The cost-plus construction agreement is one of the most widely used construction agreements. There are pros and cons that come with the use of such an agreement. One of the largest concerns for the owner in a cost-plus agreement is the potential for uncapped cost overruns and unanticipated costs. The contractor in such agreements does not have to provide a fixed cost for the work upfront but only an estimate for how much the he or she thinks the project will cost.
Why would any owner want to use this type of agreement in the first place? The cost-plus agreement is a good option when building and design plans are still fluid and time is a crucial factor in getting a project started. The cost-plus agreement also has the potential to create a scenario where the owner is able to get a “good deal” on a project, paying only the cost of the actual materials and labor in the project plus a set negotiated fee. Therefore, if there are cost savings during construction, they are passed onto the owner. However, that same “good deal” has the potential to spiral out of control, and the cost-plus agreement can become very expensive for the owner and profitable for the contractor if there are no precautions set in place.
The cost-plus agreement can be beneficial for the contractor as well. If the contractor is good at record keeping, he or she will mostly likely be paid for every reimbursable expenditure on the contract. There is also very little risk up front for the contractor with using this type of agreement, because all of the risk is borne by the owner. This agreement only requires an estimated cost of the work, therefore, a contractor will not be penalized for under-bidding or failing to account for certain costs. However, because of the fluid nature of the costs, there are additional financial duties that the contractor owes the owner. One such duty is the owner’s implicit right to a reasonable cost for the work and a right to a sense of openness in reviewing the books and accounting for what is being spent on the work.
So what happens when there is a potential dispute regarding the cost-plus agreement? Can both parties be protected from litigation when using the cost-plus agreement? Remember the old saying, “an ounce of prevention is worth a pound of cure.” In the context of the cost-plus agreement, this statement could not be more accurate. When the parties are proactive in the formation and negotiation of the agreement, the cost-plus contract can be a beneficial contract for both parties. This article will focus on some of the legal and practical implications for using the cost-plus contract agreement. It will discuss the inherent duties of the contractor when using this type of agreement. Further, it will highlight some of the best practices and some drafting techniques that the parties may negotiate and use in order to protect their interests while using this specific construction agreement.
The Duties Associated with Using the Cost-Plus Contract Agreement
Unlike a fixed-cost construction contract, a cost-plus construction agreement is a contract in which the owner pays the contractor the actual costs of the materials and labor plus an additional negotiated fee or percentage over that amount. The cost-plus contract is probably the most widely used contract in the construction industry. The additional fee or fixed percentage is the contractor’s profit. This contract shifts all of the risks associated with a project and all of the benefits of unanticipated changes in material costs, labor costs and all of the risks and benefits of the contractor’s efficiency on the project or lack thereof to the owner. Because of the nature and risk associated with the cost-plus contract, there are certain inherent duties that the contract or owes to the owner. The contractor has a duty to submit an itemization of each and every expenditure made during the course of the project because there is an implicit agreement between the parties that the costs will be reasonable.
Many courts have held that the contractor and owner’s decision to use a cost-plus construction agreement creates an additional heightened duty to the owner, but does this create a fiduciary duty? The decisions are split.
Before there can be a breach of fiduciary duty, there must be, among other things, either a fiduciary relationship or a confidential relationship. Certain recognized relationships, such as the relationship between a trustee and a beneficiary, give rise to general fiduciary duties. However, a fiduciary relationship can also arise between individuals through a relationship of trust, confidence, and reliance. A fiduciary relationship generally arises where one party has a high degree of control over the property or subject matter of another, when the benefiting party places a high level of trust and confidence in the fiduciary to look out for the beneficiary's best interest or when one party relies on another's high degree of expertise in an area.
AIA Document A102™–2017 Standard Form of Agreement between Owner and Contractor, Article 3 states in pertinent part, “The Contractor accepts the relationship of trust and confidence established by this Agreement and covenants with the Owner to cooperate with the Architect and exercise the Contractor’s skill and judgment in furthering the interests of the Owner; to furnish efficient business administration and supervision; to furnish at all times and adequate supply of workers and materials; and to perform the Work in an expeditious and economical manner consistent with the Owner’s interest.” Does this language create a fiduciary duty?
Some courts have held that this provision in the standard AIA agreement creates a fiduciary duty, while others have held that it does not. Whether the duty is created tends to be a factually intensive analysis taking into account things like the sophistication of the parties, the language set forth in the parties’ agreement and their contracting history. However, almost all courts agree that implied in every contract is the duty of good faith and fair dealing in its performance and enforcement. Courts also agree that contractors have a duty to keep accurate records for the use of materials used and labor performed on the project. While the duty of the contractor is not to show that the costs are reasonable, he or she must be able to support the spent costs to the owner by accurate record keeping.
The Risk of Disorganization
The Tennessee Court of Appeals outlines a case wherein, the contractor failed to have an organized system in place for the owner to review his books for the project. In Forrest Construction Company, LLC v. Laughlin, the owner entered into a cost-plus contract with Forrest Construction Company for a residential construction project. The actual agreement between the parties provided that Forrest Construction would recover its, “actual net costs, plus 7% for “the contractor's overhead,” plus an 8% profit, which was based on the “actual net costs of all direct materials, labor, services, and fees, that go into the entire project.” Forrest Construction was to be paid pursuant to the cost plus formula on a weekly basis; it was to submit weekly requests for draws based on the cost of the work in the previous week plus overhead and profit. The contract further provided that each draw was to be submitted with “full back-up support for all amounts requested” and that the contractor had the full responsibility and obligation to keep full and accurate records of all costs and expenses to satisfy tax laws and owner. A dispute arose between the owner and contractor regarding the growing costs of the project. The owners stopped paying for the work. When the draw requests stopped being fulfilled, the contractor stopped working on the project and filed a lien.
Pursuant to its own agreement, Forrest Construction was required to keep a detailed accounting and back-up documents for all expenditures and draw requests on the project. However, when the owner asked for the accounting records on the project, the contractor could only provide a “two-foot thick pile” of unorganized receipts. The Court found this type of record keeping to be unacceptable when it said, “in any cost-plus contract there is an implicit understanding between the parties that the cost must be reasonable and proper." The Court held that the contractor is under a duty of itemizing each and every expenditure made by it on the job, and where the owner denies being indebted to the contractor, the latter has the burden of proving each and every item of expense in connection therewith.
Forrest Construction failed to itemize the expenditures it sought to recover. Instead, it submitted essentially a stack of unsubstantiated requests for draws, and when called upon to provide proper documentation and itemization of the costs, it provided a wholly disorganized, un-itemized box of documents, many of which were unrelated to the actual project. What could Forrest Construction and the owner have done differently to protect themselves from the dispute in the first place? It’s hard to speculate; however, if the parties had negotiated more specific terms and provisions regarding the documentation that was required to be submitted with each draw request, perhaps the case would have had a different outcome. The crucial phase when using a cost-plus agreement is the drafting of the provision in the contract itself.
The Use of the Guaranteed Maximum Price (GMP)
One way an owner can seek protection when using the cost-plus contract agreement is to negotiate the use of a guaranteed maximum price (GMP) as a basis for the agreement. GMPs typically provide for the owner to pay the contractor its actual costs in constructing the project plus a stated fee; the contractor offers the owner a guarantee that she will pay no more than the GMP for the project absent allowable claims for additional compensation. Thus the GMP shifts the burden of the anticipated costs and overruns from the owner to the contractor by limiting and/or capping the amount that an owner will ultimately pay for the work. An owner will, in the end, pay the lesser of either the actual costs at the project’s completion or the final guaranteed maximum price. In this scenario, the contractor and owner agree that the owner will pay no more than a GMP unless the parties agree to additional compensation for change orders or other allowable claims.
The Use of Audit Provisions in the Contract
Another way that both the contractor and the owner can protect themselves is to negotiate audit provisions for inclusion in the contract prior to starting the work. In Forrest Construction, the parties to the contract made sure to include a clause that the contractor was subject to an accounting of his expenditures. They, however, failed to include provisions that would have assisted both the contractor and owner by setting a defined scope and clear expectation as to what exactly the contractor needed to produce, the methodology regarding how the accounting should have been conducted and the timing and frequency of the owner’s audits. This is where a carefully drafted audit provision may have helped.
Audit provisions are often contained in contracts where there are cost-reimbursable elements whether or not the agreement is subject to a GMP. These provisions are always an excellent idea in a cost-plus a fee arrangement. The owner generally has the right to reconcile or verify things like the number of units installed, the number of hours worked, and other items that are a part of the “fixed” components but not the underlying documents and records which support the contractor’s actual costs incurred during the project. To discourage the likelihood of a misunderstanding, it is crucial that the parties establish a clear breadth and scope of any audit including those audits taking place after the completion of the project.
Well drafted audit provisions will also contain a listing of the types of documents that are subject to the audit. These provisions are negotiable for both parties; however, in setting the expectation for materials subject to audit on the front end, both the owner and the contractor are protected and on notice regarding the depth and breadth of record keeping required by the audit. These provisions should define the scope, parameters, timing and rules related to: 1) accounting records or source documentation; 2) level of proof of costs; 3) description of the audit process; 4) definition of cost and rates for certain items such as labor or equipment; 5) definition of allowable and unallowable costs; 6) contractor record-keeping and reporting requirements for job cost and progress reporting; 7) definition of any audit restrictions that may apply with respect to disputes, litigation and discoverability of certain documents; 8) definition and identification of fixed unit rates, lump sum components, agreed percentages or other agreed-upon special rates for costs related to items such as: changed work, subcontractor markups, etc.; 9) record retention requirements; and 10) definition of the owner’s rights to audit subcontractors. Precision is key in the use of the audit provision. The parties should take the time to set specific examples of what is subject to the audit and what is not. Exactitude on the front end can help to alleviate disputes regarding the interpretation of the audit provision on the back end. The audit provision should also include an agreed upon tribunal or dispute resolution method should a dispute arise. It should also set forth a schedule for periodic audits while the project is taking place.
Negotiating the Resolution of the Disagreement
When negotiating and drafting the terms and provisions of the agreement, dispute resolution should always be kept in mind. If a dispute between the owner and contractor does arise, consideration should be given in the agreement to the discoverability of the underlying audit documents. The owner will most likely seek use the dispute resolution process to get sightline into all of the documents regarding the cost-plus agreement, including the documents that were not subject to the audit provisions in the agreement. This is where the savvy contractor needs to be prepared when negotiating the terms of audit provision in the cost-plus agreement at the outset. The savvy contractor can protect herself by negotiating the forum for dispute resolution and insisting that all disputes arising from the agreement be resolved by arbitration verses litigation.
Why is this so important? The rules of arbitration function to provide the contractor with the most protections, especially when it comes to the discoverability of certain agreed upon documents subject to audit in the audit provisions of the contract. Unlike the rules of civil procedure, arbitration allows the parties, by written agreement, to vary the procedures set forth in the AAA Commercial Arbitration rules. Further, the Supreme Court has held that the Federal Arbitration Act’s centerpiece provision makes the parties’ written agreement to arbitrate in, “any maritime transaction or contract evidencing a transaction involving commerce…valid, irrevocable and enforceable.” By enacting the Arbitration Act, Congress’ desire was to vigorously enforce the private agreements of parties that required arbitration.
Therefore, assuming that the bargaining power between the owner and the contractor are equal, and there are no claims of duress, fraud or coercion in the formation of the agreement, the parties’ agreement regarding the audit provisions and documents subject thereto should be enforced by the agreed upon arbitrator. This forum is significant for the contractor because where there has been an agreement regarding the documents subject to audit, the discovery process would not make every single document discoverable because of the litigation discovery process. Instead the parties would be limited to the documents previously subject to disclosure by the audit provision set forth in the contract.
There are risks and benefits associated with any contract. The cost-plus a fee agreement can be full of challenges for any owner or contractor. However, if the proper attention is given to drafting the contract in the beginning the cost-plus agreement can be a great contracting tool for both parties. The key to making the cost-plus agreement work is the consideration given in the negotiation of the terms of the agreement, specifically the addition of a GMP, detailed audit provisions and forum selection.