What does your contract mean?

Construction disputes often arise because parties have divergent views as to what a contract means or what plans and specifications require. When such a dispute arises, the meaning of contract language, specification requirements or notes on a drawing becomes critical.

How is such a dispute resolved? Whose interpretation of the contract should prevail? To resolve such a disagreement and determine a contract's meaning, a judge or arbitrator will apply a set of well-established legal principles, commonly referred to as the rules of contract interpretation or construction. The rules of contract interpretation apply to all contract documents, including documents associated with construction projects: subcontract or prime contract agreements, specifications, drawings, addenda, notes written on plans, licensed applicator agreements, purchase orders, sales contracts, insurance policies and endorsements, warranties and bonds, and any other documents incorporated into a contract.

The purpose of the rules of contract interpretation is to determine the parties' mutual intent at the time of signing a contract. California's code states a contract must be interpreted "to give effect to the mutual intention of the parties as it existed at the time of contracting, so far as the same is ascertainable and lawful."

In some states (California, Georgia, Louisiana, Montana, Oklahoma and North Dakota), the rules of contract interpretation are codified in statutes. In most states, prior court decisions describe how the rules of contract interpretation will be followed. The parties also may include language in contract documents to govern how potentially conflicting documents are to be interpreted. For instance, contract documents may state in the event of a conflict between the plans and specifications, the text of the specifications will prevail.

The rules of contract interpretation come into play only when a contract provision is ambiguous. If a contract is clear and unambiguous, a court cannot rewrite the contract. The court's role is not to write a new, fair or better contract. As often stated by judges, the court's function is to "give full force and effect to the expressed or implied intentions of the contracting parties if such can be discerned."

Parole evidence rule

If a written contract appears complete and clear on its face and seems to represent the parties' final agreement, courts often will apply the parole evidence rule to prohibit consideration of any oral testimony that seeks to modify, contradict, supplement or explain the contract's plain meaning. As lawyers often say, "the contract speaks for itself."

Contracts, including construction contracts, frequently include an integration clause. Such a clause typically states the written contract is the final and complete agreement of the parties and supersedes all prior representations and agreements. An integration clause is meant to negate consideration of any other documents, discussions, representations or agreements other than what the contract states or references.

Suppose you include a condition in a proposal for a reroofing project that states your proposal and price are based on you not contacting any asbestos-containing materials and if asbestos is encountered, you will be entitled to adjust the contract time and price. You and the building owner subsequently enter into a contract based on the roofing specification and price contained in the proposal. However, the contract is a form customarily used by the owner. It contains an integration clause and does not incorporate your proposal but rather just includes the scope of work and price.

During the course of construction, you unexpectedly encounter asbestos-containing material and request additional compensation and time. Because of the integration clause and the fact the contract did not incorporate your proposal, you cannot rely on the proposal language to obtain additional compensation or time and you may not even be able to refer to the proposal as evidence to contradict or supplement the contract terms. Therefore, if there is a condition or provision important to you, be sure it is included in a contract and incorporate your proposal into the contract.

Ambiguities

When a contract is ambiguous, a court or arbitrator will examine the contract and, following the rules of contract interpretation, seek to ascertain what the parties intended from the contract language. The court will consider outside evidence only if there is ambiguity as to the contract's meaning.

The fact that parties may disagree about what a contract requires does not create an ambiguity. If a contract can be given a definite or certain meaning, it is unambiguous. If a contract is subject to more than one reasonable interpretation, each of which appears consistent with the contract's language, the contract is ambiguous.

When resolving a dispute regarding a contract provision's meaning, a court generally will follow three steps. First, the court will determine whether the language is clear and unambiguous; if so, the court simply enforces the contract according to its terms. If the court finds the contract to be ambiguous, the court applies the rules of contract interpretation to resolve the ambiguity. If the ambiguity still cannot be resolved, the issue of what the ambiguous language means and what the parties intended may, in some states, be resolved by a jury.

There are some basic rules of contract interpretation applied by courts when seeking to resolve conflicting contract interpretations arising from an ambiguity.

First, a contract should be interpreted to give meaning to all provisions; an interpretation that leaves portions of the contract without meaning should be avoided if possible. An interpretation that gives reasonable meaning to all parts of a contract will be favored over one that leaves portions of a contract meaningless. Every part of a contract must be considered for any fair or reasonable interpretation. In addition, a court should consider a contract in its entirety and not by examining isolated clauses and provisions.

Also, contract provisions should not be interpreted as conflicting with one another unless there is no other reasonable construction. A corollary to this rule is that courts seek a reasonable interpretation that avoids two contract provisions directly conflicting with one another. Although sometimes this is not possible, an interpretation that does not result in two irreconcilable provisions is favored.

Another rule is words are to be given their ordinary and usual meanings. Judges frequently will refer to dictionary definitions when examining a contract. Technical words, words of art, or words customarily used in a particular trade or business will be interpreted as usually understood by people working in the trade, profession or business that is the subject of the contract.

If a contract is ambiguous or uses a term that has special meaning in an industry, judges will consider the term's special meaning. In construction contracts, the meaning of terms commonly used in the construction industry generally are adopted.

Specially devised language added to a preprinted form is preferred over a provision in a preprinted form. For example, specially inserted provisions take precedence over preprinted provisions of a form contract. Accordingly, when a contract is partly printed and partly handwritten, the latter part is entitled to more consideration. However, a contract's handwritten or typed portion takes precedence over the preprinted portion only when the two cannot be reconciled. Where general, preprinted form language is inconsistent with particular negotiated language, the latter prevails. And typewritten provisions prevail over preprinted provisions. When a contract is partly preprinted and partly handwritten or typed, the handwritten or typed portions are given greater weight in construing the parties' intent.

In addition, the surrounding circumstances at the time a contract is signed are considered when determining the parties' intention. When studying a contract, a court considers the conditions and circumstances of the parties and their objectives at the time the contract was made. Although courts are reluctant to imply terms not included in a contract, they will do so when the implied term does not conflict with any express provision and the surrounding circumstances and balance of contract lead the court to conclude it is absolutely necessary to imply the term to reflect the parties' intention.

In addition, trade practice and usage may be considered. If plans and specifications are ambiguous, industry practice is likely to be critical in determining what is intended. An ambiguity in specifications can be resolved by reference to an industry custom. In the case Hostetter v. Park in 1890, the U.S. Supreme Court stated "[i]t is well-settled that parties who contract on a subject matter concerning which known usages prevail, incorporate such usages by implication into their agreements, if nothing is said to the contrary."

Trade usage can be used to interpret, add terms to and qualify contracts, particularly in situations where each party knows of the trade usage or if one party intends the usage to apply and the other knows or has reason to know of the other party's intention. If contract language is unambiguous, contract terms will not be overridden by attempted testimony of common industry practice.

Prior dealings between the parties and conduct of the parties during the contract's performance also are relevant to determining intent. Evidence of the parties' dealings during a contract often is given substantial weight in ascertaining the parties' intent because the assumption is the parties are acting according to the contract. The interpretation placed on a contract by the parties, as shown by their acts, often will be followed by the court. If the conduct indicates the parties interpreted the contract a certain way, the court likely is to adopt that interpretation. An interpretation that is consistent with the views of the parties expressed during performance of the contract is a relevant consideration in interpreting the contract.

The rule of contra preferentum states an ambiguous provision should be resolved or interpreted against the party that drafted the provision. Generally, this rule is applied only as a last resort after application of the other rules has failed to resolve the dispute. The rule that a contract is interpreted against the drafter is less likely to be applied when the contract resulted from arms-length negotiations between sophisticated parties or when the parties had equal bargaining power in the negotiation process.

On the other hand, the rule of contra preferentum is applied universally in disputes concerning the meaning of insurance policies and breadth of exclusions from policy coverage. Because insurance policies are form contracts prepared by the insurer and the insured typically has little to no ability to negotiate policy terms, ambiguous terms in an insurance policy are interpreted against the insurance carrier. If a coverage provision is ambiguous, an interpretation that favors coverage for the insured will be adopted. Similarly, exclusions in an insurance policy are narrowly construed.

Case decisions

In Rivers & Bryan Inc. v. HBE Corp., the District of Columbia Court of Appeals interpreted an indemnification provision in the subcontract between Rivers & Bryan Inc., Beltsville, Md., a masonry subcontractor, and HBE Corp., the general contractor, based in St. Louis. An employee of Rivers & Bryan had fallen through a hole while performing masonry work. Both Rivers & Bryan and HBE were cited by the Occupational Safety and Health Administration (OSHA) following the fall. The estate of the deceased employee filed a wrongful-death suit against the general contractor and others. HBE paid the estate $300,000 and sought indemnification from Rivers & Bryan pursuant to an indemnification provision in the subcontract between Rivers & Bryan and HBE.

The indemnification clause read: "Subcontractor agrees to observe and comply with all federal, state and local statutes and/or ordinances relating to the performance of this subcontract (including the Occupational Safety and Health Act of 1970),* to assume all responsibilities of the Contractor thereto and to indemnify and hold harmless Contractor from all penalties, damages or other loss resulting from subcontractor's failure to do so. *Subcontractor is not responsible for others who are not in conformance with OSHA."

The subcontract was on a preprinted HBE form. The asterisk was inserted by the parties and the language to which the asterisk refers was typed at the bottom of the page.

Reversing the trial court's ruling that the subcontractor was obliged to indemnify the general contractor for the $300,000 paid to the estate of the deceased subcontractor's employee, the appellate court placed greater emphasis on the typewritten language than the preprinted indemnification language and ruled the general contractor had not proved it was entitled to indemnification.

Courts have used the rules of contract interpretation to determine whether payment clauses in subcontracts between general contractors and subcontractors create a "condition precedent" or describe the time the general contractor is to pay the subcontractor. The distinction is critical if an owner does not pay the general contractor through no fault of the subcontractor. If the payment provision is interpreted as a condition precedent, the subcontractor is not entitled to payment if the contractor does not receive payment. If the provision is interpreted as a time for payment, the subcontractor is entitled to payment after a reasonable time if the general contractor is not paid through no fault of the subcontractor. The leading case regarding this issue is Thos. J. Dyer Co. v. Bishop International Engineering Co., a 1962 decision of the 6th Circuit U.S. Court of Appeals.

In the Dyer case, the subcontract stated no part of the subcontract price was due until five days after the owner paid the general contractor. Because of its financial insolvency, the owner never paid the general contractor. When the subcontractor brought suit against the general contractor for payment, the general contractor argued it had no obligation to pay the subcontractor because the subcontract provision stated payment was not due until after five days following payment from the owner.

Ruling in favor of the subcontractor, the court concluded the contract did not transfer the credit risk of the owner's insolvency usually assumed by the general contractor to the subcontractor. Rather, the court said it was clear it was the parties' intention the subcontractor would be paid by the general contractor for labor and materials. If the contracting parties intended to shift the risk of the owner's possible insolvency to the subcontractor, unequivocal terms dealing with the possible insolvency of the owner could have been used.

In 1995, the Supreme Court of Virginia faced a similar case and examined an ambiguous contingent payment clause. In Galloway Corp. v. S. B. Ballard Construction Co., the Virginia Supreme Court sought to determine whether the payment clause in the subcontract between the general contractor, Galloway Corp., Virginia Beach, Va., and various subcontractors should be interpreted as a time-for-payment provision so the subcontractors would be entitled to payment even if the owner did not pay Galloway or a condition precedent so Galloway never would be obligated to pay the subcontractors if the owner did not pay Galloway.

Galloway contracted with a developer for construction of a 14-story commercial office complex in downtown Norfolk, Va. Galloway used a modified, standard, preprinted subcontract document from The American Institute of Architects (AIA) with its subcontractors. The critical payment provision in the subcontract stated: "The Contractor shall pay the Subcontractor each progress payment within three working days after the Contractor receives payment from the Owner. If the Architect does not issue a Certificate of Payment or the Contractor does not receive payment for any cause which is not the fault of the Subcontractor, the Contractor shall pay the Subcontractor, on demand, a progress payment as provided in Paragraphs 11.7 and 11.8."

An analogous provision in the AIA standard contract applies to final payment, again providing the general contractor is to pay the subcontractor after receiving payment from the owner but then going on to state that if the general contractor is not paid for a reason that is not the fault of the subcontractor, the subcontractor is entitled to be paid. In each subcontract, Galloway struck out the second sentence in the provision that explicitly states the subcontractor still is entitled to be paid.

The developer ran out of money and stopped paying Galloway, who, in turn, stopped paying its subcontractors. Several subcontractors filed suit against Galloway to obtain payment. Galloway said its modification of the AIA contract language created the condition precedent that Galloway must first receive payment to have any liability to the subcontractors. Based on the Dyer case, the trial court ruled the subcontractors were entitled to be paid and Galloway did not have an absolute "pay when paid" defense. Galloway appealed.

Finding the contract payment provisions ambiguous, the trial court considered extrinsic evidence. Testimony was received from the parties regarding their contract negotiations and prior dealings to determine their intent at the time the contract was made. Galloway's representatives predictably testified their intent was that Galloway would have no legal obligation to pay subcontractors if Galloway was not paid.

The court said Galloway's defense only would be available if the subcontractor had the same understanding of the payment clause. The court then considered the testimony of each subcontractor to ascertain how each had interpreted the contract and acted during the job.

The president of one subcontractor, S.B. Ballard Construction Co., Norfolk, Va., said that as a result of his having "been educated the hard way" regarding pay-when-paid clauses, he was aware Galloway had altered the AIA contract and he had taken steps so payment to his company would not depend on payments to Galloway. He testified he was relying on a separate scope of work agreement with Galloway, which included a discount to expedite payment from Galloway without regard to payment by the owner to Galloway. During the course of the job, S.B. Ballard Construction received 12 progress payments from Galloway without Galloway first receiving a payment identifiable to the work performed by S. B. Ballard Construction.

Based on this evidence, the Virginia Supreme Court ruled, as between S.B. Ballard Construction and Galloway, the altered AIA payment provision should be interpreted as a time-for-payment provision rather than a condition precedent.

The officers of other subcontractors testified they understood Galloway's intent in altering the AIA contract was "to not be obligated to pay until Galloway got paid." Through the testimony of the representatives of all subcontractors except S.B. Ballard Construction, the court found the subcontractors understood Galloway would not be obligated to pay them if Galloway was not paid. Because their understanding was that the payment clause was more than just a time-for-payment provision, Galloway was not obligated to pay them.

Summing up

The Bryan and Galloway cases illustrate a conscious effort by subcontractors and general contractors to modify preprinted contract language and how specific changes can have an enormous effect.

In the Bryan case, the subcontractor's insertion of language clarifying the scope of the general contractor's indemnification provision saved the subcontractor $300,000. In the Galloway case, the general contractor's deletion of one sentence from the standard AIA contract documents excused the general contractor from paying numerous subcontractors and the conscientiousness of one subcontractor earned him payment.

Knowing the rules of contract interpretation can help you negotiate contracts and gain insight as to how a contract may be construed if a problem arises.

Stephen M. Phillips is a partner with the law firm Hendrick, Phillips, Salzman & Flatt, Atlanta.