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Cost Increases for Construction Materials – An Overview of the Legal Issues
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July 31, 2006
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By Keith Slenkovich
Thelen Reid Brown Raysman & Steiner LLP
As the construction industry continues to experience rising material prices, participants in all sectors of it wonder what their legal rights and obligations are. Do requests for change orders and claims for equitable adjustment based on material price escalations have a legal basis? Does it make practical sense to provide some relief to a supplier or contractor rather than face a default and the need to re-procure?
These are issues that the industry did not have to confront in the nearly two decades of relatively stable prices from roughly the mid-1980s to the mid-2000s. But, rapid economic development in China, growth elsewhere, Hurricane Katrina and other factors have led to sizable increases in construction commodity prices, and more price increases may be ahead.
When steel prices began rising, the U.S. fabrication industry was not prepared for the changed economic circumstances and was hit hard early. The market channels for steel for the U.S. construction industry had enjoyed an era of relative price stability. Steel fabricators generally were willing to commit to lump sum steel pricing required to participate in most lump sum construction projects even though they did not have the benefit of lump sum or guaranteed pricing from their suppliers. When steel prices began rising rapidly, many fabricators found themselves in a bind - locked into price commitments but facing rising prices from mills and wholesalers. Similar problems have arisen with other construction commodities.
In responding to claims for relief, owners and general contractors first will want to evaluate whether clauses in their contracts, such as commodity price escalation clauses, provide guidance. Absent such contractual treatment, the parties will need to address whether a subcontractor or supplier faced with such a price escalation has an extra-contractual legal basis for a price adjustment.
Price Escalation Clauses
Some contracts, especially those for state and federal procurement and public works, contain "escalation" or "price adjustment" clauses. Federal Acquisition Regulation (FAR) §16.203-2 allows for "fixed price contracts with economic price adjustments [to] be used when there is serious doubt concerning the stability of the market or labor conditions that will exist during an extended period of contract performance." FAR §16.203-1 recognizes three types of escalation clauses: (1) adjustment clauses tied to established prices; (2) adjustment clauses tied to actual costs of labor or materials (compared to bid prices); and (3) adjustment clauses tied to indexes of labor or material. Many states have adopted some form of the Model Procurement Code. Article 6 of it also allows the use of price adjustment clauses in state and local contracts.
The concept behind these escalation clauses is that the government agency ultimately will save money when contractors or suppliers cannot predict commodity prices with assurance because the agency will avoid the large contingencies contractors would need to build into their price quotations. When such clauses are present in the contract, they will govern the price adjustment issue. When contracts are silent on material or labor cost escalation, however, the parties will need to evaluate extra-contractual doctrines to determine whether an equitable adjustment is warranted.
Goods Contracts
Contracts providing for supply of goods to a construction project, with no requirement for on-site services or in which provision of goods predominate, typically are governed by the Uniform Commercial Code. UCC §2-615 provides:
(a) Delay in delivery or non-delivery in whole or in part by a seller. is not a breach of his duty under contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid.
The official comments to §2-615 provide:
Increased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance. Neither is a rise or a collapse in the market itself a justification, for that is exactly the type of business risk which business contracts made at fixed prices are intended to cover. But a severe shortage of raw materials or of supplies due to a contingency such as war, embargo, local crop failure, unforeseen shutdown of major sources of supply or the like, which either causes a market increase in cost or altogether prevents the seller from securing supplies necessary to his performance, is within the contemplation of this section.
The courts occasionally have granted suppliers relief under §2-615 or under other analogous legal principles. For instance, in Mineral Park Land Co. v. Howard, 172 Cal. 289 (1916), the court relieved a stone supplier from having to quarry below the water table, which was unexpectedly high, because of the dramatically increased cost such effort would entail. Although the stone at issue was technically "available," it was not "practical" to supply such stone because the cost to supply the below-water stone was 10 to 12 times the cost to supply the above-water stone. Likewise, in Gay v. Seafarer Fiberglass Yachts, Inc., 14 UCC Rep. Serv. 1335 (N.Y. Supreme Court, Suffolk County 1974), the court ruled that to the extent a supplier of a fiberglass yacht could prove that the rise in petroleum-based fiberglass production costs was attributable to unexpected global economic shortages, such as the OPEC oil embargo, it could be entitled to contract relief.
Service Contracts
Where contacts involve providing significant services on the jobsite and not just goods, the UCC will not apply, and the outcome of claims will depend on the applicable contract law. Doctrines that subcontractors and suppliers may invoke include impossibility, impracticability, frustration of purpose and force majeure.
Whether these doctrines will excuse performance or provide a basis for equitable adjustment will depend on the contract terms as well as the facts and circumstances involved. Restatement (Second) Contracts §261 provides:
Where, after a contract is made, a party's performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made, his duty to render that performance is discharged, unless the language or the circumstances indicate the contrary.
This doctrine was applied in Aluminum Company of America v. Essex Group, Inc., 499 F.Supp. 53 (W.D. Pa 1980). There, Alcoa, after entering into a 15-year contract to supply aluminum conversion services (transforming alumina to molten aluminum for wire), substantial unanticipated pollution controls became necessary under federal law, which would have led to $60 million in losses for Alcoa under the long-term contract. Although the contract contained certain price escalation measures, Alcoa successfully argued that these measures did not anticipate the pollution cost controls, and it was entitled to relief under the doctrine of commercial impracticability.
Ultimately, claims for equitable adjustments based on dramatically increased steel or other commodity prices must be evaluated on a case-by-case basis. The outcome of such claims will depend on a number of factors, including the factual circumstances and whether contract language and applicable legal doctrines provide a basis for relief.
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For more information about the issues covered in this report, please contact Keith L. Slenkovich in our Silicon Valley office at 408-282-1821 or at kslenkovich@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©2006 Thelen Reid Brown Raysman & Steiner LLP
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