Contract law basics: formation, terms and interpretation

Every construction project is a web of contracts. The owner contracts with the designers and the builder, the builder with subcontractors and suppliers, the subcontractors with their own suppliers and sub-subcontractors. Most of those contracts are written, many use standard forms, and nearly all are changed during the work by change orders, letters and emails. This lesson covers the core of contract law that a construction manager uses daily: how a binding contract is formed, what its terms are, how courts interpret them, and what happens when a party does not perform.

What a contract is

A contract is an agreement that the law will enforce. It need not be a single signed document. A contract can be formed by an exchange of letters, by a purchase order and an acknowledgment, by emails, by conduct such as starting work on a written proposal, or orally, although oral construction contracts are hard to prove and some types must be in writing to be enforceable.

Under the common law of contracts applied in every state, a contract requires an offer, an acceptance that matches it, consideration (something of value given by each side), mutual assent or a meeting of the minds, and sufficient definiteness about the essential terms. Contracts for the sale of goods, such as a purchase of rebar or rooftop units, are also governed by Article 2 of the Uniform Commercial Code (UCC), adopted in some form by every state, which relaxes some common law rules.

Offer and acceptance

An offer is a definite proposal that shows a willingness to be bound if it is accepted. A bid submitted in response to a call for tenders is usually an offer; a price list or an advertisement usually is not. An acceptance must be an unqualified agreement to the offer's terms. A reply that changes the terms is not an acceptance but a counter-offer, which kills the original offer and puts a new one on the table.

This rule creates the battle of the forms, a constant feature of construction purchasing. A contractor issues a purchase order on its terms; the supplier replies with an acknowledgment on its own terms, which limit liability and exclude consequential damages; the goods are delivered and paid for without anyone reconciling the documents. Which terms govern?

For goods, UCC § 2-207 changes the common law mirror image rule. A definite acknowledgment can operate as an acceptance even if it adds or changes terms. Between merchants, additional terms become part of the contract unless they materially alter it, the offer limited acceptance to its own terms, or an objection is given; conflicting terms are often knocked out and replaced by UCC gap-fillers such as the implied warranties of merchantability and fitness for a particular purpose.

The practical lesson is the same everywhere: read the acknowledgment, object in writing to unacceptable terms, and make the purchase order say that it can be accepted only on its own terms.

Consideration, certainty and capacity

Consideration is the price of a promise. In a construction contract it is usually obvious: the contractor promises to build and the owner promises to pay. Consideration matters when contracts are changed. A promise to pay more for the same work, without anything new in return, may not be enforceable in some jurisdictions, which is one reason change orders state what new work or relief each side receives.

Certainty means that the essential terms are settled: who the parties are, what the work is, the price or a method of setting it, and enough of the time for performance. An agreement to agree, such as a letter saying the parties will negotiate a contract later, is usually not enforceable. A letter of intent can be binding, however, if it contains enough terms; many contractors have done months of work under letters of intent that were treated as contracts, sometimes with surprising terms.

Capacity refers to a party's legal ability to contract. In construction the common issue is authority: whether the person who signed a change order or approved extra work had authority to bind the company. Contracts often name the people who may give instructions, and owners often require written change orders signed by an officer. A site supervisor's verbal approval may not bind the owner, and an architect normally has only the authority the contract gives.

Express and implied terms

The terms of a contract are its promises. Express terms are stated in the documents: the agreement, the general and supplementary conditions, the drawings and specifications, addenda and change orders. Implied terms are read in by the law: by statute, such as the warranties implied by sale of goods legislation; by custom of the trade; or because the term is necessary to make the contract work, such as an implied duty on the owner to give access to the site and to cooperate.

American contract law implies a covenant of good faith and fair dealing into every contract, recognized in the Restatement (Second) of Contracts § 205 and in UCC § 1-304. The covenant prevents a party from acting to deprive the other of the benefit of the bargain, for example by unreasonably withholding an approval the contract makes discretionary or by obstructing the other's performance. The covenant does not create new obligations inconsistent with the express terms, and in most states it does not support a separate tort claim in ordinary commercial contracts. In government contracting, the government also has an implied duty to cooperate and not to hinder performance.

Interpretation

When the parties disagree about what a contract means, courts try to find the parties' objective intention, starting with the plain meaning of the words read as a whole. Most states apply some form of the parol evidence rule: if a written contract is a complete and final expression of the agreement, evidence of earlier negotiations cannot be used to add to or contradict it, although it may be used to explain a genuine ambiguity. States differ on how readily they admit outside evidence. On federal contracts, the Court of Federal Claims and the boards also apply rules about patent ambiguities, which a bidder must ask about before bidding.

Several interpretation rules recur in construction.

• The contract is read as a whole, so that every part has meaning.
• Specific terms prevail over general ones, and handwritten or typed changes over printed standard terms.
• Ambiguous terms may be interpreted against the party that drafted them, the contra proferentem rule, especially in standard forms imposed by one side.
• Order of precedence clauses tell the reader which document wins in a conflict, for example the agreement over the general conditions over the specifications over the drawings.
• Entire agreement clauses limit the contract to the signed documents, excluding earlier representations.

Performance, breach and remedies

A party performs by doing what it promised. Construction contracts rarely end in perfect performance; the law asks whether performance was substantial and whether any breach was serious. A breach of a minor term gives a right to damages but not to end the contract. A breach that goes to the root of the contract, sometimes called a fundamental or material breach or a repudiation, allows the innocent party to treat the contract as ended and claim damages. Lesson 10 covers termination in detail.

Damages for breach of contract aim to put the innocent party in the position it would have been in if the contract had been performed. They are limited in three main ways.

• Causation: the loss must be caused by the breach.
• Remoteness: the loss must be of a kind that was reasonably foreseeable when the contract was made, the rule from the English case Hadley v. Baxendale (1854), followed in Canada and the United States.
• Mitigation: the innocent party must take reasonable steps to reduce its loss.

Contracts often modify these rules with liquidated damages for delay, limitation of liability clauses and waivers of consequential damages. Other remedies include specific performance, rarely ordered for construction work, injunctions, and restitution or quantum meruit, a claim for a reasonable value of work done where there is no enforceable contract price.

Before signing any contract, a construction manager should be able to answer six questions: who are the parties and who can bind them; what exactly is the scope; how and when is payment made; what is the time for completion and the remedy for delay; how are changes priced and approved; and what notices must be given, to whom and within what time. The remaining lessons explore each of these.