You Have a G-MAX Contract — So What?
A Guaranteed Maximum Price contract, known as a G-MAX or GMP contract, is a construction agreement that puts a maximum cap on the agreed upon project costs and scope of work, regardless of the actual costs incurred. G-MAX contracts shift a significant amount of risk to the shoulders of contractors while giving customers the peace of mind that accompanies a limit on cost. When a G-MAX contract is in place, cost overruns are covered by the contractor. If the project comes in under budget, the terms of who benefits are deal specific. In some instances, savings may be shared, or an acceleration bonus is incorporated as an incentive to complete a project early.
Historically, G-MAX contracts have been beneficial to contractors because they help expedite bidding processes and make it easier to obtain financing since construction lenders like the predictability of costs and production timelines. However, economic conditions resulting from the pandemic have made G-MAX contracts a problem for many general contractors.
The Challenges
The hat trick of supply chain interruptions, labor shortages and rising inflation have put a triple whammy on the construction sector.
Upwards of 60 container ships have been sitting offshore at the Long Beach and Los Angeles terminals waiting to unload everything from electronics to building materials in an unprecedented event referred to by the media as “Containergeddon.”
Roughly 90% of the world’s global trade is shipped by sea, and 70% of that is in containers. Increasingly, the U.S. relies upon imported goods, particularly from China and other Asian nations. With the onset of the pandemic, global trade slowed as factories in China and elsewhere closed. Supply and demand fell, so shipping volume also slowed. But as it became clear that COVID was here to stay, Americans began buying everything insight to make their homes more comfortable. Now, ports are unloading record amounts of cargo — especially in Long Beach-L.A., where approximately 36% of U.S. imports land.
The years-long skilled labor shortage continues, compounding supply chain woes, with not enough workers to manufacture goods, transport them and build new projects.
Together, these factors are contributing to an imbalance of supply and demand, with demand far exceeding supply and driving labor and materials prices skyward. According to a May survey by the National Association of Homebuilders, the 12-month increase in material costs for the same house averaged 26.1 percent.
Many general contractors who have agreed to build a project at a set cost per a G-MAX contract find themselves in a difficult spot. They are legally bound by contract, yet if they complete the project, they face significant and unanticipated losses. In some cases, the potential losses are so great, general contractors attempt renegotiating prices. If they are unsuccessful, they can stop work altogether, engage legal counsel and opt to face settlement losses instead. One client told QuickDraw Fund Control: “If lumber went up 5 percent each year over the past 10 years, and it went up 5 percent this year, it’s on me. But if lumber is up 100 percent year over year, I can’t and won’t absorb that cost.”
For the borrower, replacing a general contractor mid-stream almost always comes at a higher cost and extends the project’s completion date. With a construction loan in place, these additional costs are typically required to be paid outside of the loan. Add potential legal costs to the equation, and suddenly cash flow requirements change for the worse.
Minda Johnstone, Principal and Chief Credit Officer, Freedom Financial Funds, LLC, provides the lender perspective: “Given that the lender is not a party to the G-MAX contract, the lender’s remedies amidst COVID-related cost overruns and renegotiations between contractor and developer may be somewhat limited, and largely rest on the ‘contract’ between the lender and the borrower/developer; for example, allowing use of the loan’s Contingency Reserve to absorb the overruns and enforcing the rights and remedies of a Completion Guaranty. Going forward, the lender should strongly consider obtaining a Cost Analysis, such as that offered by QuickDraw Fund Control, prior to closing its construction loan; and structure the loan with an ample Contingency Reserve. Not surprisingly, new G-MAX contracts are showing up with new COVID provisions, placing all prospective ‘impacts’ of COVID outside of the Guaranteed Maximum Price. The lender should be comfortable that its borrower/developer has the ability to withstand these potential impacts.”
The Solutions
In the current market, there is no way for even the most experienced contractor to estimate accurately. But it is in no one’s best interests for a project to fail. So, what can be done?
Put your cards on the table and your best foot forward.
Bring all of the costs, including your overhead and profit, and share it with your client. Both parties should consider making a meaningful concession. Whether it’s splitting the costs, the general contractor agreeing to perform a portion of the work sans overhead and profit, or another mutually agreed-upon structure, this is the most efficient and least expensive solution.
Allowances
Allowances are another way to plan for unknowns. Allowances are amounts that are set aside for decisions that the owner has yet to make about the work. Since these costs are only to be used for materials rather than for labor, profits or overheads, these can be useful in the current circumstances. An allowances clause should detail whether the allowance covers materials only or if it also includes labor. It should also describe notice and authorization procedures and explain how overages/savings will be handled.
Change Orders
Change orders also help contractors prepare for uncertainty in a guaranteed maximum price contract. These mutual agreements allow increases to the contract price or extensions of completion time due to unforeseen circumstances or owner changes that materially affect the project’s scope. Customary contract language includes a procedure for the owner and/or contractors to request and approve change orders, as well as a dispute resolution clause detailing how disagreements will be handled.
Invoking Force Majeure Clauses
This is the least desirable option for all parties and should be avoided whenever possible.
Relying upon a force majeure clause to mitigate liability for COVID-related delays and cost overruns in a G-MAX contract is an uncertain fix. The extent of protection to the contractor ultimately depends upon the terms and language contained in the contract. The effect of a pandemic under force majeure clauses is uncharted legal territory, and varying jurisdictions will interpret the clauses differently. For instance, in general, courts in California require the party invoking the clause to prove they made reasonable efforts to avoid consequences of the force majeure event.
Legal experts counsel that courts are likely to ask these questions when determining whether or not a force majeure applies:
- What is the precise language of the clause?
- Was the coronavirus unforeseeable?
- Can causation between the pandemic and the resulting non-performance be proven?
- Is there evidence that the pandemic is severe enough to excuse non-performance?
Under current market conditions, G-MAX contracts place additional risk on general contractors, making them liable to absorb cost overages. Until the market stabilizes, borrowers and contractors alike will want to take special care to mitigate risk through open communication and by utilizing the strategies above.