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RE Q4 2022 Newsletter

On Behalf of | Dec 21, 2022 | Newsletters

The Price Still Isn’t Right – Strategies for Price Escalation in Construction

 

Since the onset of the Covid-19 pandemic, there have been worldwide shortages of materials and supplies, including supply chain issues, labor shortages, and increased cost of materials and labor. A recent report by the Associated Builders and Contractors showed the overall increase in inputs to nonresidential construction to have increased by 40% from February 2020, just prior to the Covid-19 Pandemic, although prices of many types of materials vastly exceeded the 40% increase (see Associated Builders and Contractors News Release, ABC:  Construction Materials Prices Down 1% in November, Still up 40% Since February 2020, Dec 9, 2022; see also Construction Dive Brief, Construction Input Prices Tick Down as Supply Chains Improve, Dec 9, 2022).

Currently, the outlook is that the cost of construction is expected to return to more historical levels in 2023 and 2024 of 2% to 4% per year, although due to an aging workforce and global labor and component shortages, long lead times and material shortages are likely to continue (see CBRE 2022US Construction Cost Trends).

The sudden unavailability of supplies and materials, along with steep price escalations, were not anticipated or expected. The construction industry endured a similar situation in the 1970’s, when there were shortages of oil and steel, among other materials, and the cost of petroleum products and steel increased dramatically. In New York, the state even passed laws to provide for price escalation for certain construction contracts with New York State. For example, contractors and subcontractors were entitled to additional compensation in the event that the costs for petroleum containing products exceeded 15% (see, e.g., New York Session Laws of 1974, Chp 944, as amended by Chp 945 [as applied to transportation projects for the supply of asphalt]).

The Covid-19 pandemic unleashed havoc on the construction industry, delaying many of the projects. Contractors and subcontractors who bid projects prior to the pandemic were caught off guard with substantial increases in the cost of such items as lumber, steel, and petroleum containing products, (just to name a few), and the unavailability of those materials and of windows, doors, roofing materials and appliances.

Some contractors and subcontractors bit the bullet and did the best they could, others asked for help or adjustments to price or schedule from the owners or construction managers, and others simply had no choice but to default and not perform the contracted-for construction services and materials.

Some contractors sought legislative relief, at least with regard to New York State construction projects. There is currently pending legislation that passed both the New York State Senate and Assembly that would permit price adjustments (and in certain instances suspension or termination) to construction contracts awarded by the State of New York or a public benefit corporation for contracts where bids were submitted prior to April 1, 2020 and materials were purchased or invoiced after March 1, 2020, and if the costs increased by more than five percent (see Assembly Bill A10109, April 29, 2022).

Many owners of projects across the NYC Metropolitan area were also adversely impacted by the pandemic – delays to projects were and still are common as well as the substantial additional costs to construct those projects due to the delays, shortages of materials and labor, supply chain issues, and unprecedented price escalation.

Given that the shortages of materials and labor are likely not going to go away, owners should be proactive in developing strategies to complete ongoing projects and to bid out new projects.

Applicable Law

While the applicable laws vary somewhat from state to state, the general rule is that in agreeing to a contract for a sum certain, the seller or contractor is accepting the responsibility for any fluctuation in the cost to supply the materials or provide the services.

While the general rule holds most of the time, there are exceptions when certain unforeseen circumstances may alter what the parties had contemplated at the time they entered into the contract.

For instance, in connection with the supply of goods, Uniform Commercial Code Section 2-615 provides in relevant part as follows:

“This section excuses a seller from timely delivery of goods contracted for, where his performance has become commercially impracticable because of unforeseen supervening circumstances not within the contemplation of the parties at the time of contracting . . .”

While this section may seem favorable to a seller that incurred or would have incurred increases in cost due to the pandemic, there are certain hurdles the seller must overcome. Note 4 to UCC Section 2-615 provides the following explanation of the rule:

Increased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance. Neither is a rise or a collapse in the market in itself a justification, for that is exactly the type of business risk which business contracts made at fixed prices are intended to cover. But a severe shortage of raw materials or of supplies due to a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply or the like, which either causes a marked increase in cost or altogether prevents the seller from securing supplies necessary to his performance is within the contemplation of this section (see Ford & Sons, Ltd., v. Henry Leetham & Sons, Ltd., 21 Com.Cas. 55 (1915, K.B.D).

Similarly, Restatement of Contracts, Section 261 Discharge by Supervening Impracticability, provides as follows:

Where, after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.

However, as with UCC Section 2-615, the relevant notes to the above section make clear that a mere increase in price does not fall within this exception:

A severe shortage of raw materials or of supplies due to war, embargo, local crop failure, unforeseen shutdown of major sources of supply, or the like, which either causes a marked increase in cost or prevents performance altogether may bring the case within the rule stated in this Section. Performance may also be impracticable because it will involve a risk of injury to person or to property, of one of the parties or of others, that is disproportionate to the ends to be attained by performance. However, “impracticability” means more than “impracticality.” A mere change in the degree of difficulty or expense due to such causes as increased wages, prices of raw materials, or costs of construction, unless well beyond the normal range, does not amount to impracticability since it is this sort of risk that a fixed-price contract is intended to cover…

In Tilcon New York, Inc. v Morris County Cooperative Pricing Council, 2014 WL 839122 (Superior Court NJ, Appellate Division), the court rejected the plaintiff’s arguments that the price of asphalt cement had increased so much as to entitle plaintiff to additional compensation. The court held that “[t]he substantial weight of authority supports the principle that the mere increase in the cost of a party’s performance does not afford the defense of frustration of purpose or commercial impracticability (internal citations omitted).” The court added further: “[s]ome courts have focused on the magnitude of cost increases; however, courts reviewing increases not substantially different from those claimed here have found them insufficient to constitute commercial impracticability (internal citations omitted).”

Given the law is not 100% clear and that contractors and subcontractors faced with losses may refuse or not be able to perform, what strategies can owners employ to improve their chances that their projects are delivered on time and on budget?

Strategies for Dealing with Price Escalation, Shortages, or Unavailability of Labor or Materials

To minimize the adverse effects that price escalation, shortages of materials or labor, and supply chain issues have on construction projects, owners should not just revisit their contract forms and provisions, but also should take a proactive approach to minimizing the risks.

For example, some contracts or subcontracts have been recently updated to make it clear that regardless of any pandemics, wars, or other unexpected supervening causes, the price of the contract will not change.  While provisions such as this would appear to shift the entire burden of price escalation on the contractor or trade contractor, it does not necessarily address the situation where the contractor or trade contractor simply cannot or will not perform due to such supervening causes. In such event, the owner may have a right to default the contractor, but they will not necessarily have a remedy to keep their project on time and on budget.

Some proactive strategies that owners may want to consider include working with their construction manager in identifying long lead items or items that may be more susceptible to shortages, supply chain issues or price escalation, and procure those materials or equipment in advance.

Next, depending on the type of project, owners might want to consider varying the project delivery method. For example, instead of using a typical design-bid-build method, the owner may want to consider design-build or even progressive design-build, where the designer and builder are retained at the outset and may include the identification and bringing into the design-build process certain specialty trade contractors. This will enable the owner, designer, builder and major trades to identify and address issues that may arise, including shortages of materials or materials likely to fluctuate in price.

Another strategy would be to include in contracts with the contractor or major or specialty trade contractors, cost escalation clauses that work to try and allocate the risk of price escalation between the owner and contractor or trade contractor. Typical clauses will use as the price index easily indemnified or published price information, such as commodity index or a catalog price, and if the price exceeds more than a specified percentage, such as five percent, the contractor or trade contractor would be entitled to an increase in the cost over the five percent threshold up to a specified maximum amount.

Such price escalation clauses can have the added benefit of protecting contractor and trade contractors from variations in the price so that they can competitively bid the work without having to build into their quote excessive margins to protect themselves in the event of substantial cost increases.

In conjunction with price escalation clauses, owners may also want to consider including allowances or contingencies that a contractor or trade contractor can access in the event that the prices of materials or labor exceeds a specified threshold. Usually, the contract provisions require that the contractor or trade contractor provide sufficient back up to support the request and that such request is subject to the owner’s reasonable approval.

Due to the continued volatility of the construction market, including global shortages of supplies, an aging labor force, and supply chain uncertainty, owners are well advised to proactively address the issues that might adversely affect their project, discuss them with their construction professionals and legal team, and develop cost-effective strategies to minimize the risks.

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