When the temporary exemptions on steel and aluminum tariffs granted to Canada, Mexico and the European Union expired on May 31, 2018, the commercial development industry found itself faced with a sudden and dramatic increase in construction costs. While the tariffs had already been in effect for several weeks for steel imported from other nations, the inclusion of these U.S. allies within those countries subject to the tariffs marked a critical shift. While China currently produces around half of the world’s steel, only 3 percent of U.S. steel imports come from China. By contrast, the U.S. Department of Commerce reported nearly a third of steel imports came from Canada, Mexico and the E.U. in 2017. Similarly, almost half of aluminum imports come from these previously exempt countries. Thus, where developers and contractors had previously held out hope that these major steel and aluminum sources would avoid tariffs, they are now faced with a new question: what do they do now? While some have sought exemptions under Section 232 of the Trade Expansion Act, the process is complicated and exemption approval is far from certain.
The end result is that many are speculating about the cost of end products and the likelihood of future projects. But it is important to consider the tariff’s impact on construction projects already in development. While many projects include certain protective measures such price escalation provisions or pre-construction material purchase requirements, these are not complete solutions. Though such terms are designed to address potential changes in raw material costs, they are often limited to “reasonable” price increases or pre-purchasing raw materials for certain phases of design-build projects. Forced to deal with the sudden cost spike, parties may find themselves increasingly at odds and entering the uncertain waters of litigation. But what are the risks associated with such disputes? And how can developers and contractors work to avoid potential pitfalls in any resulting litigation?
Impact of cost spikes on construction litigation
Historically, when the cost of raw materials shifted dramatically, numerous projects resulted in litigation over which party ought to bear the additional expense. In these cases, litigation has focused on whether the price shift was sufficiently severe to excuse performance under the project’s prime contract.
Typically, the arguments were either for impracticality, frustration of purpose, mutual mistake or force majeure. While the steel and aluminum tariffs are a recent occurrence, we can look to the impact of steel shortages in 2003-2004 on the construction boom at the time as a fair comparison.
Because of the building boom in the early 2000s, a global price spike (referred to as “hyperinflation”) occurred for steel, with the price rising as much as 200 percent by 2004. Because the predominant contracting principal at the time depended on “fixed price” contracts that irrevocably set material costs for a project, there were rarely mechanisms in place to deal with the drastic market fluctuations. Thus, these price spikes led to substantial litigation. Given traditional American contract principles, the main argument was about impracticality. While there are multiple articulated tests for impracticality, the main legal question underlying these tests for price change events is whether the predicate price change event that allegedly rendered the contract impracticable was reasonably foreseeable by the parties at the time of contracting: Jennie-O Foods, Inc. v. United States, 580 F. 2d 408, 409 (1978); Raytheon Co. v. White, 305 F. 3d 1354, 1367 (Fed. Cir. 2002).
What do tariffs constitute under construction contracts?
Looking at the historical instances where courts have excused contract performance, the question becomes how courts will view the present steel and aluminum tariffs. Some may argue dramatic tariffs constitute a force majeure event, as the tariffs are certainly beyond the control of the owners and contractors. However, force majeure provisions are generally limited to only those instances that are explicitly listed as force majeure events. See United States v. Panhandle Eastern Corp., 693 F. Supp. 88, 96 (D. Del. 1988), aff’d, 868 F. 2d 1363 (3d Cir. 1989). Moreover, price fluctuation events are generally not included. Because tariffs are relatively commonplace price components of construction (albeit in lesser amounts), increases in tariffs would not generally be included. There is a plausible argument to be made that the recent tariffs were not foreseeable. However, that argument is not certain. Proponents of tariffs as measures to protect American industry have been vocal for years and it may be difficult to prove that neither party could have reasonably foreseen potential tariffs, particularly given the recent political debates. Ultimately, any determination will be on a case-by-case basis and dependent on the expectations of the parties and the terms and timing of the contract in question.
How owners and contractors can minimize risk
Given that these issues are almost always fact-intensive, litigation is generally an expensive process. Keeping this in mind, it is important for contracting parties to be proactive in minimizing litigation risks. The most important thing developers and contractors can do to minimize risk is to include clear contractual roadmaps for addressing eventualities such as price increases on raw materials. As noted above, while these tariffs are new, sudden price increases on raw materials like steel are not.
There are three primary mechanisms parties can utilize to mitigate these risks. First, pre-development material sourcing is the easiest way to limit risk. By contracting to purchase all necessary raw materials at the outset, parties can guard against cost shifts caused by tariffs or other sources of hyperinflation.
Second, where purchasing raw materials before construction is impractical, drafting clearly defined price escalation contract provisions which address the scope and assignment of risk between the owner and contractor as to material pricing can reduce the risk of disputes down the road. These provisions can be simple price adjustment clauses or more complex banded cost-sharing terms, either of which can be incorporated into both GMP contracts and time-and-materials contracts.
Third, parties should ensure their contracts contain robust and practical value engineering and project contingency mechanisms. While parties never want to be forced into the position where finance dictates design choices, having effective revision tools with a clear process map can avert project failures when contract contingencies are insufficient.
Adding these types of provisions may involve value judgments when it comes to project estimating and will certainly require significant negotiation efforts to reach an agreement. Ultimately, it is up to the contracting parties to make this effort. However, parties willing to incorporate these techniques into their estimating and negotiations will find themselves well-positioned to succeed even when faced with hardships such as severe price escalations.
Michael R. Hogue is an associate with law firm Greenberg Traurig LLP. He focuses his practice on construction law, business and financial services litigation, and bankruptcy restructuring and reorganization.