American Bar Association

Forum on the Construction Industry

 

 

 

 

 

 

 

 

 


THAT’S MINE

A Contractor’s View on Termination

 

 

Sean R. Calvert

Calvert Menicucci, P.C.

Albuquerque, New Mexico

 

 

April 24-26, 2008

La Quinta Resort and Club—Palm Springs, California

 

 


©2008 American Bar Association
 

I.          Common Law Termination Remedies

            The decision to terminate a contract, whether made by the contractor or by the owner is always one to be made with trepidation.[i] It can have profound effects on the parties to the termination as well as to the construction project as a whole.  These include not only the effects intended by the terminating party, but also effects which frequently are unintended and unforeseen by the party initiating the termination.  Accordingly, prior to exercising the right to terminate a contract or when responding to a notice of termination, the contractor, owner and counsel should carefully consider the possible ramifications of the termination.

            For most commercial construction projects the parties’ right to terminate the contract is defined by the terms of the contract itself.  However, even where the contract may specify the grounds for termination by the parties and their rights upon termination, those rights are often modified or supplemented by a party’s common law termination rights.[ii] In fact, most standard form construction contracts specifically provide that the contractual termination rights and remedies are in addition to and not in derogation of a parties’ common law rights.[iii]

            The actual grounds for termination and the remedies available upon a proper termination under the common law, however, are significantly more restrictive than those provided in most standard form construction contracts.  Unlike the expansive and enumerated grounds for termination provided by most standard form construction contracts, for example AIA A201 (1997) §14.1, the right to terminate a contract at common law is normally limited to where the other party has repudiated the contract, or has so significantly breached the contract that its nonperformance goes to the essence of the contract.[iv] Some courts allow for a slightly more relaxed approach to determining whether a party has materially breached such that termination is appropriate, but even there the breach must be “substantial nonperformance and entire or substantial failure of consideration.”[v]

            Where the breach is so substantial as to go to the essence of the contract, default termination still may not be appropriate where the nonperformance has been excused.[vi] Similarly, where after a material breach the parties continue to perform and act as if there had been no breach, the material breach may be waived.[vii]

            Presuming that a termination is properly declared, absent a contract provision providing for the measure of damages, the measure of damages will depend on where the termination occurred during the construction of the project.  Before the project has been substantially completed the owner’s remedy is the reasonable cost of completing performance less the amount of the contract with the terminated contractor.[viii] The owner may recover the difference so long as the scope of work remains the same.[ix] Obviously under this measure of damages, if the cost of completion is less than the remaining balance of the construction contract, then the owner is not entitled to any further compensation.  The jurisdictions are split, however, as to whether the cost of completion must be reasonable and who bears the burden of proving the reasonableness or unreasonableness of an owner’s completion costs.[x]

            Substantial completion of a construction project, however, alters the damages to which the owner is entitled.[xi] “This doctrine mitigates the harsh consequences that would accrue if small errors in performance were treated as material breaches, e.g., termination of the defaulting party and full damages resulting from failing to complete performance.”[xii] Where the project is substantially complete the owner may still be entitled to its actual costs to complete the work or to correct defective work.[xiii] As long as the costs of completion or correction are reasonable, the costs may still be recoverable even when substantially more than the original contract price.[xiv] However, where the cost of correction would greatly exceed the diminished value of the project, or where repair would involve unreasonable economic waste, the owner’s measure of damages should be the difference between the value of the structure as completed and the value the structure if it had been constructed in accordance with the contract.[xv] The cost of correction is inappropriate in these cases because those costs are so disproportionate to the value received for the repair as to constitute “economic waste.”[xvi] When the diminished value rule is applied, the value should be measured at the time of the breach.[xvii] 

            “Application of the proper damage measure depends, in many instances, upon a fine weighting of facts relating to the substantiality of performance versus the unreasonable economic waste or hardship to the contractor on a case-by-case basis.”[xviii] In cases involving numerous deficiencies of varying degrees of seriousness, an owner may even be entitled to a mix of damages measured both by the diminution in value and the cost of correction.[xix] 

            As with the terminating owner, a contractor having properly terminated its contract is faced with different measures of damages, all of which are intended to provide it the benefit of its bargain.[xx] One measure of damages is the total contract price, less the costs of completion, less any progress payments made through the date of termination.[xxi] Another measure of damages frequently approved is the amount due for work properly completed, plus the profit the contractor would have earned on the balance of the contract.[xxii] Of course where the contractor would have experienced a loss on its contract if it had completed its scope of work, it will not be entitled to a recovery under either theory.[xxiii] 

            Absent contract provisions giving the owner additional remedies, it may complete the contract and charge the contractor with the costs of completion, but it is not entitled to any assistance in doing so.[xxiv]  The properly terminating owner gains no rights in the material, equipment or subcontracts still owned by the terminated contractor such that it may use those in completing the project. Absent a contract provision providing the properly terminating owner with a right to material provided for the project, but for which the owner has not yet paid, the owner has no right to use that material or equipment.[xxv] Similarly, upon termination an owner assumes no privity in the subcontracts held by the contractor and cannot proceed with completing the work utilizing those subcontractors, absent an assignment of their contracts.[xxvi] Of course the owner may make a separate agreement with the subcontractor if it will agree to continue.  It is to provide the terminating party with the materials, equipment and labor contracts to complete the project as efficiently as possibly that most standard form construction contracts contain termination clauses specifically identifying the terminating party’s rights in the project materials, equipment and labor contracts.

II.        I agreed to what? – Contractual termination remedies

 

            A.         American Institute of Architects Standard Form Contracts

 

            In response to the uncertainty of common law termination and the difficulties inherent in completing a project where one of the parties has been terminated, the American Institute of Architects standard form contract documents include several risk allocation provisions governing termination.  The most obvious provisions appear in Article 14, Termination Or Suspension Of The Contract.  In fact, the index to the AIA A201 for termination or suspension lists only Article 14, with the exception of Section 4.1.3 governing termination of the Architect and Section 15.1.6 governing claims for consequential damages.  An assumption that Article 14 contains all of the relevant provisions governing termination would miss several clauses affecting the terminating party’s ability to complete the project.  In addition to Article 14, the practitioner should be aware of Section 5.4, governing the contingent assignment of subcontracts, and Sections 9.3.2 and 9.3.3, governing title to work for which a payment application has been made, and Section 13.4.1, supplementing the contractual rights and remedies.

                        1.         Article 14, Termination or Suspension of the Contract

            Section 14.1 provides three different grounds for termination by the contractor, all of which require a work stoppage of differing degrees.  Section 14.1.1 allows the contractor to terminate the contract if the work is stopped for a period of 30 consecutive days through no act or fault of the Contractor for four specified reasons:

.1         Issuance of an order of a court or other public authority having jurisdiction that requires all Work to be stopped;

.2         An act of government, such as a declaration of national emergency that requires all Work to be stopped;

.3         Because the Architect has not issued a Certificate for Payment and has not notified the Contractor of the reason for withholding certification as provided in Section 9.4.1, or because the Owner has not made payment on a Certificate for Payment within the time stated in the Contract Documents; or

.4         The Owner has failed to furnish to the Contractor promptly, upon the Contractor’s request, reasonable evidence as required by Section 2.2.1.[xxvii]

Section 14.1.2 provides the owner a similar right to terminate the contract where the project has been suspended or delayed pursuant to Section 14.3 for more than 100 percent of the total number of days scheduled for completion, or for 120 days in any 365 day period, whichever is less.[xxviii] Termination under Section 14.1.2 does not require that any of the additional conditions set forth in 14.1.1 have occurred.  For a termination to be effective under either 14.1.1 or 14.1.2 once the delays and work stoppages justifying termination have occurred the contractor must provide a seven-day written notice to the owner and the architect prior to terminating the contract.[xxix]

            One of the issues that comes up when the contractor attempts to terminate pursuant to Article 14 is whether the written notice required by Section 14.1.3 is purely a notice of the election to terminate the contract, or whether the written notice gives the owner the right to cure the defect in performance.  Section 14.1.3 does not specifically indicate that the owner has a right to cure the default in performance, but the AIA section giving the owner the right to terminate upon the giving of a similar seven-day written notice has been interpreted to include an opportunity for the contractor to cure the default.[xxx] Generally a breaching party’s right to cure its default is required in equity.[xxxi] For the most part, however, the defaults justifying termination by the contractor are not defaults which are subject to ready cure by the owner, with the exception of 14.1.1.3 and 14.1.1.4.

            In addition to the right to terminate granted to the contractor by Sections 14.1.1 and 14.1.2, the AIA documents provide the contractor the right to terminate its contract if the work is stopped for a period of sixty consecutive days because the owner has repeatedly failed to fulfill the owner’s obligations under the contract documents with respect to matters important to the progress of the Work.[xxxii] As with a termination under Sections 14.1.1 and 14.1.2, the contractor must give seven days’ written notice of its intent to terminate the contract.  Since there is no prior written notice requirement for termination under Section 14.1.4, the language of that section requiring an “additional” seven days may refer back to the seven day notice contemplated by Section 14.1.3 and require the giving of two separate notices to the owner and the architect.  At least one commentator has indicated that presumably the notice in Section 14.1.4 is in addition to the notice required by 14.1.3, although the sections do not specifically reference each other.[xxxiii] Termination under Section 14.1.4 is particularly troubling for the contractor seeking to terminate the contract, as while Section 14.1.4 requires a breach by the owner of its obligations under the contract, it is not specific as to breach of which obligations would justify termination.  Section 14.1.4 merely provides that termination is justified if the work has been stopped for a period of 60 consecutive days because of the owner’s repeated failure to fulfill its “obligations under the Contract Documents with respect to matters important to the progress of the Work.”[xxxiv] Presumably this would include repeated breaches of the owner’s obligations under the contract as explicitly set forth in Article 2.  The question arises, however, whether Article 14.1.4 justifies termination for an owner’s breach of duties imposed or implied in other sections of the contract, and whether Article 14.1.4 as it refers to “obligations under the Contract Documents” bars termination for breach of duties implied in law.

            The AIA family of documents provides similar specific grounds for the owner to terminate its contract with the contractor.[xxxv] Like the contractor’s right to terminate under Section 14.1.1, the owner’s right to terminate is expressed for specific causes.

.1         repeatedly refuses or fails to supply enough properly skilled workers or proper materials;

.2         fails to make payment to Subcontractors for materials or labor in accordance with the respective agreements between the Contractor and the Subcontractors;

.3         repeatedly disregards applicable laws, statutes, ordinances, codes, rules and regulations, or lawful orders of a public authority; or

.4         otherwise is guilty of substantial breach of a provision of the Contract Documents[xxxvi]

Unlike the contractor’s termination rights under Section 14.1.1, the owner’s termination right is frequently not subject to an easy determination as to whether the required event for termination has occurred.  Thus the determination of whether the contractor is supplying sufficient properly skilled workers or proper materials, has failed to make payment to subcontractors in accordance with the subcontract terms or is guilty of a substantial breach of the contract is often a factual dispute.[xxxvii]

            In order to effectuate the termination under Section 14.2.1, the owner must both give the contractor and the contractor’s surety, if any, seven days’ written notice of the intent to terminate, but the owner must obtain a certificate by the architect[xxxviii] (Initial Decision Maker) that sufficient cause exists to justify termination.[xxxix] Generally the owner must strictly comply with these conditions precedent.[xl] Frequently, the owner may provide the required notice, but fails to obtain a determination from the architect that termination is justified.[xli] Where the owner has failed to provide the required architect’s certification, the termination for default is wrongful.[xlii] Even where the default is wrongful, however, for lack of an architect’s certificate, the owner may in certain circumstances still be entitled to terminate its contract.[xliii] In Ingrassia the Court held that a defective certificate or the lack of an architect’s certificate, while a condition precedent to termination under the contract, is not a condition precedent to common law termination and the owner was entitled to terminate its contract, but without the presumptive effect of the architect’s certification.

            Where the conditions for termination have been met and the owner has complied procedurally with the termination requirements of Section 14.2.2, the owner is entitled not only to terminate the contractor, but also to certain additional rights.

.1         Exclude the Contractor from the site and take possession of all materials, equipment, tools and construction equipment and machinery thereon owned by the Contractor;

.2         Accept assignment of subcontracts pursuant to Section 5.4; and

.3         Finish the Work by whatever reasonable method the Owner may deem expedient.  Upon written request of the Contractor, the Owner shall furnish to the Contractor a detailed accounting of the costs incurred by the Owner in finishing the Work.[xliv]

Unlike the common law termination, the owner’s termination under Section 14.2.2, if properly commenced, can provide the owner with the means with which to complete the contract.  Where the owner has properly terminated the contract, the contractor is not entitled to any further payment until the owner has finished the work.[xlv] Once the contract has been completed by the owner, the contractor is entitled only to the unpaid balance of the contract, less the costs of finishing the work and other damages incurred by the owner.[xlvi] If the costs of finishing the work and other damages incurred by the owner exceed the contract balance at the time of termination, then the contractor is not entitled to any further compensation and the owner is entitled to damages against the contractor for the excess costs and damages.[xlvii] Section 14.2.4 contemplates yet another certification by the architect, this time as to the amount to be paid to the owner or the contractor under Section 14.2.4.  It is unclear what the effect of the architect’s certification is, or what would be the effect where the architect’s certification is not obtained.[xlviii]

                        2.         Section 5.4 Contingent Assignment of Subcontracts

            Where the owner has properly terminated its contract with the contractor, the AIA documents provide for the assignment of the contractor’s subcontracts to the owner on certain conditions:

.1         assignment is effective only after termination of the Contract by the Owner for cause pursuant to Section 14.2 and only for those subcontract agreements that the Owner accepts by notifying the Subcontractor and Contractor in writing; and

.2         assignment is subject to the prior rights of the surety, if any, obligated under bond relating to the Contract.[xlix]

This provides the owner with the ability to selectively accept assignment of the subcontracts for the performance of the work.[l]  By allowing for assignment of the subcontracts the owner can avoid delays in the completion of the project incident to reprocuring subcontractors and can avoid having to negotiate with existing or replacement subcontractors for completion of the work at prices in excess of the original subcontract costs.  Where the owner accepts the assignment of the subcontract agreement, the owner assumes the contractor’s rights and obligations to the subcontractor.[li] In some cases this may include the obligation to make payments to the subcontractor which the owner had already made to the contractor, but which the contractor had not made to its subcontractors.[lii] When the owner accepts assignment of a subcontract, its steps into the shoes of the contractor and is bound by the terms of the subcontract, even where those terms differed from the terms of its prime contract and where the owner subsequently assigns the subcontract to a completion contractor.[liii]

            If the work had been suspended more than 30 days prior to the owner’s execution of the assignment, then the subcontractor is entitled to an equitable adjustment for cost increases resulting from the suspension.[liv] Presumably the cost increases are limited to those actually resulting from the suspension and the subcontractor must prove that the additional costs arose as a result of the suspension.  There is some issue as to whether Section 5.4.2 would give rise to an owner’s liability for Eichleay type damages.[lv] Once the owner has accepted assignment of the subcontract, it is entitled to further assign the subcontract to its completion contractor.[lvi] Even where the subcontract is assigned to a completion contractor, the owner remains liable to the subcontractor.[lvii]

            B.         ConsensusDOCS

1.         Article 11 Suspension, Notice to Cure and  Termination of The Agreement

            Like the AIA family of documents, the new ConsensusDOCS specifically provide grounds for the owner to terminate its contract.  The bases for owner termination of the contract are almost identical to those specified in the AIA documents: 1) failure to supply enough properly skilled workers or materials, 2) failure to promptly pay its workers, subcontractors or suppliers, 3) failure to comply with laws, ordinances, rules, regulations or orders of any authority having jurisdiction, and 4) material breach of a provision of the contract.[lviii] The ConsensusDOCS, like the AIA documents, also require a seven-day notice of default, which the ConsensusDOCS specifically indicate is intended as a time when the contractor may cure its default.[lix]

            There are some significant differences, however, when it comes to owner termination under the ConsensusDOCS.  The most obvious difference is that the ConsensusDOCS provide alternate interim remedies other than termination.  If a contractor is in default and has failed to cure such default within seven days of written notice of the default, upon an additional three days’ written notice and failure to correct the default, the owner is entitled to elect certain specified remedies short of declaring the contract terminated.

11.2.1 supply workers and materials, equipment and other facilities as the Owner deems necessary for the satisfactory correction of the default, and charge the cost to the Contractor, who shall be liable for the payment of same including reasonable Overhead, profit and attorney’s fees;

11.2.2 contract with Others to perform such part of the Work as the Owner determines shall provide the most expeditious correction of the default, and charge the costs to the Contractor;

11.2.3 withhold payment due the Contractor in accordance with Paragraph 9.3; and

11.2.4 in the event of an emergency affecting the safety of persons or property, immediately commence and continue satisfactory correction of such default as provided in Subparagraphs 11.2.1 and 11.2.2 without first giving written notice to the Contractor, but shall give prompt written notice of such action to the Contractor following commencement of the action.[lx]

While these actions are allowed under the AIA documents -- for instance the AIA documents provide for the owner to perform portions of the work through other contractors -- there is no specific provision entitling the owner to do so as a remedy for default and to charge the contractor for the costs.  The obvious exception is the owner’s right to withhold payment, which the owner is entitled to do under the AIA documents for breach as well.  The remedies provided in Section 11.2 of the ConsensusDOCS 200 are in addition to the owner’s right to terminate the contract; however the notice requirements for the two remedies differ.[lxi] 

            Another significant difference between termination under the ConsensusDOCS and the AIA documents is that termination under the ConsensusDOCS requires two, and in some cases three, notices and cure periods prior to termination.  As discussed above, the AIA documents provide for seven days’ written notice of default and an opportunity to cure before the owner can terminate the contract.[lxii] The ConsensusDOCS, however, provide for an initial seven-day written notice of default and an opportunity to cure, and then before the owner can either terminate the contract or elect the lesser interim remedies discussed above, a second written notice must be given and further period for cure allowed.  In the case of the interim remedies provided under Section 11.2, the owner must give an additional three-day written notice.[lxiii] In the case of actual termination of the contract, the owner must give an additional fourteen days’ written notice.[lxiv]

            Upon termination under the ConsensusDOCS, the owner’s remedies are almost identical to those provided for under the AIA documents, but there is a linguistic difference which may result in differences in application.  As with the AIA documents, the owner is entitled to recover from the contractor if the costs of completing the contract scope exceed the contract balance.  The ConsensusDOCS’ provision, however, provides for the owner’s recovery of its completion costs, plus reasonable attorney’s fees, less the contract balance.[lxv] Compare this to the owner’s ability to recover the costs of completing the work, including any compensation for architect’s services and other damages incurred by the owner.[lxvi] While the AIA documents do not specify what other damages the owner might be entitled to upon termination, it could reasonably cover more than just the attorney’s fees provided for in the ConsensusDOCS.

            While, with the exception of the notice periods, there is not a significant difference between the AIA and ConsensusDOCS regarding termination by the owner, that is not true when it comes to termination of the contract by the contractor.  The actual bases for termination by the contractor are the same as those provided for in the AIA documents, with one exception, but where the AIA documents require significant periods of work stoppage before the contractor can terminate, this is not always true for the ConsensusDOCS.  Where the work has been stopped for a thirty-day period through no fault of the contractor the ConsensusDOCS provide for the contractor to be able to terminate the contract on grounds similar to those in the AIA documents:

11.5.1.1 under court order or order of other governmental authorities having jurisdiction;

11.5.1.2 as a result of the declaration of a national emergency or other governmental act during which through no act or fault of the Contractor, materials are not available; or

11.5.1.3       suspension by the Owner for convenience pursuant to Paragraph 11.1[lxvii]

It should be noted that as this clause refers to suspension for a thirty-day period, rather than for thirty days, termination under this clause will probably require a period of work stoppage for at least thirty consecutive days.  Another point worth noting in the above provision is that the ConsensusDOCS provide for termination where the work stoppage is a result of a government act during which materials are not available.[lxviii] This is broader than the basis for termination under the AIA documents, which requires that the government act utilized as the basis for the termination actually require that the work be stopped.[lxix] Presumably the ConsensusDOCS clause would cover situations where the contractor was unable to obtain material, even though the government had not declared the work actually stopped.[lxx] It should also be noted that the ConsensusDOCS provides for termination because of owner-directed suspension of the work in excess of thirty consecutive days, whereas the AIA documents require work stoppage in aggregate more than 100 percent of the total number of days scheduled for the work, or more than 120 days in any 365-day period.[lxxi]

            Unlike the AIA documents, there exist four grounds for termination by the contractor which do not require any work stoppage at all.  Where the owner:

11.5.2.1           fails to furnish reasonable evidence pursuant to Paragraph 4.2 that sufficient funds are available and committed for Project financing, or

11.5.2.2       assigns this Agreement over the Contractor’s reasonable objection, or

11.5.2.3     fails to pay the Contractor in accordance with this Agreement and the Contractor has complied with the notice provisions of Paragraph 9.6, or

11.5.2.4  otherwise materially breaches this Agreement.[lxxii]

All of these grounds, with the exception of 11.5.2.2, exist in the AIA documents.[lxxiii] Unlike the AIA documents, however, no work stoppage is required as a result of the defaults before the Contractor terminates the contract.

            Another significant difference between the AIA documents and the ConsensusDOCS relates to the contractor’s recoverable damages in the event of termination.  Like the AIA documents, upon a proper termination by the contractor, it is entitled to recover the costs of the work executed through the termination, plus its costs for demobilization and a reasonable overhead and profit.[lxxiv] Unlike the AIA documents, however, the ConsensusDOCS specifically entitle the contractor to recover overhead and profit on the work that was not performed as a result of the termination.[lxxv] The contractor is also entitled to recover for “any proven loss, cost or expense in connection with the Work”.[lxxvi]

            I noted with respect to the AIA documents, the remedies provided in the contract have been interpreted to be in addition to the common law remedies, and the contract actually indicates that the contractual remedies are in addition to all other remedies available to the parties.[lxxvii] This is not true with respect to the ConsensusDOCS.  The ConsensusDOCS specifically provide that the parties’ “rights, liabilities, responsibilities and remedies with respect to this Agreement, whether in contract, tort, negligence or otherwise, shall be exclusively those expressly set forth” in the contract.[lxxviii] Accordingly, a failure to comply with the conditions precedent to termination under the ConsensusDOCS is probably fatal to the termination.

                        2.         5.5 Contingent Assignment of Subcontracts

            The ConsensusDOCS provide for the assignment of the contractor’s subcontracts to the owner in specific circumstances.

5.5.1.1            this Agreement is terminated by the Owner pursuant to Paragraphs 11.3 or 11.4; and

5.5.1.2             the Owner accepts such assignment after termination by notifying the Subcontractor and Contractor in writing, and assumes all rights and obligations of the Contractor pursuant to each subcontract agreement[lxxix]

These are almost the conditions for contingent assignment that appear in the AIA documents.  Accordingly the discussion above on the assignment of subcontracts under the AIA documents would apply equally well here, with one significant exception.  The ConsensusDOCS, unlike the AIA documents, allow for the assignment to the owner of the contractor’s subcontracts upon the owner’s terminating the contract for its convenience.[lxxx] By way of contrast, the AIA documents allow only for assignment where the contract is terminated for default.[lxxxi] Obviously, the owner’s interest in obtaining assignment of the contractor’s subcontracts so that it can complete the scope of work applies with equal force when the termination is one for the owner’s convenience as it does when the contractor is terminated for cause.

III.       Completion Concerns

            A.         Who Owns The Materials

            As discussed above, most standard form construction contracts provide that upon termination of the contract by the owner for the contractor’s default, the owner is entitled to take possession of the contractor’s materials located at the project site.[lxxxii] This same remedy, although broader in scope, is available to the government on projects under the Federal Acquisition Regulations.[lxxxiii] 

            This remedy is certainly useful to the terminating owner and is not otherwise available to them.  Professor Sweet noted the reasons given for the post termination remedy as:

1.         to provide incentive to the contractor to take away its property from the site so that the owner can efficiently bring in a successor;

2.         to provide the owner with material and equipment by which it can expeditiously continue the work with a successor (Note the conflict with (1) above); and

3.         to give the owner property from which it can obtain payment for any claim it may have against the contractor.[lxxxiv]

            When purchasing materials, absent a contract provision specifically addressing the transfer of title to the property, title will transfer at the time and place where the seller physically delivers the goods.[lxxxv] Contrary to the above, where the contract specifically identifies the manner and conditions on which title is to pass to the owner, the contract provisions will control.[lxxxvi] However, the contract clauses do not provide the terminating owner or the terminated contractor with a clear delineation as to which materials the owner has obtained title and which materials it may seize as a result of the default.

                        1.         Effect of Payment

            The standard construction contract clauses providing for the owner to take possession of materials at the project site are limited to those materials belonging to the terminated contractor and do not automatically apply to materials delivered to the project site by subcontractors and material suppliers.[lxxxvii] For government contracts the government may take possession of all material on the project site regardless of who supplied the material to the project.[lxxxviii] Accordingly, upon a proper termination of the contractor, except for federal government contracts, the owner is entitled to the possession and use of the materials only of the contractor, and any other material on the project site, title for which has already been transferred to the owner.  Even as to the contractor’s materials, pursuant to the termination clause the owner obtains only the right to take possession of and utilize the materials, but does not obtain any title in the materials other than equitable title to the material as security against a deficiency judgment against the contractor.[lxxxix] Thus the owner would not qualify as a buyer in the ordinary course and would not be entitled to avoid replevin of material for which it had not obtained title.

            Before taking possession of construction materials, therefore, the owner must determine what material it actually holds title to and what material it is entitled to take possession of as a result of the termination.  The AIA contract documents provide for title to materials to pass to the owner “no later than upon payment” to the contractor.[xc] Unfortunately, this clause does not specify with any certainty when title will pass, only that title should pass to the owner not later than payment.  Professor Sweet notes that when the AIA adopted the “no later than upon payment” approach, it intended title to pass according to state law.[xci] Of course, as noted above, the Uniform Commercial Code, which generally governs passing of title to goods, provides that the contract controls as to the time of passing of the title.[xcii] This results in a lack of clarity, to say the least, as to when title is presumed to have passed.  Even if the a court were to look to the backup provision of the Uniform Commercial Code to determine that title passes upon delivery, such a presumption would probably be valid only as between the owner and contractor, since the contract fails to specify the event for passing of title.  Most purchase orders, however, do specify the conditions precedent to the passing of title, normally receipt of payment by the supplier.[xciii] Accordingly, it is not clear that where the owner has paid the contractor and the materials have been incorporated into the project that the owner has actually obtained clear title to the materials.  In such circumstances the owner may be subject to a replevin action or action for conversion, even though the material has been incorporated into the building.[xciv]

            Where the owner has paid the contractor for the materials and the materials have been incorporated into the project, it can at least be said that the owner should be entitled to title to the materials.[xcv] Unfortunately, just because the contract calls for title to pass not later than payment to the contractor does not mean that title will actually pass.  In fact the AIA documents contemplate that title will not pass, and instead what the owner obtains upon payment is a warranty from the contractor that title will pass to the owner no later than receipt of payment and that all materials contained in prior applications for payment for which the contractor has received payment are free of liens, encumbrances or other security interests.[xcvi] As noted by Professor Sweet:

If the contractor has breached whatever warranty the contractor has given, under A201 subparagraph 9.3.3 the owner has a claim, perhaps a worthless one, against the contractor if a third party asserts an ownership or security interest in materials or equipment for which the owner has paid.[xcvii]

            The ConsensusDOCS take a different and slightly more straightforward, if ungainly, approach.[xcviii] The ConsensusDOCS require as a condition precedent to the approval of a payment application that the contractor submit:

bills of sale and proof of required insurance, or such other procedures satisfactory to the Owner to establish the proper valuation of the stored materials and equipment, the Owner’s title to such materials and equipment, and to otherwise protect the Owner’s interests therein, including transportation to the site.[xcix]

By actually requiring that the contractor provide documents evidencing the passing of title to the property to the owner, the ConsensusDOCS would satisfy the objection raised by Professor Sweet.  Unfortunately the process as envisioned is difficult in application and would require a high level of sophistication by the contractor and the owner for it to operate properly.  Initially, it is worth noting that the clause actually refers to the contractor’s providing bills of sale as evidence of title, but bills of sale are generally not documents that would pass title to material, other than cars, boats, airplanes and other registered vehicles.[c] Presumably the drafters of the clause intended for title to transfer by use of bills of lading or other documents sufficient to pass title under the Uniform Commercial Code, but the clause as drafted may not quite realize that intent.  A second problem for the contractor and owner under the ConsensusDOCS clause is that it requires a transfer of documentation and inspection and approval of documentation with each application for payment for all of the materials included in the application.  This would certainly make auditing the project easier, but is not particularly conducive to the efficient administration of the contract.  More troublesome is the likely event where the contractor and owner either ignore the requirements of this clause for passing of title, or agree to payment based on documents which do not effectively pass title to the owner.

            As discussed above, it not always easy for a terminating owner or a terminated contractor to determine in the run up to a termination or in the limited cure periods granted by the contracts what material are the property of the owner and what belongs to the contractor or to third parties.[ci] Unfortunately the effect of a wrong conclusion as to ownership of material immediately prior to or immediately after termination may be substantial.  The owner who wrongfully seizes material belonging to the contractor or third parties, or the contractor who seizes material which properly belonged to the owner, may be guilty of conversion and subject to extra contractual damages.

            It does not get any easier when the termination is between the contractor and a subcontractor.  The same problems that occur when determining the parties’ rights in material following a termination by the owner occur when the contractor terminates a subcontractor.  Under the ConsensusDOCS the issues are almost identical, since the ConsensusDOCS subcontract form, if used, provides for the same provisions regarding passing of title and rights in material after termination.[cii] Other standard contract documents, including the AIA documents, however, do not contain any provision for title to materials to pass to the contractor, or for possession of the subcontractor’s materials upon termination.  This may actually be to the contractor’s benefit since, as noted above, absent a contract term specifying the passing of title, the title is presumed to pass upon delivery of the materials.[ciii] Unfortunately, the presumption that title to goods passes upon delivery will not assist the contractor where the subcontractor did not have good title to the goods as may be the case when a supplier had conditioned transfer of title upon receipt of payment.  If the contractor has not made payment to the subcontractor, it will not be entitled to a “buyer in the ordinary course” defense to the supplier’s action to replevin the goods or for conversion. It should be noted, however, that at least one court has found the contractor’s right to take the subcontractor’s materials to have been incorporated into the subcontract through a general incorporation by reference provision to the prime contract.[civ]

                        2.         Effect of Delivery to the Project Site

            As discussed above, most standard construction contracts make at least some attempt at defining when title to materials will pass to the project owner.  Where the contract actually succeeds in specifying the conditions precedent to or the timing for the passing of title, those contract provisions will be controlling.[cv]

            In the absence of a contract provision, however, the presumption is that title will pass upon delivery of the goods.  Title can pass upon shipping or upon actual delivery of the goods to the project site.[cvi] However, where title passes upon delivery, there is no requirement that the title not be subject to a security interest in the seller.[cvii] Accordingly, just because the goods have been delivered to the project and the contract does not specifically identify a different time for passing of title, does not mean that the owner automatically has free and clear title to the goods.

            Disregarding for the moment the effect of delivery upon title, delivery of the materials to the project can have a substantial impact on the supplier’s rights, and accordingly upon the contractor’s and owner’s decisions in terminating a contract.  Delivery of materials to a project is generally sufficient to entitle the supplier to a claim under the Miller Act, and most state Miller Acts, even where the material is not incorporated into the project.[cviii] Even where it is not sufficient to entitle the supplier to recovery, it often establishes a rebuttable presumption of incorporation into the project.[cix]  Similarly, depending on the state, delivery of materials to the construction project can 1) entitle a supplier to a mechanic’s lien, 2) entitle a supplier to rebuttable presumption of incorporation into the project and a mechanic’s lien, or 3) can be of no effect.[cx]

            Thus delivery of material to the project prior to termination in some circumstances will control whether a claim for the material may be made and against whom.  It is critical for the owner and contractor prior to or immediately after termination to determine what part of the material delivered to the project site has been paid for and if a claim is made for the material, who that claim will be against.  The terminating owner has an interest in ascertaining whether the supplier of material to the project has been paid for the material so that the owner can use that material in the completion of the project.  If materials supplied by the terminated contractor are not to be utilized by the completing contractor, then the terminating owner would be well-advised to consider the burden of proof for establishing a lien against the project.  If the material supplier has the burden of proof of incorporation or if there is a rebuttable presumption upon delivery, then the owner should in writing reject the materials and direct the contractor to remove the materials from the project site.  If delivery creates an irrebuttable presumption of incorporation into the completed project, then the owner may want to investigate whether the completion contractor could utilize the materials on the project site and thus reduce the completion costs.

            The terminated contractor and its surety may have the same concerns, but will normally have even less ability to influence the owner or completion contractor to take and utilize the material. 

                        3.         Specially Fabricated Materials

            Specially fabricated or custom built items create unique problems for the contractor and owner on terminated projects.  Normally fabricated or custom built materials have been constructed in accordance with the owner’s specifications for a specific purpose.  As such they are often more expensive, more time-consuming to replicate and are particularly needed by the project owner.

            For the owner terminating the project, therefore, there is frequently a particular interest in obtaining the specially manufactured goods as part of the termination.  Obtaining the manufactured goods from the contractor will avoid significant delays and lead time in obtaining the material from another source, especially where the owner has made partial payments for the fabrication of the material prior to termination.  Specially fabricated items, however, are rarely fabricated at the project site. Accordingly, the owner’s ability to seize material and equipment at the project site upon termination often will not result in the owner’s obtaining the items that are most critical to its completion of the project.

            Specially fabricated goods are particularly troubling for the terminated contractor, as frequently the contractor may be liable for the goods, notwithstanding the fact that the owner rejects delivery where the contract was terminated.  While not controlling, the special manufacture of materials will frequently make the supplier a subcontractor for purposes of establishing a Miller Act or “Little Miller Act” claim against the contractor.[cxi] Accordingly, special fabrication of materials may subject the contractor to an action on his bond for the cost of the materials.  This is true even where the materials have been destroyed after identification to the contract.[cxii]

            Even more troubling for the terminated contractor are the supplier’s rights and remedies under the Uniform Commercial Code.  Where the contractor has rejected or otherwise breached the terms of a purchase order as a result of the owner’s termination, the supplier may be entitled to identify the materials to the contract, or if the material has not been completely manufactured, may either complete fabrication of the material or cease fabrication and resell the material as scrap.[cxiii] Under either of the above options, once the materials have been identified for the project the supplier can tender delivery of the materials in return for payment.[cxiv] This puts the terminated contractor in the position of either having to accept goods for which it has no reasonable use, or rejecting the goods and thereby breaching the purchase order.  Of particular concern wit