March 1, 2004
By Dean B. Thomson
In recent months, prices for steel have increased precipitously. As a result, suppliers and fabricators of steel are having great difficulties honoring price commitments they gave months ago, which could result in defaults and project delays. This Briefing Paper will explore the cause of the problem and possible remedies.
Rarely do a confluence of factors merge to create the type of shortages currently being experienced by the steel industry. China is reported to be buying as much as 31% of all scrap metal sold worldwide and paying any market price. This has created a huge shortage of scrap, which mini mills use to melt and produce new steel products. As an example, United States’ scrap prices have increased from $100 per ton in December 2002 to over $260 per ton in February 2004. According to the National Steel Bridge Alliance (“NSBA”), mini mills have raised their base prices and have added raw material surcharges to orders because of the increase in scrap costs.
Alternate sources, such as integrated steel mills, have not been able to provide relief because their production methods rely on coke, and coke prices have jumped from approximately $200 per ton to $370 per ton. To compound the problem, prices for iron are rising, the Chinese are not exporting coke, the international freight rates for coke and ore have increased 600% in six months, and the cost of specialty metals, necessary for mini and integrated mill production, has increased.
Unfortunately, the increased inter-national demand that has driven these price increases does not appear to be temporary. For example, China is expected to produce 4.2 million cars and trucks this year with production expected to rise to 11 to 12 million by 2007, well above the previous estimate of 7 million vehicles. As a result, rather than stabilizing, prices still appear to be rising.
The production, fabrication and delivery of steel is a lengthy process. The fabricator typically has to bid a project and commit to a price months before the order is placed with the mill to produce the raw steel. Before prices became volatile, a mill would commit to a price until the fabricator received and placed the order, but now mills and suppliers are shortening the time during which their quotes are valid. As a result, the risk of excessive price increases after the supplier’s quote expires falls on the fabricator and the general contractor that incorporated the fabricator’s quote into its bid. As the NSBA summarized the situation, “The current problem is that the degree and frequency of the steel price volatility can no longer be absorbed through the thin revenue cushions contractors may try to include in competitive bids.”
Aside from price, one of the biggest worry for small companies is finding steel at all. “When prices started to go up there was a lot of what I guess you would call panic buying or maybe even hedge buying… Now there are shortages in a lot of types of sizes,” said Ulis Fleming, sales manager at American Eagle Steel Corp. in Annapolis, Maryland, which brokers steel purchases for other companies.
Ordinarily, the situation would correct itself because foreign producers would step in with lower-cost products. But the value of the dollar is down, making foreign goods as expensive as domestic. Steel users worry that the big U.S. producers are taking advantage of that situation, riding the price hikes to profits at the expense of the little guy. See Greg Schneider, Trapped by Rising Steel Prices, Wash. Post, March 23, 2004, at E01.
Because material shortages of this magnitude do not frequently occur, there is also a shortage of recognized remedies. Nevertheless, the following responses should be considered:
a. Association Initiatives
National and state associations of highway, bridge, and general contractors have approached federal and state government with this problem and requested relief through equitable price adjustments to their contracts.
Many have analogized the situation to the oil shortages and subsequent price increases in the 1970s, which many governmental agencies addressed through fuel and oil escalation clauses. As an example, MnDOT adopted such a clause to relieve contractors from absorbing the price increases caused by OPEC’s oil embargo.
To address the current problem, NSBA is proposing that the FHWA authorize limited use of price adjustments in existing contracts, covering raw steel not yet invoiced by steel mills before January 1, 2004. The NSBA proposes that only the actual cost variance be recoverable between the bid and payment price for the actual steel being used. The NSBA is not seeking an adjustment through an average index because they argue that there is no index which accurately reflects the varied grades and specifications of steel that bridge fabricators buy. It may be possible, however, to refer to an averaged index for the price of building structural steel, rebar or piling, the pricing of which does not typically vary within each category. The effective advocacy of industry organizations will be crucial in obtaining relief on public projects.
b. Legal Theories
The early common law took the view that when a party contracted to do something he had to perform or respond in damages. The first relief from this doctrine of strict performance was developed in cases that excused the duty to perform where it was absolutely impossible to do so. The common law excuses performance on the grounds of “impossibility,” but often the excuse of impossibility is limited to something that is physically or objectively impossible – i.e., it cannot be done. Traditionally, the impossibility defense did not apply to situations in which performance was made more difficult by an intervening event, such as increase in pricing.
As commercial transactions become more complicated and integrated, the courts developed the more flexible doctrine of “commercial impracticability,” as an excuse to performance. Under this theory, a court may excuse performance where an unexpected intervening event makes continued performance unreasonably expensive even though it may still be physically possible. The U.C.C. has codified this concept in § 2-615, but the common law recognizes it as well. In addition, contracting parties have attempted to develop a contingency clause that may provide relief under the contract itself, commonly known as a Force Majeure clause.
1. U.C.C. § 2-615
Westinghouse ran into a similar problem when it promised a fuel supply to its reactor customers (electric utilities) with no firm source for that fuel (“uranium”). Westinghouse sought relief by alleging “Excuse by Failure of Presupposed Conditions” pursuant to § 2-615 of the Uniform Commercial Code.
To invoke § 2-615, the seller must prove: (1) his performance has been made impracticable (2) by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract made. In addition, a seller meeting these requirements of subsection (a) of § 2-615, must satisfy the requirements of subsections (b) and (c) to be excused. Subsection 2-615(c) requires the seller to notify the buyer seasonably that there will be a delay or nondelivery. Subsection 2-615(b) requires the seller in appropriate cases to allocate production among his customers.
Comment four (4) to § 2-615, states that “increased cost alone does not excuse performance unless the rise in cost is due to some unforeseen contingency which alters the essential nature of the performance.”
One of only a few cases that has excused the duty to perform on account of price increases is Aluminum Co. America v. Essex Group, Inc., 499 F. Supp 53 (W.D. Pa. 1980). In Essex Group, the court granted relief from a contract where production expenses increased by 475%, and as a consequence, the seller lost approximately $9 million on the contract in 1978 and projected a loss of about $75 million over the life of the contract.
In Upsher-Smith Laboratories, Inc. v. Mylan Laboratories, Inc., 944 F. Supp. 1411, 1429 (D. Minn. 1996), the United States District Court for the District of Minnesota examined the three elements that must be shown for the court to find commercial impracticability under the Minnesota version of the U.C.C. The court in Upsher-Smith explained that under the doctrine of commercial impracticability, the element of unforseeability requires a “determination of whether the risk of the given contingency was so unusual or unforeseen and would have such severe consequences that to require performance would be to grant [the other party] an advantage for which he could not be said to have bargained in making the contract.” Id. In other words, the court in Upsher-Smith recognizes the intensely factual nature of the unforseeability inquiry required to determine commercial impracticability.
2. Restatement (Second) of Contracts
Courts have accepted the excuse of impossibility of performance, but most have rejected the doctrine of frustration of purpose. The courts, however, may find that an implied condition in the contract has excused the promisor on account of changed circumstances. The Restatement (Second) of Contracts states that the duty to perform a contract is excused on the basis of “impracticability” upon the “occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made,” and that was not the result of the negligence of the party seeking relief. According to the Reporter’s Comments, the foreseeability of an event does not dictate whether its non-occurrence is a “basic assumption.”
3. Force Majeure clauses
Some events are not foreseeable and are beyond any party’s control. These events are often referred to in construction contracts as “Acts of God” or, more broadly, Force Majeure. Because of the potentially devastating impact of Force Majeure events on a construction project, most construction contracts today contain provisions allocating the time related risks and impacts of such events.
The most common type of events that are included in Force Majeure clauses can be classified as “Acts of God.” Thus, acts of God typically include such events as tornadoes, earthquakes, floods and other unusual weather conditions. There are other unpredictable human-caused events, including strikes, riots, government acts, war, and terrorism, that are also typically included in Force Majeure clauses.
In addition to identifying the events that may qualify as Force Majeure, construction contracts also normally address the rights and remedies of the parties when such events occur. Whether a given contract’s Force Majeure clause provides a contractor relief from escalating supply prices will depend on the particular language used in the clause. In many cases, the parties agree that if a Force Majeure event delays performance, the contractor is entitled to a time extension, but is not entitled to recover any of its additional costs associated with that delay.
For example, the standard AIA documents offer time extensions for Force Majeure events, but no price adjustment. The AIA A201 General Conditions list labor disputes, fire, unusual delays in deliveries, unavailable casualties, “or other causes beyond Contractor’s control” as events that excuse a contractor’s performance. Thus, contractors will have to argue that industry wide steel shortages and price increases are equivalent to “causes beyond Contractor’s control” in order to obtain at least a time extension. The AGC standard contract is predictably more industry friendly and allows the contractor not only an extension of time, but also an equitable contract price adjustment if “causes beyond the contractor’s control” delay the start or progress of the work. Because of the potential cost and schedule impact associated with a major Force Majeure event, parties should carefully consider the allocation of risk for such events in drafting their construction contracts.
Relief from a contractual commitment under any of these theories, however, is difficult and highly fact dependent. The degree of difficulty caused by the event, the cause of the problem and the ability to control the problem are all factors that courts consider in determining whether a fabricator or contractor will be excused from its performance obligations.
c. Practical Concerns
For some the problem has become so severe that they are driven to brinksmanship bargaining. They argue that they are going to go broke either delivering the steel well below cost or go broke when they are sued for non-delivery at the promised price. Either way they claim they are ruined, so they threaten not to deliver unless they receive a price adjustment. The hope is that the owner will make an adjustment when it factors in the delay in seeking an alternative supplier, the higher cost of the replacement steel and the risk of protracted litigation.
In the future, fabricators and suppliers will surely begin to limit the time for which their bids are valid or will condition their bids with a price escalator. General contractors in turn will demand firm bids from subcontractors consistent with the general’s bid commitments. To address the risk of subcontractor defaults, general contractors will look for more performance and payment bonds from fabricators. All involved in the industry will have to address these new realities with owners through discussions during bid solicitations and request addenda allowing equitable adjustments or price escalation clauses for steel prices.
Owners should also encourage fabricators to purchase and store raw steel as quickly as possible, but prompt payment for material stored offsite prior to fabrication has to be assured and not simply an option at the discretion of the owner.
This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T