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August 23, 2018
The United States' strong economy and consumers' demand for residential, commercial and industrial projects have provided the construction industry with ample development opportunities. However, President Trump's new tariffs and ongoing trade negotiations concerning building commodities like steel, aluminum and lumber have resulted in uncertain market conditions, which make it nearly impossible for owners, developers, contractors and suppliers to accurately analyze and allocate risks during contract negotiations.
This article provides owners and developers with a brief overview of the new tariffs on building materials and the key contract provisions they should review and revise to hedge against the risks associated with the uncertain market conditions.
By way of background, on March 8 President Trump issued proclamations 9704 and 9705 on adjusting imports of steel and aluminum into the U.S. under Section 232 of the Trade Expansion Act of 1962, providing for additional import duties for steel and aluminum products, effective March 23.
On April 30, the President issued proclamations 9739 and 9740. Notably, Trump's trade negotiations have resulted in a 25 percent duty for certain steel products, and a 10 percent duty for certain aluminum products.
Generally, second quarter earnings reports showed that domestic manufacturers and suppliers benefited from the tariffs because of the increased demand and price of their products. Likewise, downstream parties are still showing healthy growth margins despite the tariffs and increased labor and transportation costs.
Regardless, project owners and developers are wary of these developments and naturally want to understand how provisions in their construction contracts can mitigate risks regarding sudden changes in market conditions and escalating material costs.
Developers should pay special attention to the price escalation, change-of-law, and force majeure provisions in their construction contracts.
Traditionally, contractors have employed these provisions for their own benefit. However, these provisions can and should be revised to protect the interests of owners and developers given ongoing trade negotiations. The time spent considering the allocation of risk under these provisions will likely pay great dividends in the future, especially if the price of materials continues to be volatile as we progress into the third quarter.
Escalation clauses are a developer's first defense to dramatic changes in the price of materials.
Most veteran developers first encountered escalation clauses after the price of oil increased 260 percent between September 1973 and March 1974. In response, escalation clauses became common place in many construction contracts.
Since then, these provisions have been popularized by their ability to hedge against spikes in the cost of steel, wages and asphalt.
While the organization and operation of these clauses vary, escalation clauses generally operate to increase the contract price for materials based on either the difference between the bid price and the final price or a previously selected price index, such as the consumer price index.
Parties on both sides can benefit from the application of an escalation clause because it allocates risk and increases predictability in the face of changing market conditions. However, escalation clauses usually serve the interests of the contractor.
To counter, developers should aggressively negotiate for minimum and maximum limits on escalation. Then the contractor will bear the risk for all price increases within a certain range, and the owner will be protected from exorbitant price jumps.
Change-of-law clauses may also be used to defend against significant changes in the price of materials after construction has started.
Most major form documents do not address subsequent changes in applicable laws. Generally, all major construction contracts should include a change-of-law clause to allocate the risk of price escalation because of newly enacted tariffs that increase the price of building materials.
Developers should work with their attorneys to draft a broad definition for change-of-law that encapsulates more than the status quo. The best definitions consider changes in all laws — at the city, county, state, federal and international levels — by implementing language like “all statutes and regulations applicable to the project.”
If drafted correctly, the party asserting the provision will have a colorable argument that the at-risk party bears the burden of price escalation.
In addition to the broad definition, developers should be sure to include language that defines when the risk allocation takes effect. The best effective dates for change-of-law clauses are either post-bid or post-execution because they are nearest in time to the date of the bids the parties relied on when negotiating the contract.
Force majeure clauses
Finally, force majeure clauses provide developers with another defense to ongoing trade negotiations.
Typically, force majeure clauses allocate risk between the parties by allowing a contractor to either suspend or terminate its performance under a contract because of an “unanticipated” or “unforeseeable” event, such as acts of God, wars, strikes, government actions and tariffs.
Like the change-of-law provision, broad language should be implemented to capture all force majeure events, including the imposition of new tariffs on materials from foreign countries.
In addition, developers should check to see if the force majeure clause provides the invoking party with only more time, as opposed to more money. Obviously, in the case of a new tariff, the parties will be focused on the latter.
Early in the contract negotiation process, developers should consult with their attorneys about the status of current and pending tariffs, and how to revise the provisions in their construction contracts to combat changing market conditions that could potentially derail an otherwise successful project.
When escalation, change-of-law and force majeure provisions allocate risk correctly, developers can continue to meet the market's increasing demand for property developments. Seasoned developers know that successful contract administration and project completion is dependent on the quality of the original contract documents.
Carefully crafted construction contracts should be treated just like any other investment in the project to ensure a favorable result for all parties involved.
Loni L. Hinton is an associate attorney in Stoel Rives' Seattle office and practices with the firm's Construction and Design group. Hinton assists clients with risk management, contract drafting and negotiation, course of construction disputes, and construction defect claims.