The Importance of Contracts in the Construction Industry

Occasionally, potential clients, be they general contractors or subcontractors, come to me with issues regarding a project that they’ve been involved with. More often than not those questions revolve around what their rights are, and what their duties are, when a problem has arisen on the project that they’re working on.

The first document that I ask for when presented with these questions is the contract that governs the work the contractor was doing, and, unfortunately, I am often told that there was no contract—which is almost as bad as when the contract that is in place is a form contract pulled from the internet that is not specific to the work that was actually being performed.
In the construction industry, contracts serve many purposes. The main purposes are to outline the rights and duties of all the parties involved in the contract, and to allocate the risk between those parties. Typically, most people are interested in the rights and duties part of a contract and somewhat ignore the allocation as a risk. However, as you will see below, this can be a costly mistake.

If a contract allocates too much of the risk involved in a project to one party (e.g. a general contractor shifting all of the risk to its subcontractor), then the party that is assuming the lion’s share of the risk likely will not want to enter into the contract. Properly and fairly allocating the risk in contracts also allows the parties to the contracts to effectively plan ahead and will likely result in fewer insurance claims, lower costs, and projects being completed on time.

​This point was well made in a recent case decided by the United States Court of Appeal for the Federal Circuit. The contract in question was between the Department of the Navy and DG21, a contractor doing business with the Navy. The contract was a fixed price contract in which DG21 would be paid a fixed sum of money to perform all the tasks that it was agreeing to. The issue that arose, was that of fuel costs. The contract was to be performed in Diego Garcia, which is located approximately 1,800 miles east of Africa and 1,20 miles south of India, not a place where you can drive to the local gas station to get gas for your fleet of vehicles!

The contract stated that DG21 was to use a certain type of fuel while operating on Diego Garcia and the fuel was to be paid for by DG21 at the prevailing Department of Defense rate at the time of purchase. DG21 examined the Department of Defense fuel rate at the time it was bidding for the contract, bid accordingly, and was awarded the contract.

The Navy, in response to DG21’s bid, advised that the fuel cost information it provided was for informational purposes only and that the bid was for a firm fixed price, meaning that DG21 would assume the full risk of fuel consumption and/or fuel rate changes. During the term of the contract, fuel prices, and the prevailing Department of Defense rate for fuel rose dramatically, reaching more than double the rate DG21 relied on when preparing its bid. As you can imagine, as a result of the fuel costs doubling, the contract no longer made financial sense to DG21.

DG21 requested that the Navy increase the price of the contract so that DG21 could be properly compensated in light of the increased fuel costs. The Navy denied this request leaving DG21 to finish out a contract that, due to the dramatic increase in fuel costs, it was likely losing money on.
The Court sided with the Navy. All the Court had to do was review the contract that was in place which allocated the risk of fuel price changes to DG21. Even more damning to DG21’s case was the fact that DG21 itself recognized that fuel prices fluctuate dramatically from year to year. Yet even though DG21 was aware of this risk, it did nothing during the contract negotiations to protect itself from fuel price fluctuations.

While not everyone will be contracting with the government, the point that this case makes is valuable to anyone involved in the construction industry, whether they are competitively bidding for work or simply negotiating the price of a project. Had DG21 fully examined the risk that was being allocated to it regarding fuel prices, DG21 may well have decided that it needed additional protections from that risk written into the contract; or that it needed to increase its bid price for the contract; or that it simply did not want to take the job due to the excessive risk that it would be taking. Unfortunately, DG21 did not undertake that analysis when negotiating its contract and was left in the unenviable position of finishing out a contract on which it would be losing money.
It is important to examine any contracts that are being entered into to see where the various risks are being allocated and to make sure that those risks are being fairly distributed between the parties.  Failing to do so could result in a job in which your profit margins are slashed completely, or in which you actually lose money.

​