Risks of Termination
While most construction contracts permit the owner to terminate a contractor in the event of default, any owner will be well counseled to exercise such rights cautiously. The risks of termination are both practical and legal. Terminating the contractor will almost certainly result in delays. Finding a replacement contractor can be difficult, particularly if the project suffers from defective work. The cost of a replacement contractor can be significantly more than the amount left in the contract, and this in turn can lead to financing problems and perhaps even result in a default of the construction loan. The owner might not have the ability to assume the subcontracts, which could require any replacement contractor to also find subs to take over uncompleted work. Enforcing warranties later on could be difficult due to disputes over who was responsible for which portion of the work. And perhaps most concerning of all is that in most cases, the termination is likely to generate a lawsuit in which the contractor will be seeking all sorts of damages, including lost profits on this and possibly other projects.
Faced with these risks and problems, owners often elect to continue with a defaulting contractor, sometimes even in the face of enormous problems. Nevertheless, there are circumstances when termination needs to be considered and exercised. Careful planning, detailed analysis, and good documentation are critical.
Importance of a Well-Drafted Contract
Termination needs to be considered at the contracting stage, and well-drafted default and termination provisions are critical. The contract needs to set out clear, objective standards for what will constitute events of default and reasonable, but not overly burdensome, notice provisions. Many contracts will provide that the contractor is entitled to notice and an opportunity to cure. The time periods for curing need to be spelled out and should not be unreasonably short or long.
Termination for Convenience Provisions
Owners should try to include in their contracts provisions allowing them to terminate the contract for convenience. Such provisions are common in most public construction contracts. Owners should resist provisions that require the owner to pay the contractor some amount of unearned overhead and profit and instead commit only to payment for compensation earned up to the point of termination, plus reasonable winding-down (demobilization) expenses.
Right to Supplement Work Provisions
Owners might also consider trying to include in their contracts a provision authorizing them to supplement the contractor’s work force in the event of default. Such a provision essentially permits the owner to hire additional work crews to supplement the contractor’s work force. Any such provisions need to be drafted carefully, and such an arrangement presents its own set of risks and problems, but is a less risky option than termination and one that, in appropriate circumstances, might be of real benefit to the owner.
Strict Compliance with Contract Termination Provisions
When problems arise during the course of a project that might warrant termination, the owner needs to refer to the contract and follow all of the notice and pre-termination procedures precisely. At the same time, though, the owner’s initial response should be to consider options other than termination. One step might be a meeting with the contractor to discuss the defaults and to try to reach an agreement on a schedule and procedure for curing them. In the course of pursing termination alternatives, the owner needs to notify the contractor that efforts to resolve the defaults short of termination will not result in a waiver of the defaults or of any rights. If the owner agrees to give the contractor additional time for curing defaults or agrees to other concessions, the agreement needs to be spelled out clearly in a writing that clarifies precisely what the owner has agreed to and when the owner will be permitted to proceed with termination. Any such agreement will effectively result in an amendment of the contract and will therefore warrant the same attention to detail that went into drafting the original contract.
Notice to Surety
If the contractor is bonded, the surety should be notified as soon as the defaults occur and should be involved in any communications between the owner and the contractor. Likewise, any agreement between the owner and the contractor needs to include the surety. Failing to notify the surety and involve it in any agreements could result in the surety later arguing that the owner’s agreements with the contractor resulted in a waiver of its rights under the bond.
It is important for the owner to thoroughly document any defaults early on. If the defaults relate to defective construction, the architect should prepare a written report and the defects should be photographed. Communications about the defaults should be set out in letters to the contractor and its surety, and the letters should be prepared at the time of the defaults.
Evaluating Whether to Terminate
If efforts to resolve the defaults have failed, the owner will need to weigh carefully the costs of continuing with the contractor versus the costs associated with termination. That will often be an involved analysis, and many owners will decide that the costs and risks of termination outweigh the costs of keeping a problem contractor. In most cases, the decision to terminate will likely result in litigation. In the event of a lawsuit, the contractor will likely seek a host of damages, including lost profits on the existing project and possibly even on other projects. The litigation costs for these types of lawsuits can be enormous.
The decision to terminate a contractor needs to be made with extreme caution and only after other appropriate alternatives have been pursued. Well-drafted contract provisions are important, and it will be critical to follow the contract requirements closely. An owner considering termination should consult with an attorney as soon as the defaults occur and should have legal guidance throughout the entire decision-making process.