Every Construction Project Comes With Risk, but It Can Be Managed

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on January 20, 2022.

Here are some ideas about how contractors can manage risk through a construction contract. These ideas may be useful to owners as well.

One foreseeable risk is breach. If a contractor’s work is defective, the owner may pay others to fix it. This may cause delay that affects the owner’s profit or other business opportunities. The owner’s cost to fix the work is “direct” or “general” damages. Its lost profit and opportunity would be “indirect” or “consequential” damages. Direct damages are usually predictable; consequential damages may not be.

To manage risk of breach, a contractor may ask the owner to limit its potential claims to direct damages and to waive claims for consequential damages. Unfortunately, the direct/consequential distinction is not clearly defined in the law. Contractors should think about what damages are foreseeable. If the owner plans to rent space in the building, delayed completion will affect revenue and extend the time that the owner must pay interest on its construction loan. Consider addressing these specific risks in the definition of “consequential damages.” The owner may ask that a waiver of consequential damages be mutual. In that case, a contractor should think about its potential damages (if the owner delays work) and address them specifically.

Consider limiting damages by amount rather than (or as well as) by type. The contract could provide that the contractor’s maximum liability to the owner be capped at a stated sum. Of course, a major element in the management of risk is insurance, so the owner will probably want any damages limitation to take insurance into account, as well as leaving the contractor with some “skin in the game.” Here is an example of a damages limitation provision:

The contractor’s maximum liability to the owner shall not exceed the sum of (a) the amount paid by the contractor’s liability insurer and (b) the contractor’s fee.

This provision leaves the owner at risk if the contractor fails to maintain insurance or if the policy is eroded by other claims. Those risks could be addressed through modified language. Notice that, even if enforced, the above provision would leave the contractor exposed to claims by third parties, such as parties injured on the project.

Another way to limit the amount of damages is through “liquidated damages,” by using a provision like the following:

If the contractor fails to achieve substantial completion by the deadline set forth in this agreement, the contractor shall reimburse the owner $____ for each calendar day until substantial completion is achieved.

This provision could be combined with an overall cap on potential damages.

Liquidated damages are most often used in the context of delay but can be used in other ways. A piece of mechanical equipment or an assembly may be warranted to have a certain output if it is supplied with power meeting certain requirements. The output warranty could include liquidated damages to be applied (perhaps on a sliding scale) if the equipment or assembly fails to perform as specified.

Another risk is that a contractor’s work may turn out to be more difficult than expected. Bad weather, a pandemic, or rising material prices may upset the contractor’s budget. If the work involves excavation, unforeseen underground conditions may make it more expensive. A contractor can guard against unknown risks by including a contingency amount in its bids. But this raises a problem for the owner. If difficult conditions are found, the owner may be willing to pay, but it doesn’t want to pay the contingency amount if conditions are good. What can be done?

One approach is for the owner to shift some of the risk to itself. For example, the owner can tell the bidders: “You should calculate your bid on the assumption that there will be no more than three days on which snow affects access to the site; if there are more than three snow days you will be entitled to an increase to the contract price.” Similar provisions can address material price escalation and “force majeure” events like pandemics.

For big infrastructure projects, owners typically direct bidders to assume that certain underground conditions will be found; the intent is to minimize bid contingencies. If the owner’s information turns out to be correct, fine. If the information turns out to be incorrect, the owner will pay more, but only if difficult conditions are found.

The foregoing comments only scratch the surface about how construction contracts can anticipate and manage risk. Particularly for large and complex projects, it pays to think ahead and tailor one’s contract to the risks foreseen