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Why Real Estate Construction Contract Disputes Are Reaching New Heights

Lessons learned over the last couple years representing owners as it relates to high-end residential and smaller-to-midsize commercial construction projects.

It wasn’t long after the lockdowns in the U.S. in March of 2020 due to the Covid-19 pandemic that we started getting calls from clients telling us that their construction projects were flailing, and they were in need of life-sustaining measures—in the contractual sense of those words. At the time, we were telling our clients that interruptions in projects were likely temporary and that since construction was in many states in the U.S. considered whether construction was an “essential business” so that projects could be re-started or even commence. Most states quickly adopted phrases to describe businesses and personnel that were considered essential, such as “Essential Infrastructure Operations”, “Essential Services and Critical Workforce Infrastructure”, “Essential Critical Infrastructure Workers” and the like. (See, for example, the following blog discussion issued by the Construction Management Association of America, dated March 23, 2020, and updated on April 28, 2020, How COVID-19 Is Affecting Construction Bidding & Jobsite Activity (ConstructConnect) on state-by-state essential construction work.) Some or most forms of the construction industry and its workers were covered by the various laws, ordinances and orders, and owners and developers initially exhaled with relief that projects could continue or proceed.

 At that time, no one had any clue how long the pandemic would last, when it would subside, how many would become sick or die from the virus, or whether the virus could be eradicated or reduced to an endemic disease. There was no crystal ball or clairvoyance that could divine the pandemic’s impact on the myriad of legal and business challenges that face the construction industry. Like the virus, the situation for all parties was novel and continually mutating.

At first, we all turned to the applicable construction contracts for these projects and used our reasoning and experience like divining or dousing rods to figure out whether the delay and force majeure provisions could conceivably cover or shed light on the compounding issues our clients were having. Over two years later, the construction industry is still coping from the tectonic shift in almost all areas of business, life and governance. Compounded with issues related to defaulting tenancies in commercial and residential real estate products, owners and developers saw profits and potential drain from their projects, impacting loan-to-value ratios, financing opportunities and other financing vehicles such as low-income housing tax credits. (See, for example, the following blog post issued by Novogradac Affordable Housing Resource Center, House Releases $1.5 Trillion FY 2022 Omnibus Spending Bill, Including $65.7 Billion in Gross Appropriations for HUD, $295 Million for the CDFI Fund, Published by Peter Lawrence on Wednesday, March 9, 2022.)

More than two years later, we still regularly receive calls from clients struggling with their projects, getting them started, continuing and/or completed. I want to address here what we learned over the last couple of years representing owners as it relates to high-end residential and smaller-to-midsize commercial construction projects in a brief and lighthearted manner to balance the obviously serious issues counsel are facing these days. I will also offer practice tips that maybe (just maybe) may help alleviate some future issues.

The Issues, a Condensed Discussion

Captain Obvious and the Economy. When I attended law school, I studied under a contract law professor who reminded his students almost daily that the single most important issue that has always and will forever confront mankind and the planet is the competition for resources. We see a constant struggle between humans, nature (flora and fauna), governments, geopolitical allies and adversaries, for finite resources. While training associates over the years, I tried to ingrain that simple truth as a primer for the fact that we need to be continually conscious of basic supply and demand principles. The impact of supply chain disruptions, labor force shortages due to scarcity, illness and/or death, the “Great Resignation”, and inflation has been discussed exhaustively globally. (See, for example, McKinsey & Company article, How COVID-19 is Reshaping Supply Chains, dated November 23, 2021, by Knut Alicke, Ed Barriball, and Vera Trautwein. Referring to the “Great Resignation”, according to the U.S. Bureau of Labor Statistics in 2021, approximately 47 million Americans voluntarily quit their jobs, which was deemed an unprecedented mass exodus from the labor markets as a result of Covid-19, that is now widely being called the “Great Resignation”.) While these conditions began even before the pandemic, it is no understatement to say that they have been greatly exacerbated by it, as well as by the advent of Russia’s war against Ukraine.

On both macro and micro levels (as a matter of perspective), for many Americans the shortage of foodstuffs, consumer goods, major asset purchases such as automobiles, construction materials and supplies, sufficient and trained labor, as well as oil and gas resources, has been exasperating since they are not generally used to any measurable level of continuing scarcity. No one person or government has been able to predict the overall impact of shortages and how long disruptions in the supply chain will last, although many have tried their hands at making forecasts. (Id., see the previous parenthetical in the paragraph above.) Simply stated, until manufacturers are able to increase capacity to meet demand and institute other measures to bring resiliency to the supply and distribution networks, those systems will continue to be vulnerable. (On November 29, 2021, the Federal Trade Commission (FTC) issued orders under Section 6(b) of the Federal Trade Commission Act to Walmart Inc.,, Inc., Kroger Co., C&S Wholesale Grocers, Inc., Associated Wholesale Grocers, Inc., McLane Co, Inc. Procter & Gamble Co., Tyson Foods, Inc., and Kraft Heinz Co., requesting information that will show the cause of supply chain issues and the negative impact on the U.S. economy.) Also, unless people are healthy enough to work sustained periods without exposure to continual infection and continual illness, the labor supply will be compromised. Boiled down to the most simplistic and famous colloquial cliché, “it’s the economy, stupid”, and we are all the economy. ("The economy, stupid" is a phrase that was invented by James Carville in 1992 when Carville was a strategist in Bill Clinton's 1992 presidential campaign against incumbent George H.W. Bush.)

Humans Aren’t Perfect, and Neither are Their Construction Contracts

Construction contracts had issues well before the pandemic. We’ll explore what continues to pose challenges for clients in new contracts, and how tweaking those agreements can provide a better blueprint (pun intended) to manage expectations and foster better outcomes. Construction contracts are living or dynamic documents, which require constant tending and vigilance. Once drafted, they should be referred to and revised or amended as necessary to cover changes in the scope of a project and work, the administration of the project, and financial projections.

The provisions that I have seen that cause the most failures include the following: (i) the lack of a sufficient scope of work and specifications; (ii) erroneous or insufficiently detailed budgets and contract timelines; (iii) lack of any or a clear change order or work authorization process; (iv) lack of or any clear provisions addressing delays and force majeure provisions; (v) non-existent express termination rights; vi) non-existent terms addressing the owner’s right to stop work/complete work; and (vii) proper retainage provisions for progress and final payments. Especially as it relates to home improvement construction contracts, which in California are governed by very specific content parameters, more often than not, some or all of these terms were missing or significantly ambiguous in all of the failed contracts we reviewed.  (See California Business and Professions Code - BPC Division 3. Professions and vocations generally [5000 - 9998.11] (Heading of Division 3 added by Stats. 1939, Ch. 30.) CHAPTER 9. Contractors [7000 - 7191] (Chapter 9 added by Stats. 1939, Ch. 37.)  ARTICLE 10. Home Improvement Business [7150 - 7170] (Article 10 added by Stats. 1961, Ch. 1021); and see, for example, Contractors State License Board, California Department of Consumer Affairs.). 

Also, clients often fail to conduct sufficient due diligence on a contractor or its materialmen and subcontractors to ensure that licenses are active, they are sufficiently bonded and insured, and have positive reputations in the industry in the geographic areas where they are active. We understand that oftentimes this due diligence work is overlooked because a client received a referral, or because the parties “clicked” on a visceral level. However, remember that the phrase, “Good fences make good neighbors” applies to the owner/contractor relationship, which should have clear, professional boundaries. (From The Mending Wall, Robert Frost, 1914.)

Keep in mind that even the most detailed and seemingly water-tight construction contracts involve projects that go awry. When that happens, the single largest factors appear to be two-fold – the contractor, its materialmen, suppliers and subcontractors did not perform according to the terms of their contracts and/or were over-committed to other competing projects, and 2) the communications between the owner and contractor broke down.

Start a New Best Practices Practice.  Rather than trying to be predictors of outcomes for our clients on the success of their construction contracts, which is a fool’s errand, I recommend that legal practitioners adopt a checklist of best practices to apply to each project they are aware of:

  • Stay informed.  Stay up to date on existing and potential laws will affect the project and the contractual relationship between the parties and communicate those to your clients. The new normal is that there is no “normal” globally; get used to educating yourself regularly to continuing fluid situations and legal hurdles. If your project is involved with infrastructure improvements, help your clients track funds that will be available for construction as a result of the passing of the American Rescue Plan Act. (See Public Law 117 - 2 - American Rescue Plan Act of 2021.)
  • Keep “Intuition” in Check and Throw Out the Crystal Ball.  Advise your clients that they should resist the urge to enter into a contract based on an “intuition” or “gut feeling” about how you think the contractor will perform. No one can predict the outcome of a construction project under the best circumstances.
  • Make The Contract Stronger and Help Manage Expectations.  Encourage your clients to get help with drafting the contract at the outset, even if they have in-house counsel, and make sure that the contract deficiencies noted above are addressed. Proactively advise clients that their contractors, suppliers and materialmen will have ongoing challenges meeting construction deadlines and budgets well before they enter into contract negotiations, and that amendments to the document will need to be made. Make an abstract of the critical duties and obligations of the parties under the contract, and calendar performance deadlines.
  • Look at Alternative Forms of Construction Contracts. Some clients may want to consider looking at design-build contracts since all elements, architectural, engineering, contracting and subcontracting, are under one roof and the design-builder has a heightened level of duty to design, build and complete the project for a unified project vision within the parameters of the contract. These types of contractual arrangements are by no means a panacea for the construction dispute issues we have experienced lately, and separate issues arise with these arrangements that will be reserved for another article.
  • Activate the Support of the Construction Lender. If a lender is involved, incorporate their best practices into the transaction process with the owner and contractor.
  • There is No Substitute for Building Effective Communication Skills. Owners and contractors don’t speak the same language. They rarely have the same types of education and experience and manage their businesses in vastly different ways. Find a “language” that works sufficiently so that there are open avenues of communication for both parties. This means you will want to set up a communication chain of command that must be followed and document those communications. The method and means of communication are equally important, and with the now widespread use of video conferencing and collaborative software modules, there is no reason for a total breakdown of communications. All parties should strive to be active and considerate listeners and should regularly ask for feedback from each other.

Loretta Thompson is a partner on the real estate team of international law firm Withers whose practice includes both commercial and residential real estate matters. She regularly negotiates and facilitates real estate acquisitions and dispositions, leasing, handles tax exchanges for REITs, public and private corporations and high net worth individuals, and has extensive experience negotiating and administrating finance transactions, construction, architecture and design contracts, and development agreements and easements.

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