Category: Commercial

No recent law has received as much attention as the enactment of the Sarbanes-Oxley Act. Although it was passed in 2002, the financial transparency issues it raises are still being discussed and debated three years later. Every industry has had its problems with interpretation and certainly, construction is no exception. Sarbanes-Oxley has cast a new light on the function of the internal audit department in any publicly held construction firm.

The center of all the controversy is Section 404. It requires companies that file annual reports with the SEC to discuss management’s responsibilities to develop and maintain adequate internal control over the company’s financial reporting process. As if that weren’t enough, the law also requires management to perform a self-assessment of the effectiveness of those internal controls. The process of scrutinizing financial reporting mandates that internal audits go beyond the usual definitions of loss prevention to take a much broader view of the company’s financial health.

This broader vision actually breaks down into a few different areas. The first is recognizing the growing demand for management’s accountability regarding capital stewardship. Internal audits should assume a more proactive role when it comes to providing decision support data. Accurate project scope definitions and cost/effort estimation models that are completed before a contract is finalized, and exemplify a project’s real cost and schedule to complete, will provide management the ability to make an informed decision about whether or not to proceed. Completing a scope definition midway through a project with a change order is an expensive fix for perceived risks that only weaken the firm’s financial state.

Internal audits need to have a watchful eye when it comes to assessing a project’s risk impact on the company’s capital reserves. It is no longer sufficient to assign a standard percentage of the contract’s value to allow for unforeseen events. There needs to be real transparency as to what the perceived risks are and their potential impact on the company’s finances in dollars and cents.

Along with the assessment of risk comes the allocation of risk. One of the biggest hindrances to management’s capital stewardship is inadequate contractual allocation of risk. For example, the firm failing to assign risks to those projects best suited by virtue of their operating margin or the nature of the firm’s expertise. An internal audit is needed to verify the firm’s contractual risks are well within its ability to maintain them without seriously impacting the firm’s capability to complete the project within budget and on time.

While these areas are not really new to internal auditing, the one area of uncharted waters is the company’s potential risks and costs associated with environmental, health, and safety issues. This is the area where Section 404 has made the biggest impact, by requiring increased transparency in reporting these risks.

Any activity the firm undertakes, whether a new project, retooling to become more competitive, or modifying a facility to accept a more diverse range of projects, will have some environmental, health and safety issues attached to it. Ensuring that solid internal controls are in place can minimize the potential impact of these issues. When internal audits consistently monitor these controls, company profitability is protected by reducing environmental, health and safety liabilities.

To that end, internal auditing needs to fully understand the company’s environmental, health and safety policies and how they are integrated with internal controls. Audit teams also need to review compliance documentation. Such documentation includes environmental, health and safety policies, procedures, checklists and training programs. Audit teams need to take a proactive stance by observing the system of controls to see if they work and making recommendations to management about areas that need improvement.

The importance of a construction contract should never be underestimated. It literally spells out the entire understanding between the owner and the contractor. The contract is usually comprised of an agreement, drawings, specifications, general and supplemental conditions, addenda, and contract modifications made during the duration of the contract.

Although all of these aspects of the contract are important in their own right, the general conditions section has the greatest impact because it typically contains the most provisions relating to the project’s risks. The correct allocation of risks and responsibilities is a significant factor in determining whether or not a particular contract is a workable contract. That’s because allocating risk appropriately will set the project on a winning course. It fosters positive relationships among the respective parties in the contract because everyone is on the same page. The “us against them” mentality that accompanies an unexpected crisis when there is no contingency plan can be avoided. Eliminating uncertainty about responsibilities makes it possible for contractors to avoid adding cost contingencies in their bids to protect themselves from being caught short. It also allows them to plan ahead for contingencies and schedule them as part of the contract performance. In summary, proper risk allocation will ensure fewer claims, lower costs and enable the project to be completed on time.

Using this risk allocation yardstick, how does the standard construction industry contract measure up in terms of being a good contract? In their favor, standard form contracts have had a stabilizing influence on the way construction projects are transacted. Because the industry is not governed by a cohesive set of regulations, industry associations were forced to develop standard contracts to provide members with guidelines for proceeding expeditiously. Legally, they are considered fair and advantageous, which is why they are used so prevalently.

Because most of these contracts are developed with input from industry participants, they incorporate current customs and best practices. Even when the parties choose to draft their own contract, industry standard forms are used as a reference. Because the standard terms and conditions they contain are familiar to industry members, it substantially reduces drafting and review time, which lowers overall costs. This familiarity with terms and conditions and the understanding of their consequences allows contractors and subcontractors to offer lower bids because there are no surprises when establishing the bid price.

In spite of the effectiveness of the standard form contracts, the American Corporate Counsel Association says they should not be used without taking certain cautions into consideration:

• Standard forms should not be used without modifications. Since they are drafted for broad applicability, standard form contracts cannot account for all transaction-specific and jurisdiction-specific terms that the parties require.
• Be wary of the “ripple effect.”Because standard form construction documents often reference other parts of the contract, changes made in one may have repercussions in another. Pay particular attention when changing the definition of a word or term.
• Do not become “contract complacent.”Read the contract, even if it is a standard form. New projects or circumstances may necessitate a “fresh look” at specific boilerplate language.
• Custom-drafted and industry-drafted forms do not mix.Industry-drafted forms usually are coordinated only with other industry-drafted forms from the same organization/publisher. Unless the drafter of the custom form has attempted to coordinate the document with the industry-drafted form, chances are they will not be compatible. Industry-drafted forms from different organizations/publishers usually are not compatible.
• Every contract contains the bias of the drafter. Bias is an inescapable element of any contract. Turn that knowledge into an advantage by knowing both the relative merits and features of and the circumstances under which to use the various standard forms published by different industry organizations.

The January 2, 2006 explosion in West Virginia’s Sago Mine is a graphic reminder of how someone can leave for work one morning not knowing whether it will be his or her last. News reports after the tragedy indicated that in the past two years, the mine was given 273 safety violation citations, and almost a third were classified as “significant and substantial” by the Department of Labor’s Mine Safety and Health Administration. Numerous citations were for problems that could contribute to accidental explosions or the collapse of mine tunnels.

This tragic scenario of worker fatalities is not all that uncommon, according to a recent report entitled Decent Work-Safe Work prepared by the United Nations International Labor Office. The report concluded that at least 2.2 million people die annually from work-related accidents or illness worldwide. Estimates based on statistics gathered from around the world show a 10 percent increase in worker fatalities from 1998 to 2001, the last year such statistics were collected. Accidents decreased slightly in industrialized countries. However, the number of work-related deaths rose in Asia and other developing nations in such industries as mining, farming and construction.

Researchers cited rapid economic development and increased pressures on business to compete globally as the chief reasons for the significant rise in the number of deaths. On the bright side, the report also noted that businesses around the world are beginning to realize that good safety practices make sound business sense. Not only does a worker fatality affect the worker and his family, it affects the productivity and profitability of the business itself and, over the long-term, diminished productivity and profitability negatively impact society. In other words, the notion of corporate citizenship, or the corporation becoming accountable to society at large for its actions, is beginning to take hold in the minds of the management running companies.

There is still a long way to go before safety and health on the job reaches acceptable levels. The researchers discovered that reporting systems and coverage of occupational safety and health in many developing nations is poor and quite often deteriorating even further. Men are especially vulnerable to dying before age 65 because of accidents, lung disease and work-related cancers. Women, on the other hand, suffer from work-related communicable diseases, psychosocial factors and long-term musculoskeletal disorders. Workers ranging in age from 15 to 24 are less likely to suffer fatal occupational accidents than their older colleagues. Workers aged 55 and older are more likely to die in work related accidents and suffer from bad health.

The Decent Work-Safe Work report concluded with a call to action on international, national, regional and enterprise levels. It emphasized that decent work must be safe work and that occupational safety and health were imperative to maintaining the dignity of all workers.

The issue of civil rights has always been hotly contested in this country. Heated debates resulted in the passage of the landmark Civil Rights Act of 1964. Originally intended to secure the rights of African Americans, it was later amended to safeguard women’s rights.

Title VII of this law prohibits discrimination in employment on the basis of race, national origin, gender, or religion. In the late 1970s courts began ruling that it applied to sexual harassment as well. Though Title VII only applies to employers with fifteen or more employees, it is how the definition of employee bears on the case that is the center of the most significant controvery regarding discrimination suits.

Consider the case of Jenifer Arbaugh vs. Y&H Corp. The suit involves an employee of the Moonlight CafГ(c) in New Orleans who alleged she was victimized by a sexually hostile work environment while employed as a bartender and waitress. Y&H Corp., a corporation with two individual owners, owned the Moonlight CafГ(c). The case was tried in the U.S. District Court for the Eastern District of Louisiana, and in 2002, a jury awarded Arbaugh $40,000 in damages.

Y&H Corp filed a motion, arguing the action should be dismissed because the federal court had no jurisdiction as the company had less than 15 employees, which meant Title VII didn’t apply. The methodology they used in determining the number of employees involved excluding the two owners, their wives, who also worked for the business, and their delivery truck drivers.

In 2003, the district court agreed with Y&H Corp and dismissed the case on the grounds of subject matter jurisdiction. That is they agreed that given the number of employees was less than 15, the court had no authority to decide on the case. A year later, a three-judge panel of the U.S. 5th Circuit Court of Appeals upheld the district court’s 2003 decision.

However, Arbaugh made an appeal to the Supreme Court and it began hearing arguments on January 11, 2006. The basis of the appeal is that Section 701(b) of Title VII does, in fact, state that the prohibition against employment discrimination applies to employers with fifteen or more employees. The question is whether this provision also limits the subject matter jurisdiction of the federal courts as was previously decided, or does it only raise an issue about the merits of a Title VII claim? Arbaugh’s attorney argued that the number of employees went to the merits of the case, rather than to the question of whether or not the court had the right to rule.

What stands at the heart of this case is whether the definition of an employee is decided as one of the facts of the case or as determination of the court’s authority. This decision has profound implications for employers. If the definition of an employee is a deciding factor in the court’s right to rule, an employee can postpone raising the question of who are the legitimate employees of the company being sued until after he/she knows the outcome of a trial on the case’s merits. This means a suit of this type can drag on costing the company being sued millions of dollars in legal fees. If the definition of an employee is determined to be part of the merits of the case, than a jury would decide on that factor along with the rest of the case’s merits, which would expedite litigation.

The Supreme Court is expected to decide on this issue as part of their ruling in the Arbaugh case.

The 10-year housing and real estate boom in this country has been a double-edged sword for the construction industry. While the top 100 U.S. homebuilders were reported to have sold an estimated 1,000 new homes a day in 2002, such performance isn’t without a downside.

In the January 2004 issue, Consumer Reports noted that approximately 15 percent of all new homes built each year have serious problems. They place this startling statistic right at the doorstep of the building boom. The construction industry has been bombarded from all sides because of this phenomenon. Building defects have resulted in lawsuits costing the industry millions of dollars, general liability insurance costs are rising, and increasingly knowledgeable consumers are more critical of the finished product and more likely to sue.

On the heels of all of this, comes a survey of quality assurance data tabulated for the construction industry that proves leading construction defects are mostly the result of failure to follow building code requirements or installation instructions. And as if to add insult to injury, the survey goes on to show most of these defects are preventable.  The survey completed by Quality Built, a provider in risk management and quality assurance services, used data gathered by their field inspectors during inspections of 31,995 completed homes and condominiums across 27 U.S. states for the 12-month period ending Oct. 1, 2005.

Single-family homes averaged $5,398 in corrected defects per home while multi-family homes and mixed commercial use construction averaged $4,556 in corrected defects. The survey also identified the leading risk items for each housing type. With regards to single-family housing, the top defects included:

• Building paper and house wrap installation flaws
• Improper framing around windows and doors
• Missing structural straps and connectors

Multi-family and mixed commercial use construction were most frequently cited for:

• Unprotected penetrations in life-safety assemblies
• Missing fire-rated materials at electrical device boxes

None of these defects are visible to a homeowner or building owner upon completion, but can lead to serious consequences and legal battles down the road. However, all of them can be easily corrected during construction if identified early through a quality assurance inspection.

Construction firms should take the following precautions to prevent a defect lawsuit:

• Hire a lawyer to get your contracts tightened up.
• Include Right-to-Cure, mediation and arbitration clauses as stopgap measures to prevent lawsuits.
• Find a set of national construction standards that you back and include them up front in your contract.
• Spend time going over the contract with the potential home buyer before they sign to make sure they understand what they’re signing, and agree to the construction standards you’ve specified. If your attorney agrees, consider allowing clients three days to review the contract before signing, or three days after signing to cancel the deal.
• Create a small fact sheet or brochure for your clients that remind them of the key points of the contract – that you have the right to be notified first and granted the opportunity to fix the problem, the acceptable method for repair (included in the construction standards), and that mediation and arbitration are the next opportunities to resolve the issue prior to a lawsuit.