Contracts: An Important Tool for Minimizing Risk in Construction

Minimizing risk involves doing everything within your power to diminish the possibility of an unfavorable circumstance and its probable effects. 

The ability of construction contractors, subcontractors and clients to manage risks contributes largely to the success of a project. To minimize risk, you can manage a foreseen risk to the point where its probability is greatly reduced by allocating it to the party that is best equipped to bear it. 

Construction contracts are a very important tool for minimizing risk. They should be carefully prepared and reviewed; ideally, they must contain allocation of risk responsibility. 

Four Ways to Minimize Risks Using Construction Contracts

1. Assign Risk to the Party Most Suited to Control It 

The construction industry is subject to more risks than most other industries. When it comes to drawing up a contract, risks should be assigned to the party in the most favorable position to control it. Before a project commences, a client and a contractor are expected to make provisions for potential risks and assign the responsibility for those risks to the suitable party.

It is common practice for parties involved in a contract to try to include provisions that distribute their corresponding risks or liabilities. Sometimes, these provisions can be ridiculously unexpected, so it is important that they be examined properly while conferring and creating a contract. 

In a situation where shareholders embark on a project to build a school and come up with specifications for the building, as the contractor you are allowed to assign responsibility for errors in design to the owner. 

At the completion of the project, the library or other rooms in the building may not be big enough to hold the number of students the owners had in mind. The owners assume responsibility for this occurrence because they are in direct contract with the designer or architect and are in the best position to minimize that risk. 

2. Thoroughly Review the Documents in a Construction Contract

To minimize risk in construction contracts, it is important to properly review the documents with suitable consultants. A contract review involves a rational analysis that aims to specify facts within the contract, and determine the practicability of the contract. 

Construction projects are usually characterized by multiple contracts. These documents have to be consistent. For instance, the prerequisites for payment and the conditions under which it will be made should correlate down the chain of project contracts. 

One problem that occurs in contracts is the use of terms that do not concur with the current practices of the insurance industry. To avoid conflicts that may arise from inconsistencies and obsolete vocabulary, it is necessary to employ the services of experienced consultants.  

3. Transfer Risks Using Additional Insured Endorsements

To minimize risk to yourself as a contractor, it has to be transferred to subcontractors using additional insured endorsements. These endorsements inevitably add the person or company under whose instructions the insured is carrying out certain operations as an additional insured or any individual whom the insured agrees —in writing— to name as an additional insured. 

In recent times, most additional insured endorsements only become functional when the contract is performed. The time gap between a subcontractor starting work and signing a subcontractor agreement leaves you exposed to risks. This time gap can be evaded by getting your frequently employed subcontractors to sign a master subcontract agreement. This master agreement will apply to every job that particular subcontractor performs for you. 

A primary reason for adopting the additional insured status is that the insurer is obligated to defend the additional insureds in the case of any complaint against them. So, as a contractor, you should demand that subcontractors add you as an additional insured and present evidence of their insurance. 

4. Include Indemnity Clauses in Your Contracts

Indemnification provisions appropriate risks and incurred costs in the case of a default or misbehavior by one party in a contract. The indemnification clause makes it possible for compensation or costs of a potential risk to be shouldered by the indemnifying party in the case of situations that arise as a result of or in connection to the indemnifying party’s misbehavior. 

For instance, in a construction contract, an indemnification provision may read:

“Party A (owner) indemnifies party B (contractor) and assumes responsibility for any losses or lawsuits, including legal fees and other costs, that occur as a result of a violation of contract by party A.”

In this case, the contractor is indemnified and will not be accountable for occurrences that fall within the specifications of the indemnity. Indemnification can be either mutual or one-way. When it is mutual, both parties agree to be responsible for any risks caused by the indemnifying party’s actions. 

It is advisable to back any provisions of indemnity with insurance coverage because this assures that the indemnifying party can fulfill its duties. 

Conclusion

Contractors face other risks that are not directly related to construction contracts. Finance risks occur due to a lack of planning and cooperation. A project going over budget can threaten the future of your company, delay or halt workers’ payments, and halt current projects. The contract will also play a key role in case of payment disputes and a party makes a claim through a mechanics lien or other legal options.

There are weighty regulations put in place by the local and state governments which can cause great compliance difficulties. The draining and complicated nature of these prerequisites cause companies to drag their feet when ensuring compliance. 

It is important to note that failure to meet contractor licensing requirements can bring dire results. Not having adequate licensing for a particular project can also impede the success of a contractor’s bid. As a contractor without proper licensing, you’re open to the risk of penalties and lawsuits. Project permits and licenses must be adequate to minimize the risk of delays and legal issues.

About the Author: 

Patrick Hogan is the CEO of Handle.com, where they build software that helps contractors, subcontractors, and material suppliers with late payments. Handle.com also provides funding for construction businesses in the form of invoice factoring, material supply trade credit, and mechanics lien purchasing.

Harbor Compliance does not provide tax, financial, or legal advice. Use of our services does not create an attorney-client relationship. Harbor Compliance is not acting as your attorney and does not review information you provide to us for legal accuracy or sufficiency.