In my last column, I discussed ways to protect an owner’s interests via a construction contract. In this one, I do the same for contractors, explaining that through proper due diligence, negotiation, drafting and administration of a construction contract, a general contractor can ensure, among other things, that it: (1) contracts with financially secure and trustworthy owners, subcontractors and suppliers; (2) minimizes the risk of lien claims from its subcontractors and suppliers; and (3) is responsible only for damages associated with its own performance.

Know Your Counterparties

The easiest way to limit risks on a construction project is to do business with reputable owners, subcontractors and suppliers. And the best way to ensure that a contractor is working for and with individuals and entities of good character is to perform due diligence before entering into contracts with them.

Prior to entering into a contract with an owner, a contractor should perform a corporate family search to determine where in a corporate family tree the named owner falls. It is important to know whether you are contracting with a primary corporate entity or with a corporate shell or a single-purpose entity, as the latter two are less likely to have independent assets to pursue in the event of payment failures. For larger projects, a contractor should request that the owner supply answers to a financial questionnaire or otherwise provide detailed information concerning its financial health and wherewithal. Indeed, American Institute of Architects documents and many state statutes require owners to provide financial assurances to general contractors.

Similarly, prior to entering into contracts with subcontractors or suppliers, a contractor should determine whether its subcontractors and suppliers are properly licensed and insured, and whether complaints have been lodged against them with the Better Business Bureau, the Consumer Affairs Department of the Attorney General’s Office, and the local building and zoning officials. In projects where subcontractors will retain sub-subcontractors, it is good practice to perform financial due diligence on the subcontractors to make sure that they have sufficient resources to complete their work without relying on receiving payments from the general contractor. In fact, there are credit agencies, such as Profiles Plus in Trenton, N.J., that are devoted exclusively to the construction industry and track contractor, subcontractor and supplier credit worthiness.

A contractor should also do a litigation search to see whether the owner has been sued on other projects for payment failures and has had mechanics’ liens filed against it, and whether its subcontractors and suppliers have been sued for performance failures and whether they have sued owners or contractors for payment failures.

Require and Obtain Partial and Final Lien Wavers

Although it is an owner’s property that would be subject to a mechanics’ lien claim, the owner can and will seek indemnification for such claims from its contractor. To guard against such claims, a contractor should require that its subcontractors and suppliers provide partial lien waivers for all payments received and claim releases (releasing any and all potential claims up to the date of payment). If all parties do so, and withhold subsequent payments until partial lien waivers for the prior payments and claim releases are received, a contractor will limit the size of potential indemnification claims to a single pay period.

Furthermore, if a contractor posts a bond guaranteeing payment for labor and materials provided by subcontractors, the contractor can and should require its subcontractors and suppliers to execute and file global mechanics’ lien waivers for a project before any work on the site commences — this being an exception to the prohibition of advance lien waivers on nonresidential construction projects.

Limit Retainage

When an owner insists that retainage be withheld from all progress payments, a contractor should, in addition to negotiating for the lowest possible rate, seek to: (1) reduce the rate of retainage; (2) obtain a partial release of retainage at the halfway point of a project; and (3) negotiate the release of retainage for subcontractors that complete their scope of work in the early portions of the project. The contractor should also endeavor to reach an agreement to release all or most of the retainage on the date of substantial completion (and not final acceptance). This will prevent an owner from holding a general contractor hostage during the completion of minor punch list work.

Watch Out for the Contractor and Subcontractor Payment Act

Like most states, Pennsylvania has a Contractor and Subcontractor Payment Act, 73 P.S. §§ 501, et seq. (CASPA). While CASPA provides a powerful remedy for a contractor against an owner for payment failures, it can also be used by subcontractors and suppliers against the contractor — even when the contractor has not received payment from an owner for the work in question. To guard against this eventuality, a contractor need only include a pay-when-paid clause in its contracts with subcontractors and suppliers. Of equal importance, and often overlooked, if a contractor wishes to withhold payment because of a deficiency in the work or materials provided by its subcontractors or suppliers, CASPA requires the contractor to notify the offending party within seven days after an invoice is received or risk a waiver of the objection.

Ensure Owner and General Contractors Are Additional Insureds

While most construction lawyers will require that subcontractors have proper and sufficient insurance coverage, it is important that all subcontracts require that the owner and the contractor be named as additional insureds on such policies. This eliminates potential arguments from carriers that the owner and contractor are not entitled to receive insurance payments where appropriate.

Waive Consequential Damages, but Not Delay Damage Claims

A contractor should seek mutual waivers of consequential damages in contracts with owners. This is so because in actuality, it is the owner — and not the contractor — that is likely to incur significant consequential damages on a project. For example, if an owner is constructing a dormitory, and it waives consequential damages, it will not be able to recover damages, such as the cost of alternative housing for students, if construction is late. Likewise, having waived consequential damages, an owner that is constructing a widget factory with contracts to deliver a million widgets by a date certain will not be able to recoup its lost profits for breaching those contracts if the factory is not completed on time. So, it is important for a contractor — to the extent possible — to include waivers of consequential damages in its contract with an owner. If an owner will not agree to waive consequential damages, a contractor could seek to negotiate a cap on potential consequential damages (e.g., to the extent of its fee on the project) or limit consequential damages to the extent of its insurance coverage.

Conversely, a contractor should resist a waiver of delay damages claims and should attempt to strike from any contract any “no damages for delay” clause.

Include Carefully Worded Indemnification, Design Responsibility Clauses

An owner will almost certainly require some form of indemnification from its contractor. While it is reasonable to include indemnification provisions in contracts with owners, a contractor should try to limit such clauses to the extent of damages caused by the general contractor and should not agree to indemnify an owner, architect or engineer for their own negligent acts or contractual breaches. Contractors must be aware of any applicable state “anti-indemnity” statute when negotiating an indemnification clause. And, of course, a contractor should require its subcontractors and suppliers to indemnify it for damages caused by the actions of its subcontractors and suppliers, including any damages that the contractor may owe to the owner. Design decisions are the responsibility of owners, architects and engineers, so a contractor should make sure that it is not contractually responsible for design issues. And a contractor should also strike any clauses that suggest that it is responsible to construct in accordance with all applicable laws, as the responsibility for ensuring that designs comply with building codes and regulations is the purview of architects, engineers and certain professionally licensed subcontractors (who prepare shop drawings).

Ensure All Preconditions of Warranties Have Been Met

Most construction contracts will require the contractor to warrant its work and to provide manufacturers’ warranties for many of the materials used and construction elements completed, such as roofs, windows, doors and HVAC systems. Most warranties, however, contain preconditions that must be met in order for the warranty to be valid. These preconditions often include pre- and post-installation manufacturers’ inspections, notice provisions and regular maintenance requirements. The failure to comply with any of these conditions can void a warranty, so it is good practice for a contractor to carefully read and comply with all such conditions.

Document All Problems and Communicate Them

One of the most common mistakes made by a contractor on a construction project is the failure to document problems, including payment issues and delays, as they occur and to communicate them to its owner, subcontractors and suppliers. Not only will proper documentation and quick communication help address and head off problems while they are manageable, but they often make the difference between winning and losing in court if the issues cannot be resolved between the parties. This is so because it demonstrates that the contractor gave the other side a chance to address the issues and mitigate damages before resorting to litigation, and it enables a contractor to present the problems in the most favorable light.

Home Improvement Contracts

In 2009, Pennsylvania enacted the state Home Improvement Consumer Protection Act, 73 P.S. Sections 517.1 to 517.19. The act requires all home improvement contractors to register with the Pennsylvania Attorney General’s Office. The act states that no home improvement contract is valid or enforceable against an owner unless it: (1) is in writing; (2) is signed by the owner and contractor; (3) describes the work; (4) specifies start and end dates; (5) specifies down payments; (6) provides for insurance by the contractor; and (7) includes a right of rescission. It also requires arbitration clauses to be conspicuous. Furthermore, the act states that contracts are voidable if they contain a hold harmless clause, waivers of building codes, confessions of judgment, waivers of claims, provisions under which contractors are awarded attorney fees, and clauses that relieve a contractor from liability for acts of agents.

Include a ‘Clarifications’ Exhibit With the Contract

While construction contracts generally do a good job at describing the responsibilities of the parties, it is good practice to include a “Clarifications” exhibit with the contract that specifies everything that is not in the contractor’s scope of work. This exhibit heads off many arguments during a project where an owner argues that unspecified tasks nonetheless fall within a contractor’s scope of work.

Andrew D. Klein is counsel in the Philadelphia and Princeton, N.J., offices of Drinker Biddle & Reath. A member of the commercial litigation practice group, a significant portion of Klein’s practice focuses on complex construction, land use and real estate litigation. He can be reached at 215-988-2632 or andrew.klein@dbr.com.