Avoiding Moral Hazard When Allocating COVID-19 Force Majeure Risk in Construction Contracts [Gaille Energy Blog Issue 87]

Avoiding Moral Hazard When Allocating COVID-19 Force Majeure Risk in Construction Contracts [Gaille Energy Blog Issue 87]

  • Posted by scottgaille
  • On May 13, 2020

One of the principal COVID-19 issues facing the construction industry is a work shutdown due to an employee exhibiting COVID-19 symptoms, testing positive for COVID-19, or being exposed to someone who has tested positive for COVID-19.  In such cases, the entire construction crew may be quarantined for several days (a “Quarantine Suspension“).  During the Quarantine Suspension, who should pay for contractor’s non-productive equipment and personnel?

This question transports me back to my days as a law student at The University of Chicago, where I participated in bi-weekly Law & Economics Workshops there.  Chicago’s Nobel Laureates often spoke about the importance of structuring contracts to avoid the risk of moral hazard, which is a:

“lack of incentive to guard against risk where one is protected from its consequences.”

As my former law professor, Judge Richard Posner, explained in one of his judicial opinions for the United States Court of Appeals for the Seventh Circuit:

“[the farmhand] knew that the accident was caused only by his momentary lapse of judgment. . . .  Thus in terms of deterrence, [the farmhand] was in the best possible position to prevent this accident.  It would be in error to shift the responsibility for this gruesome accident onto other parties who were in no position to prevent the accident.”

To avoid such moral hazard, the best contract clause is usually the one that places the risk on the party best able to prevent its occurrence.

If the project owner is responsible for paying a contractor’s standby costs for a Quarantine Suspension, the contract creates a moral hazard because it greatly reduces the contractor’s incentive to guard against its personnel being exposed to COVID-19 outside of the work place, including:

  • the nature of housing for its work force;
  • how people are transported to and from the work site;
  • the manner in which they take their meals;
  • whether or not curfews are in place to minimize exposure to others in the community; and
  • when and how often COVID-19 testing occurs.

If the project owner is contractually required to pay for a contractor’s COVID-19 standby costs, then the contractor is less incentivized to take such precautions (and is less likely to incur these costs).  Standby compensation for Quarantine Suspensions likely makes the workplace less safe by leading to more COVID-19 cases over the course of the project.

What about the owner’s personnel?  After all, what is good for the goose should be good for the gander.  The project owner also has employees at the construction site, such as inspectors.  Applying the rule of moral hazard to owner’s personnel similarly would allocate the costs of a Quarantine Suspension to the project owner in cases where its own personnel cause the shutdown.  For example, if an owner’s inspector tested positive for COVID-19 and work was suspended as a result, the owner would be required to pay the contractor standby compensation.  Such a clause would similarly incentivize the owner to take additional precautions regarding its own personnel (to avoid having to pay the substantial costs of a shut-down).

How risk is allocated in a contract matters.  The “your watch, my watch” standard for COVID-19 shutdowns is a simple compromise for a real problem that is well-grounded in law and economics.  It is likely to lead to fewer job interruptions, better health at the job site, and improved safety for the communities in which construction projects take place.

About the Gaille Energy Blog. The Gaille Energy Blog (view counter = 140,033) discusses issues in the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at the University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, and the author of three books on energy law (Construction Energy Development, Shale Energy Development, and International Energy Development), and co-author of the award-winning travel compilation, Strange Tales of World Travel (Bronze Medalist, IPPY Awards for Best 2019 Travel Essay; ForeWord Magazine Finalist for Best Travel Book of 2019; North American Travel Journalists’ Honorable Mention for Best Travel Book of 2019).

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