Key Contractual Considerations for Owners
Written by David J. Wahl and Brian P. Reid
Regardless of project size or scope, a comprehensive and tailor-made written construction contract provides the foundation for success. At a project's outset, it is also imperative that owners understand their contractual rights, duties, and obligations, particularly when using a standard form contract. While the negotiation of any construction contract will involve the consideration of numerous factors and potential contract provisions, the following provides an example of several key factors, which, if carefully considered, will allow an owner to mitigate its risk of cost overruns and delays.
Fixed-Price vs. Cost-Plus Contracts
Selecting the appropriate payment model is a critical first step, with the majority of commercial and residential projects typically priced on either a lump-sum or cost-plus basis. While unit prices are also commonly used on certain types of projects that can be broken down into units (e.g., roads, fencing, pipelines, etc.), for this article, we focus only on commercial and residential projects that do not typically lend themselves to this form of pricing. Each of these payment models contains different advantages and risks depending on the nature of the project status.
When the project scope and schedule are clearly defined, a lump-sum contract may be preferred as it provides cost certainty and encourages contractors to work efficiently and cost-effectively. While this approach transfers a significant portion of risk to the contractor, this risk may be reflected in an increased bid price. If the scope of the project is not well defined or if the design has not been finalized at the time of award, an owner may be faced with a steady flow of change order requests thereby defeating the cost certainty objective of a lump-sum contract.
Under most lump-sum contracts, the contractor's entitlement to payment is based upon the percentage of project completion. Accordingly, it is imperative that the contract contain a clear process for determining the stage of project completion and the amount owing to the general contractor for that state of completion. This mitigates the risk of the contractor recovering a disproportionate amount of the lump-sum fee early on in a project relative to the status of construction. While this may not seem like a significant risk given that the contractor is still obligated to complete the work for the same lump-sum amount, a contractor's performance may start to falter when they realize there is not enough money left in the project to cover the remaining work. This creates a risk of default or abandonment, leaving the owner in the undesirable position of having overpaid for the work received and having to decide whether to pay the contractor more to get the job done or terminate, pay another contractor to complete the work, and sue for damages.
A cost-plus contract is often used where work must commence early in the design or planning stages and may allow an owner to avoid the large risk premiums often seen with a lump-sum contract. Under a cost-plus contract, an owner will typically pay the contractor's actual costs and expenses, plus a pre-negotiated amount to cover overhead and profit.
To avoid run-away costs, this approach requires vigilant supervision and enforceable schedule milestones. Furthermore, it may also be desirable to include a "not to exceed" price to ensure that any increase to budget pricing requires the owner's prior written approval. A liquidated damages clause may also mitigate the schedule risk to the owner.
The owner's cost risk can also be mitigated by requiring that the contractor provide multiple quotes for all sub-trades for owner approval. However, this strategy necessitates a timely, attentive response by the owner to avoid a claim of owner-caused delay. In a cost-plus contract, it is crucial that the owner carefully review all progress invoices to ensure that the contractor is responsibly back-charging sub-trades where necessary, and generally maintaining the schedule and cost estimates of the project. It is also critical that a cost-plus contract include broad audit rights to ensure that the owner is only paying for actual costs and is receiving the benefit of any discounts offered by a subcontractor or supplier to the contractor.
Clear Change Process and Payment Schedules
Despite advance planning, nearly all construction projects will encounter unforeseen circumstances and the corresponding need to change the scope of work and schedule. Without question, changes are the primary source of disputes on any project and accordingly, regardless of the pricing model used, all contracts should include a clear and effective change regime. An effective change regime should include, at a minimum, a requirement that the contractor provide written notice of any proposed changes that will increase costs or cause delays before any work is performed in respect of that change. The contract should also clearly state that such notice is a condition precedent to advancing a claim against the owner.
Compliance with the Alberta Builder's Lien Act
A common mistake which many owners make (in particular, on residential projects), is the failure to comply with the holdback obligations under the Builder's Lien Act (BLA). While the scope of rights and obligations under the BLA is beyond the scope of this article, at a minimum, all owners should retain 10 percent of all payments made to the general contractor during the course of a project. Unless the project involves an "oil and gas well site" (in which case a 90-day holdback period applies), this holdback can only be released to the general contractor 45 days after the posting of a certificate of substantial performance and provided no builders' liens have been registered against the project. If no certificate of substantial performance has been posted, the owner should retain the 10-percent holdback until 45 days after all work under the contract has been completed and again, the holdback should only be paid to the general contractor if no liens have been registered.
While almost all projects start out on good terms, only a carefully considered and comprehensive construction contract will help to ensure project success. All too often, a lack of upfront planning leads to delays, cost overruns and costly litigation. To mitigate this risk, it is critical that owners develop a good understanding of the various contract options available and the rights and risks associated with each. Once work commences, it is also crucial that costs, changes, and schedule be carefully monitored to ensure contract compliance. Finally, to avoid the risks of builders' liens, owners must ensure that they comply with the BLA.