Construction CCIM Feature

Mitigating Risk

Reduce the threat of litigation on your next construction project.

Anyone involved in construction  projects, directly or indirectly, likely has seen a few go sideways. Projects as small as a single-family home and as large as  a skyscraper sometimes go completely off the rails and wind up in court. Owners, architects, contractors, and engineers all need to consider the possibility that the next project could ruin them financially.

But there are ways to reduce risks. Any job will have its share of difficulties. Not all of them will be foreseeable, and many will be unpreventable. While full-scale litigation is not inevitable, some of the most expensive cases have started with a small problem that escalated due to mismanagement.

A variety of factors can cause a job to break down. The most common are contractors being overextended, inadequate job administration by architects, and poorly organized owners. An owner can't do much about the contractor or architectural issues beyond ordinary due diligence at the time of hiring. However, even the most diligent of processes ultimately cannot prevent breakdowns by the contractor (including related subcontractors) or by the architects and engineers. But you can prepare and be suitably organized.

Identifying the Problem

The first step is understanding the source of your problem. The truth is, an overextended contractor or a major subcontractor can derail a project. Overextension of contractors is not tied to how many projects they currently are working; it is a function of cash flow. Contractors and their subs typically are thinly capitalized. A simple adverse change in materials pricing can be fatal to a subcontractor operating at 5 to 10 percent margins.

How you handle the problem will depend on the specifics of the situation. But, as a rule of thumb, structural inflexibility is not favorable. Risks usually are passed down the food chain because the party with the most leverage can pass the risks of adverse circumstances to the party with less. But there's a problem: The party that ends up bearing the burden is often the one that can least afford it.

For example, say there is a price change in materials that would be inconvenient for the owner. It can be the death knell to the drywall subcontractor. This mushrooms into a major problem for the owner if the sub fails and the general must find a replacement, which always costs more and tends to cause delays. Each, in turn, can put the general under stress. If the general fails, then the owner must find a replacement, resulting in higher costs and likely more delays. For many owners, delays in completion translate into lost revenue from tenants.

Whether you build subdivisions, luxury high-rises, or shopping centers, your two most impactful tools are the contract forms at your disposal and your sales force.

In most cases like this, the general contractors and their subs bear the risk of material price changes. Structural inflexibility by the owner on that point could cause a domino effect of failures. To steadfastly maintain pricing, per the contracts, the sub is bound by its bid and must bear the costs. But that bid does not bind any replacement. Likewise, the general is stuck with its bid even if it replaces a sub at a higher price. But again, any replacement is not. What started as a minor price issue has ballooned into a significant cost to the owner. Having surety bonds at one tier or another may provide some cover. On the other hand, the owner may just wind up litigating with a well-funded surety instead.

Then consider project administration - a task most design professionals offer as part of their services. Use them. In one example, litigation resulted over a simple structure - so simple that it didn't require design professionals in an oversight role. To save on costs, the owner nixed them. A year or so after the building was completed, cracks developed. The design professional would have discovered the error (no rebar in the block walls) by simply looking down into the cells. The cost of remediation was almost equal to the cost of building. Litigation costs over who was responsible were even more. So much for the owner saving himself money by not having monthly site visits by the architect.

Owners should not hand out money happily to any and all contractors and designers. The point is to look at each situation as what it is. There is a huge difference between a sudden adverse market change and a sub that is simply not doing its job in a timely manner. Likewise, most jobs do not require daily oversight; monthly reviews may do. The goal is to avoid decisions based on stubbornness or to save a marginal sum (“marginal” being measured by the overall cost of the job).

Avoiding Disaster

Whether you build subdivisions, luxury high-rises, or shopping centers, your two most impactful tools are the contract forms at your disposal and your sales force. The first may seem obvious, the second not so much. But either can turn a small inconvenience into a mega-disaster on your project.

Some owners have a standard contract they use with every contractor on every project, while others are happy to use whatever their architect pulls off the shelf. While both approaches are understandable - and in many instances perfectly fine - both can lead to trouble. Developing a new contract unique to each project also can lead to woe. It is safer to use the American Institute of Architects form that is most suitable under the particular circumstances of the project. However, the AIA updates its forms every 10 years, so avoid using the latest version of that form if it is less than five years old becasue in all likelihood, there is no existing case law yet interpreting its language. Conversely, the forms that have been around awhile have probably been litigated a few times.

The AIA forms adequately state the relationship between the parties, define success, provide remedies for failure - and do all three in terms that have but one meaning.

The AIA forms adequately state the relationship between the parties, define success, provide remedies for failure - and do all three in terms that have but one meaning. Most contracts have flaws in their language that can lead to disagreements in interpretation. A court may have to interpret the language and determine its meaning. If the owner is using his own form or one chosen by the architect, there is a good chance no court has ever interpreted it - at least with respect to the issue now facing the project. That is seldom true of AIA forms.

The goal is to avoid litigation. Still, if a court already has  interpreted the relevant portion of a contract, the resolution becomes easier. A typical example is where a problem arises with monthly pay applications. How much the contractor and each of the subs are entitled to depends on production plus stored materials. The contract generally establishes the criteria and the means of determining the proper amounts. If the parties cannot agree on how that mechanism is to be interpreted, disputes can and do arise. The problem can be exacerbated if both sides are taking a principled position.

Another common example is schedule updates. Every project has some sort of fixed scheduling. Depending on the complexity, the scheduling tool could be relatively simple or could be based on critical path methodology. In either event, updates usually are necessary as the project progresses. Because activities on the project tend to be interrelated, the timing on one activity is going to impact others. Changes usually occur when each trade can, or must, mobilize. If the contract does not address that reality binding the contractors to the updates as they are produced, a problem will develop when a given trade is accelerated or delayed. Such changes also affect the critical path, which is the chain of interrelated activities required to attain substantial completion by the deadline. A trade or activity that was not on the path last month may now be needed and vice versa. Being on the critical path means that a delay to any one activity delays the entire project. Hence, there are consequences to a sub if it falls behind. These issues must be expressed clearly in the contract.

No AIA form (or any other form) of contract is suitable for every circumstance. But they all have been subjected to judicial scrutiny at some point, and they can be modified to include language specific to a job. If nothing else, they can provide the base contract, and you can prepare and execute an addendum. The same is true of the general conditions. Again, an AIA version is likely to have been scrutinized at some point. Knowing how a court will likely interpret yours is a big step toward resolving disputes early.

A sales force cannot make a project proceed on schedule, but it can easily put it behind. A healthy percentage of modern construction is build-to-suit; many projects are sold or rented before ground is broken. Understandably, the owner wants to fit out the building as requested by the buyer/renter. It is up to the sales force to work with customers to make decisions on a variety of options. Many options have little to no impact on the construction itself, though they often impact procurement and finishing trades such as the carpet/tile installer, millworker, and painter. But in other cases, especially multistory structures, they do impact the construction process and can, therefore, be a source of delays and job friction. The sales force must know the difference and understand the impact. The sales force also must get customers to make their selections on time. Tardiness could result in delays.

If the job falls behind schedule, customers cannot take possession when promised, and revenue does not come into your pockets when you told the bank it would.

Moving Forward

Addressing these issues can help you assess whether your operation is organized and optimized to recognize and address small problems before they grow. All that is required is understanding both the source of a problem and an efficient means of fixing it. Some can be fixed prior to putting the bids out; some will be a bit more on the fly. Whatever the problem, it is not a disaster - at least not yet. Your job is to make sure it never becomes one.

Wendell L. Jones

Wendell L. Jones is an attorney at Kentucky Surety & Construction Law PLLC in Louisville, Ky. Contact him at wjones@kysuretylaw.com.

 

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