The Cost-Benefit Analysis of One-Sided Contract Terms
The design and construction process always has been a high-risk proposition.[i] Owners rely on economic assumptions that, if incorrect, will undermine the viability or value of a project. Contractors estimate significant costs in a competitive market, sometimes resulting in thin margins that can be easily eroded by unknown circumstances. And design professionals are tasked with creating a design for a physical project out of ideas or programmatic criteria. There is a lot at stake for all project participants.
Such development, construction, and design risk is managed, at least initially, through the terms of the contracts that regulate the relationships between the principal parties involved in the project; conferring rights and delegating duties which then reverberate throughout the web of contracts subsequently formed to carry out different aspects of the project. Prime contractors delegate to subcontractors, who delegate to lower tiers, and so on. It all must be coordinated, preferably in a consistent and efficient manner.
Nonetheless, drafters of contracts and their clients often are inclined to transfer broad risk to the other party to a contract. Moreover, the risk transferred frequently grows each time it is allocated to a downstream party. That approach is easy and almost seems perceived as providing some sort of talismanic protection to the party that transfers the risk away (or at least is thought to provide the basis for a really strong claim if things go awry). Unfortunately, the reality of project risk rarely is that simple. Project risks and the resulting financial consequences are very hard to predict, and project participants do not eagerly accept the transfer of such burdens.
At some point, transferring risk creates one-sided contract terms. The magnitude of a particular risk, or the sheer volume of risks, transferred to the other party can be perceived as excessive. When that imbalance occurs, however, can be a matter of perspective.
For example, many construction contracts contain a so-called no-damage-for-delay clause. Such a clause provides that the contractor’s sole remedy for any delay not caused by the contractor, such as a force majeure event, is an extension in contractual time periods. The clause will prohibit, or at least limit, the contractor’s right to additional compensation.
Contractors contend such clauses are one-sided and unfair, as additional costs and expenses are a common and almost inevitable result from a delay in performance of the work. Why should the contract prohibit the right of the contractor to recover such costs and expenses that are not its fault? Owners on the other hand, see such clauses as a bargained for allocation of risk that isn’t caused by either party.[ii]
Clearly, one’s vantage point contributes to whether contractual terms are perceived as fair. Despite the challenges of perspective, contractual provisions that possess the following characteristics are more likely to trigger a negative reaction and be viewed as one-sided:
- transferring risk that can’t be well managed by the party to which it has been transferred (e.g., shifting design risk to a contractor);
- imposing very high liability for failure to perform adequately (e.g., excessive liquidated damages for delay);
- transferring risk that cannot be priced with certainty (e.g., responsibility for unknown concealed conditions);
- forfeiting rights that otherwise would be available under the law (e.g., waivers); and,
- allowing one party to exercise discretion in an abusive way (e.g., unreasonable approval rights).
Whether the benefit of transferring risk through one-sided contractual terms outweighs the potential for adverse consequences is a question worth considering. Surprisingly, little has been published on the topic and much of what has been written is largely anecdotal — although still instructive. For example, the American College of Construction Lawyers conducted a short survey among experienced construction lawyers to probe whether one-sided contractual terms in a construction contract likely would produce adverse consequences (the “ACCL Survey”).[iii]
The lawyers responding to the ACCL Survey self-identified as representing principally contractors, principally owners, or both on a reasonably frequent basis. The ACCL Survey was admittedly unscientific, and the 145 responses may not be considered statistically significant. Nonetheless, while perhaps not conclusive, the resulting data is interesting.
The vast majority of respondents, regardless of the group to which they self-identified, believed that including one-sided terms in a construction contract is likely to have negative ramifications. The responses to survey questions, and additional comments provided by those responding, consistently identified certain problems that one-sided contract terms produce, including the following:
- contractors will increase prices to fund contingent or unknown risks;
- one-sided provisions will discourage contractors from bidding on a project, creating the possibility that only less qualified contractors, or those that don’t fully comprehend the risk, will participate in the procurement;
- the naturally adversarial relationship between the owner and contractor will worsen, resulting in unproductive or wasteful behavior taken to protect against risk;
- an increased likelihood of claims;
- escalation in transaction costs because of the time spent in reviewing and negotiating contractual terms.
The above list summarizes how a contractor might react to terms that excessively favor the owner, but the converse is also true. Terms that excessively favor the contractor will cause an owner to react negatively. For example, an owner may expect a significantly lower price when the owner retains risk that a contractor limits or simply won’t accept, or may be less inclined to work with a contractor that insists on terms that the owner perceives as unfair.
The magnitude of likely adverse consequences is not easily estimated. The quantum of a risk contingency may depend on numerous factors, such as specific contract terms and market conditions. Respondents to the survey, however, appear confident that a premium will be paid for any unbalanced risk transfer.
No lawyer, and likely no client, questions the need to address risks associated with a transaction and to allocate responsibility and liability for the consequences that arise from those risks. But when contracts allocate risk through one-sided terms, the benefits may not outweigh the potential for adverse consequences. Although those consequences are difficult to quantify when a contract is drafted and negotiated, the responses to the ACCL Survey certainly question the wisdom of automatically employing one-sided contract terms and failing to evaluate the potential adverse consequences.
There also is another side to this equation that often is ignored. Although perhaps unintended, contract terms might presume the failure. Indeed, the use of one-sided terms surely confirms that such contracts focus on the consequences of the failure to perform adequately. That is understandable and even appropriate to some extent, but such considerations should not come at the expense of using the contract to facilitate successful completion of a transaction or project.
Indeed, one professional organization periodically conducts a study to identify the most heavily negotiated contract terms, as well the contract terms that bear most directly on the success of the transaction.[iv] While the study involves numerous commercial sectors, the results don’t distinguish among sector (other than most renegotiated terms) or jurisdiction. Yet the overall tabulations appear consistent with experience common in the what the study refers to as the Engineering/Construction sector.
Not surprisingly the most negotiated terms generally pertain to liability, such as limitations of liability, indemnification, liquidated damages, and termination. The same study, however, also identifies the terms that are most important for a successful outcome as pertaining more to the commercial relationship, such as scope and goals, price and changes, time/delivery, service levels, and responsibilities of the parties,
That is revealing and warrants further thought. Why is there such a disconnect between the time and effort in drafting and negotiating certain liability terms that may never come into play as compared to those terms that may bear directly on a successful outcome? Indeed, there are circumstances where risk transfer and even one-sided contractual terms are appropriate. But, adopting such terms should not be reflexive. There is a price to pay when using such terms, not the least of which might be forfeiting the opportunity to describe and allocate responsibility for a transaction that facilitates its success.
Ross J. Altman is Senior Counsel with Laurie & Brennan LLP, based in Chicago, IL. He is a Fellow in the American College of Construction Lawyers (former member of the Board of Governors) and an adjunct professor at the University of Miami School of Law.
This article is based on an earlier version published September 14, 2017, in the Contracting Excellence Journal of World Commerce & Contracting, which was a summary of the original version co-written by Ross J. Altman, Jeffrey R Cruz, and Peter C. Halls, published in the Journal of the American College of Construction Lawyers, Vol. 11, No. 1 (Winter, 2017). The Journal is available on Westlaw, where issues may be viewed and searched in the Westlaw database ACCLJ.
[i] Examples of projects gone very terribly wrong are plentiful and hardly a recent occurrence. In fact, the history of the design and construction of the Parthenon in Athens, Greece over 2,400 years ago demonstrates that design and construction risks such as cost overruns, design errors, construction defects, and delays are not a new phenomenon, and are simply endemic to the process. See Mary Beard, The Parthenon, Harvard University Press, 2003.
[ii] Another example are clauses that convert a wrongful termination for cause by the Owner to a termination for convenience (assuming the contract provides the Owner with such a right). Owners often view such clauses as simply logical, because the Owner could always have terminated for convenience. Contractors on the other hand point to the negative consequences of a termination for cause (e.g., damage to reputation, obligation to make disclosures, harm to relationship with sureties), and find it unfair that an Owner gets a free pass for improperly causing such problems.
[iii] See earlier version published September 14, 2017, in the Contracting Excellence Journal of World Commerce & Contracting, which was a summary of the original version co-written by Ross J. Altman, Jeffrey R Cruz, and Peter C. Halls, published in the Journal of the American College of Construction Lawyers, Vol. 11, No. 1 (Winter, 2017). The Journal is available on Westlaw, where issues may be viewed and searched in the Westlaw database ACCLJ.
[iv] See Most Negotiated Terms 2022, World Commerce & Contracting (supported by Icertis), https://www.worldcc.com/Resources/Content-Hub/View/ArticleId/11463/Most-Negotiated%C2%A0Terms-2022-%C2%A0Negotiating-in-a-time-of-turmoil, last accessed February 20, 2023.