Pricing construction goods and services during the pandemic has become a roll of the dice. Early manufacturing lockdowns and a downturn in the economy caused labor pools to shrink, and material production to slow. As construction recovered from the initial shock, demand began to outstrip supply, causing prices to soar. This phenomenon triggered breakdowns in several key sectors, including manufacturing, labor and transportation. The net effects on construction and other industries have been dubbed “supply chain issues.”
Inevitably, supply chain issues lead to price escalation and delays. When goods and services are more difficult to obtain, prices increase and delivery schedules are unreliable. Since October of 2020, steel prices have increased by more than 140 percent, gypsum products rose nearly 25 percent, and insulation jumped by 17 percent. In the transportation sector, trucking costs are up 16 percent, and fuel costs have nearly doubled. Scheduling issues are also becoming the norm. A local client recently shared that the wait for cabinets is 16 to 20 weeks, high end kitchen and laundry appliances are 6 to 8 months, and most furnishings are a minimum of 9 months.
Although the basic concepts of price escalation and schedule slippage are not new to owners or contractors, the confluence of supply chain issues and market volatility in the wake of COVID-19 have made it extremely difficult to guaranty firm completion dates or deliver projects under traditional fixed price models. Contractors are faced with the choice of building escalation risks into fixed pricing and potentially overbidding, or using current pricing and footing the bill for all post-contract increases. The choice can be equally vexing to owners who overpay in one scenario, and face significant cost overruns in the other.
The construction industry has addressed this dilemma by incorporating “price escalation clauses” into commercial and residential contracts. A typical clause entitles the contractor to a post-contract price adjustment when certain predetermined market conditions occur, resulting in significant increases in its cost of labor, equipment, materials or services. The clause may compensate the contractor for every dollar of the escalation, resulting in the lowest bid value to the Owner, or only for escalations reaching a certain minimum threshold, requiring the owner and the contractor to share the risk. Escalation compensation may also be subject to caps or percentage limits.
A well written clause will identify the covered categories of goods and services, a benchmark by which the escalation will be measured, any applicable threshold or cap, the mark-up for overhead and profit to be applied (if any), and how the request will be documented and supported by the contractor. After more than two years of dealing with supply chain issues, I do believe that owners and contractors appear to be settling into a cautious detente. Owners are learning that escalation clauses can bring initial pricing down, and that controls that can be written into these clauses to avoid uncontrolled exposure. Contractors are realizing that they can use escalation clauses to deliver competitive pricing in a very volatile market. As a result, if drafted thoughtfully, these clauses are not likely to draw as much fire from either side.
Unfortunately, the open-ended delays caused by supply chain issues can be far more problematic than pricing issues. Originally, the industry turned to force majeure (FM) clauses for protection. FM clauses generally require the owner to excuse and grant schedule extensions for delays caused by circumstances that are beyond the contractor’s control. In traditional form, however, FM clauses require the conditions causing the delay to be unforeseeable and provide no compensation for the delays to either side, regardless of how long they continue. Moreover, FM clauses are often unclear on whether the contractor can demobilize during the delay to pursue other work, or whether it must “stand by” and attempt to make progress in where possible.
The alternative to FM clauses is somewhat counter-intuitive because it requires resort to the suspension and termination provisions of the contract. The risk of damages flowing from a termination is difficult to justify unless victory is clear. However, there are times when both parties would be best served by an escape clause that allows them to negotiate a proper end to, or hiatus from, the project as originally envisioned. This is particularly true when supply chain issues create a “cardinal change” in the nature of the work, or a substantial deviation in contract obligations so profound that it changes the nature of the bargain. Excessive schedule delays can rise to this level.
Furthermore, although many standard contract forms do allow termination by the contractor under dire circumstances, these provisions usually require a government-imposed order to stop all project work. This rarely occurs and leaves the contractor subject to many scenarios where it must continue despite extremely unfavorable circumstances. On the flip side, although the owner typically has the right to terminate “for convenience,” allowing it to walk away from the project for any reason or no reason at all, a hefty termination fee often applies to this decision. That result may not be fair where supply chain issues are responsible for the delay.
In light of these considerations, it makes sense to consider giving owners and contractors a contractual path to end or postpone the project where supply chain issues are likely to inflict undue hardship. This can be accomplished by adding or modifying suspension and termination provisions. A well drafted clause should narrowly define the circumstances under which a supply chain impact justifies suspension or termination, and how each party will be protected without creating unwarranted financial windfalls or pitfalls for either side. This saves the parties from a Hobson’s choice between continuing forward during a costly and indefinite delay, or pulling the trigger on typical termination clauses which are designed for a default scenario and often lead to punitive results.
In short, triumphing over supply chain issues requires a creative contract negotiation process. Heavy-handed penalty clauses and draconian pricing policies simply do not work. The goal is to leave both sides with some flexibility to decide their own fate when supply chain issues confound pricing and progress expectations. This motivates the parties to resolve supply issues fairly and preserve their mutual interest in completing the project, without risking financial ruin.