April 8, 2021

Four Key Steps for a Successful Construction Audit Process

By: Ronald L. Williams Partner, Construction Practice Co-Chair, Fox Rothschild LLP.

The implications of the audit provisions contained in construction agreements between owners and contractors owners extend far beyond post-completion bean counting, and can affect multiple aspects of a project, from project administration to relationships with key subcontractors. It is critically important that contractors give audits the attention they deserve by taking the following four steps. First, invest the time to negotiate the audit provisions that ultimately appear in contracts with the owner. Second, ensure that the project team and the owner’s project auditors engage in timely communication during construction. Third, make certain that post-completion audit administration is prompt and complete. And finally, carefully draft adequate “flow-down” provisions with subcontractors and vendors so that they understand and comply with their contractual obligations, as well as the expectations of the contractor and owner. All four aspects are critical, and if not addressed effectively can undermine the profitability of the contract, and contractors’ business relationships with both upstream and downstream parties.

Negotiations

At the outset of contract negotiations, a contractor must completely understand the owner’s audit process expectations. An owner’s understanding of the audit process and its potential pitfalls depends on their own experience, as well as the knowledge of their personnel, including internal audit members and external auditors. Negotiations, which like the audit itself need not be adversarial, can be educational for both the owner and any representatives involved.

For example, an owner may think that the scope of an audit is broad and the likely “return” that it will produce is more significant than construction experience demonstrates. Depending upon the type of contract (e.g. guaranteed maximum price or cost-plus), the items subject to audit may be limited. Frequently, other factors such as the existence of a project labor agreement affect the audit without the owner fully understanding the impact on costs. It is important to discuss general conditions as well as the process by which they will be documented, to avoid the possibility of overlap or worse.

Construction audits can be oversold as a way to recoup money after a project has been successfully completed. Rather than dismiss or ignore this possibility, a wise approach in negotiation is to have a frank and detailed discussion about the scope of the audit, what is not going to be audited, what processes will be implemented during construction to monitor costs and expenses and the paper trail that needs to be generated. An audit can have value for all parties. But to maximize that value, all parties much understand each other’s expectations and ensure that the contractual language reflects those expectations. Through these negotiations, the parties can identify what is and isn’t feasible, avoiding subsequent disappointment. Owners frequently have unreasonable expectations about the amount of money they can recoup in an audit. However, an audit can meet owner expectations if the negotiations and the audit provisions in the contract fully delineate the scope, documentation and process. This negotiation naturally should lead to a discussion of project administration, the second area of focus.

Project Administration

With fast-track construction, the parties should recognize the need for effective, efficient processing of payment applications. Comprehensive, concise communication between the parties is critical to success. To that end, if the owner plans simply to make payments and wait until the project is completed to conduct the audit, the contractor should be advised of the practical considerations involved in that approach. By the time of the audit, the contractor will have already paid third parties based upon subcontractors’ payment applications and vendors’ invoices. If the owner expects to examine those payments, payment applications and invoices at the end of the project, the contractor would be wise to provide documentation during construction, confirming the adequacy of the documentation for current payments but also the audit. Otherwise, depending upon the language in the contract, the owner may have the right to require production of additional documentation, which, after project completion, can be time-consuming if not impossible to produce. Depending upon the nature of the project and the scope of the subcontractors’ work, much of the documentation the contractor may need to provide is that of subcontractors and vendors. Obtaining that documentation during the project from subcontractors and vendors is much easier than after it’s completed. Frequently, field personnel, especially in the area of general conditions, do not understand or truly appreciate what documentation they need to generate to avoid confusion or a dispute later on. If the owner has a contractual right to withhold payments until it has satisfactory documentation, the contractor needs to make sure that it is providing all of the documentation in a timely fashion. This maximizes the contractor’s likelihood of retaining the monies paid by the owner.

Audit After Project Completion

If the owner plans to conduct the main portion of its audit after the project is finished and any portion of payment is dependent upon the audit’s satisfactory completion, the contractor should make sure that it and its subcontractors and suppliers have provided the owner with all necessary documentation in a timely fashion. Failing to do so could delay the final payment. Ideally, by the time the project is complete, the contractor, through its designated representatives, will have provided all of the documentation contractually required not only for a satisfactory audit but to give the owner and its representatives confidence that all costs and expenses have been incurred in accordance with the contract. The contractor should delineate audit processes and dispute resolution methods in the contract. It is in the contractor’s interests to satisfy an owner’s reasonable expectations. If an owner finishes a project, confident that all expenses were proper and commercially reasonable, it strengthens the owner-contractor relationship.

Subcontractor and Vendor Flow-Down Provisions

For a contractor to successfully build its relationship with the owner and avoid disaster in an audit, the contractor must have appropriate flow-down provisions to its subcontractors and vendors. Those flow-down provisions should ensure that each subcontractor and vendor timely provides all documentation contractually necessary for prompt processing of payment requests. The flow-down provisions must also ensure that the subcontractors and vendors understand the importance of compliance and the need to be continuously diligent in providing documentation needed for project closeout and timely conclusion of the audit. To that end, the contractor must communicate those expectations as well as the ramifications for noncompliance to each subcontractor and vendor. These messages are communicated most effectively in a positive, constructive fashion, rather than as heavy-handed criticism. To succeed, especially with subcontractors, the contractor must communicate the economic structure of its contract with the owner. Otherwise, a reasonable subcontractor may think that the audit provisions that flow down are simply being used to obtain economic advantage for this or perhaps future projects. Through timely and constructive communications, contractors can help subcontractors understand the goals that are being achieved through the audit process. Otherwise, the subcontractors may not have the documentation needed to respond to an audit, leaving the contractor vulnerable to a claim by an owner.

Conclusion

A thoughtful approach to discussion, negotiation and implementation of the audit process enables a contractor to build its relationship with the owner, as well as its subcontractors and vendors. If these measures are successful, the contractor can minimize the obstacles to creating documentation during a project and ensure prompt processing of each payment application. In turn, the contractor can maintain prompt payments to subcontractors and vendors. Additionally, the contractor can minimize the expense associated with an audit at the end of the project. If the audit results lead to a difference of opinion, the parties can timely meet to resolve the issues and avoid legal disputes, thereby enhancing the profitability of the project and the overall success of the relationships.

Fox Rothschild LLP is home to one of the deepest Construction Practice Groups in the United States. With offices in major construction hubs nationwide, Fox’s experienced team advises on major construction and infrastructure projects, including drafting and negotiating contracts and litigating disputes involving such projects. Harnessing the combined strength of a nationally recognized construction practice and a deep bench of lawyers focused on Federal Government Contracts, we provide business-friendly advice to help our clients complete projects in the United States and internationally. Fox construction law practice is backed by a national firm of 950 attorneys providing a comprehensive suite of legal services from 27 offices coast to coast. For more information, visit foxrothschild.com/construction.

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