United States: The Contractor's Contingency: What Contractors And Construction Managers Need To Know And Be Wary Of

This article was written for the ConsensusDocs newsletter and first appeared here.

Contractors and construction managers who enter into cost reimbursable contracts subject to a guaranteed maximum price (GMP) are responsible for all project costs exceeding the GMP. For this reason, it is imperative that contractors negotiate and incorporate into the GMP a financial buffer that accounts for the unanticipated project costs that are not reimbursable as change orders or costs of the work. This is where the contractor's contingency comes into play.¹

The contractor's contingency is a vehicle that allows contractors to mitigate some of the risks inherent in GMP contracts. When drafted properly, a contingency clause allows the contractor and only the contractor to access funds set aside by the owner to address unpredictable or unknown project costs.

A contractual contingency clause should, among other things, set a contingency budget, which is typically a percentage of the cost of the work, explain the procedure by which the contingency funds may be accessed, including through notices, backup documentation, and approvals, and, most importantly, define the purposes for which the contingency may be used. A well drafted contingency clause provides that the contingency fund is available only for the contractor's use, not the owner's, and lists all the costs that may be paid from the fund, including, for example, the following:

1. scope yet to be finally designed,
2. missed scope or estimating errors,
3. labor and material cost escalations,
4. acceleration expenses,
5. costs incurred to correct defective, damaged, or nonconforming work,
6. general conditions overruns, and
7. costs associated with subcontractor defaults.

While the decision as to what potential types of costs are included in the contingency clause will often be a point of serious negotiations between the contractor and the owner, the contingency clause usually provides that the contingency cannot be applied to fund work that would otherwise qualify for a change order. The contractor should harmonize the qualifications and exceptions from its bid estimates with the costs included in the contingency.

Quite often, the owner engages the contractor or construction manager when the project designs are still in the development phase. In this case, the contract may require that the contractor submit a proposed GMP to the owner once a certain percentage of the drawings is finalized and issued for construction. The size of the proposed contingency should reflect the extent to which the project scope has not been finalized.

Contractors must also be mindful of what happens to any unused contingency. Some contracts may incorporate a "shared savings" clause, which typically provides that any leftover contingency will be split, according to some predetermined allocation, between the contractor and the owner. Alternatively, some contracts may provide that unused contingency reverts back to the owner or some other funding source. Owners are generally receptive to including a shared savings clause into their contracts because it incentivizes contractors to dutifully monitor and control construction costs. Some contracts provide that the contractor's savings from the buy-out of the trades should be carried in the contingency, rather than reducing line items in the GMP.

Several things can go wrong if a contingency clause is not crafted carefully. For example, if a contingency clause does not clearly define permitted uses of the fund, the owner may feel entitled to use contractor contingency for its own purposes, including by paying for changes to the work. This can result in the premature erosion of the contingency fund, such that the contractor will have less money available to pay for unexpected or non-reimbursable project costs, forcing the contractor to go out-of-pocket. A similar issue can occur if the owner tries to negotiate a reduction of the contingency fund as the project proceeds, especially nearing completion. Contractors should be wary of this trap as all too often something does go wrong at the end of the project requiring significant expenditures of the contractor's own labor and money, such as a subcontractor default or the discovery of a latent defect in the work. A vaguely worded or ambiguous contingency clause may open the door to future disputes with the owner regarding access to the contingency and permitted uses.

In conclusion, having a contingency is in essence a risk management tool that all contractors working under GMP contracts should utilize. Contractors need to be both proactive in negotiating a well-defined contingency clause and mindful of the consequences resulting from improper implementation.

Footnote

1. Contingency is a concept that is different than the concept of allowance.  The latter is typically used only to cover the costs of items that are expected to be part of the project scope but have not yet been fully defined at the time of estimating in terms of quantity, quality, or design.  Also, the contractor's contingency is distinct from the owner's contingency, which is something that may be contained in the owner's loan agreements and is typically used to fund change orders.