There is uncertainty in the economy. Rising interest rates, shortage of labor, the war in Ukraine, post-pandemic catch-up in supply chains and other factors continue to cause costs of goods to rise.
The construction industry is not immune from the rising costs in supply chain goods and services; when the prices of goods and services increase, construction incurs delays and, under certain circumstances, results in a complete project shutdown.
How can the construction industry avoid disruption caused by unforeseen and unexpected price increases? The construction contract is the best means to control risk, such as rising costs, to allow projects to continue without interruption. There are several “protective” type clauses which provide protection when costs get out of control, post-contract formation.
An Escalator Clause: Calculating a Price Change
An escalator clause, also known as a price-adjustment clause, may permit an increase of an already agreed-upon contract price. Although price is typically a key contract term determined prior to contract formation, an escalator clause is a contract term that permits an increase in pricing after the contract is signed. Escalator clauses are valid and enforceable if the language is clear and the method to calculate the increase is tied into an acceptable standard.
An effective escalator clause will specify how the price increase will be calculated and when it will be triggered. The price adjustment should be based on an objective or verifiable standard, such as an economic index, to calculate the price change.
In some cases, an escalator clause may even permit the parties to cancel the contract altogether, if the circumstances specified in the escalator clause are triggered.
A party entering into a contract with an escalator clause should carefully consider how a sudden or unexpected change in economic circumstance should be addressed. The clause may be crafted in such a way as to accommodate various circumstances, as long as it is clear and specific. A clear and specific escalator clause is the most effective mechanism to address a cost change and to minimize additional costs arising from increased prices.
Proof is typically required to obtain the price increase in the escalator clause, including evidence of the cost at the time the contract was signed, the cost increase after the contract was signed, and the reasons for the price increase after the parties signed the contract.
In certain situations, litigation may be necessary if the performance of the contract would cause an unforeseen financial hardship and/or the contract parties cannot agree to modify the price or terminate the contract. Unclear language in the escalator clause or other contract provisions could also lead to litigation. Litigation may also be necessary if costs have already been expended to perform the contract or if there will be costs or losses if the contract is canceled.
A Force Majeure Clause: Modifying a Contract Without an Escalator Clause
A force majeure clause permits modifications to, or cancellation of, the contract after it is signed. This clause is typically contained in a contract and permits the modification or cancellation of a contract based on unforeseen circumstances, such as acts of God, natural disasters, acts of war or other unavoidable catastrophes. It is unlikely a force majeure clause will be triggered based solely on a price increase without other extenuating circumstances.
The Doctrines of Impossibility & Frustration of Purpose: Not Meeting the Contract’s Obligations
In cases where it is impossible to perform the contract, or the purpose of performing the contract can no longer be effectuated, it can be argued that to perform the contract would not be impossible or the purpose of the contract is frustrated. A court may consider whether it is truly impossible to perform the contract, or if the purpose of the contract simply cannot be achieved even if the contract may be performed.
Under these circumstances, a party may not be required to meet its obligations under the contract. These doctrines usually consider events that were unforeseeable or unanticipated by the contracting parties.
The Remedies of Rescission & Reformation: Modifying or Canceling the Contract
If a contract does not contain an escalator or price adjustment clause and/or the contract’s force majeure clause is inapplicable under the circumstances, other legal doctrines may permit the cancellation or modification of an executed contract.
Rescission terminates a contract, as if it had never been executed, and reformation allows a contract to be modified in order to reflect the parties’ intent. These remedies are available in certain situations in which an unforeseen change in circumstances occurs that goes to the very heart of the purpose of the contract, and/or the parties do not intend to perform the contract under the new and unforeseen circumstances.
These remedies are difficult to obtain and require litigation.
Construction contracts are complex legal documents that require careful evaluation and consideration. Protective terms should be carefully considered to protect against unforeseen risk and changed circumstance. Legal advice is often necessary to understand the risks and to ensure that your company is protected.