Material Cost Escalation: Who Bears the Cost Now? And, What Can Be Done to Address the Problem in the Future?
While an increase in construction costs for materials is not new to the industry, the extent of the cost increases during this COVID-19 time may be beyond anyone's experience. Prior to COVID-19, material costs have spiked for many products, such as oil, asphalt, concrete and plywood. Those cost increases may have arisen from certain tragedies involving Mother Nature's hand, such as flooding, hurricanes, fires and tornadoes. In other instances, increased costs may have been prompted by tariffs recently implemented over the past few years by governmental actions. In each case, the increased cost is usually unforeseen and the parties are faced with the basic dilemma: who should bear the cost of the increased costs? Owner? Contractor? Subcontractor? Or, some or all of the above?
With the COVID-19 pandemic, the increased costs and delays appear to affect far more materials than ever before. Beginning in early 2020, construction projects are facing increased costs with structural steel, lumber, copper, plumbing and electrical materials. There is no uniform assessment as to the degree of increase in prices, which have ranged from 25% for tariff-affected materials to more than 70% to 300% for lumber. Some have observed that structural steel has increased by more than 250%.
Coping with Cost Increases and Delays on an Existing Project
A common scenario now involves a construction client who calls and asks two essential questions: (1) who must bear the brunt of the increased cost for a particular material; and (2) whether the increase can be passed on to other parties associated with the project. The construction lawyer's first response should be: "What does your contract provide?" Indeed, the first step in any analysis must start with the contract that the parties negotiated (or maybe just blindly signed) at the outset of the project. Does the prime contract or subcontract include a "force majeure" clause? (For those new to construction contracts, the title "force majeure" may not appear in the body of the contract but the concept is often present.) The French term "force majeure" means a "greater force" and usually excuses delays experienced by a contractor or subcontractor when the delays are unforeseen and caused by reasons beyond their reasonable control. A common example of a force majeure clause is found in AIA Documents A201, in the underscored portion of Section 8.3.1 below:
§8.3.1 If the Contractor is delayed at any time in the commencement or progress of the Work by (1) an act or neglect of the Owner or Architect, of an employee of either, or of a Separate Contractor; (2) by changes ordered in the Work; (3) by labor disputes, fire, unusual delay in deliveries, unavoidable casualties, adverse weather conditions documented in accordance with Section 126.96.36.199, or other causes beyond the Contractor’s control; (4) by delay authorized by the Owner pending mediation and binding dispute resolution; or (5) by other causes that the Contractor asserts, and the Architect determines, justify delay, then the Contract Time shall be extended for such reasonable time as the Architect may determine.
Would delays and dramatically increased costs in materials caused by COVID-19 be covered by this contract clause in one of the most common contract templates in the construction industry? First, stating the obvious—this clause does not expressly refer to COVID-19 nor does it refer to "epidemics" or "pandemics." (These words may be found in other published templates.) Because the provision in this instance makes no mention of the pandemic, should the contractor's or subcontractor's delayed performance be excused because of a COVID-19-caused event? There is no black and white answer in this regard.
Some would argue that the use of the word "unusual" in Section 8.3.1 means that the event must be unforeseen and that the COVID-19 events are NOT unforeseen or "unusual" because all parties in the construction industry have been dealing with COVID-19 for a long time, at least since the President declared the Coronavirus to be a pandemic on March 13, 2020. The argument continues that, since COVID-19 is a known event, experienced contractors and subcontractors should have learned how to address the risk of cost increases by locking down quotes from suppliers or advanced ordering of materials.
Many would argue, though, that the pandemic need not be expressly mentioned in the provision and that it should certainly qualify as an "unusual delay…. or cause beyond the Contractor's control." This is an important delay claim for the contractor or subcontractor to submit, particularly if the contractor or subcontractor faces the risk of a liquidated damage assessment. But an extension of contract time may be the only remedy available to the contractor or subcontractor under this provision. The potential for an increase in the contract sum is not mentioned here and its absence may be damning to a contractor's request for increased compensation, unless the remedy of increasing the contract sum was negotiated into the contract.
It is important to note, however, that Section 8.3.1 may refer to only contract time extensions but it does not absolutely bar requests for increased costs. Indeed, Section 8.3.3 provides:
"§ 8.3.3 This Section 8.3 does not preclude recovery of damages for delay by either party under other provisions of the Contract Documents."
As such, the request for increased cost recovery may still be submitted provided that the subcontractor's or contractor's claim complies with the applicable notice provisions in the contract. In addition, the claimant should consider submitting the claim in the in the form of an equitable request for additional compensation as discussed below.
If the contract provides no relief to the contractor or subcontractor for significantly increased costs, an equitable argument must be presented to deal with the facts at hand. The subcontractor may be placed in such a position that it is not able to perform its duties under its subcontract if it is forced to bear the burden of all increases in costs. Obviously, an assumption of a 300% increase in materials would likely put many subcontractors out of business. If a subcontractor walks off the project for that reason, the project will likely face substantial delays and increased costs that others would have to bear if the project is to continue and if there is no performance bond relief available.
The subcontractor should consider making a very prompt request for equitable adjustment in compensation under the doctrine of impracticality or impossibility to address the increased costs. The equitable claim should be submitted to the tier contractor above it so that it can be processed up the contracting chain. The claim must emphasize that the dramatic increase in costs is unforeseen and renders the subcontractor's performance an impossibility and that the increased costs will negatively impact the subcontractor's ability to successfully and timely perform if no relief is provided.
The net result of the increase and the subcontractor's inability to perform can cripple the completion of the project, which is not in the best interest of any party to the project. Through timely communication among the parties, there may be acceptable alternatives to avoid a shutdown to the project. Perhaps other materials can be used? Perhaps there can be a sharing in the cost? Perhaps design changes can be made?
The courts have reviewed whether dramatic increases in cost of materials will excuse performance by a contractor but jurisdictions vary as to the outcome. On the excused performance side, consider the analysis by the New York court in Moyer v. City of Little Falls, 134 Misc. 2d 299, 301–02, 510 N.Y.S.2d 813 (Sup. Ct. 1986), and its observation and ultimate conclusion that:
[T]here is a growing trend that performance should be excused (1) if governmental action or other contingencies create a substantially unjust situation totally outside contemplation of the parties and (2) which an experienced draftsman would not reasonably anticipate. In this instance, it is stipulated that the 666% price increase [in dumping costs at the required landfill] was not and could not have been within the contemplation of the parties. Such a massive cost escalation is 'excessive' as a matter of law and future performance by plaintiff must be excused.
In Pennsylvania, in Aluminum Co. of Am. v. Essex Grp., Inc., 499 F. Supp. 53, 70 (W.D. Pa. 1980), new regulations for oil and pollution control dramatically increased the seller's smelting costs and would have caused the seller to lose more than $75 million during the life of the contract while the buyer conversely stood to gain a windfall profit. The court found that regulatory changes of this sort were an unforeseen supervening circumstance, not within the contemplation of the parties at the time of contracting. To the relief of the seller, the court found that the seller's performance became commercially impracticable.
By contrast, some courts in the Eighth Circuit have found that even excessive increases would not excuse performance by a contractor. In Iowa Electric Light and Power Company v. Atlas Corporation, 467 F. Supp. 129, 140 (N.D. Iowa, 1978), the U.S. District Court for the Northern District of Iowa held that an increase in seller's costs by 52.2%, resulting in the seller's loss of approximately $2,673,125.00, failed to constitute commercial impracticability, and precluding judicial adjustment or discharge of the contract for supply of uranium concentrate. In making such a determination, the court noted that cost increases of 50-58 percent had generally not been considered of sufficient magnitude to excuse performance under a contractual agreement. Iowa Electric was cited shortly after by Missouri Pub. Serv. Co. v. Peabody Coal Co., 583 S.W.2d 721, 726 (Mo. Ct. App. 1979), where the Missouri Court of Appeals for the Western District found that an escalation in costs did not render the contract "commercially impracticable" or excuse the contractor's performance: "[i]ncreased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters [t[he essential nature of the performance."
Proactive Steps for Future Projects
For new projects and new contracts, contractors and owners should consider discussing how the risk of cost escalation can be minimized or shared in the future. If past contracts did not provide any answers, a price escalation clause is often discussed for future contracts. The clauses come in all shapes and forms. Frequently, the clause describes a certain limitation or percentage guideline as to when a cost increase will be considered significant enough for cost relief. Consider the following:
Cost Escalation: In the event of significant delay or price increase of material, equipment or energy occurring during the performance of the contract through no fault of Contractor or its subcontractors, the contract sum, time of completion or contract requirements shall be equitably adjusted by change order in accordance with the procedures of the contract documents. A change in price of an item of material, equipment, or energy shall be considered significant when the price of an items increases ___% or more between the date of this contract and the date of installation. If the increase in price is at least ___%, but less than ___%, the equitable adjustment shall be based only on the amount of increase or decrease greater than ___%, but if the price increase is ___% or more, then the equitable adjustment shall be based on the entire amount of the price increase. If Contractor makes a request for an equitable adjustment to the contract price based on an increase in price, Contractor shall be required at that time to disclose its original price that has increased.
Richard A. Stockenberg, Material Price Escalation Clauses, as contained in The Anatomy of a Construction Contract, The Missouri Bar 2004.
Contractors may find some owners unwilling to consider a price escalation clause. From an owner's perspective, the owner will expect the contractor or its subcontractor to take all necessary steps to control material costs at the outset of the project. These may include:
- Requiring the contractor or its subcontractors to purchase materials in advance.
- Requiring the contractor or its subcontractors to "lockdown" the price with its supplier.
- If a supplier is unwilling to lock down its pricing, an owner would expect the contractor or subcontractor to shop with another supplier. The problem with this alternative is that the market is changing and a growing number of suppliers are unwilling to lock down pricing for an entire project and will sell their materials at whatever price may exist at the time of the delivery.
To counter an owner's refusal to consider a cost escalation clause, a contractor may include a very healthy contingency in its bid to accommodate the fluctuation in material costs. Is this what the owner wants?
The circumstances for recovery or rejection of increased costs in an existing project or drafting of an escalation clause for future contracts will require consultation with an experienced construction lawyer. Please contact Stinson for questions and assistance with these matters.