Understanding the fundamentals of contracts is an important skill that leaders need to gain a competitive advantage over competitors. Construction companies are constantly searching for competitive prices, preferred clients, ideal contractors and other methods of increasing the profit margin. Through the profit-oriented nature of the industry, promises are routinely broken and projects fail to be completed. Broken promises affect the profit margins and can cause additional unexpected costs to the project, affecting the overall performance. Therefore, contracts aim to ensure that construction projects are completed according to the agreements between the parties.
Good contracts are similar to fences making good neighbors — having them improves the relationship. Contracts also promote economic efficiency by ensuring that agreements are completed, insulating parties from additional unexpected costs and providing remedies for any breaches. Contracts are much more than a promise, and certain characteristics are required to ensure that a promise is enforceable through the creation of a legal contract. The common definition of a contract is that an agreement is made between parties and is enforceable by law. Although correct, the common definition is shortsighted and can lead to inadvertent mistakes by a company’s leadership. A legal definition, such as an agreement with specific terms between two or more persons or entities in which there is a promise to do something in return for a valuable benefit known as consideration, provides a more thorough understanding of contracts and their importance in construction. Understanding the legalities of contracts is a competitive advantage to construction leaders.
BASIC CONTRACT FORMATION
The creation of a contract can occur at any point during a project, and each project likely includes several contracts to ensure that the specifications of the project are met. The basic elements required for a legally enforceable contract are an offer, an acceptance and consideration.
An offer is a proposal to make a deal by promising to provide a service, purchase goods, abstain from conduct, etc. An offer includes terms that are useful in defining the scope of the agreement. These terms must be specific and definitive to sufficiently identify the promise and allow the offer to be valid. For example, Knowinlaw Construction is the general contractor for a hospital project and is actively seeking bids from subcontractors. A bid from Contractors USA is an offer to perform the work for a specific price. The offer includes crucial terms that, upon acceptance, bind the parties to the terms.
Acceptance is an unconditional willingness by the party who received the offer to be bound by the other party’s offer. The acceptance must comply completely with the terms of the offer without modifications (known as the “mirror-image” rule); otherwise, it is a counteroffer. Depending on the type of contract, an acceptance most often occurs orally or through performance. In our scenario, Knowinlaw Construction can choose to accept Contractors USA’s offer, not accept the offer (which terminates the offer), or counteroffer for a different price or condition (which terminates the original offer and creates a new offer, with Knowinlaw now providing the offer). Of course, Contractors USA can decide to withdraw the offer at any time before Knowinlaw Construction accepts it and prevent a contract from being created, as long as the desire to withdraw the offer is communicated to Knowinlaw.
The final basic element of contract formation is the concept of consideration. Consideration is the bargained-for exchange between the parties and is the mutual exchange of value, such as the benefit received by one party and the detriment imposed on another party. It is the reason that parties create contracts. Most commonly, consideration takes the form of money, objects or services. For instance, the consideration involved in our example is Knowinlaw Construction providing money in exchange for Contractors USA’s services. Knowinlaw’s consideration is the money, and Contractors USA’s consideration is the provided service. Agreements usually require consideration in order to be a contract, although there are rare situations where an agreement without consideration is still valid; but those circumstances are too technical and advanced for the purpose of this article.
The most common mistakes made in contracts in the construction industry occur during the offer and acceptance phases of contract development. These mistakes usually are inadvertent, but may have a significant impact on the contractor’s operations. For instance, specifications on materials and resources may be misunderstood, price quotes incorrectly entered or time estimates flawed. The prevalence of mistakes emphasizes the importance of being precise in the creation of a contract. As a side note, the general rule of thumb is that honest mistakes, such as mathematical errors, are often excusable and relieve the party of the contract.
To summarize, a basic contract requires:
- Offer — Terms that define the scope of the agreement (e.g., Contractors USA offering to perform the work for $200,000).
- Acceptance — Communicates that the party assents to the offer through conduct, which most commonly includes words of performance; must comply to the terms of the offer (the “mirror image rule”) (e.g., Knowinlaw Construction accepts Contractors USA’s offer).
- Consideration — Benefit that each party receives or expects to receive (e.g., Knowinlaw Construction will receive Contractors USA’s services and Contractors USA will receive $200,000).
Through an offer, an acceptance and consideration, a legally enforceable contract is created. Legal contracts use an objective standard to determine the parties’ intent to be bound by a valid contract. If it is reasonable that the parties intended to be bound by a contract, then a contract is created and the law will enforce it.
OTHER ESSENTIAL CHARACTERISTICS
Aside from the basic elements of a contract, there are certain characteristics that are essential to maintain contract validity. The parties to the contract must be competent and legally capable of fulfilling their proposal. This requirement mostly applies to individuals who lack mental capacity (e.g., mental illness or inability to comprehend a contract) or to individuals who lack legal capacity (e.g., due to a young age). Another important characteristic is that the contract’s subject including the duties of each party must be lawful. For instance, a contract that violates municipal building codes is neither binding nor enforceable since it is based on an illegal premise. A contract also requires free consent of the parties to enter into a contract by not including force, undue influence, fraud or misinterpretation.
A common misconception is that contracts must be in writing and include a signature. This is not true. Contracts can be oral or written. However, there are certain situations when certain contracts need to be in writing, and these situations can be found throughout the construction industry. The statute of frauds is designed to prevent fraudulent conduct by requiring a written record of a contract in a few situations. Although the statute of frauds slightly varies by state, there are a few situations where the statute of frauds requires a contract to be in writing in order for it to be enforceable. Put simply, the statute of frauds traditionally requires a written form in the following examples in most states:
- Marriage contracts
- Contracts by the executor of a will to pay a debt of an estate
- Contracts that cannot be performed within one year
- Contracts for the transfer of an interest in land
- Contracts for the sale of goods involving a purchase price of $500
- Contracts when one party becomes a surety for another party’s debt
The last four are most applicable to construction projects, and if an agreement deals with one of those situations, then a contract needs to be in writing to be enforceable. Certain circumstances allow agreements to be enforced even if the agreement does not comply with the statute of frauds, such as when:
- One merchant confirms an agreement in writing and the other merchant, knowing of this written agreement, does not object within 10 days.
- A defendant in litigation admits the existence of a contract under oath.
- A portion of the contract is performed; the agreement is enforceable for the portion of the contract delivered.
- Specialty manufacturing is performed or subcontracted and performed.
TERMINATION OF A CONTRACT AND REMEDIES
A contract is terminated when the parties have completed full and satisfactory performance of their obligations under the contract. A contract also is terminated when:
- There is a breach of contract caused by a party defaulting from its obligations.
- There is a mutual agreement to terminate the contract.
- Unforeseen circumstances render it impossible for a party to perform the duties.
- The contract is terminated due to an operation of law.
If a contract is terminated through a failure to perform by one party, then the other party will likely receive damages.
Contractual damages are primarily designed to provide the nonbreaching party with the benefit that was lost or to “make the party whole.” Depending on the type of damages that are awarded, the nonbreaching party will likely receive money damages, restitution, rescission, reformation or specific performance. Money damages mostly are designed to compensate the nonbreaching party for the damages equal to the value that the party would have received if the contract had been fully performed or damages for the cost to complete the project after the breach. The difference is primarily on the stage of the project when the breach occurred; the earlier the breach, the more likely that the damages will be designed to provide the loss value. Restitution is a remedy that restores the nonbreaching party to a position prior to the formation of the contract and can include money or property. Rescission allows a nonbreaching party to terminate contractual duties if that party entered into the contract by mistake, fraud, undue influence or duress. Reformation allows a court to change the substance of a contract to correct any inequities that were suffered due to mistake, fraud, undue influence or duress. Lastly, specific performance is a remedy that compels a breaching party to complete specific duties and is available usually when money damages are inadequate.
ADDITIONAL CONSTRUCTION INDUSTRY APPLICATION
Certain situations in the construction industry provide additional angst. These situations can arise through clauses that are included in the contract. For example, the force majeure clause is used in contracts to free all parties of any liability or obligation for extraordinary events that occur beyond the control of any of the parties. This clause is designed to protect the parties from catastrophic circumstances that could not reasonably be expected to occur during a contract’s completion. The force majeure clause would be relevant if flooding occurred that ruined the land on which Knowinlaw Construction was going to build the hospital. The contract between Knowinlaw and Contractors USA may no longer be effective due to this incident, and all parties may be relieved of their duties because the event was not due to fault or negligence. The force majeure clause is often included in the standard terms of a contract so a general contractor should diligently read the fine print but understand that the courts will most often recognize force majeure if the event is completely unforeseeable. However, courts have placed a high standard in proving the application of the force majeure clause to ensure that it is reserved for situations that are catastrophic.
Another clause that causes frustration is the “pay when paid/pay if paid” clause. The most common version of this clause is that the subcontractor is not paid until the general contractor is paid from the owner. This clause is generally within the standard terms of the contract and is largely enforceable in most courts as long as the conditions of the clause are expressed clearly. By expressing the conditions of the clause, general contracts can maintain a “pay when paid” clause that some courts will recognize although the standard is high to prevent other contractual issues such as unjust enrichment.
The “No Damages for Delay” (NDFD) clause is a common clause that is added to construction contracts. Usually the project owner will add a NDFD clause to bar a contractor’s attempt to recover payment or compensation due to delays, but allow completion of the project. Courts will generally enforce NDFD clauses except in situations in which the delay is caused by fraud, bad faith or interference. For example, if Contractors USA is not able to perform its requirements due to Knowinlaw’s knowledge of a failure in the plans, then Contractors USA may be entitled to damages for the delay and the inefficiencies it caused, since Knowinlaw Construction was aware of the situation.
Indemnification clauses are added to construction contracts to expand the risk that a party will undertake and shift liability to other parties. It usually applies to additional remedies that are available and obligates one party to certain damages for specific occurrences that happen related to the contract. The definition of these occurrences and the damages are identified and defined in the agreement between the parties. For example, the contract between Knowinlaw Construction and Contractors USA includes an indemnification clause against all damages for personal injuries caused by or in connection with Contractors USA’s services. If a personal injury occurred on-site related to Contractors USA’s services, Knowinlaw will likely succeed in shifting liability to Contractors USA despite the fact Knowinlaw is the general contractor. This allows Knowinlaw to shift the risk and responsibility.
Few industries require the use of contracts more than the construction industry. Each decision for completing a project likely requires the use of a contract. Therefore, construction leaders need to be aware of the fundamentals of contracts to be better prepared to bring projects to profitable conclusions. Understanding these fundamentals allows a leader to assess a project and make better decisions as well as understand available options. This article aims to provide the reader with an introductory perspective on the basic elements of contracts within the construction industry. It is not exhaustive, and legal questions should be directed to an attorney specializing in construction law. This article serves to provide an exposure to basic contractual elements and to expose the readers to introductory legal concepts dealt with by contractors and other members of the construction industry.
Gregg Schoppman is a principal with FMI. He may be reached at 813.636.1259 or via email at firstname.lastname@example.org.