Broken promises impact profit margins and can cause additional unexpected costs to the project, affecting the overall performance. Therefore, contracts aim to ensure construction projects are completed according to the agreements between the parties.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 that 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 verbally or through performance. In this 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 prevents 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 parties create contracts. Most commonly, consideration takes the form of money, objects or services. For instance, the consideration involved in this 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 in which 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 a mistake 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 via 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, certain characteristics 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 because 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; and
- 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); and
- specialty manufacturing is performed or subcontracted and performed.
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. Good contracts are similar to fences in making good neighbors — having them improves the relationship. This is only an introductory perspective on the basic elements of contracts within the construction industry. Specific legal questions should be directed to an attorney specializing in construction law.
Part II of Contracts for Construction Leaders, has been published in the next issue of Risk Management, addresses contract termination, force majeure, pay-if-paid/pay-when-paid, no damage for delay and indemnification clauses.