Most construction professionals probably would not enter a contract if they were not absolutely certain what the work was, when it needed to be done, and how they would be paid.
Surprisingly then, some of the most important ways a contract might allocate risk and responsibility during the job—and even long afterward—might be overlooked in contract review. We will take a look at some more common provisions for allocating risk in construction contracts, what they do, and how they operate.
As an initial consideration: The state law governing a construction contract could greatly impact how these risk-allocating provisions function, including whether they are effective at all. Some states have very specific guidelines for these provisions. For example, including terms from an old Alabama project for a new project where Arizona law governs could carry significant risk.
Additionally, the actual words used in the contract matter. Particularly with contracts between sophisticated parties, the law in most jurisdictions is to apply a contract’s terms as written unless those terms are vague, ambiguous, or there is a public policy limiting their enforceability. Importantly, just because the parties now disagree what a particular term or provision means does not mean that the contract is actually vague or ambiguous. Therefore, it is vitally important to understand how these provisions apply before the contract is signed.
INDEMNIFICATION
An indemnification agreement shifts liability for claims from one party of the contract to another. Indemnity clauses typically concern third-party claims, meaning those brought by parties outside the contract. For example, if a bystander is injured when tile falls from a building and sues the building owner, the owner might seek indemnification from the contractor who installed the tile work pursuant to an indemnification clause in the agreement between the contractor and the building owner for the tile work. Since the purpose of indemnification is to shift the financial burden for a claim, that might include allowing the indemnified party to recover any amount they paid to settle a claim and reimbursement for any costs to defend against it—such as attorneys’ fees.
Importantly, most states have anti-indemnity statutes of some fashion. If a contract’s indemnity provisions are not cognizant of this and tailored to state-specific limitations, the provision might not apply as the parties expect or could even be found unenforceable.
HOLD HARMLESS
A hold harmless agreement operates similarly to indemnification, but with a slightly different effect. Whereas indemnification shifts the financial responsibility for a claim from one party to the other, a hold harmless clause shifts liability for a claim.
A well-crafted “Hold Harmless” clause does exactly that and might provide, for example, that a prime contractor has no responsibility or liability for any claims arising out of a subcontractors’ work. Like indemnity provisions, understanding how a contract’s hold harmless provisions operate within the relevant state law is crucial to ensuring the terms are enforceable with the effects intended.
LIMITATIONS ON DAMAGES AND LIABILITY
While indemnification and hold harmless clauses typically concern third-party claims, other provisions are more tailored to claims between the parties who entered the contract, i.e., first-party disputes. Depending on the jurisdiction, many different types of damages can flow from an alleged breach of contract. However, by contract, the parties can typically limit what types of damages are recoverable or even agree on a cap for damages. The most obvious and common of those are compensatory damages, sometimes called “expectation” damages. Put simply, these are damages to compensate the non-breaching party for their direct and actual losses resulting from a breach of contract. These damages might include the costs of hiring another contractor to complete the job or performing rework.
Other forms of damages a non-breaching party might seek include “incidental” and “consequential” damages. Incidental damages are what they sound like—those incidental costs and expenses incurred by the non-breaching party because of the breach. On the other hand, consequential damages can be much more expansive and include a contractors’ lost profits on other jobs, which they were not able to perform, or include an owner’s lost profits from future tenants, increased financing costs, or even reputational damages if the project is delayed, for example. Additionally, in some states and in some circumstances, a party may even be able to seek punitive damages for a breach of contract claim.
Defining precisely what types of damages are recoverable and any limitations on their recovery—such as a monetary cap on compensatory damages—can be vitally important to ensuring risk is appropriately understood before work begins.
ATTORNEYS’ FEES, COSTS, AND EXPENSES
One of the most common questions construction professionals have when a dispute arises is whether they may be able to recover—or be responsible for—attorneys’ fees. Virtually all states apply the “American Rule” for the recovery of attorneys’ fees: Attorneys fees generally are not recoverable. However, a very common and very important exception to this rule exists when the parties agree otherwise by contract.
Recovering attorneys’ fees via these provisions differs from indemnification. While with indemnification a party may be able to seek reimbursement of fees incurred to defend against a third-party claim, with a fee-shifting provision, a non-breaching party may be able to seek their attorneys’ fees in a first-party claim brought against the breaching party.
As with the other provisions discussed, understanding what substantive state law applies to an attorneys’ fee provision and the way the specific language in a contract operates is necessary to understanding whether a party might be able to recover all, some, or none of their attorneys’ fees in a dispute—which could be an important consideration in deciding whether to bring a claim at all.
Standardized contract clauses, like those available from the American Institute of Architects (AIA), can be a helpful starting point for these risk-allocating provisions. Since many courts, construction legal professionals, and industry experts have contributed to interpreting these more standardized terms, using well-established terms as a starting point can aid immensely in predicting an outcome before a dispute arises.
Additionally, involving counsel in the contract development and negotiation phase can be important to ensure these and other risk and responsibility allocation provisions are considered and understood before the contract is signed.
Of course, these are just a handful of the many risk-allocating terms that can be found in a typical construction contract. Others include delay and liquidated damages, warranty, insurance requirement, and force majeure provisions. Since many of these provisions have effects long after the work is done, understanding precisely how to allocate risk and responsibility can—and should—be just as important in negotiating a contract as scope, schedule, and costs.
about the authors
Dixie T. Wells is a partner in the Greensboro, North Carolina, office of Ellis & Winters LLP. She represents clients in lawsuits involving engineering issues, higher education law, complex commercial transactions, and products liability. She is a member of the Construction Law and Litigation Committee of the International Association of Defense Counsel. She can be reached at dixie.wells@elliswinters.com. Chris Flurry is an attorney in the Raleigh, North Carolina, office of Ellis & Winters LLP. He focuses his practice on construction law and commercial contract disputes. A Marine Corps veteran and son of a brick mason, he is a member of the Associated Builders and Contractors of the Carolinas. He can be reached at chris.flurry@elliswinters.com.