Strategies for shifting risk of increased tariff costs in contracts
The Trump Administration is changing the way America builds. From its “War on Regulations,” to its crackdown on illegal immigration, to its emphasis on Buy America rules, the 45th President has quickly reshaped the construction industry. Trump has also been willing to utilize tariffs as a point of negotiation leverage to a greater extent than any other recent administration. While this tactic has made President Trump a thorn in the side of countries like China and Mexico, who find it difficult to predict his next move, this same unpredictability means American companies negotiating long-term construction contracts or supply agreements are similarly unable to predict the regulatory environment in which those contracts will be administered.
There are several strategies by which prudent negotiators can shift the risk of increased tariff costs in their contract. The approach will vary based on whether or not you represent the contractor or the owner, but the strategy is the same—lock in as much guarantee as possible, as quickly as possible.
An owner negotiating a “fixed-price” contract typically expects the price to remain constant. Assuming the anticipated costs will not change, the owner makes decisions during the design phase to bring the scope of the project within the owner’s budget. The budget becomes even more serious as the project moves from the design phase into the construction phase. For this reason, most owners desire to shift any risk of price escalations after contract execution to the contractor.
Similarly, an owner negotiating a “cost plus” contract with a Guaranteed Maximum Price will usually allow a contractor to recoup increased costs due to changes in market conditions, but usually does not want to allow the contractor to increase their Guaranteed Maximum Price to cover those costs. Instead, most owners expect the contractor to cover the costs out of contingency or other cost-savings measures.
Conversely, a contractor in either situation will want an increase in its price to the extent the market conditions have changed its costs and the unit prices upon which the contractor based its bid.
This issue is not new. The price of raw materials and manufactured equipment has always been subject to market conditions, demand due to natural disasters, and government regulations. However, no president before Trump has shifted the world’s markets so drastically and so quickly by wielding the power of Twitter. The usual strategy, to “lock in” downstream prices of contractors, subcontractors, and suppliers for certain periods of time, often does not account for the new realities faced in our industry. In an age when a trade war may be launched or a tariff announced with a tweet, the risk of volatility is always present, even with short-term pricing guarantees.
Many contractors are now demanding better protection from price increases. Similarly, owners are struggling to accurately project pricing (and secure financing from lenders) when the markets are in a constant state of fluctuation.
A prudent owner will demand the contractor lock in its prices and buy out its materials as far in advance as possible. Some owners will go so far as to dictate the schedule by which all supply contracts must be finalized. While the risk of price escalation is limited on shorter-duration projects, an owner may seek to insert language protecting itself even on longer-duration projects. One such approach is the following:
“The Contract Sum includes all sales, consumer, use, and other taxes for the Work. Nothing in this Agreement shall authorize an increase in the Cost of the Work resulting from price escalations or unavailability of materials or labor. The contractor is expressly prohibited from seeking a Change Order for any escalation in price, whether caused by labor or materials shortages, tax increases or the enactment of new taxes, tariffs, or any import duties or fees imposed on materials or equipment, or any other reason.”
A prudent contractor will buy out materials for the project as quickly as it can. However, even this may not be enough to protect a contractor in an environment with wildly fluctuating prices. A contractor will want a clause like the one below:
“Notwithstanding any other contrary provision, the Parties acknowledge that the assumptions of materials and labor are subject to price escalation or unavailability at any time after the Effective Date of this Agreement as a result of factors beyond Contractor’s control. Such factors include, but are not limited to, Force Majeure events, other acts of God, whether or not they directly impact the Project, changes in the domestic or international markets, and changes in laws or regulations, including, but not limited to the imposition of taxes, quotas, or tariffs. The parties are unable to predict the amount of escalation or unavailability that may result from events occurring before or after the Effective Date. The Cost of the Work is based on Contractor’s current pricing. Contractor shall seek labor and materials at competitive prices so as to avoid delay in the Work. In the event of price escalations beyond the control of the Contractor, the Cost of the Work shall be increased by Change Order for any difference between the Contractor’s actual costs and the cost originally estimated. In the event of any unavailability of labor and materials beyond the control of the Contractor, the Owner shall execute a Change Order to either extend the Contract Time for the period of such unavailability or use an alternative material available at the same or lower cost.”
The proposed clauses above, for both the owner and the contractor, are admittedly biased toward each respective side. Each position can be edited and revised in a negotiation to reach a reasonable compromise while still protecting the interests of the contractor or owner.
One approach would be to allow for a change order increasing the contract sum, contract time, or both if the contractor acted prudently by attempting to lock in its prices and labor costs, but factors outside the contractor’s control nevertheless resulted in unforeseen costs. A contractor may be required to prove the reasonableness of its actions by providing evidence it made efforts to procure materials in advance, such as negotiating long-lead items or supply contracts, as well as procuring contingent subcontractors if the first-choice subcontractor is no longer available.
No two projects are the same. The risks posed by trade wars, tariffs, and market-shifting tweets vary on each project. However, the longer the construction schedule for any given project, the greater the risk of unforeseen influences on the availability or price of materials and labor. Prudent contractors and owners would do well to preempt these risks by addressing them during the negotiation of a contract, rather than waiting for the next 140-character trade war to determine their fate.