by Drew Colby
Construction contingency clauses fund events or factors that arise during the course of a project. What constitutes a “contingency,” the process for releasing contingency funds, and how the residual contingency funds are distributed are often heavily negotiated.
The owner and contractor must negotiate the factors or events constituting a contingency. They often involve items not fully developed or understood when construction commences. For example, the plans might not be fully developed so increased costs associated with the completed plans may qualify. Likewise, unexpected material cost escalations or force majeure events might also qualify.
As a general rule, owners usually do not want contingency funds used to correct contractor errors. Conversely, contractors usually do not want contingency funds used for work that otherwise would qualify for a change order. However, these general rules are broken so frequently that even calling them general rules might be misleading.
For example, the owner may permit the use of contingency funds for bidding errors arising from the owner’s rush to obtain a bid before the contractor could fully develop its bid. In these circumstances, the owner may put a cap on the amount or a limit on the type of errors that qualify (e.g., bidding errors up to a maximum of $10,000). Likewise, a contractor may permit unforeseen conditions (that would otherwise qualify as a change order) on a project where the owner does not have the ability to obtain additional construction funds. In short, contingencies narrowly tailored to the specific needs of the project are mutually beneficial.
The process for releasing contingencies is also heavily negotiated. For example, does the contractor or owner control the release or is the release subject to collaboration? Many contingencies provide the contractor with an absolute right to use the contingency for a discreet number of items. Other items might fall within the owner’s control or be subject to a collaborative process. Alternatively, the contractor might have the right to access contingency funds up to a certain dollar amount after which the owner controls or the process is collaborative. Regardless, it is imperative that the owner get an accounting of the use of the contingency funds. This is often done in conjunction with the payment application process.
Another heavily negotiated aspect of contingency clauses involves what happens to the residual contingency funds at project’s end. For example, the parties start with a $100,000 contingency that is drawn down to $15,000 at project’s end. What happens to that $15,000? The answer is whatever the parties negotiated.
For example, if the parties split the contingency 50/50, then, at least in theory, the contractor will be less likely to use the contingency fund during construction. For example, if the contractor is earning 15% profit on contingency work, the contractor would have to burn through the entire $100,000 contingency to get $15,000. If, on the other hand, the contractor burned through $50,000 of the contingency, then the contractor would earn $4,500 on the contingency work, but another $25,000 for splitting the residual contingency. In short, the contractor may make more money by splitting the residual contingency rather than devoting it entirely to the contingency work.
If, however, the residual contingency goes 100% to the owner, then the contractor has little incentive to realize cost-savings on the project. All cost-savings activities would be at the contractor’s sole expense. Conversely, if the contractor gets 100%, then the owner should vastly broaden the items for which the contingency must be used to avoid a windfall to the contractor.
In summary, contingency clauses provide the parties with the flexibility to cover unexpected costs. Carefully crafted, these clauses provide a vital tool for the parties to achieve balance and certainty in the construction realm where both are in short supply.
Drew Colby is a director at Kenney & Sams, a firm specializing in construction law.