As the world recovers from the COVID-19 pandemic, the effects of the virus continue to linger in the construction industry. Unlike the early days of the virus, there is no run on toilet paper, Clorox wipes, or hand sanitizer. Instead, constraints upon the global supply chain have constricted the availability of raw materials that are essential to the operation of several industries, including the construction industry. In combination with increased demand for both new construction and renovation projects across all industry segments, the restricted supply of the materials needed for construction projects has caused the prices of lumber, steel, and other key construction materials and components to skyrocket since late 2019. There is no immediate end in sight – as the global economy continues to regain its footing following the shock of COVID-19, the prices of raw materials are expected to continue to rise.
In light of this, the risk of increased materials prices in construction contracts and how to address it becomes of paramount importance. The answer to that question depends upon the type of owner/contractor contract utilized and the specific language within each contract.
Effect of the form of a contract on a party’s responsibility for material cost increases
Generally, contracts that allow contractors to receive unlimited upward adjustments of the Contract Sum (such as cost-plus contracts without a guaranteed maximum price or contracts with key materials priced as allowances) saddle the project owners with all of the risks for increased prices over the life of a construction project. Conversely, contracts with fixed pricing (such as cost-plus contracts with a guaranteed maximum price (hereinafter GMP contracts) or lump sum contracts with no material escalation provisions) shift the risk of increased materials costs to the general contractor.
The boilerplate provisions of the AIA form contracts do not address the parties’ responsibility for price escalation. Section 4.1 of the A101, which is the industry-standard contract sum for a lump sum contract, notes that the Contract Sum is “subject to additions and deductions as provided in the Contract Documents.” Likewise, the A102, the industry standard for a GMP contract, contains nearly identical language noting that the Contract Sum is “subject to additions and deductions by Change Order as provided in the Contract Documents.” Article 7 of the A201, which is used in conjunction with both documents, addresses how changes may be made to the Contract Sum – via Change Order or Construction Change Directive.
Noticeably absent from the A101, A102, and A201 is any language directly addressing what happens in the event of substantial and/or unforeseen increases in the prices for materials and how risk is to be allocated amongst the parties.
Options for addressing the risk of price volatility in the contract
In response to increased price volatility in the current market, contractors have begun inserting extremely open-ended language in the contract itself and/or in the contractor’s clarifications exhibit attached to the contract, which entitles the contractor to a change order for any increase in materials pricing throughout the construction process. As these provisions unfairly shift 100% of the risk to the owner, they should be rejected in favor of a more even-handed approach.
Rather than blindly accepting all the risk of increased materials prices or, conversely, pushing all of the risk onto the contractor, owners can then tailor their approach to clearly allocate the risk of the increased price of materials between both owners and contractors.
Owners have several options:
1. A contingency within the GMP
When using a GMP, many owners include a contingency line item in the GMP to address certain unforeseen costs that arise during construction, including materials price increases. Owners should limit the contractor’s right to request an increase of the Contract Sum to the amount of available contingency funds. Under this scenario, the contractor is allowed to exhaust the contingency funds to address any increased materials prices, but the owner’s exposure to increased costs is limited to the contractor’s use of the contingency funds. If the contract is structured so that any savings realized in buying out other line items also accrue to the contingency, and the contractor is entitled to share in any savings realized for delivering the project under the guaranteed maximum price, this strategy is even more attractive. This approach encourages the contractor to buy out the project as efficiently as possible.
2. Limit the material buy-out period
Owners can also manage the risk of price escalation by limiting the time during which the terms of an otherwise open-ended price escalation clause would apply. Such a clause provides that the owner will assume liability for material cost increases for a limited window of time (typically 30 to 45 days) after the contract is executed, but the contractor bears all risk of increased prices beginning after this period. This approach incentivizes the contractor to complete buy-out of project-related materials early in the life of the project, which thereby minimizes the opportunity for the price of necessary materials to increase over the life of the project.
3. Set a threshold for the owner’s liability for increased material costs
Another approach is to set a threshold percentage above which the owner covers price increases and below which the contractor bears the risk. Here, the owner and contractor would agree that the owner covers the amount of increased cost if the cost incurred is 10% above the line item amount shown in the schedule of values. If, for example, if the cost of lumber increases by only 9%, then the contractor is responsible for all of the increased cost. However, if the cost of lumber increases by 15%, then the contractor is responsible for 10% of the increased cost, and the owner must cover the remaining 5% of the increased cost. The threshold figure can be tied to the line item in the schedule of values or to a standardized price or commodities index. This approach sets a clear standard for addressing price increases and may provide enough flexibility to allow the price volatility to subside.
4. Any combination of the above
Of course, none of these concepts have to stand on their own. Owners can mix and match any or all of these provisions. The most important concept is addressing the uncertainty of material price escalation in a clear manner.
Fairly negotiating the details of materials price escalation provisions in this volatile market is crucial. Morris, Manning & Martin’s Construction Law Practice is experienced in drafting and negotiating fair and appropriate price escalation provisions. If you need any assistance in the process of drafting a construction contract for your development projects or evaluating what effect increasing materials prices may have upon your project, please contact Bruce Smith, chair of MMM’s Construction Law Practice, Vianney Lopez, or JD Howard.