United States: Residential Construction Contracts—10 Issues to Consider

From time to time our private clients embark on substantial construction projects involving the renovation or ground up construction of residential homes and related amenities. Often these projects involve many millions of dollars. It makes sense then that the construction contracts relating to these projects be carefully reviewed by competent legal counsel. The following is a list of 10 issues to consider when entering into a residential construction contract:

Use of Forms. Many general contractors use their own form of construction contract. In our experience, these forms are generally inadequate. They are often one-sided and—equally significant—poorly written, usually due to modifications made over many years of use. Some general contractors use, or at least are familiar with, the forms of contract generated by the American Institute of Architects. In our experience these forms are much preferable to a general contractor’s form. We often suggest that a client use one of the shorter AIA forms (A105 (Residential or Small Commercial Project) or A-107 (Project Limited Scope)), which we customize to fit the transaction and further protect the client.

Cost Structure. There are three basic approaches to structuring construction costs in construction contracts: (1) stipulated sum, (2) cost of work plus a fee, and (3) cost of work plus a fee subject to a guaranteed maximum price. We do not recommend the “cost of work plus a fee” approach because there is no cap on costs and it rewards the contractor for higher construction costs. Ideally, the plans will have been developed to such a stage that the contractor can provide a fixed (stipulated) bid, or at least a guaranteed maximum price, for the work with a minimum of unknowns in the form of alternatives or allowances. Most contracts provide for allowances—an amount specified for a certain item of work (e.g., appliances, fixtures, etc.) whose details are not yet determined at the time the contract is signed. The construction cost is then adjusted if the item of work turns out to cost more or less than the specified allowance. We recommend keeping allowances to a minimum and providing for realistic amounts. It is also important to understand whether the allowances take into account delivery, labor, installation, and the contractor’s fee, or whether these costs are otherwise part of the bid.

Warranty. A general contractor should provide a warranty for the work it performs. The client should understand that the breadth and length of warranties are negotiable. Many clients mistakenly assume that a warranty should last only a year. We recommend longer warranties. And, of course, manufacturer’s warranties on materials (such as roofing) and equipment should be passed through to the client.

Retention. We believe that every construction contract should provide for a significant retention (up to 10%, subject to the possibility of partial releases when certain elements of the work are completed well in advance of the final completion date). The retention (or at least a significant portion of it) should not be released until the work is finally complete (including punch list items) and the contractor has provided appropriate lien waivers for itself, the subcontractors and the suppliers, as well as other close-out items such as product warranties and manuals.

Lien Waivers. As a condition to each progress payment and the final payment, the contractor should provide lien waivers for itself and its subcontractors and suppliers who are entitled to lien the property. This could be difficult for a client to manage. The client may wish to engage the architect or a project manager to perform this task.

Project Manager. Unless the client has the time and energy to keep close track of the project, we recommend that the client consider retaining a project manager to monitor the work, approve bids, review shop drawings, review and approve change orders, manage requests for information, and certify applications for payment (which would include confirming that the work has been completed to such a level as to justify the payment). The architect may also perform some of these functions, although usually at a higher cost.

Change Orders. Change orders are an unavoidable part of any major construction project and often result in an increase in cost. They can be minimized by having as complete a set of plans and specifications as reasonably practicable prior to commencing construction. No change to the project should be permitted without a written change order signed by the contractor and owner (or owner’s agent) which details the nature of the change, any impact on cost and any effect on the schedule.

Arbitration. We typically recommend that a construction contract provide for streamlined arbitration of disputes because, in our experience, it tends to be quicker, less expensive and more private than litigation. The contract should provide that the work continue notwithstanding a dispute.

Interior Designer. An interior designer should work closely with the architect and contractor, particularly with respect to choosing fixtures and finishes and weighing in on other specifications. If the designer is brought into a project after the plans are complete and work has commenced, the client should expect many more change orders and, hence, more cost.

Insurance. Many clients are surprised to learn that ordinary homeowner’s insurance may not cover major construction. Builders risk insurance may be necessary. Also, many construction contracts ask the owner to require its insurer to waive subrogation against the contractor. Some insurers do not permit this in a builders risk policy. Before commencing construction, the owner should confer with its insurance company on these and other insurance issues.

While there are many other issues to consider before entering into a construction contract, the above list includes some of the most important ones. We look forward to assisting our clients with these matters and answering any questions they may have.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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