Top ten most important clauses of construction contract: how to reduce the likelihood of disputes during and after the project.

• Author: Fisher, Timothy S.

CONSTRUCTION projects are extremely complex undertakings and are usually governed by highly detailed contracts. While any one of hundreds of clauses in a large contract can be crucial, certain issues are important on almost every job.

This paper addresses what the authors consider to be the ten most important clauses in a typical construction contract. We believe that focusing on these clauses prior to commencing a construction project will reduce the likelihood of disputes during and after the work. For each clause, we spell out the issue and its importance to the project, then set out the most common approaches used by owners, contactors, and designers. We often make reference to the standard form contracts promulgated by the American Institute of Architects ("AIA"), since those are a comprehensive and widely-used standard in the building industry. (1)

1. Payment

   One of the most sensitive areas for all parties involved in a construction project is the payment process. While all parties bear a significant risk in this area, it is important to understand each parties' unique concerns. Owners, as well as their lenders, are concerned about overpaying the general contractor before the work is completed and failing to hold back adequate retainage as security. On the other hand, general contractors and subcontractors are concerned about prompt payment. Any delay in the cash flow can essentially force the general contractors or subcontractors to finance the project, which may ultimately result in the contractors' insolvency.

   Neither the owners, nor the contractors, of course, desire this result. Accordingly, the terms of payment clauses should be designed to balance the parties' concerns.

   1. What Documents Must be Submitted for Payment?

      The AIA form contracts require progress payments for projects of any considerable size. (2) The contractor initiates the process by submitting an "Application for Payment" to the architect on a monthly basis. (3) The Application must be itemized and "shall be notarized, if required, and supported by such data substantiating the Contractor's right to payment as the Owner or Architect may require. ..."(4) Typically, owners will require supporting back-up documents such as lien waivers, certified payrolls (for public sector work), schedule updates, and test results on work performed to date. Lien waivers are of particular importance as they protect the owner and lender, if applicable. Indeed, if a lender is involved, it will most likely require lien waivers before any distribution is made under a construction loan. Because lien laws can differ between states, owners and lenders should examine the lien laws of the state in which the project is located before specifying the requirements.

      Before the contractor submits the first Application for Payment, however, the contractor must submit a "Schedule of Values," subject to the architect's approval. (6) The Schedule allocates portions of the contract price to designated portions of the work. After receiving the Applications for Payment, the architect will use this Schedule to scrutinize the Applications, which is then used as a check and balance system to prevent front-end loading by the contractor. An owner, in essence, does not want to overpay for work completed. Otherwise, the contractor would have little incentive to complete the project. It is crucial, therefore, to have a balanced schedule of values to keep cash flow fairly distributed through the end of the project.

   2. How Quickly Will the Contractor Get Paid?

      The parties are left to set their own deadlines for the payment process. Section 5.1.3 of A101 states that an owner will make payment "not later than the--day of the month." Such payment is conditioned on the architect receiving the Application for Payment "not later than the--day of the month." Alternatively, if the contractor submits a late Application, the owner will pay the contractor "not later than--days after the Architect receives the Application ..." (7)

      Parties should always specify the deadlines in the payment process by filling in the blanks. If they do not, disputes are certain to ensue as to the payment schedule. The parties may be left with the uncertain reasonableness standard. With respect to the AIA form contracts, Section 9.3.1 of A201 creates a residual standard in the event A101 payment deadlines are left blank. Nevertheless, the parties should always specify the deadlines for the payment process. One must keep in mind, however, that the deadlines should differ depending on the owner's financing source. If the money is in the owner's hands, then the payment process can be faster. On the other hand, if the owner must draw from a construction loan, the owner will need additional time.

   3. Retainage

      Under most contracts, the owner retains a specified percentage from progress payments until the end of the project which protects the owner in the event of a contractor breach or subcontractor liens. In addition, retainage provides an excellent incentive for the contractor to finish the project.

      The typical retainage amount ranges from five to ten percent. Because contractors or subcontractors do not typically obtain the retainage until the end of the project, this process essentially forces them to finance part of the project. Several states have sought to limit such inequities by imposing limitations on the amount of retainage, both on public and private projects. Some contracts reduce or eliminate retainage as a certain portion of the work is completed. For example, if fifty percent of the work has been completed to the owner's satisfaction, the retainage can be reduced or eliminated completely. The goal is ultimately to balance the interests of the contractors and owners. Other contracts exempt certain parts of the billing from retainage, such as a construction manager's fee or general conditions billings.

   4. What Third-Party Roles May Impact The Payment Process?

      To further complicate the payment process, one must address third-party roles, specifically, the roles of architects and lenders. The architect's role may have a significant impact on the payment process. The architect must have time to scrutinize an Application for Payment before it can be paid. The Architect must, within seven days "after receipt of the contractor's Application for Payment, either issue to the Owner a Certificate of Payment ..." or give notice of the reasons why certification is being withheld. (8) Thus, before considering any payment deadlines, the parties should consult with the architects, or others responsible for the review process, to ensure that they have adequate time to perform their duties. Architects are not always responsible for the review process; at times, owners may decide to remove the architect from the process to save costs or use a different advisor. The AIA form contracts emphasize the architect's role.

      The lender's role will also likely impact the payment process. Most lenders require that contractors and subcontractors provide lien waivers before any amounts are released for progress payments. Lenders may also independently verify the work on the project to ensure that the amount of the progress payment is proper. In light of these examples, owners should consult with their lenders to determine what particular requirements they may have with respect to the payment process.

   5. What Right To Interest On Late Payment?

      Section 7.2 of A101 provides parties with the option of determining the interest rate amount for late payments. A fair method is to use an interest rate that the owner is being charged on the construction loan for the project. By doing so, the owner would be discouraged from using the contractor as a financing source. An interest rate that is very high may at a glance seem favorable to the contractor. Nevertheless, state usury laws and truth-in-lending acts may impact the validity of such rates. The parties, therefore, should always consider these factors before determining the interest rate.

      If the parties leave the rate blank, Section 7.2 provides for a default rate. That rate is the legal rate prevailing at the place where the project is located. Typically, this rate in most states is the same as the rate for unpaid court judgments, which can range from five to ten percent.

   6. What Provisions For Billing Disputed Work?

      It should come as no surprise that contractors and owners often disagree over certain work. For instance, additional work may be needed, but the parties cannot agree as to the price for a change order. To avoid delaying the project, the owner and architect may issue a construction change directive ("CCD") that orders the contractor to carry out the work, with the amount to be determined at a later time by a specific formula. Section 9.3.1.1 of A201 allows the contractor to bill for this work up to the amount agreed by the owner which treats both parties fairly. (9)

2. Pay-When-Paid Clauses

   Most of the clauses discussed so far involve the relationship between the owner and general contractor. Equally as important is the relationship between the general contractors and subcontractors. This section examines an often-litigated issue concerning whether the general contractor's obligation to pay the sub-contractor is conditioned on payment from the owner.

   As a threshold matter, one must consider the parties' view points. General contractors agree that subcontractors should be paid if nonpayment by the owner is the general contractor's fault. Subcontractors agree that they should not be paid if payment by the owner is delayed due to the subcontractor's failure to perform work or process the required paperwork.

   The dispute arises in circumstances under which the nonpayment by the owner is unexcused or another subcontractor has breached. General contractors believe that they should not have to pay until they are paid and that any loss should be shared equally. Subcontractors, in...