Construction contractors are no strangers to contracts and agreements. They provide the backbone for all relationships in the industry. General contractors contract with owners, subcontractors contract with general contractors, and suppliers contract with subcontractors. Projects create a tier of contracts, like a pyramid, with the owner and general contractor on top and all the suppliers and subcontractors at the bottom. Contracts and their terms are reviewed and interpreted using what is called contract law. It governs all contracts entered into in a certain location, usually a state.
Here, we’re going to provide an overview of what contract law is, the underlying laws that govern contracts, and the elements of contract law that affect agreements in the construction industry.
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What is contract law?
Contract law is law that governs the making of contracts, carrying them out, and the remedies when there’s a breach. The law comes from many sources, which we will discuss below. These laws are about the types of contracts, their terms, and how they are to be interpreted when there’s a disagreement.
While construction projects may be completed under a variety of different contract types, the fundamental legal concepts are the same.
What makes a contract?
A contract requires three things: offer, consideration, and acceptance. What that means is that one party has to make an offer to the other, stating what they will provide, either goods or services.
There must be consideration between the parties, which means that both parties should get something from the relationship (work for payment, usually). And finally, the parties must both agree to all the terms of the agreement. If any one of these elements is missing, the contract is not valid.
Comparing written, oral, and implied contracts
Written contracts are expressed on paper and both parties sign the document to signify their agreement. Signatures can be either written or electronic, as federal law has upheld the validity of electronic signatures.
Oral contracts are entered into verbally, not in writing. In the eyes of the law, these contracts are just as valid as a written contract. Note: There still needs to be an offer, consideration, and acceptance of the agreement, albeit verbally.
Oral contracts can be hard to prove if the parties don’t agree on whether there was a contract or not — so many contractors follow up a verbal contract with a written one.
Implied contracts are entered into when the terms and conditions of the agreement can be inferred by the actions of the parties, and are just as legally binding as written and oral contracts.
For example: When you walk into a store, there is an implied agreement that you will pay for anything you remove from the store. If you do not pay for an item, you are breaking the implied contract. Courts have held that intent doesn’t matter when it comes to upholding implied contracts. They have repeatedly ruled to ensure just and fair treatment for both parties.
Laws governing contracts
Contract laws vary by location. Almost all contract laws are bound by the state they are written in, and some have been adopted by multiple states. The laws that govern contracts include the Uniform Commercial Code, common law, [SD1] and state statutes and regulations.
The Uniform Commercial Code or UCC is a set of laws governing commercial transactions in the United States. They have been uniformly adopted by all 50 states. There are nine sections that deal with sales, leases, payments, liens, and other contract terms. In construction, the UCC lien is most commonly seen in supply contracts.
Common law, also called case law, is law stated in written opinions by judges in court cases. To use common law, research past cases to determine the principles that can be applied to a current case. If a judge ruled in a particular way on a previous case, a similar case will probably be ruled in the same way, unless there are extenuating circumstances. Common law is given equal footing with state statutes when it comes to enforcement, so it isn’t to be ignored.
State and federal statutes and regulations also govern contracts, depending on the type of project and the parties that are involved in it. For example, federal projects are subject to Federal Acquisition Regulations (FAR), and state contracts related to public projects are subject to various public contract codes. Some states also have a business professions code and other statutes that govern contracts in the state.
Elements of contract law
Contracts should be clear and spell out the scope of work to be performed and the quality of work that is expected. Many construction contract disputes are over the scope of work and whether work is included or not included in the contract. It’s best to spell out the details of the work and the quality that is expected so there is no disagreement.
Issues of cash flow are very important for contractors when reviewing contracts. Make sure that you know the terms and timing of payments for your work. Pay special attention to force account terms, which say you must keep working on work you dispute — without payment.
According to civil litigation and construction attorney Sean Dowsing, doing force account work can negatively affect cash flow when contractors are forced to incur costs for labor and materials without getting paid.
Dowsing gives this example: “You’re doing a remodel, and you find asbestos. And the owner says you’ve got to keep working and they think you should have known about the asbestos. Even if there’s no way a contractor could have known, the force account clause says you have to keep working. So now you’re hiring an abatement contractor on your own dime and trying to figure out how to pay them.”
Dowsing recommends putting a limit on the amount of force account work that you’ll take on without payment during contract negotiation, such as 25% of the contract value. He says, “try and put a limit on it so you’re not just expending huge sums of money and going out of business.”
Another clause that is important in today’s market is an escalation clause. This protects contractors if material prices continue to skyrocket. Any material or labor cost increases over a certain percentage can be passed on to the customer through an escalation clause.
Collecting payment on additional work isn’t as much of a problem as paying for it while it’s being performed.
Dowsing says, “When you’re done with the work, you can file a lawsuit, go to arbitration, or file a lien on the property. You can do all kinds of things to try and get that money back. The problem is, what if you didn’t have the money to front in the first place?”
Contractors should always have backup funds or credit to pay for added work that they may be forced to take on.
While contract law includes built-in payment protection, they can be expensive to enforce, since they often require litigation or other dispute resolution to settle. As a result, all states have laws that give construction businesses additional power to collect payment.
Contractors should be aware of the statutory terms for warranty on finished construction work. Most contractors must provide at least one year of coverage for their work and materials. The statute of limitations for defect claims can be as long as 10 years, so contractors need to keep records for at least that long.
Most warranty periods begin at the point of substantial completion, but some work may require a different warranty starting time, like when equipment is used before occupancy. Make sure that’s clearly defined in the contract.
Indemnification clauses attempt to push responsibility for issues on the project to other parties further down the payment chain. Generally, all contracts will have an indemnification clause making the tier below responsible for issues they cause.
The problem comes when indemnification clauses are interpreted broadly, and companies further down are held responsible for actions by others outside their control.
Dowsing recommends contractors look at indemnification through the lens of what’s riskiest on their contract. How much risk are you being exposed to, can you limit it in some way, and can you insure against it?
Read all indemnification clauses carefully and, if possible, request limits to the damages, such as the limit of your insurance policy or your fee for the project. This protects your future insurance premiums or your company from being wiped out financially by an indemnification claim that exceeds policy limits. Not all owners or contractors will be able to negotiate a limit, as requirements from their own insurance carriers may prohibit it.
You can also pass indemnification language down to your subs and suppliers.
“When you see an indemnification clause, if you’re going to have your own subcontractors, make sure it flows down[SD3] so they’re held to the same standard that you are,” Dowsing recommends.
Contract disputes or breach of contract
Most contracts will contain language regarding how contract disputes will be settled and what the parties’ responsibilities are if a breach of contract occurs.
Pay particular attention to what damages can be recovered for a breach of contract, no matter which party causes it. Liquidated damages are often spelled out in this area of the contract, as they are assessed damages for not meeting the project schedule. Try to negotiate them as low as possible — or get them removed if you can. If not, contractors need to be diligent in making claims for schedule changes if there are delays or added work.
Contract law: Your framework for understanding any contract
Contract law offers a framework for interpreting contract language, and generally varies from state to state. If you’re signing a contract from another state, make sure you know what laws will be used to interpret it. It’s always best to have a contract or construction attorney review any contract before you sign.