As members of the construction industry are well aware, COVID-19 has created, and continues to create, production delays that have caused uncertainty in the availability and pricing of materials. Questions continue to be raised as to whether a contractor pursuant to a stipulated sum or guaranteed maximum price contract is entitled to COVID-19 related cost increases and/or schedule delays due to scarcity of supplies or has the right to terminate the contract.
While many cases are pending and have not reached a resolution in the New York Courts, some basic principles of contract law are likely to be the basis for claims by contractors across the country. Proactively keeping these principles in mind during contract drafting can mitigate the risk of such claims.
Such legal arguments include force majeure, impossibility/improbability/frustration of purpose, cardinal change or mistake of fact.
While a contract’s force majeure clause is commonly the first place to look for an extension of time to perform (See AIA A201-2017 §8.3.1), which may address some COVID-19 related delays, these clauses are not generally a basis for price increases or a loss of profitability claim.
Impossibility/improbability/frustration of purpose are recognized in unforeseen events that make performance impossible or impractical, but price escalations do not generally justify rescission of the contract. However, the commentary to the Uniform Construction Code (UCC) opens the door to a potential defense. UCC §2-615, Excuse by Failure of Presupposed Conditions, Comment #4 states:
“Increased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance. Neither is the rise or a collapse in the market in itself a justification, for that is exactly the type of business risk which business contracts made at fixed prices are intended to cover. But a severe shortage of raw materials or in supplies of major sources of supply or the like, which are necessary to his performance, is within the contemplation of this section.”
The recent decision in Cai Rail, Inc., v. Badger Mining Corporation, 2021 WL 705880 in the U.S. District Court for the Southern District of New York, offers additional insights:
- Frustration of purpose may offer a defense against enforcement of a contract when the reasons for performing the contract cease to exist due to an unforeseeable event that destroys those reasons. Cai Rail, Inc., v. Badger Mining Corporation, 2021 WL 705880, citing, Structure Tone, Inc. v. Universal Servs. Grp., 929 N.Y.S. 2d 242, 246 (App. Div 2011).
- “The frustrated purpose must be so completely the basis of the contract that, as both parties understood, the transaction would have made little sense.” Cai Rail, Inc. at 7, citingIn re Condada Plaza Acquisition LLC, 620 B.R. 820, 839-840 (Bankr. S.D.N.Y. 2020).
- However, it is not enough that the transaction has become less profitable for the affected party or even that the affected party may suffer a financial loss. Cai Rail, Inc. at 7, citingRockland Dev. Assocs. v. Richlou Auto Body, Inc., 570 N.Y.S.2d 343, 344 (App. Div. 1991).
- Impossibility can be a defense where the impossibility was produced by an unanticipated event that could not have been foreseen or guarded against in the contract but New York Courts do not excuse performance of a contract merely because the performance would be economically difficult or unprofitable to perform. Cai Rail, Inc. at 7, citing Kel Kim Corp. v. Cent. Mkts., Inc., 70 N.Y.2d 900, 902 (1987).
The time at which the contract was entered into could also impact defenses regarding cardinal change or mistake of fact.
How these cases and theories apply to COVID-19 related delays and shortages are yet to be fully understood.
Attempting to mitigate these issues in contract drafting is essential. Here are some suggested terms:
- Identifying materials susceptible to volatility
- Determining a market index or other measure of volatile pricing which the parties can use to determine escalations that would entitle the contractor to relief
- Limitations on time for fixed prices
- Price escalation clauses (any increase, threshold and/or delay)
- Allowances or contingencies
- Payment/performance bonds or subcontractor default insurance
- Owner entitlement to reduction if there is a significant decrease
After contract execution, good practices include: routine monitoring of costs and pricing; allowing for potential early purchases (consider offsets for storage costs); and good communication between the parties regarding notice of market changes.
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