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Material Escalation and The Ultimate Risk Bearer

Material Escalation And The Ultimate Risk BearerGiven the current environment, heavy emphasis is placed on material price escalation in construction projects and contracts. As construction material pricing reaches historical volatility levels, the question on everyone’s mind is, who bears the risk that will inevitably result from such a volatile market? And how can we mitigate such risks?

Three Types of Pricing Structures for Construction Agreements

When contemplating who will bear the risk of material price escalation, the contracting parties should first determine the type of contract pricing structure. Some of the most commonly used construction contract structures include the following: (1) fixed-price contract; (2) cost plus fee contract; and (3) cost plus fee with guaranteed maximum price contract.

Fixed-Price Contracts

Fixed-price or “hard bid” contracts are structured so that the contractor bears the risk of material price escalation because the price is fixed and not subject to adjustment due to changing market conditions. In other words, if that contract is signed on the first of the month, material prices spike shortly thereafter so that the pricing proposal received by the contractor from the subcontractor on which that fixed-price was based are no longer honored, the contractor will have to absorb the price increase and will, therefore, lose anticipated profits on that fixed-price contract.

Cost-Plus Contracts

Cost-plus contracts result in the owner absorbing the risk of material price escalations. The owner may not favor this contract pricing structure because there is no cap on pricing, making financial budgeting difficult. However, a mitigating factor is the contractor is typically required to keep the owner apprised of all known material price increases.

Cost-Plus Fee with a Guaranteed Maximum Price Contracts

A cost-plus fee with a guaranteed maximum price (“GMP”) contract is structured to protect the owner and the contractor. This contract structure permits the contractor to reduce the risk toward price escalation by factoring in potential material escalation costs as a contingency or allowance line item. These material escalation provisions vary significantly and may include such elements as thresholds (i.e., price adjustment not allowed unless there is a 10% increase in material prices) based on an established baseline costs on which the GMP is based, financial caps, or that the price escalation must result in actual GMP being exceeded which was unavoidable by the contractor exercising commercially reasonable best efforts.

More Than One Way to Skin a Cat

Mitigating Material Price Escalation

Material price escalation can be mitigated before a contract has ever been signed or agreed upon. Contractors can mitigate this risk by placing language in their bid proposals that establish a period of time in which their proposal must be accepted to be valid. This approach would allow the contractor bidding the job to update their pricing and proposal to reflect any increases or decreases after the allowed time has passed. However, contractors need to watch out for any bid instructions or RFP documents that preemptively exclude any price increases or require bids to remain valid for a specified period of time.

Additionally, locking in pricing (or “buy out”) as quickly as possible can serve to guard against material price escalation, but owners must be willing to allow contractors to bill, and be paid for, these commitments when made. To that end, if the contractor can identify materials with the most price volatility, it may be an option to buy those materials in advance and store them, assuming the owner is willing to make the requisite cash flow available.

Without a Crystal Ball

It has become commonplace to heavily scrutinize excusable delay or force majeure provisions in construction contracts. Without going too far into this since it is worthy of its own article, it is advisable to review these types of provisions carefully. The contract law doctrine says the specific will control over general provisions. Case law indicates that courts will look more favorably to grant relief for specific force majeure provisions versus the general “beyond contractor’s reasonable control.” Further, case law indicates that creating general categories prior to “beyond contractor’s reasonable control” will be interpreted more favorably and relief granted for the specific event.

For example, if a tsunami hits a project site and you failed to mention unusually adverse weather or acts of God preceding “or anything beyond contractor’s reasonable control,” it is less likely that relief will be granted. Moreover, it is important to be mindful of any “not reasonably foreseeable or anticipated” or similar qualifiers with force majeure.

Additionally, COVID-19 is not your typical force majeure event. Most force majeure events, such as unusually adverse weather, are relatively sudden and temporary in nature. But COVID-19 is an ongoing occurrence and impacts unknown, making it difficult to identify specific events or understand such potential impacts. For example, it could be argued that hurricanes in Florida are reasonably foreseeable or anticipated during hurricane season. With regard to COVID-19 impacts, it is more challenging to take a position that impacts are not reasonably foreseeable or anticipated for a construction contract entered into in June 2021 versus one entered into in June 2019.

Regarding excusable delay or force majeure provisions, it is common in construction contracts to state whether the contractor is entitled to additional money or just additional time.

Lastly, it is important to consider the interplay of these provisions with other provisions of the contract. For example, it is market standard to include a mutual waiver of consequential damages. It could be argued, without clarification in the contract documents, that material price increases are consequential in nature. So it is important to include examples in the contract of what is to be considered consequential damages.

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In conclusion, there are a variety of approaches to mitigate the risk of material escalation depending on the pricing model selected for construction contracts. While none of these will completely insulate and shed all risk, these are some helpful mechanisms to manage this risk. Regardless of which approach is taken, it is critical that project teams at all levels with responsibility for administering the contract clearly understand the inner workings of these mechanisms in the contract so that the intended benefit can be fully realized and cost-overruns can be either avoided or properly managed to the extent possible.

Josh Bell co-wrote this article with Blake Head and Jackson Parker. Josh Bell has years of experience in the energy and construction sectors. In his current role, Josh regularly reviews, negotiates, and drafts various construction and design contracts (e.g., AIA), as well as ancillary deal documents. His in-house practice at Hoar Construction is focused on transactional matters and legal operations in support of the company’s efforts to reduce waste in the industry through better planning, processes, communication, and safety. Blake and Jackson regularly assist with reviewing and drafting various construction and design contracts (e.g., AIA). At Hoar Construction they are focused on transactional matters and legal operations in support of the company’s efforts to reduce waste in the industry through better planning, processes, communication, and safety.
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