The Lowdown on Significant Risk-Allocation Clauses (Part 1 of 2)

Recognition and allocation of risk should be major concerns for all parties in a construction project. Allocating unavoidable risks between the parties is a major function of construction-related contracts. This article will outline some of the most significant risk-allocation clauses and their importance to the parties.

General contractors typically do not have much flexibility in negotiating contracts with owners/developers, but it is important for them to recognize opportunities they do have and understand the risks certain clauses may create. 

Indemnity

A well-drafted indemnity clause can help protect a general contractor against having to indemnify a developer from third-party claims arising from the developer’s own actions or inactions.

Several states have enacted “anti-indemnity” statutes limiting the types of indemnity clauses in construction contracts. Such legislation generally precludes any indemnity provision requiring one party to indemnify another for the results of the other’s negligence or other fault. Accordingly, there is limited flexibility in drafting indemnity clauses, but contractors
should read clauses carefully to ensure compliance with the applicable law.

Notwithstanding this, some discretion may be allowed. For example, the relevant anti-indemnity statute may apply only to claims based on bodily injury or death, or damage or destruction of property. Therefore, a clause requiring the contractor to indemnify the developer might be enforceable if the claims are based on causes other than personal injury or property damage. This could shift the risk of the developer’s actions or inactions to the general contractor.

If the clause is not governed by statute, the contractor should resist a ”broad form” clause that, on its face, requires the contractor to indemnify the developer against third-party claims resulting from the developer’s own negligence or other fault. Such clauses are extremely one-sided and should not appear in contracts intended to foster teamwork rather than disputes. 

Also, general contracts often include clauses that grant indemnity rights to the developer but not the contractor. The contractor should seek to make such clauses reciprocal so that the contractor’s rights are identical — or at least similar — to the developer’s.

Payment

Certain payment clauses in subcontracts, frequently called conditional payment clauses, can be generally categorized either as pay-when-paid or pay-if-paid provisions. Under a pay-when-paid clause, the general contractor ultimately bears the risk when a developer fails to pay the contractor for the subcontractor’s work. Under a pay-if-paid clause, the subcontractor bears that risk. Understanding the differences can be critical to managing a contractor’s cash flow, among other benefits.

Pay-when-paid clauses typically state that the subcontractor will be paid within a specified time after the general contractor receives payment from the developer and may allow the contractor to delay payment to the subcontractor for a period. 

However, unless they are specifically drafted to so provide, these clauses do not allow the contractor to postpone payment to the subcontractor indefinitely or to avoid payment entirely. The time frame depends on all the facts and circumstances, including the specific language of the payment clause.

Pay-if-paid clauses allow the contractor to withhold the subcontractor’s payment until the developer pays the contractor. This delay could be indefinite, or even forever, if the general contractor never receives payment. These clauses are generally enforceable when properly drafted, but several states have statutes that prohibit such clauses if agreed to before starting the work.

The general rule is that the general contractor bears the risk of the developer’s nonpayment. If the parties intend to shift the risk to the subcontractor, the clause must clearly and unequivocally state this. If there is any ambiguity, the clause is typically interpreted as a pay-when-paid clause. 

Pay-if-paid clauses are enforceable in some states if they state that payment by the developer is a “condition precedent” to the contractor’s obligation to pay the subcontractor, and that the subcontractor “assumes the risk” of the developer’s nonpayment, and that the subcontractor “waives and releases” any claims if the developer doesn’t pay the contractor.

Waivers of Lien & Bond Rights

Developers have a powerful tool for allocating some of the risk of their nonpayment to a general contractor in a clause where the contractor waives its rights to assert a lien claim against a private project or a claim against a payment bond on a public project. Such a waiver removes substantial leverage for the contractor to obtain payment. Contractors should seek to remove any such clause from the general contract.

Site Investigation

Contracts often require contractors to conduct site investigations to assess factors affecting cost and duration like limited storage or staging space; availability of labor, water, power or access; topography; and legal restrictions such as limitations on working hours. Even without a specific requirement, the contractor should conduct such an investigation and report any concerns to the developer. This may seem counterintuitive because of the time and money it requires, but as a general rule, the contractor who undertakes a project — especially at a fixed price — bears the risk of site conditions that an investigation could have uncovered. Compliance with a site investigation clause can help to shift such risk to the developer.

If a contract includes a site investigation clause, the general contractor should ensure it doesn’t require costly or time-consuming testing. This typically is not required, but it does appear occasionally.

Differing Site Conditions

Differing site conditions are conditions at a construction site that were unknown when the contract was executed. Examples include a high-water table, expansive soils or other subsurface conditions, and characteristics of existing structures on the site. A differing site condition clause allocates the risk of changes in the scope, cost and time resulting from such conditions, by allowing the contractor to request equitable adjustments to the contractual price and time. 

This departs from common law, where contractors must meet the requirements of the contract even when previously unknown conditions are discovered. To mitigate the risk, contractors usually include contingencies in the bid. The differing site conditions clause gives the developer the benefit of a lower base bid price that does not include contingencies by shifting the risk of such conditions to the developer.

Waivers of Consequential Damages

Waivers of consequential damages have been common in general contracts and subcontracts for many years. Such clauses typically require both parties to waive claims for consequential damages, and most clauses will attempt to define some of the types of damages that are deemed, or not deemed, waived by each party. The rationale of these clauses is in part to narrow the extent or type of damages a party may be liable for should it breach the contract. Hypothetically, this allows both parties to assess their risks more accurately, thus influencing related business decisions.

Notwithstanding this, disputes arise frequently over whether damages claimed on a particular project are consequential or general (or direct) damages as defined by the applicable law. Various jurisdictions have come to different conclusions, even with the same type of damages. In the author’s experience and opinion, a waiver clause should attempt to specify the types of damage claims to be waived (or not waived) rather than risking disputes over whether a given type of damage is consequential. 

If a contractor does not wish to waive potential claims for damages based on loss of bonding capacity from an improper termination for default, the contractor should attempt to specifically carve out that type of damages from the clause, irrespective of whether that type of damages is deemed consequential or direct under applicable law. 

Read Part 2 here.