By Carl J. CircoA small construction project could be defined as one for which the client has not budgeted time or money for legal review. Usually, a lawyer must respond quickly and efficiently to a client's request for help with a small construction project and cannot craft a contract at leisure after extended client consultation. This article discusses the typical legal issues in small construction projects and how to select and develop contract forms for small projects.
Major IssuesSmall projects involve many of the same issues as major commercial and industrial projects do, such as the need to complete the project on time and in budget, define clearly the scope of the contractor's services, include appropriate payment procedures and address insurance and liability issues. Small projects typically do not, however, involve other complications that major projects may present due to their size and sophistication. Generally, a lawyer must consider the following issues in small projects.
PartiesToo often, the parties to construction contracts_especially the contractor_are careless in setting out their identities. The contractor may be a sole proprietorship or legal entity, and many contractors do business under more than one name and through more than one legal vehicle. The contract preamble and signature blocks should accurately identify the parties and specify the type of any entity and the place of its organization. For example, a financially strong contractor may have a financially weak affiliate, making proper identification critical. The contractor should also be qualified to do business and, if required, licensed in the appropriate jurisdiction to perform the contract work.
Project Delivery SystemThe construction industry has developed several alternative contract structures that parties sometimes refer to as "project delivery systems." These arrangements differ in how they allocate the basic responsibilities and risks of a construction project, affecting how a lawyer will address contract issues. Contractors usually understand the nuances of these arrangements, but inexperienced owners frequently do not. An owner's lawyer should not assume that his or her client fully understands the project delivery system proposed by the contractor. Although the contractor may only operate under one approach to contracting, the owner's lawyer should nevertheless explain to the owner the special risks and limitations of that approach.
No matter what system the parties select, the contract should unambiguously describe the role of the contractor and others involved and not just make shorthand references to a particular system. Different people may use the same term to mean different things. The contract must leave no doubt about basic matters, such as the extent to which the contractor has design responsibility and whether the plans are essentially final. Although parties often use terms loosely and inconsist-ently to refer to concepts that continue to evolve, a few generalizations may help a novice understand how different project delivery systems affect important contract issues.
- Traditional. Under the traditional project delivery system, one or more design professionals prepare complete plans and specifications. General contractors then bid on that basis for the total project, resulting in a fixed price and a firm completion schedule.
- Cost plus fee. Under a cost plus fee contract, the project may or may not be fully designed. The contract price is based on reimbursable costs the general contractor actually incurs during construction, plus the contractor's fee, which may be fixed or based on a percentage of costs. The contract may or may not have a guaranteed maximum price.
- Construction management. Under a construction management contract, the owner hires a construction manager that may or may not have direct responsibility for any construction work. The construction manager coordinates with a general contractor or multiple prime contractors to provide project management and protect the owner's interests.
- Design-build. Under a design-build contract, a single contractor has responsibility for both design and construction. There is usually a project definition phase, a detailed design phase (that may result in a fixed construction price) and a construction phase.
- Fast track or phased project. In a fast track or phased project, design and bid packages are issued for distinct aspects of the project in a serial fashion to allow construction on some phases to begin before the design is complete for later phases. This project delivery system may be combined with other formats.
- Turnkey. A turnkey contract provides single point responsibility through a developer/contractor that may hold title to the project and that retains all risks until the completed project is ready for delivery to the owner.
Scope of WorkMany construction disputes stem from an incomplete or ambiguous statement of the work that the contractor will perform. For example, in A.W. Wendell & Sons, Inc. v. Qazi, 626 N.E.2d 280, 292-93 (Ill. Ct. App. 1993), a construction contract for a single-family residence stated that the contractor assumed liability for all work. The court held that the contract was ambiguous as to the contractor's duty to supervise marble installation.
Small residential projects are particularly susceptible to disagreements over the scope of work. A residential owner may envision that the contractor will build the owner's dream house exactly on time and in budget. The contractor may think that it will build the house more or less to a set of plans that leave much to the contractor's discretion. Without a written meeting of the minds, disaster is only a step away.
Ideally, the parties will agree on complete, final plans and specifications that describe the contractor's obligations in detail. Unfortunately, that process is not feasible in some smaller projects. Even then, a lawyer should try to confirm that the list of plans and specifications incorporated into the contract includes all revisions and addenda and that the contract resolves all conflicts among the bid documents, on the one hand, and any questions, clarifications, alternates and proposals the parties may have discussed, on the other hand. It is especially important that owner's counsel press for the most complete description of plans and specifications available.
The very process of identifying the construction documents may raise important issues. Does correspondence between the owner and the contractor, or anything in the contractor's proposal, create potential conflicts over what is or is not included in the scope? Does the price include landscaping and specialty work? Does the owner understand what allowance items the contract includes? How will the parties resolve open details if the existing plans do not cover them?
The scope of work in many contracts is ambiguous because the contract documents include a confusing array of proposals, modified proposals, contractor "clarifications" and miscellaneous correspondence that led to the agreed price. In most cases, the contract should clearly restate the cumulative agreement that these documents embody, rather than incorporating by reference, or simply having as exhibits, potentially conflicting, incomplete or extraneous correspondence and memoranda.
Construction AdministrationSome industry forms_especially the popular forms issued by the American Institute of Architects (AIA)_assume that the owner's architect will monitor construction, inspect for the owner, approve requests for progress payments, interpret construction documents, resolve disputes and certify completion. In many small projects, the architect will not fulfill this role or will do so only in a limited way. The contract should accurately portray the role, if any, of the architect or other owner representative. Striking the word "architect" each time it appears or simply replacing "architect" with "owner" or "contractor" is usually not enough. If the design professional's role differs from the one assumed by a particular form, then the lawyer should carefully modify the provisions that reflect the faulty assumption. When appropriate, the owner's lawyer should not hesitate to place approval rights or other discretion directly in the owner. The contractor's lawyer, however, should critically review these provisions with the contractor. In all events, the role assigned to the design professional in the owner-contractor agreement must comport with the contract between the owner and the design professional.
PaymentPayment is the one topic that the parties will probably address in some meaningful way before calling a lawyer. Even if the parties seem to have resolved the basic payment terms, a lawyer should make sure that his or her client understands the risks involved in each payment approach. Even in the basic payment structures common to simple projects, many variations exist, some of which the parties may combine.
- Fixed price. This payment method is simple enough. For a fixed price to be realistic and reliable, the description of the scope of work must be clear and complete.
- Cost plus fee. In a cost plus fee contract, the parties must decide whether to state the contractor's fee as a dollar amount or a percentage of costs, whether the contract will provide for a guaranteed maximum price, whether the contract will provide an economic incentive for the contractor to complete the project below budget and whether owner changes that reduce the cost will also reduce the fee. Even in small projects, the lawyer must carefully review how the contract defines reimbursable costs and what cost items the contractor's fee already includes.
- Turnkey. In the simplest form of turnkey contract, the contractor owns the property, there is a combined contract for construction and sale of the improved property, the sale closes when the contractor has substantially completed the project and the contractor finances the project during construction. With the possible exception of a deposit, the buyer pays for the project only after completion. This method works well in residential construction. Alternatively, the buyer pays the contractor in installments as construction progresses. Under the latter alternative, the buyer takes the (often unreasonable) risk of paying for work on a project that the buyer does not yet own.
- Progress payments. The timing of payment raises several issues. Does the owner make a substantial initial payment to the contractor? In that case, the contractor may "get ahead" of the owner from the start by having the owner's money before earning it. Will the owner make progress payments based on time intervals, project milestones or actual costs incurred? How often will the owner make progress payments? Must the con-tractor submit a detailed application for payment? If so, what supporting documentation must the contractor provide? Can the owner have the right to withhold amounts in dispute?
- Retention. With each payment method, the owner normally holds back some money until completion. Retention protects the owner against the contractor's default and gives the owner some leverage to make the contractor finish the "punch list," the minor items to be completed after substantial completion but before the project is finally complete in accordance with the plans and speci-fications. In a cost plus fee contract, it often makes sense to withhold from the contractor's fee rather than from the entire progress payment. In any case, the contract should specify relevant procedures. For example, when will the owner pay the withheld payments, and what requirements must the contractor meet to receive them (e.g, final lien waivers, delivery of manufacturer's warranties and agreement on completion of miscellaneous items)? Often the contract will reduce or discontinue withholding at some stage during construction, say on 50% completion, if all is proceeding well.
- Punch list withholding. Many contracts provide for release of all withheld amounts upon substantial completion, except for an amount based on the estimated cost of completing the punch list.
- Allowances and alternates. An allowance is an estimate or arbitrary amount included in the price to cover an item of undetermined cost, and an alternate is another item or items that the contractor may substitute for items the contract specifies. If the contract price is based on any allowances or alternates, the contract should clearly identify them. The owner should understand that it will pay the excess if an allowance item ultimately costs more than the allowance built into the contract price.
WarrantiesThe contract should contain a standard of performance. The contract may include a simple representation that the contractor is qualified to perform the work, will use only new material of good quality, will employ qualified workers and subcontractors and will complete the work as required by the plans and specifications listed in the contract and in conformance with all applicable building codes and legal requirements. See Garden City Osteopathic Hosp. v. HBE Corp., 55 F.3d 1126, 1129 (6th Cir. 1995) (involving a standard form contract stating that all work would be of good quality and according to the contract specifications). Commonly, the contractor warrants all work and materials for one year after completion (or substantial completion). See Barrack v. Kolea, 651 A.2d 149, 153 (Pa. Super. Ct. 1994) (contract providing that warranties continue for 12 months). In many circumstances, a contractor should not independently warrant appliances and equipment but should pass through to the owner all manufacturers' warranties. The contractor should deliver to the owner any warranty documentation from manufacturers.
Some contracts will contain an express acknowledgment from the owner that the contractor must only "substantially comply" with plans and specifications and that some minor imperfections may exist in the final product. See Weidner v. Szostek, 614 N.E.2d 879, 882 (Ill. Ct. App. 1993) (stating that "[t]he general rule is that a builder is not required to perform perfectly, but rather is held only to a duty of substantial performance in a workmanlike manner"). Some contractors also try to limit the period during which an owner can make claims for defective work and to exclude consequential damages and owner claims of lost profits.
Changes to the WorkOrdinarily, an owner should reserve the right to make changes in the work that do not radically alter the contractor's responsibilities. In all but the simplest projects, the contract should set out a procedure for the approval and implementation of proposed changes. That procedure should require that change orders be in writing and signed by both parties (as well as the owner's architect or engineer, if appropriate). The contract should also require the parties to agree on any changes to the contract price or completion schedule before the contractor starts any additional work. Many contract disputes involve changes or claims for "extras." Conduct by the parties that is inconsistent with the contract may waive the protections intended by the change order provisions. Cf. Johnson Constr., Inc. v. Rugby Mun. Airport Auth., 492 N.W.2d 61, 63-64 (N.D. 1992) (failing to provide notice of claim for additional compensation as required by the contract resulted in waiver of right to make the claim).
Contractor Defaults and Mechanics' LiensPayment and performance bonds in the full contract amount are the customary protection against a contractor default and liens. Bonds, which are expensive, are impractical in many smaller projects, and small contractors may be unable to provide bonds. In some situations, the contractor may be able and willing to provide assurance to the owner through a letter of credit. Although this device may be better in some respects than surety bonds, construction contracts in the United States (no matter what size) do not often provide for letters of credit.
In all cases, but especially in the absence of bonds or a letter of credit, the contract should obligate the contractor to provide lien waivers. At a minimum, the contractor should provide full lien waivers on its own behalf and from all major subcontractors and suppliers before final payment. Careful owners that are willing to spend time monitoring the project will require partial waivers with each progress payment. See Country Serv. & Supply Co. v. Harris Trust & Sav. Bank, 430 N.E.2d 631, 634 (Ill. Ct. App. 1981).
To use the partial lien waiver process effectively, the owner must have a reliable list of at least the principal subcontractors and suppliers and must have some way of knowing what amounts the contractor owes to whom. A contractor may resist a requirement for partial lien waivers because it involves administrative time. Nevertheless, partial lien waivers provide the owner with important protection against paying twice for the same work. Small contractors may operate on thin capital and can be tempted to use progress payments from one job to pay overdue amounts on another job. Compromise approaches include allowing the contractor 15-30 days to provide partial lien waivers from subcontractors and suppliers; using conditional waivers that only become effective when the party giving the waiver receives a specified sum; limiting the requirement for lien waivers to the completion dates for specific project milestones; and requiring partial lien waivers only from selected subcontractors and suppliers. The owner should also have the right to retain an amount equal to any mechanic's lien claims that a subcontractor or supplier asserts.
Alternatively, the owner can disburse progress payments through a disbursing agent under an escrow agreement. A title insurance company may provide the disbursement service, either in conjunction with issuing and updating a title insurance policy that insures against mechanics' liens, or independently as a service for a fee apart from title insurance coverage. Some other companies specialize in acting as disbursing agents. In either case, the parties should enter into an escrow agreement that sets out the requirements for funding each progress payment. Under these arrangements, the disbursing agent takes some responsibility to obtain lien waivers or other evidence that the contractor is paying its subcontractors and suppliers and that the contractor has met other conditions to payment. This process, which is commonplace in some areas of the country, may be ideal for owners that cannot administer the contract themselves.
Property Damage and Personal InjuryA contractor should indemnify the owner against most claims for damage and injury arising out of performance of the work. In significant commercial projects, the parties may argue extensively over the scope of the indemnity. The contractor should try to avoid an indemnity provision that is broader than the contractual liability coverage under its public liability insurance policy. The indemnity provisions in many industry form documents strike a balance between the parties' conflicting objectives.
InsuranceEvery construction project involves insurance requirements, including: (1) builder's all-risk coverage to insure the construction work in progress; (2) commercial general liability insurance; (3) automobile insurance; (4) contractual liability coverage for the contractor's indemnity obligations; and (5) workers' compensation and employers' liability coverage. Each party should consult with an insurance advisor. The owner should obtain an insurance certificate from the contractor. Form contracts often omit details of the required insurance, such as the precise limits of coverage, the specific risks that the liability policy should cover and special coverage requirements for the use of explosives, motor vehicles, watercraft or aircraft in construction activities.
ScheduleIf the schedule is truly important to the owner, the contract should put teeth in the schedule. There are a number of questions the parties should consider. Should the contract identify one overall completion date or multiple completion dates for proj-ect milestones? Should the parties agree to liquidated damages for late completion? Should the contractor receive a bonus for early completion? Will too much emphasis on deadlines compromise quality and flexibility? What constitutes force majeure?
What responsibilities should the owner have for avoiding delays, such as the prompt approval of plans and samples? The owner and its lawyer should assess the damages that may result from a project delay and how the owner can protect against those damages. The contractor and its lawyer should consider how to limit the contractor's responsibility for damages the owner may claim if a delay occurs.
What Else?Any issue that may be important in a large commercial project may also be important in a construction contract for a particular small project. The lawyers for the parties should consider: special services that the contractor may provide or services for which the contractor will receive additional payment; requirements for subcontractors or suppliers; any special features of the site or location, such as the need for rezoning and the availability of basic utilities; the contractor's obligation to keep the site clean and provide final cleanup; coordination between the contractor's work and any work the owner will provide directly or through separate contractors; whether to designate individuals who will act in a binding capacity as the parties' representatives; permitting and building code requirements; whether deed restrictions require a design committee to review the plans; whether the contractor should provide as-built drawings or any operating manuals for appliances or equipment; the right of either party to terminate the contract for cause or, in the case of the owner, solely for convenience; contract assignability; arbitration or other alternative dispute resolution procedures; special procedures for sales tax exemptions; compliance with legal requirements, including envi-ronmental laws; attorneys' fee and cost provisions; and special requirements that a construction lender may impose.
Construction Contract FormsConstruction industry contract forms have the advantages of reflecting valuable experience and having wide acceptance and familiarity in the industry. The AIA, for example, has developed its forms over several decades and numerous projects. As a result, commentators and courts have interpreted and applied these forms in many different circumstances. See, e.g., Volt Info. Sciences, Inc. v. Board of Trustees, 109 S. Ct. 1248, 1254-56 (1989) (arbitration and choice of law); United States v. M.J. Kelley Corp., 995 F.2d 656, 657 (6th Cir. 1995) (Brennan, J., dissenting) (arbitration). Developers, design professionals, contractors, subcontractors, lenders and surety companies all have experience with these forms.
Committees for trade or professional associations of architects, engineers and general contractors have drafted the forms most commonly used. Consequently, the forms reflect the viewpoints of those organizations and their constituencies. The lawyer who uses an industry form starts with some built-in concessions to the other party and adopts someone else's presumptions about the way to run a project. Some clients benefit from developing their own design and construction contract forms, such as a builder that can craft an individualized form to fit its business or an experienced owner with established preferences and methods of operation and the bargaining position to impose them (which may be rare in a small project).
A lawyer preparing an individualized contract form should carefully weigh the countervailing considerations. On the one hand, no industry form will perfectly fit a client's needs. On the other hand, for many clients, especially owners, the probable ben-efits will not justify the time and expense of creating a completely individualized contract. Design and construction contracts are complicated legal documents governing the rights and obligations of several principal players with divergent interests. Moreover, the prospect of contract dispute is always present. For these reasons, design and construction contracts must adequately cover the most important considerations and the contingencies that are likely to occur and attempt to resolve common areas of misunderstanding. An owner that is inexperienced or is not continuously in the business of development may be well advised to rely on established industry forms. Many residential contractors can and do successfully develop their own contract forms. Small commercial contractors often will find it difficult to convince owners and their architects and lawyers to abandon the security of industry forms.
In small projects, lawyers frequently will work with form documents and suggest changes to make the forms better fit their clients' needs. Industry forms, especially the AIA's form documents, may involve intricate relationships among separate documents and among the numerous provisions within a single document. Consequently, the reviewing lawyer must recognize the relationships among all relevant documents and provisions and must determine how any change affects other documents or provisions. A lawyer should not, however, hesitate to propose changes merely because the parties have selected a popular form as the basis for their agreement.
ConclusionThe dynamics of the small construction project may produce a dilemma for a lawyer. From a client's perspective, many construction proj- ects may seem too routine, too small or on too tight a schedule and budget to justify extensive legal work. When something goes wrong during or after construction, however, even routine and small projects can lead to severe consequences. To serve a client effectively, a lawyer must have a sound understanding of common construction issues and the common techniques available to address them.
Carl J. Circo is a shareholder of Stinson, Mag & Fizzell in Overland Park, Kansas. He is the co-chair of the Real Property Division's Design and Construction (Including Americans with Disabilities Act) (G-2) Committee.
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