Target Price Contracts: Drafting and Enforcing These Risk Allocation Provisions

What is a Target Price Contract?

The purpose of a target price contract is to incentivize efficiency and cost-effectiveness, and to disincentivize the opposite.  They can be used in both prime contracts and subcontracts, for design and construction.  In a target price contract, the parties negotiate the target price, which is the amount expected to complete the scope of work.  If the final invoice amount is less than the target, the parties split the savings according to a pre-negotiated ratio.  This is the incentive.  On the other hand, if the final invoice amount exceeds the target, only a partial payment is made according to a pre-negotiated ratio.  This is the disincentive.   

The pre-negotiated ratios can be fixed or a sliding scale.  For example, a prime contract sliding scale could provide:

• The payment or discount will be calculated using the following formula:
• Total = Total Invoice Amount – Target Price
• If Total is negative by over $100,000, Owner will pay Prime 50% of such amount as a bonus.
• If the Total is negative by $100,000 or less, Owner will pay Prime 25% of such amount as a bonus.
• For Totals of $0 to $100,000, Owner will pay Prime 50% of such amounts to compensate Owner for unanticipated costs.
• For Totals of $100,001 or more, Owner will pay Prime 25% of such amount to compensate Owner for unanticipated costs.

In the subcontracting context, target price language from the prime contract should be incorporated into, or duplicated in, the subcontract with an additional provision.  Below is an example of a common target price provision to include in a subcontract when the prime contract contains a target price provision.

Subcontractor shall share in any incentive or disincentive payment. Subcontractor share of any incentive or disincentive payment shall be 30% of the total incentive or disincentive assessed to Prime including any adjustments made by Owner.

Is a Target Price Contract Enforceable?

Challenges to the enforceability of target price contracts usually argue it is an unenforceable penalty and violates applicable anti-indemnity laws.  Application of these defenses are state-by-state, but in general terms neither argument should be likely to succeed.

Unenforceable Penalty

While published authority is scarce, whether a target price provision is an unenforceable penalty turns on whether it allows for double recovery or constitutes an impermissible liquidated damage.

The Alabama Supreme Court has provided some guidance whether a target price provision should be unenforceable because it allows for double recovery.  In Milton Construction Co. v. State Highway Department, 568 So.2d 784, 785 (Ala. 1990), the Alabama Highway Department entered into a contract with a general contractor for work on Interstate Highway 65.  The contract included a target price provision, a liquidated damage provision, an actual damage provision, and provided that multiple damage provisions could apply to the same loss.  After exceeding the target price, the general contractor challenged the enforceability of the disincentive portion of the target price provision. 

The Alabama Supreme Court held the disincentive provision was an unenforceable penalty because the multiplicity of damage provisions led the Highway Department to receiving more than a double recovery for the same damage, which was out of proportion to the damages it incurred.  Further, because the Highway Department conceded that it arbitrarily set the dollar amount of the disincentive and the maximum time limit for the assessment in the disincentive clause, these arbitrary calculations had no correlation to the damages the Highway Department sustained and, thus, were unreasonable.  Finally, the general contractor bid on the project with the disincentive clause included as part of the bid documents, not as a negotiated term or condition.

The second unenforceable penalty analysis is whether the target price provision is an unenforceable liquidated damage.  Even though the Milton court analyzed the target price provision under a liquidated damage analysis, there is a strong argument that such analysis should not apply because the disincentive portion of a target price provision has a distinct legal identity separate from a liquidated damage provision.  For example, in Colorado, a liquidated damage provision determines difficult-to-calculate damages in advance of a breach and, importantly, only would apply if there is a breach. See Planned Pethood Plus, Inc. v. KeyCorp, Inc., 228 P.3d 262, 264 (Colo. App. 2010).  In contrast, exceeding the target price does not necessarily constitute a breach.  If no breach occurs, it would be inappropriate to analyze a target price provision under a liquidated damages framework.  Rather, a target price clause should be analyzed simply as a risk allocation provision that should be mutually bargained for by parties. See Appeal of Fairchild Camera and Instrument Corp., 68-2 BCA P 7327 (1968) (concluding that the delivery incentive type of provision is not a liquidated damages provision because the incentive provision has a distinct legal identity that operates by force of the parties’ agreement and without any occurrence of breach).

Anti-indemnity Analysis

Anti-indemnity laws in some states void, as a matter of public policy, clauses that shift liability from negligent parties onto innocent parties.  In Colorado, for example:

any provision in a construction agreement that requires a person to indemnify … another person against liability for damage arising out of death or bodily injury to persons or damage to property caused by the negligence or fault of the indemnitee or any third party under the control or supervision of the indemnitee is void as against public policy and unenforceable. 

Colo. Rev. Stat. § 13-21-111.5(6) (2019).

An anti-indemnity argument against a target price provision should not be successful in any state with a law similar to Colorado’s because a target price provision does not shift liability due to negligence or third-party claims and no property damage or bodily injury exists.  Importantly, a target price disincentive provision is not invoked by negligence or tort law.  However, if such a law were to apply and if the Subcontractor stayed below its subcontract price but the target price was still exceeded, the Subcontractor could argue that the disincentive part of the target price provision shifts liability from the negligent parties, i.e. the Prime and other subcontractor, onto the innocent party, i.e. itself.  While the Subcontractor may make this argument, no court has ever applied an anti-indemnity analysis to a target price clause. 

Other Considerations

In government contracting, parties routinely use target price contracts.  In fact, the FAR provides for target price contracting as one of several approved methods for federal contracting.  See FAR 16.201(a) (“Fixed-price contracts providing for an adjustable price may include a ceiling price, a target price (including target cost), or both.”).  Additionally, courts routinely enforce target price clauses.  For example, in federal court in Massachusetts, a court denied summary judgment related to the target price incentive clause in an environmental clean-up project.  AECOM Tech. Servs. v. Mallinckrodt LLC, 117 F. Supp. 3d 98, 110 (D. Mass. 2015).  Similarly, the Court of Claims upheld a target price provision and found they “encourage specific efforts and discourage inefficiency and waste.”  McDonnell Douglas Corp. v. United States, 37 Fed. Cl. 295, 299 (Ct. Cl. 1997).

Drafting Enforceable Target Price Provisions

While target price provisions are generally upheld, drafting to address existing case law may avoid later challenges.  Word choice should be deliberate (avoid characterizing the disincentive as a “penalty,” for example).  Avoid duplicative damage provisions.  Negotiate the provision and ratio and use some reasonable basis to choose the ratio (for a subcontractor, for example, it may be reasonable to choose a ratio equal to the subcontract value’s percentage of the prime contract value).  Finally, make sure the parties mutually intend for the provision to be a risk allocation provision and not a liquidated damage or indemnity provision.   

Conclusion

Target price contracts are becoming more widely used in the construction industry because they provide an alternative method for shifting portions of price risk.  And while they are usually upheld, careful drafting is required to avoid known traps and clearly communicate the intent of the parties to incentivize efficient performance and disincentivize inefficient performance, not to penalize one party for exceeding the target price.