Unenforceable? Not All Clauses in Your Contract Are a Lock

It is not unusual to see contracts in the construction industry that shift risks downstream. Especially in markets where new projects are scarce, subcontractors often have little leverage to modify unfavorable contract provisions dictated by the project owner or general contractor. In some instances, this has prompted legislatures to pass a variety of statutes designed to level the playing field. Examples include "prompt payment acts" (which are designed to protect subcontractors from slow payers), anti-indemnity acts and other "construction fairness" legislation. Additionally, in individual cases, courts have imposed exceptions to specific types of contract clauses, effectively limiting some types of liability.

It's important to have a handle on these risks since the effect of including voided or unenforceable clauses in a contract could void an entire section or even, in some cases, the entire contract. In short, knowing these rules and their trends can be critical.

1. Pay If/When Paid Clauses

There are two primary conditional payment clauses: "pay-if-paid" provisions and "pay-when-paid" provisions. Such clauses provide that the GC is under no obligation to pay its subcontractor or supplier unless (or until) the GC is paid by the project owner.

For example, if subcontractor A is not initially paid because of a dispute that has nothing to do with him-such as the owner's insolvency or the owner's holding payment from the GC because of subcontractor B's defective work-subcontractor A may never receive payment. Some subcontractors try to modify the clause to require that they be paid as long as the reason for the owner's refusal to pay the GC does not stem from inadequacies in the subcontractor's work. Often, though, subcontractors lack the leverage to negotiate these clauses.

However, some state courts do not favor and/or will not enforce these clauses. Other courts reinterpret them, holding they merely require the subcontractor to wait a "reasonable period of time" for payment. In other words, if the GC does not receive his payment from the owner or does not make the payment to the subcontractor within that reasonable period of time, the GC is obligated to make the payment to the subcontractor. On the other hand, some state courts enforce these provisions and make the subcontractor the ultimate banker. However, a growing minority of states have held pay-if-paid clauses to be unenforceable, declaring that by preventing payment to the subcontractors these clauses go against mechanic's lien statutes.

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2. Change-Order Clauses

One of the greatest sources of construction litigation is making claims for additional compensation. These claims are often based on change requests that are performed and then subsequently denied by the GC, architect or owner as not being required in the end since the work completed was within the scope of the original project. Most clauses require that change orders be approved in writing in advance and impose a number of conditions, dispute resolution procedures and time limitations before claims for additional compensation be approved by change order.

Despite the general enforceability of such clauses, some courts recognize the difficulties that contractors face in the real world when they are directed to perform extra work and told not to wait for formal owner approval. Some courts recognize that the requirements for written agreement to change orders in advance can be waived by conduct. Courts may also allow claims for extras or orally directed work but require an elevated burden of proof. Depending on the circumstances, some courts may look closely at whether the contractor sent or obtained a written confirmation for an oral directive to proceed and the basis for compensation. Practically speaking, while such clauses are often included in contracts, in many instances it becomes a question of fact as to whether or not they are enforceable.

3. Anti-Indemnity Clauses

Typically, construction contracts require downstream parties (such as subcontractors) to indemnify upstream parties (like the GC) in the event of a lawsuit due to personal injury and property damage claims. Upstream parties typically seek such clauses by arguing that they should not be responsible when something goes wrong due to events primarily controlled by the downstream party. The argument goes that the subcontractor that installed the wood floor, for example, should be responsible for the resulting liability, not the owner or GC. It is not unusual, however, for construction indemnification clauses to require the downstream party to indemnify the upstream parties for any claim resulting from the downstream party's work-even where the downstream indemnitor had nothing to do with the acts giving rise to liability.

Many, but not all, state legislatures have responded to perceptions that upstream parties have too much leverage in these situations by passing what are known as "anti-indemnity" acts, which limit or void the effect of certain contractual indemnity clauses. The scope of the various anti-indemnity acts varies greatly. Some acts-known as "sole negligence" acts-void indemnity clauses that do anything more than make a downstream contractor responsible for its own sole negligence. Other anti-indemnity acts-known as "partial negligence" acts-are narrower and allow the contract to specify that the downstream party is required to indemnify the upstream parties if the indemnitee was a partial cause of the injury at issue.

4. Additional-Insured Clauses

Closely related to indemnification clauses are "additional insured" clauses. These clauses typically require the downstream party to include the upstream party as an "additional insured" on the downstream party's insurance-particularly on the party's commercial general liability insurance. This way, if an injury occurs, the upstream party can seek insurance under the downstream party's policy. In their broadest form, these clauses are not limited in any way. In theory, if anything goes wrong on a project, the owner could seek coverage under the GC and all subcontractors' policies regardless of whether the subcontractor, for example, had anything to do with causing the liability.

There are two potential problems with additional insured clauses. First, anti-indemnity acts increasingly bar such clauses or severely limit their application. Legislatures in some states have determined that upstream parties should not be able to force downstream parties to provide insurance. Second, and not surprisingly, insurers seek to limit and control their own exposure. Some contractors or subcontractors may not be able to add parties to their insurance or may only be able to do so on a limited basis.

5. Choice Of Law Clauses

Parties with leverage often impose "choice of law" clauses that allow them the protection of state laws with which they are most familiar. Similarly, they impose forum-selection clauses in their home states, creating cost and time impediments to claims and affording perceived "home court advantage" when claims are filed.In some states, statutes have been enacted prohibiting construction contracts from subjecting disputes to the laws of a state other than where the project is located. Similarly, mechanic's lien acts and other statutes often specify what court is to hear a construction dispute.

When it comes to the construction industry, there is a surprising lack of uniformity to fairly common contract provisions. Even within states, courts are less than uniform in their approaches, and many statutes and court decisions have left open critical questions about the enforceability of certain types of clauses. To craft an effective and enforceable contract for clients doing business in multiple states, a drafter must be aware of state-by-state nuances and trends. Every situation is different, but one must also keep in mind the practical realities of what is required in a contract. Contract provisions that no contractor or subcontractor can comply with or that result in extreme price increases may not serve either party's business interests.