Fair is Fair…Right? Basic Principles of Risk Allocation in Construction Documents – Part 2 by Kevin O’Beirne, PE

Continued from Part 1–How do [sub-standard] clauses get into [construction] contracts? The answer is twofold: 1) . . . as provisions are added and modified on an individual-paragraph basis. . . 2) They are often drafted by the owner’s attorney, who is often not a “contracts attorney” and may not fully-understand the effects of such provisions. . .[and is] paid to represent their client in a partisan manner, and some owners’ attorneys appear to believe that lopsided risk allocations mean a contract that is better for their client.

What’s a Contractor to Do?

The contract language excerpts above naturally lead one to contemplate a contractor’s options when faced with such terms and conditions.  A risk-conscious contractor may either incorporate into their pricing larger contingencies as the cost of accepting the risk (as discussed further in the following section of this article), or they may simply elect to not submit a bid or proposal for a risky contract—perhaps because of atypical contractual risk allocations, or because of the reputation of the owner or design professional.  Some consequences to the owner of the contractors’ latter option include:

  • Quality of construction can suffer with decreased competition, particularly if “better” contractors prefer to avoid such projects.
  • Construction costs will increase with decreased competition.
  • As fewer local contractors pursue projects for a particular owner, out-of-town contractors may become more common. Out-of-town contractors lack familiarity with particular owners and their facilities, and can have increased pricing for changes if their workers are not local. It may be more-difficult to properly coordinate with out-of-town contractors, and knowledge of local licensing and permitting may be lacking.  Out-of-town contractors may be less-willing to provide the same service that a given owner expects from its local contractors, and therefore there may be greater potential for claims and disputes.
  • If the contract value is small, atypical risk allocations may result in few or no bids on the contract, because the potential reward is not worth accepting the risks.  This could result in lost time and money to rebid or value-engineer the contract.

Results of Atypical Risk Allocations

Onerous provisions like the examples presented above provide the owner with limited advantage and frequently work against the owner.  Such terms may save the owner the cost of some claims but there are numerous associated drawbacks.

At the outset of each project the owner possesses virtually all the risk.  The transfer of any element of risk from the owner to another participant (contractor, design professional or another entity) will have an associated financial cost to the owner.  Although it may be contrary to many entrenched opinions, the owner should avoid taking the view that any party is trying to take advantage of a situation to get the owner to retain a certain risk, because, the owner starts out with all the risk anyway, except for negligence-based risk.

Unequitable risk allocations that are to a contractor’s disadvantage can result in fewer change orders and claims in favor of the contractor, but in the long run the owner always pays.  Atypical risk allocations can burn a contractor once, twice, or perhaps three times.  After that, any contractor will learn from their hard-earned experience and will, in the future, price the risk accordingly, both in their bids and in pricing owner-ordered changes.

Assuming that the construction documents are prepared by a competent team of design professionals, and a competent, honest contractor (most of them are), it is typically cheaper for the owner to pay, say, two to five percent change orders on a project instead of paying a “hidden” but still very-real cost of, say, 10 to 15 percent added on to the contractor’s pricing to cover risk-based contingency factors.

My own experience supports this point.  Although not precisely regarding contractual risk allocations, the basic principles still apply: Around 20 years ago, I had a boss who was very tough on construction contractors; some would have perhaps argued that he was unreasonable in negotiating change orders.  Within six months following the boss’s retirement, I received separate phone calls from three different local contractors, each telling me that bid pricing on our design team’s projects would henceforth be “about ten percent less” than had been the case for some years.  The reason was because the former boss was gone, and the local contractors—who all knew how difficult he could be—no longer had to include a ten percent contingency in their bids.  The former boss had been proud of his “one to two percent change order” record, when in fact his difficult attitude cost project owners a “hidden” extra ten percent.  The same can, and does, apply to onerous contractual risk allocations.

In addition to impacting contractors’ pricing, unfair clauses often lead to reduced competition; contentious, stressful, unpleasant projects; and in some cases may be unenforceable when challenged.  Of the contract language excerpts presented above, the one where the contractor was required to indemnify the owner for the owner’s own negligence is probably useless to the owner, because arbitration boards and courts in various jurisdictions have repeatedly ruled such provisions to be unenforceable.

“Proper” Risk Allocations

Now that we’ve established that fair contracts are desirable for all parties, how does one write a “fair” contract?  After all, isn’t fairness, like beauty, in the eye of the beholder?  And a fair contract cannot make the risk go away—someone has to accept it.

Arguably, a fair contract is one that consistently allocates risk to the party best-able to control that risk.  In the case of a risk that neither party can control, such as a force majeure event (e.g., abnormal weather, acts of God, and similar uncontrollable events) the risk should probably be equitably allocated to both parties.

For the most part, the standard contract forms of industry organizations such as EJCDC and others do a good job at fairly allocating risk.  EJCDC often has regular participation by stakeholders representing different interests in the project: owners, contractors, design professionals, attorneys (experienced in representing all sides), insurers, sureties, and more.  For example, a representative of APWA is a regular participant in EJCDC.  The give-and-take discussions during the drafting of many standard contract documents by such organizations, including the free exchange of ideas on risk allocations, results in standard documents that generally allocate risk to the entity best able to control that risk.  Furthermore, the committee members who draft such provisions have the experience and knowledge to explain to users the rationale for the risk allocations in the model language.

While the specifics of suggested, “proper” risk allocations for individual topics are beyond the scope of this article, this writer recommends that drafters of construction documents either use standard-form contract documents by entities such as EJCDC, AIA, DBIA, or others, or use such standard documents as a baseline for drafting project-specific risk allocations.

Conclusion

Construction contractors should be expected to include in their pricing only those costs that a prudent, experienced contractor can reasonably foresee—particularly on projects awarded to the bidder who submits the lowest-priced bid.  When a contractual provision requires the contractor to know more than does the owner or design professional about the site selected by the owner, or to have a crystal ball to foresee the cost-effects of risks that they will be expected to absorb at their own expense, then the stage is set for discord, stress, claims, and disputes.  When the contractual provisions are fair, however, the project is more-likely to be completed on time, on-budget, and with all involved ready to work together again as a team striving toward a common goal: success of the overall project.

Kevin O’Beirne, PE, CSI, CCS, CCCA is a Principal Engineer and Manager of Standard Construction Documents at ARCADIS U.S., Inc.(www.arcadis-us.com) in Buffalo, NY.  He is the FY 2014-2015 Chair of the Engineers Joint Contract Documents Committee (EJCDC) and is a member of CSI’s MasterFormat Maintenance Task Team.  Kevin is a professional engineer licensed in NY and PA