Contemplating Construction Contracts

Most dentists will be involved in one or more dental-office construction or renovation projects during their careers. Perhaps one of the most overlooked, but most important, aspects of such a project is the written agreement with the contractor. This is the one item that holds the job together and ensures that all parties involved agree to the same vision and scope for the project.

Debra Gray King, DDS, FAACD, and

Daniel R. King, JD, CPA

Most dentists will be involved in one or more dental-office construction or renovation projects during their careers. Perhaps one of the most overlooked, but most important, aspects of such a project is the written agreement with the contractor. This is the one item that holds the job together and ensures that all parties involved agree to the same vision and scope for the project.

This article is not designed to turn you into an attorney or architect, or take their places on a construction project. But, before embarking on a project that will probably represent a practice`s biggest investment, a dentist should have at least a basic understanding of key areas before signing any construction agreement. This article discusses what most industry experts would probably consider the five most critical sections of any construction contract - scope of work, pricing and payment, changes, warranties, and termination.

The scope of work

The description of what the contractor will perform and the contractor`s role in delivering the project should be outlined in the "scope of work" section, which usually appears in general terms near the beginning of the contract. Contractors will often draft this section from an exclusive standpoint with statements such as, "The contractor will only perform the items listed below." A tip for the dentist, however, is to have the scope of work drafted inclusively, with language such as, "The contractor`s obligations includes all work, labor, materials, and services that may be required or reasonably inferred to complete the project, specifically including..."

Defining precisely what work the contractor is to perform is a cornerstone of a well-drafted agreement and will go a long way toward eliminating later disputes. A vague description of the work may cause the dentist to think that more work is required, while the contractor believes that the dentist is asking for more work than was agreed. Therefore, the dentist and advisers should thoroughly review all contract documents - including special conditions, specifications, and even drawings - to ensure that all work has been identified for inclusion or exclusion, and attempt to eliminate ambiguities or conflicts within the contract documents.

One of the more common acceptable "scope of work" descriptions defines the work as being shown on identifiable drawings and specifications that exist as of the time of making the contract. These details are usually set out in one or more appendices, which are incorporated into the agreement. As an example, it may define a portion of the work as "all work shown on the drawings and specifications by Smith & Jones, Architects, dated Nov. 10, 2000." Dentists should also make sure that the specifications for equipment and materials include the specific type of product, brand name, model number, size, and color.

Pricing and payment

The dentist must understand the financial terms - the total price, the payment schedule, and any other fees - and make sure that they are clearly spelled out in the contract. There are, essentially, three ways that a dentist pays a contractor for the work - lump sum or fixed price, unit prices, and cost plus. In selecting the amount and type of payment, the parties are implicitly allocating the risk of the unknown, and sometimes unknowable, between the dentist and contractor.

A lump sum pricing arrangement is commonly used in situations where the dentist competitively bids out the work to a few contractors. The intent is that the competition factor results in the best possible price to the dentist. At the end of the bidding process, the contractor will have agreed to perform "X" scope of work for "Y" price. Advantages to this type of pricing include increased certainty as to the rights and obligations of the parties with less opportunity for disputes to arise. In a properly drafted agreement, the contractor assumes a significant degree of risk of loss for such unknown variables as the difficulty of construction, rising costs, weather, availability of labor, materials, and equipment. The dentist, however, will likely pay a premium (that the contractor builds into the lump sum) to cover such contingencies, which may or may not occur.

Another potential disadvantage to the dentist is that the contractor has an incentive to seek change orders, increasing the price where possible and cut corners on the quantity and quality of the work to maximize the profit margin. This risk is one reason why it is very important at the bidding phase to have detailed plans and specifications setting out the scope of the work for the project.

In a cost-plus arrangement, the dentist agrees to pay the actual cost of the work - which should be broken down and carefully defined along with what things are not considered costs of the work - plus a specified amount payable to the contractor for overhead and profit. Under a pure cost-plus arrangement, the dentist assumes virtually all of the risk of the unknown variables. However, the dentist, theoretically, does not have to pay for contingencies that may not occur as with a lump sum. Furthermore, there is no built-in incentive for the contractor to cut quality or quantity since he or she is assured of full payment for all costs of labor and material that go into the project. This system also requires the dentist to carefully review the contractor`s invoice and supporting documents. There are several variations of cost-plus payment arrangements, including:

- cost plus a fixed fee, whereby the contractor assumes the risk of substantial changes and additional work

- cost plus a percentage (of the cost) fee, whereby the dentist assumes the risk of unknown variables

- cost plus with a guaranteed maximum, whereby a not-to-exceed ceiling on costs protects the dentist

- cost plus with a guaranteed max and a cost-saving arrangement (such as the contractor receiving 25 percent of any "savings" or amounts beneath the cap) so as to provide a financial incentive for the contractor to keep costs to a minimum.

In a unit pricing arrangement, the cost per unit of work is fixed. The total quantities of material and labor, however, are unknown. Under this payment format, both the dentist and contractor assume a share of the risk of the unknown; the contractor takes the risks of rising costs, difficulty of construction, and weather, etc., while the dentist assumes the risk of a higher cost of construction for the overall project. This type of pricing is typically used for portions of the work as opposed to the entire project.

Payment provisions in a construction agreement usually call for periodic "progress payments" - typically on a monthly basis - for work completed in the previous month. It is vitally important that the construction agreement contain strong and enforceable payment provisions that require:

- periodic inspections and reviews of the work before payment is authorized

- a right to suspend or stop the work for defaults in performance

- a right to withhold payment for defective or questionable work

- payment to be made according to defined milestones or fairly balanced schedule of values

- that the pay application be sufficiently documented with such items as cost information, waivers of liens, and contractor`s affidavits that all subcontractors and suppliers have been paid.

Typically, the parties will also agree that the owner may withhold up to 10 percent of progress payments - called "retainage" - until the project has reached "substantial completion," along with some lesser amount retained until final completion of the project, including any "punch list" work. This retainage provides incentive to the contractor to complete the project and some assurance that the dentist will have sufficient funds to complete the work or pay subcontractors if the contractor does not.

Changes

Changes are virtually inevitable on every construction project for any number of reasons, including the dentist`s changing requirements or budget limitations, errors and omissions in the design, and site conditions that differ from what one or more parties expected. Therefore, it is crucial that the construction agreement clearly grant the dentist the right to make certain changes to the contract and the scope of work. Construction contracts are unusual in this respect, as most commercial contracts are fixed and cannot be changed except by a mutual amendment. In the construction context, however, unilateral changes by the owner are permitted only when there is an accompanying provision for making fair compensation to the contractor, and when the change is generally within the scope of the work.

A properly drafted change order clause should provide for a dentist`s absolute right to order a change within the scope of the agreement. He or she can also obtain the contractor`s cost proposal with an assessment of the impact on the remaining work, and provide a procedure for determining compensation. A typical procedure for determining an equitable adjustment of the contract price will provide for the payment of the contractor`s direct field costs and a reasonable allowance for overhead and profit.

Some suggested approaches to limit changes and cost overruns on the project are:

- include a site and documents inspection clause, whereby the contractor states that he or she has made a diligent inspection of the site for the construction, thoroughly reviewed the plans and specifications applicable to the project, and has taken this information into account in pricing the project.

- include a clause that specifies that the dentist can make up to a certain number of changes at cost with no additional fees or limited mark-for overhead and profit.

- include a provision that if the contractor is delayed on a project for any cause, his or her sole remedy is an extension of time only - and this, only if the contractor gives timely notice - and the dentist will not be liable for payment of money.

Warranties

Under typical construction contracts, a contractor makes a general warranty to the owner concerning the quality of the work, which should be along the following lines:

The contractor warrants to the owner that:

(1) the project will be constructed in a fit and workmanlike manner

(2) the project will be constructed in compliance with all applicable laws, regulations, building codes, and manufacturer`s specifications

(3) the materials and equipment furnished under the contract will be of good quality and new unless otherwise required under the agreement

(4) all work will be free from defects not inherent in the quality required or permitted

(5) the work will conform with the requirements of the agreement. Work not conforming to these requirements, including substitutions not properly pre-approved, will be considered defective.

If there is additional warranty or "guarantee" language, it should not state that, after the warranty or guarantee period expires, "all bets are off" and the contractor has no liability to the dentist. If there is any doubt, an additional statement should be added such as, "These warranties are in addition to, and not a limitation of, any other rights and remedies available under this agreement, at law, or in equity." Be wary of a contractor`s attempts to include a time limit for enforcement of warranties or other limitations and disclaimers of warranties.

The contractor should also be contractually required to pass to the dentist all manufacturer and equipment warranties and not impair the validity of such warranties during installation or construction.

Termination

There are two types of terminations - for cause or default and for no cause or "for convenience." Termination for default is a serious act that results in serious risks to both the owner and contractor if it is not handled properly. A properly drafted termination clause should include as grounds for default the contractor?s failure to meet the time schedule for construction, standards of quality, and failure to make payments to subcontractors and suppliers. At the same time, however, because all possible breaches can never be known at the time of contracting, a general provision providing for termination in the event of repeated breaches or a material breach should be provided in the agreement.

A termination clause should also contain a requirement for notice of the breach, which provides a set period of time for the breaching party to cure the default, and specific rights and obligations in the event of termination, with the nature and scope of damages available to the non-breaching party.

Many construction agreements also provide for termination for convenience, which allows a party who desires termination to do so without regard to whether the other party is in material breach of the agreement. A termination for convenience clause will typically provide that, upon receipt of written notice from the owner of a termination for the owner?s convenience, the contractor must:

- cease operations as directed by the owner in the notice

- take actions necessary for the protection and preservation of the work

- except for work directed to be performed prior to the effective date of termination stated in the notice, terminate all existing subcontracts and purchase orders, and enter into no further subcontracts and purchase orders.

In a typical termination for convenience clause, the contractor is entitled to receive payment for work already performed as well as the costs directly incurred by reason of such termination, but will bar the contractor from recovering lost or anticipated profits as a result of the early termination.

Don`t forget to:

- Thoroughly review the entire contract and make sure you understand it before signing. Make sure all items you want in the project are included in the written agreement. If it`s not there, you should assume that it`s not included.

- Be sure that the contract includes the contractor`s name, address, telephone number, and any applicable license number.

- Never sign an incomplete contract and always be sure to keep a copy of the final signed agreement for your records.

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