Cost Escalation - Are You Ready? Contract Tune Up for 2022

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Snell & WilmerLooming large on the 2022 construction landscape horizon is the specter of cost escalation claims. Over the past year, rising prices have become extreme, and the clauses governing cost escalation have come under greater scrutiny as the construction industry struggles with a series of impacts coalescing around challenges to cost predictability and stability. The emergence of Covid 19 in early 2020 is still with us. This has led to worldwide shutdowns, supply chains interruptions, material shortages, labor shortages, changing safety requirements and a rate of inflation of the likes of which has not been seen in the past 40+ years.

Construction industry players, including the owner, design, and construction management side, may want to spend time reading and reviewing their standard contracts with the view towards analyzing language addressing cost impacts and price escalation. The challenges will be with us throughout 2022. It is of vital importance that your contracts address cost escalation considerations; and, if your existing contracts do not address such considerations, you may want to address this issue forthwith by revising existing contracts.

The three most common types of cost escalation clauses are (1) any-increase escalation, (2) threshold escalation, and (3) delay escalation. An any-increase escalation claim entitles the contractor or supplier to reimbursement for the price increases that occurs after the execution of the contract. This type of clause typically attaches to specific types of materials and equipment which will likely have a benchmark and allowance associated with the specific material.

A threshold escalation clause allows for an increase in material cost up to a certain amount or threshold, whatever the parties agree upon which is usually a certain percentage. In the case of public works, a threshold escalation clause may be standard, set by the federal, state, or local government. In private works, it is what the parties typically negotiate.

The delay escalation clause entitles the contractor, or provider of services, to claim and recover for increased costs due to the delay in the project progress beyond a predetermined date or dates of work.

Importantly, without an express price escalation clause in your agreement or contractual right to recover increase costs grounded in law or governmental regulation, the contractor or service provider harmed by pricing increases will face a steep and difficult battle trying to recover increased costs on a fixed price contract. Furthermore, escalation clauses usually never allow a contractor to recover costs resulting from under bidding a job if the contractor chooses to not rely on information relevant to the bid preparation. Thus, a contractor or service provider may want to routinely thoroughly back up and support its bid or proposal price.

Best practices may include a bid sheet which estimates the price of the job down to the labor and material required. This bid sheet may then be supplemented with actual material invoices or quotes received for labor materials listed on the bid sheet or subcontractor quotations including those identified in change orders. You may want to obtain multiple quotations. The contractor may want to document proof of payment for purchased material and labor to demonstrate that it was paid for at the prices invoiced or quoted. Transparency is usually your best option, so you may want to document carefully and thoroughly. Generally, the more transparent you are in providing documentation, the more persuasive your claim.

A contractor may want to be more proactive to avoid, or at least mitigate, any costs escalation in the current construction environment. Such proactive steps may include providing notice as soon as the project manager learns of longer than usual lead time for materials, or a significant increase. The contractor project manager usually should also promptly request a substitution, if possible. Document the process and submit change order requests for price increases. Included in this documentation should be the price on which the bid was based to establish the delta in cost. Comply with your claim notice requirements.

You may want to be proactive and review your time extension, cost escalation, and force majeure extension clauses now. There’s usually no advantage to waiting until a problem arises to understand what your options are. It is still too recent in the current era of COVID-19 to expect much in the way of relevant legal cases to guide your analysis and decision making so there is a greater element of unpredictability of who bears the risk. If the specifications include a clause that provides for change orders when there is a “change in the character” of the work, this type of generic language may provide a good argument for justifying additional payment. Certainly, many of the supply chain issues have completely altered the nature and character of the work in terms of acquiring materials and equipment.

There may be other possible avenues for recovery of extreme cost increase including a cause of action for breach of the covenant of good faith and fair dealing implied in all contracts. This theory will not relieve a party from performing contractual obligations because the contract is no longer profitable; however, it may prevent parties from acting in bad faith in dealing with these cost escalation problems.

Two other legal theories which may be useful to potential avenues of recovery include commercial impracticability and frustration of purpose. With commercial impracticability, a contract is commercially impracticable because performance would cause extreme and unreasonable difficulty, expense, injury, or loss to one of the parties. This is usually a difficult burden to prove. Just because it may cost a lot more to do the work does not mean the doctrine of commercial impracticability will apply. Similarly, there is the doctrine of frustration of purpose of contract. This legal theory allows the court to excuse an obligation to perform under the contract if the contractor can no longer achieve its purpose for the transaction and the contractor did not cause the frustration of performance. Basically, the frustration must be so severe that completing the transaction makes little sense. In either case, commercial impracticability, or frustration of purpose, you may be able to recover the cost incurred in attempting to perform the contract. However, these generally are difficult legal theories to prevail upon and there is no guarantee of recovery. They also typically only apply to cases of extreme or monumental cost increases.

Be proactive. You may want to review your contracts now and take the time to learn and understand both the content and application of any potential cost increase recovery mechanisms in your agreements. Going forward, you may want to confirm that any new contract you are about to enter addresses cost escalation. The threat of extreme cost escalation disruption may be with us for some time so you may want to get prepared now.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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