold an amount sufficient to ensure the completion of punch-list items.

Payments — Progress and Final. The contract should identify the supporting documentation for progress payment applications, including lien waivers from the contractor and subcontractors and lender-required items. The owner should be entitled to withhold the portion of payments necessary to protect its interests on account of the contractor’s failure to deliver required lien releases, defective work, claims filed by third parties or other failures of the contractor relating to the performance of the work.

As conditions precedent to final payment, the owner should require final approval from the architect, a certificate of occupancy, as-built surveys and drawings, final lien releases (with any lien claims bonded around) and satisfaction of all lender and project close-out requirements. Warranty claims should not hold up final payment.

Cost of the Work. Unlike a stipulated sum contract that provides a fixed cost (inclusive of overhead and profit), a cost-plus arrangement includes a cost component covering labor, materials, and a fee component for the contractor’s overhead and profit. However, in a cost-plus arrangement, even with a guaranteed maximum price, the owner desires to create incentives for the contractor to save costs through sharing savings or otherwise. One of the most important issues is the definition of “included costs” and “excluded costs.” Other key issues involve which party pays for mistakes, the avoidance of double-dipping by the contractor, and what is included in the contractor’s fee.

Insurance. Due to the complexity of construction-related insurance, owner’s and contractor’s insurance advisors help to provide comprehensive coverage. At a minimum, the insurance provisions of the contract should cover the following items:

• the contractor’s commercial general liability (cgl) limits and policy form
• certificates of insurance
• no cancellation or amendment of coverage without notice
• the builder’s risk coverage
• primary coverage and additional insured status and type of endorsements for the owner and the lender with respect to the contractor’s and subcontractors’ cgl coverage
• cgl, worker’s compensation and general waiver of subrogation endorsements benefitting the applicable parties.

Separate Contractors. The contractor must accommodate the work of the owner’s separate contractors, and the coordination, cooperation and scheduling provisions of each contract should be consistent, as should the dispute resolution procedures and delay, damage, insurance and indemnity requirements.

Warranties. The contractor must correct defective work or remove it and replace it with non-defective work for 1 year following completion. In addition, the contractor must correct any damage caused by defective work. If the contractor fails to perform in a timely manner, the owner must be able to make the repairs at the contractor’s expense. The warranty should exclude defects inherent in the required work and damage caused by owner abuse, modifications or improper maintenance.

Termination Without Cause. Current versions of AIA documents permit the owner to terminate without cause. This allows the owner to change its mind and may avoid a bitter dispute between the parties following a breakdown of communication or trust. At a minimum, a fair termination without cause provision covers the following issues: protection of the work; termination or assignment of subcontracts; termination date and additional work performable by the contractor; the contractor’s mitigation of damages; and the amount of final payment to the contractor.

Default and Remedies. The contract must address the circumstances in which the owner or contractor will be in default and the remedies available to the non-defaulting party. The owner must be able to take possession and control of the work and subcontracts, under defined circumstances, without substantial delay. The owner should coordinate its exercise of remedies with its lender and any surety. Following completion, the owner will seek to recover its damages from the contractor. If the owner fails to make required payments, the work may be stopped for an extended time period, or if the owner otherwise defaults, the contractor should be able to terminate and recover for worked performed and proven loss. The parties also should consider utilizing mediation/arbitration to resolve disputes. Unless the contract has been terminated, the contractor should be obligated to continue performance during the pendancy of a dispute, and owner should make undisputed payments.

While these issues are among the most important in negotiating construction contracts, a number of other issues require special attention to produce a contract that reflects the requirements of the project and the respective ability of all parties involved and satisfies the requirements and expectations of the parties.

Bruce Merwin is a partner in the real estate transactions practice group for Haynes and Boone LLP in Houston.

©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.