Contracts Can Provide Protection From Escalating Prices

If you work in the construction industry and you aren’t familiar with the impact of price escalation, chances are you are about to learn.

It’s hard to make sense of the so-called “trade war” between the United States and China, and the economic forces in play are complex. But in essence, reports are that the events of past months are continuing to impact building costs in the United States.

President Trump and his administration have imposed tariff increases on certain Chinese goods in a claimed effort to boost the United States’ economy. As several news outlets have reported, Trump started with a 10 percent increase on certain Chinese products; then on May 10, he announced an increase from 10 percent to 25 percent on products like electronics, clothing, and seafood. A May 14 Los Angeles Times story reported that the tariffs had already added $1 billion – a number that could increase to $2.5 billion – to the annual cost of housing construction due to price increases in Chinese granite, cement, vinyl floor coverings, waferboard, tile, and stainless steel. Some roofing materials, like aluminum, are projected to cost more in the near future, too. (See, for example, BBC News’ May 10 article “Trade wars, Trump tariffs, and protectionism explained.”)

The Los Angeles Times’ prediction was that cost increases would be borne by American consumers investing in housing and construction. But the only thing that truly allocates risk of price increases will be contract terms.

And this gets us back to why we care about material price escalation and how players in the construction industry can assert some control over what are, at their core, factors beyond their control.

None of us can control what President Trump says, does, or tweets, or what China does in response. But if parties think about these issues before entering into construction contracts, they can at least know who will bear the risk of these types of increases and try to prepare accordingly. Although factors like federal economic policy and market forces can impact material prices, who bears the cost of these increases in a commercial setting is solely dependent on the parties’ contract terms. 

Assessing Risk in Pre-Existing Contracts for a Fixed Price

If standard-form construction agreements, like AIA or ConsensusDocs contracts, are a guide, then contractors and subcontractors will probably bear the risk of material price increases in contracts to which they are already a party, assuming they are contracts for a fixed sum or guaranteed maximum price. (Of course, cost-plus agreements will give contractors much more potential to recover for price increases.) Although price escalation can be addressed in provisions on contingencies — percentages of the contract value set aside for unpredictable changes in the work — unless the agreement specifically mentions price increases or escalation, contractors probably are not entitled to an increase in a fixed contract sum due to price escalation.

To understand the legal significance of a price escalation claim, it is important to understand the distinction between changes in scope of work and changes in price. Nearly all standard-form construction agreements provide for how “changes in the work” will be handled. For example, AIA A201 (General Conditions of the Contract for Construction) provides in §7.3.1 that “the Owner may … without invalidating the Contract, order changes in the Work within the general scope of the Contract consisting of additions, deletions, or other revisions, the Contract Sum and Contract Time being adjusted accordingly.” However, because per §1.1.3 the term “Work” includes “all … labor, materials, equipment, and services provided or to be provided by the Contractor to fulfill the Contractor’s obligations,” contractors will not be entitled to an increase in the contract sum unless there is a change in the scope of the work or materials themselves.

Addressing Price Escalation in Future Contracts

Because price escalation claims don’t fit neatly into most standard provisions on change orders or equitable adjustments, parties who want to reduce their risk with respect to material price increases should explicitly address the issue when negotiating contracts. Contractors can do this by considering cost-plus contracts, inserting a price escalation clause into fixed-price agreements, or simply increasing the contract sum in an attempt to protect themselves in the event of price increases.

Cost-plus contracts could be a useful tool for contractors hoping to shift away, or more evenly distribute, the risk of higher material costs. While most cost-plus agreements will still contain a guaranteed maximum price that potentially won’t cover builders for all price increases, these arrangements still probably give contractors greater ability to pass cost increases to owners than fixed-price agreements. Because these contracts charge owners for the cost of labor and materials plus a fee, owners can also benefit from any decreases in material costs. Negotiating a guaranteed maximum price may also allay owners’ concerns about rising costs.

In fixed-price agreements, parties who want to address material cost issues should likely insert clauses that either condition the contract sum on material costs existing at the time of the contract, or clauses explicitly entitling them to make a claim for additional payment in the event of price increases. Such provisions might be more appealing to owners if they similarly entitle owners to the right to reduce the contract amount in the event of material price decreases.

If price escalation clauses are based upon time, they should specifically state the date through which the contract sum can be guaranteed. They should then specify how a contract increase, if any, should be imposed so that the parties will have a clear understanding of how a new price will be calculated. If provisions are contingent not on time but on the amount of the price increase, they should address how much of a cost increase is actionable — for example, a clause could apply to material cost increases of 3 percent and above — and should explicitly state what documentation is required in order for the contractor to make a claim for increases. In anticipation of making such a claim, contractors should consider preserving documentation of prices as they exist at the time of bid so that they can prove that price increases in fact occurred later when they are asserting a claim for price escalation. With both types of clauses, providing cost savings for the owner in the event of a price decrease, or placing some limit on the ability to claim an increase, could be crucial to making a deal with owners.

About the author: Caroline Trautman is an attorney with Oak City Law, LLP, based in Durham, North Carolina. Questions about this article can be directed to her at [email protected].

Author’s note: This article does not constitute, and should not be construed as, legal advice on any particular scenario. For specific advice, consult with an attorney licensed in your state.