Stayin’ Alive: How to Preserve a Project’s Profitability by Combatting Price Escalation

In FINANCE, Legally Speaking, Outlook & Trends, Payment, Risk Management
November 22, 2022
99 Views

By Michael Metz-Topodas, Saul Ewing

Despite the pandemic’s wane, the construction industry is still facing price escalation volatility. Finding a path to negotiate contracts in this environment requires understanding how the problem emerged and knowing the full range of solutions and remedies to employ on current and future projects.

The Problem

COVID-19’s disruptive force continues to reverberate through all aspects of construction, with materials pricing escalation a foremost concern. The pandemic wreaked havoc on supply chains worldwide, which, along with rising tariffs and production costs, led to shortages that created volatility across all markets, but especially for construction materials where prices have spiked to historic levels. Since 2020, the industry has endured up to doubling and tripling of pricing across certain periods for lumber, steel, copper, plastic, and other products. In an industry where contractors traditionally absorb material price changes as part of business risk, unpredictable pricing can impact a project’s bottom line or, worse, drive companies out of business.

Trying to cope with such a treacherous market has given severe heartburn to even the most seasoned estimators and project managers. At the more granular level, material price fluctuations have caused suppliers to reduce or limit the time they will guarantee pricing. Unable to lock in pricing, estimators now need to prepare bids that try to accommodate potential future price spikes and delivery delays, all of which threaten to erode or eliminate a project’s profit margin. With this volatility persisting, contractors can address these extreme price fluctuations by relying on their contracts, both existing and future.

Existing Contracts

Where price escalations threaten projects after a subcontractor and a general contractor (“GC”) have already executed an agreement, subcontractors will have more constrained options. So, the situation demands creative thinking and persuasion with arguments having a more business, than legal, tone. Strategies include:

Change Order. Just about every construction contract provides a mechanism and process for a subcontractor to request a change order for an increase in the contract sum due to changes in the work performed. When a GC fails to timely return submittals or otherwise delays a subcontractor in ordering materials, the subcontractor often is permitted to attribute associated price escalations to the GC, and thereby justify a change order request for increased payment. Absent GC delay, construction subcontracts seldom provide relief to a subcontractor for price escalation.

Force Majeure Clause. Most construction contracts, including the AIA A201, include a provision giving subcontractors an extension of time to perform their work in the event of unexpected events beyond their control. Before COVID-19, such clauses rarely listed pandemics as an event that would trigger this right to a time extension, making it challenging to apply a force majeure clause to pandemic-related delays and costs. And now, over two years after the onset of the pandemic, it hardly qualifies as unpredictable. Finally, such clauses usually afford only a time extension, so they may not apply to price escalation. In short, the force majeure clause does not offer a “magic bullet” for resolving price changes.

Impracticability or Impossibility. Some states’ laws permit a subcontractor to be excused from performing a contract as originally drafted when doing so becomes impracticable or impossible. This can occur when dramatic price escalation creates a change in circumstances beyond what the subcontractor and GC intended when making their agreement. Such a change could justify canceling and revising the agreement, but only for extreme pricing changes that threaten to subject the subcontractor to huge losses, possibly bankruptcy, because typical price increases fall under the accepted assumed risk in contracting. Further, pursuing this argument could require bringing litigation, often not a cost-effective path where small amounts are at stake.

Breach of Good Faith and Fair Dealing. Typically, contracts have an implicit requirement that the parties perform the agreement in good faith to accomplish the agreement’s purposes. Where a GC insists a subcontractor honor the contract sum in the original agreement despite the subcontractor facing massive downstream price escalations, the GC potentially risks breaching its good faith obligations. A breach of good faith claim in this context would make a for a novel approach and likely require litigation, making it cost effective for only large amount disputes.

Ultimately, unless an existing contract has a price escalation clause, subcontractors usually have limited contractual bases to obtain relief from price escalations. Nonetheless, they can still ask the GC for an equitable adjustment to the contract—essentially a revision based on a shared recognition of fairness. Such a request should: (1) describe the type and degree of price escalation; (2) propose any possible substitutions, alternates, or value engineering; (3) offer to share all available industry and vendor pricing information (confidentially, of course); and (4) outline how the subcontractor and GC can fairly share such costs. Should the GC reject such a request, a subcontractor could seek a termination for convenience in which it receives full payment for work performed and a release from any further obligations. Failing that, a subcontractor could abandon the project, especially where continued performance would incur costs greater than any liability to pay the replacement contractor’s premium price. Finally, the subcontractor could accept the losses from price escalations and perform the contract to preserve the relationship with the GC, which the subcontractor could leverage to recover the loss on the next project through a higher price, and thus greater margin. In short, even without a price escalation clause, a subcontractor likely has several levers it can use to resolve price escalation costs.

Prospective Contracts

Given the current volatile pricing environment, subcontractors should seek to include in their future contracts several key terms addressing price escalation. If, however, they cannot obtain such protection from extreme price escalation, the unavoidable risk should be reflected in a higher contract price. With extreme price increases broadly impacting most subcontractors, GCs will unlikely refuse reasonable price adjustments because they probably cannot switch to another subcontractor who is also likely affected by these industry-wide price instability.

Price Escalation Clause. Such now-famous clauses seek to distribute the risks from ongoing dramatic price changes to both the subcontractor and GC and come in almost endless varieties. Typically they establish triggering criteria under which the GC agrees to pay an increased contract price due to a demonstrated rise in materials costs. For example, some clauses require that for any material price increase over 10%, the GC will compensate the subcontractor half of that increase. Other provisions tie escalations for a specific product to an identified price index or other publicly recognized industry metric. Some contracts even allow escalation for any price increase regardless of amount, but subject to approval under the change order process.

GC Delays. Because the submittal process and other scheduled events drive when a subcontractor can purchase certain materials, subcontractors should negotiate for provisions that require the GC to compensate the subcontractor for any price increase that occurs between the scheduled and actual dates for a submittal return or other event.

Substitution, Alternates, and Value Engineering. Often price escalations and even materials delays can be addressed by using a different product or otherwise modifying the project design. Nonetheless, typically fixed price contracts impose no obligations on owners or GCs to accept such adjustments. Therefore, the contract should include language that requires the GC to use its “best efforts” to accept substitute materials, alternate materials, and any value engineering or compensate the subcontractor for increased material costs incurred in sticking with the original design and materials requirements.

Line Item Contingency. Subcontractors can negotiate a fixed contingency amount to cover materials costs increases and have that added to the schedule of values. Doing so affords the subcontractor a certain amount of coverage for price escalations, but caps the GC’s obligations.

Advance Purchase of Materials. To eliminate price escalations entirely, the parties could agree to purchase all or some materials far in advance of their scheduled installation or use in the project. Such provisions, however, need to account for storage costs and risk of loss for insurance and other liability purposes.

Cost Plus. To the extent a subcontractor is comfortable disclosing price information a cost-plus contract could eliminate any risk from price escalation. In such an agreement, the GC agrees to pay the subcontractor’s materials and labor costs to perform the work, plus an agreed upon percentage mark-up to cover overhead and profit. As a result, any materials price escalation gets passed up to the GC. Obtaining such an agreement with a GC may depend on what contract the GC has with the owner.

No Damages for Delay. Some subcontracts expressly prohibit a subcontractor from recovering monetary damages from any delay, limiting the remedy to only a time extension. Subcontractors should insist upon language expressly exempting price escalation payments from a no damages for delay clause’s reach to prevent GCs from trying to skip out on such payments by calling them impermissible delay damages.

In addition to these key contract terms, subcontractors can also protect themselves from losses due to price escalations by taking certain deliberate measures in carrying out their work. Subcontractors should perform all contract obligations in strict accordance with contractual deadlines, especially those regarding submittals, and document any GC delays in that process. Because prices can fluctuate while waiting for submittals to come back, subcontractors have a right to recover any increased costs that result from a GC’s delays in approving submittals. To support price escalation claims properly, subcontractors will need robust documentation demonstrating increases in pricing for which they seek compensation. Subcontractors should also propose in writing any substitutions, alternates, or value engineering and demand GCs do the same for their reasons for rejecting such proposals.

Conclusion

All of these proposed measures arise out of the tried and true business adage—“Failing to prepare means preparing to fail” (paraphrasing Benjamin Franklin). Subcontractors should address in advance problems from increased materials costs by both negotiating contract terms and developing action plans to address price escalation. As the above examples illustrate, however, such contract provisions often require detailed and precise language to establish the exact conditions and terms for adjusting the subcontract price to account for materials escalation costs. Preparing such agreements requires experienced and competent counsel to achieve this end and thus protect subcontractors from excess risk.

About the Author:

Michael Metz-Topodas is a partner in the Construction Group at Saul Ewing. His practice includes construction litigation, day-to-day project and claims counseling, and OSHA compliance and citation defense. Mr. Metz-Topodas represents general contractors, subcontractors, owners, designers, and suppliers on private, public, and federal projects. He counsels clients and handles construction disputes involving delay and inefficiency claims, design and construction defects, unforeseen site conditions, project scope disputes, bid protests, and payment claims, including mechanics liens, bond claims, and Miller Act claims. He can be reached at michael.metz-topodas@saul.com.