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Five Contract Provisions That May Be Unenforceable

Construction contracts frequently shift risks downstream. Especially in markets where new projects are scarce, contractors and design professionals often have little leverage to modify contract provisions that shift significant risk to them.

Legislatures have passed a variety of construction-specific statutes to help level the playing field, such as:

  • prompt payment acts, which are designed to protect contractors from slow payers;
  • anti-indemnity acts, which limit the effectiveness of contractual indemnity clauses; and
  • other construction “fairness” legislation.

In individual cases, courts have imposed exceptions to the enforceability of specific types of clauses limiting certain types of liability risks, such as no damages for delay clauses and conditional payment clauses. The practical impact has been to limit the effectiveness of such clauses in certain jurisdictions, but at the same time increase litigation costs.

Ten to 20 years ago, it may have been possible to obtain outright dismissal of most contractor delay claims because of the bars against no damages for delay clauses. In some jurisdictions today, the legislative or judicial exceptions to the enforceability of those clauses can be so wide that obtaining dismissal of delay claims even on summary judgment may be difficult, especially without well-drafted clauses that anticipate the recognized exceptions.

Enforceability rules can change from state to state, from court to court, and from situation to situation, making it difficult for counsel to draft clauses that would be generally enforced. Furthermore, in some situations state law protections can be waived and in others they cannot. In some situations a “savings clause” may be used to “save” an otherwise unenforceable clause to the extent it is enforceable, and in others it cannot.

The effect of including a void or unenforceable clause also varies. In some situations, if a contract includes a clause that is invalid under the applicable state’s law, the clause could void an entire contractual section or provision, or even the entire contract. Confusing things further, in many states the various statutes and case law addressing these clauses is new and unsettled, so the effect of “void” clauses is not completely known.

In short, knowing these rules and their trends can be crucial to proper contract drafting. Following are five types of critical clauses and related case law.

1. Contingent Payment Clauses

There are two different types of conditional payment clauses: pay-if-paid provisions and pay-when-paid provisions. Such clauses provide that the general contractor is under no obligation to pay its subcontractor or supplier unless (or until) the general contractor is paid by the owner.

The practical effects are apparent. If subcontractor A is not paid because of a dispute unrelated to its performance, such as the owner holding back payment from the general contractor because of subcontractor B’s defective work or because of the owner’s insolvency, subcontractor A may never receive payment. Therefore, some subcontractors try to modify the clause to require that they be paid as long as the reason for the owner’s refusal to pay the general contractor does not stem from inadequacies in its work. Subcontractors frequently lack the leverage to negotiate these clauses.

Some state courts disfavor or will not enforce such clauses. Other courts will reinterpret such clauses and hold that they are merely provisions that require the subcontractor to wait a “reasonable period of time” for payment. In other words, if the general contractor does not receive  payment from the owner or does not make the payment to the subcontractor within that reasonable period of time, the general contractor is obligated to make the payment to the subcontractor.

But, some state courts enforce these provisions and make the subcontractor the ultimate banker. Other courts inquire whether the parties intended to cover certain risks of non-payment, such as owner or general contractor insolvency. In many states, pay-if-paid clauses are enforceable if they are clearly worded in condition precedent-type language. However, a growing minority of states have held pay-if-paid clauses to be unenforceable, declaring they go against the public policy established by the legislature in the state’s mechanics’ lien statute by preventing payment to the subcontractors.

Some states have approached the issue of conditional payment clauses by means of statutes. The language of these statutes may vary, but the general purpose is to render pay-if- paid provisions unenforceable, or significantly more difficult to enforce. Some states have passed statutes stating that pay-if-paid clauses cannot be used as defenses to valid mechanics’ lien claims.

2. No Damages for Delays or Disruption Clauses

Customarily, a “no damages for delay” clause provides that a contractor or designer is not entitled to a claim for delay damages, and will only be entitled to a schedule extension. An extension of time remedy may be an inadequate remedy; when combined with a no-damages-for-delay clause, it can shift substantial risk. While the extension of time remedy (if granted in a timely fashion) may help prevent acceleration costs, it will not prevent extended overhead costs, labor inefficiency costs and costs due to escalated materials prices.

Counsel for some owners, general contractors and architects try to tighten these clauses further by adding notice and time deadlines and requiring that claims be supported by critical path analyses or other damages methodologies. They also have learned to try and extend the limitations on delay damages to “disruption,” “acceleration,” “out-of-sequence work,” “efficiency loss” and other types of damages that courts might consider different than “delay” damages.

During the last 10 years, courts and legislatures in many states have carved out numerous exceptions to the enforceability of these clauses, such as where the upstream party “actively interfered” or where the delays where due to “unforeseeable circumstances” — exceptions which in some cases have been interpreted so broadly that they threaten to swallow the rule of general enforceability. Some states recognize certain exceptions, but not others, and some states simply lack enough case law from which to draw any conclusion. Additionally, some states have enacted statutes rendering certain types of no damages for delay clauses unenforceable, some of which differentiate between claims on public and private projects.

3. Requirements That Change Orders Be Approved in Writing

One of the greatest sources of controversy is claims for additional compensation based on change requests that are performed and then subsequently denied by the general contractor, architect or  owner as not being required because the work performed was within the scope of the original project. Although some agreements make a distinction between “change orders” and “construction change directives,” these same agreements often do not detail the procedures for obtaining additional compensation in both types of situations. However, most agreements require that change orders be approved in writing in advance and impose a number of conditions, dispute resolution procedures and time limitations before claims for additional compensation are approved by change order.

Despite the general enforceability of such clauses, some courts recognize the difficulties contractors face in the real world when they are directed to perform extra work and told not to wait for formal owner approval. Such courts recognize that the requirements for written agreement to change orders in advance can be waived by conduct and allow claims for extras for orally directed work, but as a type of quid pro quo require elevated burdens of proof, such as proof by clear and convincing evidence rather than by a preponderance of the evidence. Depending on the circumstances, some courts may closely examine whether the contractor sent or obtained a written confirmation detailing an oral directive to proceed and the basis for compensation. While such clauses often are included in contracts, in many instances it becomes a question of fact as to whether they are enforceable.

4. No-Lien Clauses and Broad Lien Waiver Forms

In no-lien clauses, the contractor waives its claims for mechanics liens in advance of construction. Those seeking to enforce such clauses argue that because mechanics liens claims are derivative, all parties claiming by, through or under the general contractor have implicitly waived their respective mechanics lien rights.

Additionally, in lien waiver forms, upstream parties seek as a condition of payment broad waivers of all claims for additional compensation relating to work performed through the end of the applicable pay period. Often contractors are asked to pre-sign such clauses even before they receive payment. Contractors are also often asked to disclose in sworn statements all their subcontractors, their subcontract amounts, the amounts paid to each subcontractor and all amounts due and owing.

Many states will not enforce no-lien clauses, while some states permitting no-lien contracts have strict requirements for recording and notice provisions. Additionally, some state courts have carved out protections from broad lien waivers. Examples include invalidation of waivers where owners were separately put on notice of claims or where owners were supposedly aware of the existence of subcontractors whose names did not appear on general contractor’s sworn statements.

5. Contractual Statutes of Limitation and Repair and Replace Clauses

Many construction contracts specify that all claims related to the construction project must be made within a certain period of time. Other related provisions state that all claims relating to the construction accrue upon substantial completion, and the owner must assert the claim within a certain number of years from substantial completion. Another variation of such provisions is to offer limited warranties, which call for repairs within certain periods of time (known as repair and replace clauses). Downstream parties often advocate for these types of provisions by asserting such clauses take the uncertainty out of calculating time periods for claims and that without these provisions, the bidding party would have to increase its price to do the work.

These types of provisions can face a variety of enforceability hurdles. In many states, a clause that simply gives a party a limited period of time to bring a claim, but does not address accrual of claims, will be subject to the “discovery rule,” which specifies that the time period to assert a claim does not begin until the claimant “discovers” the claim. Even when accrual is addressed (e.g., by stating that all claims related to the construction accrue at substantial completion), such provisions are not always enforceable. Some state legislatures or courts have barred waiver of the discovery rules or limited or rendered unenforceable attempts to define contractual statutes of limitations.

Similarly, repair and replace clauses that state an owner’s remedy in the event of a construction defect is for the contractor to repair the defect for some period of time often do not have the desired effect. Typically, downstream parties (i.e., contractors) argue that such provisions limit an upstream party’s remedy to repair and replacement of defective work brought to the constructor’s attention within the proscribed time period. Many courts, however, take a much broader view of such provisions. Unless the language of the provision is very clear, many courts find such provisions only provide one remedy, but do not eliminate other remedies.

A follow-up article will address five more contract provisions that may be unenforceable.

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