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COMMERCIAL FINANCE 701 — Construction contracts and risk mitigation

Commercial Finance 701 is a continuing series on commercial loans written exclusively for the Mississippi Business Journal. This series is geared to lenders, developers, investors and transactional attorneys.

 

MOLLY MOODY & BEN WILLIAMS

MOLLY MOODY & BEN WILLIAMS

A commercial construction project is a multifaceted venture.  The numerous parties, erratic pricing of materials, potential for defects, unpredictable local governments, tight profit margins, and vital financing all contribute to a challenging project.  The parties need a well-drafted construction contract.

THE PROCESS

Reaching the point of actually needing a construction contract can be exhausting.  Necessary steps include site selection, design concepts, plans and specs, value engineering, pricing, revisions, bidding, delays, and loan negotiations.  Deal fatigue may set in even before the first draft construction contract hits the table.  Stale bids, a slipping projected timeline, and resolute desire to break ground all may lead to a perilous rush to sign a contract.  Our advice?  Slow down.

WHAT COULD GO WRONG?

What could go wrong?  In a word — everything.  Improper zoning.  Cost overruns.  Boundary line disputes. Plans and specs revisions.  Insufficient utility capacity.  Delayed COs.  Insolvency of a major player.  Defaulted leases.  Interest rate moves.  Material shortages.  Natural disasters.  Lack of loan approval.  An untimely recession.  Construction is challenging.

While the probability of any one particular thing going wrong isn’t very high, the incident rate of one non-specific thing heading south approaches a near certainty.   Generally, due diligence reduces risk and helps the parties avoid the untimely discovery of problems.  Even without a lender’s insistence, a developer should obtain a survey, title and zoning reports, soil borings, and utility company will-serve letters.

THE CONSTRUCTION CONTRACT

Now for the construction contract.  The purpose of any contract is simple – to assign rights, duties and responsibilities and to provide specificity so as to reduce the risk of a misunderstanding.  In the construction world, an ounce of prevention forgoes a ton of grief and attorneys’ fees.

Competing forms, in various degrees of neutrality, are ubiquitous.  The American Institute of Architects publishes a frequently used series of contract documents, which it self-describes as “The Industry Standard.”  http://www.aia.org/contractdocs/. These architect-friendly documents leave little unsaid.  One example is the AIA’s A102-2007 form, known less succinctly as the “Standard Form of Agreement Between Owner and Contractor where the basis of the payment is the Cost of the Work Plus a Fee with a Guaranteed Maximum Price.”  This 23-page contract incorporates by reference the 57-page ancillary A201-2007 General Conditions of the Contract for Construction, which contains a treasure-trove of detailed contract provisions.

NUANCES and MORE

Aside from the obvious problem of contract nuance, some of the more critical issues stem from seemingly obvious provisions.

The Parties.   Is the contracting party the same party with whom you have been negotiating?   For good reasons, a developer might form a single purpose entity (SPE) for a transaction.  A construction company might have specialized subsidiaries.  Each entity could have a different performance record, net worth, bonding capacity, and ownership.  Know your contracting party.   XYZ Contractors, Inc. and XYZ Construction, LLC. aren’t the same company.

Details.   Do you have finalized plans and specs and a detailed budget?  A contract that postpones finalization of key elements is more like a contract to contract and an open invitation for acrimony in the form of a biting change order.  If the details are not finalized, you may be getting the cart before the horse.

Pricing and Scope.   Typical pricing options include stipulated sum, cost plus, and the aforementioned GMP contract.  Each involves a shifting of price risk, which naturally is factored into cost.  This focal election necessitates a full understanding of the scope of the project.  What is not included?  Is this a turnkey project?

Timelines.   Read carefully the provisions on “contract time” to “substantial competition.”  High-fives at contract execution can turn into clinched fists after the project misses a critical date.  What if the opening of a new hotel in a football powerhouse college town slips from late August to mid-November?

Retainage & Payments.  Retainage is the portion of a payment held until work is substantially complete.  Contractors hold retainage on subs.  Developers hold retainage on contractors.  Lenders hold retainage on developers.  A comprehensive contract describes in detail the progress payment procedure.  Retainage and payment provisions in a construction contract and loan agreement often differ – but shouldn’t.

Payment & Performance Bonds.  In the AIA series, a brief section at the end of the form references bonds.  The placement and brevity of this section belies its importance.   A developer, who foots the bill, tends to be less interested in a payment and performance bond than a lender.  A payment bond, which grants payment rights to first and second tier subcontractors and materialmen, will go a long way in protecting the property from liens.

Law & Venue.   Consider that innocuous law and venue provision with care.  Do you really want to litigate in another state?

TWO BIG ISSUES

Timing.  If we had to pick one “wildcard,” it is timing.   Delays can be problematic and expensive.  Depending on how many of the proverbial project ducks are in a row at the contracting stage, the adequacy of the contingency component may need special scrutiny.

Change Orders.  Change orders are a fact of life.  Still, executing a contract prematurely with the plan to change something is fraught with issues.  Changes could ripple through cost estimates, timeline and permits.  Also, substantive changes will likely require the consent of the bonding company and lender.

NON-PRINT CAN BE PITFALL

While the fine print is important, the non-existent print can be devastating.  What wasn’t addressed? Using an industry standard contract may help eliminate that question.

Naturally, the topic of construction contracts is considerably more complicated than we’ve discussed. And we haven’t even addressed subcontracts.  The goal is to avoid a construction dispute by prudent planning and painstaking drafting.  As Albert Einstein noted, “Intellectuals solve problems; geniuses prevent them.”

» Ben Williams and Molly Jeffcoat Moody  are attorneys in a commercial law practice at Watkins & Eager PLLC (watkinseager.com).   Ben and Molly are both recognized by Chambers USA and Best Lawyers in America.   Ben was selected as Best Lawyer’s 2016 Project Finance Lawyer of the Year in Jackson, Mississippi.

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