Failure of Payment as a Material Breach

The prompt flow of funds is essential to any construction project and is probably the Owner’s most important obligation. Payment of subcontractors by the Contractor is equally important. In both instances, the prompt payment of funds necessary to pay for ongoing work is necessary for the other contracting party to honor its reciprocal performance obligations.

The failure to comply with contractual payment obligations can quickly derail a contractual relationship, and more importantly, constitute a material breach of contract. For example, in Manganaro Corp. v. HITT Contracting, Inc,1 a subcontractor ceased performance when the general contractor failed to pay timely for change order work. The subcontract contained language making receipt of payment from the owner a condition precedent to the contractor’s payment obligation to the subcontractor, but an addenda to the subcontract provided that the contractor had the obligation to pay the subcontractor within a reasonable time, regardless of the payment status with the owner. When change order work was not funded, the subcontractor suspended performance for nonpayment, and the contractor terminated the subcontract.

The court in Manganaro held that the contractor’s failure to honor the payment provision in the subcontract constituted a material breach and thus justified the subcontractor’s cessation of performance.2 Emphasizing the importance of the steady flow of funds on any construction project, the court, citing Corbin on Contracts, stated as follows:

There is a special factor to be considered in the case of a building contract, or any other contract the financing of which requires a progressive expenditure in the course of performance. In these cases, one reason for providing for installment payments as construction proceeds is to supply the funds necessary for the agreed performance; and failure to pay one or more installments is more likely to cause inconvenience and difficulty to the building contractor. Therefore, a failure to make one of the progress payments, even though the contract is not divisible into pairs of separate equivalents and the installment unpaid is only a small part of the whole consideration, is more likely to justify suspension of performance by the builder, or even total renunciation of further duty.3

While Manganaro addressed a Contractor’s failure to pay its subcontractor, and the subcontractor’s right to terminate the subcontract for nonpayment, a Contractor’s non-payment of its subcontractors can also lead to the Owner’s termination of the prime contract. This is what happened in In re Stone & Webster, Inc., where the bankruptcy court held that Stone & Webster’s failure to timely pay its subcontractors constituted a material breach entitling the Owner to terminate its contract with Stone & Webster for the decommissioning of a nuclear power plant.4  

When evaluating payment applications, Owners and Contractors certainly have the right to ensure that monies requested have actually been earned or actually are owed, and refusing to make payment when a good faith basis exists to challenge the payment request does not constitute a material breach. A good example is Pack v. Case,5 where the Owner engaged the Contractor to replace a roof and the parties agreed to a unit price based upon square footages. The Owner and the Contractor came up with different square footage amounts since the Owner excluded the footage associated with a skylight and the Contractor did not. The contract provided that nonpayment voided any warranties, and when the roof subsequently leaked, the Contractor refused to honor the warranty due to the unresolved payment issue, claiming the Owner’s nonpayment of the disputed amounts constituted a material breach.  

The court held that the Owner’s refusal to pay the disputed amounts did not constitute a breach of the contract and did not excuse the Contractor from honoring its warranty obligations. The court found the contract ambiguous as to how square footage of the roof would be measured (with or without the skylight), and notwithstanding the nonpayment of the disputed amount, the Contactor had substantially obtained the benefits it reasonably expected under the contract. Also important to the court’s analysis was the fact that the Contractor could be compensated in money damages for any benefit under the contract it was deprived. Since it had obtained substantially what it was entitled to receive under the contract, and money damages would adequately compensate the Contractor, the Owner’s nonpayment was not a material breach and did not justify the Contractor’s refusal to honor its warranty obligations.6

As these cases make clear, payment obligations are very important and are certainly viewed as essential elements or terms of any construction contract. Nonpayment, if authorized under the terms of the contract, or a nonpayment that does not substantially deprive a party of the benefits of the contract, will not justify termination and does not constitute a material breach. Nonpayment that is at odds with the requirements of the contract, or nonpayment that substantially deprives a party of the benefits of a contract, can constitute a material breach and can justify contract termination.

Failure to Follow the Design Documents or Specifications as a Material Breach

As important as the flow of funding is to the Contractor, following the design or specifications can be of equal importance to the Owner. A structure or project that does not meet the Owner’s expectations and is not in conformity with the design deprives the Owner of the benefit of the contract and can constitute a material breach. Two cases illustrate this point: Strouth v. Pools by Murphy & Sons.7 and Winter v. Pleasant.8

In Strouth, a homeowner contracted for the construction of a peanut-shaped pool and a circular spa, but when the work commenced, the pool contractor laid out and started to construct a kidney-shaped pool and an almond-shaped spa. The homeowner stopped the work shortly thereafter, and while the contractor offered to change the shape of the spa, it never offered to reconfigure the shape of the pool. The court affirmed the trial court’s conclusion that a kidney shaped pool was a substantial deviation from the shape required by the contract and constituted a material breach of the pool construction contract. The pool contractor’s refusal to change the layout of the pool so as to comply with the contract made it unlikely that the owner would ever obtain future performance in substantial compliance with the contract and thus justified termination. 9

Similarly in Winter v. Pleasant,10 the contractor stopped the work and eventually terminated the contract when the owner withheld payments, but the evidence at trial showed that the owner stopped paying due to the contractor’s failure to follow the specifications. The evidence showed that the contractor installed rotated embed plates, failed to install all of the specified embed plates and constructed the building out of plumb. All of these conditions were substantially in violation of the specifications and constituted a material breach by the contractor of its contractual obligations.

In all cases involving termination, but particularly when compliance with the design or specifications is at issue, the doctrine of substantial performance will apply. The doctrine of substantial performance applies to all contracts involving bilateral promises. Where a contract is for an exchange of performance, such as performance of the work in exchange for the payment of compensation, the common law required strict and literal compliance by the party required to first perform, and the failure to strictly comply with the contract terms discharged the reciprocal promise by the second performer. Courts of equity have relaxed this requirement, and now the rule is that substantial performance with the first promise requires performance of the second promise, and precludes termination for default, since the promisee has obtained substantially what it contracted for, and any deficiencies in performance can be adequately compensated in damages.11

In construction cases, the contractor is not required to be perfect, but it must substantially comply with the contract. The contractor has substantially performed if any deficiencies in its performance can be remedied, and the owner made whole, by an offsetting allowance against the contract price. The rule applies if the owner can use the property as intended even though relatively minor matters remain to be completed or corrected, so that that the owner has obtained substantially the benefit of the bargain. The rule does not apply if significant defects exist that are not readily repaired or the defects resulted in a complete frustration of the purpose of the contract.12

As stated by the court in Curtis Construction Co. v. American Steel Span, Inc.: 13

The doctrine of substantial performance allows a contractor to recover on a contract even when it has not fully complied with the contract, as long as it has performed the contract in good faith and has mostly performed its responsibilities under the contract, except as to unimportant omissions or deviations, which are the result of mistake or inadvertence, and were not intentional, and which are susceptible of remedy, so that the other party will get substantially the building he contracted for. The contractor’s default must not be willful, and the defects in its work must not be so serious as to deprive the property of its value for the intended use nor so pervade the whole work that a deduction in damages will not be fair compensation. If a contractor has failed to substantially perform, it cannot recover an amount due under the contract. A contractor has not substantially performed when the defects are intentional, willful, or so serious as to deprive the property of its value or intended use.

The remedy allowed when a contractor has substantially but not fully performed is an adjustment of the amount the property owner is required to pay the contractor to allow for the defects. Generally, if the defects can be repaired without reconstructing a substantial portion of the project, the contractor can recover the contract price less the expense required to repair the defects. When the defects cannot be remedied without substantial reconstruction, however, the remedy is the value of a properly constructed project less the value of the project as actually constructed.14

Timeliness of Performance as a Material Breach

Timeliness of performance as a basis for termination is another frequently litigated topic. A delay in completing the work by the contractual completion is not a material default and does not justify termination unless the time of performance is specified in the contract to be of the essence or unless the circumstances under which the contract was negotiated demonstrate an intention by the parties to make the timeliness of performance an essential or material term.15

A good example is Madden Phillips. In this case involving a residential development outside of Memphis, the site contractor and the owner had an acrimonious relationship from the very start, fighting over the responsibility for, among other things, additional fill materials. The site contractor suspended performance for about 45 days due to the dispute, but eventually resumed performance after the owner agreed to provide the fill materials. The dispute reignited when the contractor began complaining about the amount of fill available, and eventually the owner had enough and terminated the contractor. One of the several issues litigated was the contractor’s timeliness of performance.

The owner claimed that termination was justified due to the contractor’s delay in completion, caused in part by the time lost due to the suspension of the work. However, the contract did not contain a “time is of the essence” provision, and the absence of such a provision precluded the owner from terminating the contractor for late completion. As stated by the court:

A party’s failure to complete a construction project within a time for completion does not constitute material breach absent a provision making time of the essence. The existence of an agreement that “time is of the essence” can be shown by “‘stipulation, a manifestation of intention from the contract or subject matter involved, or an implication from the nature of the contract or circumstances of the case.’” “Generally, time is not of the essence of a building and construction contract.” Thus, a party to a construction contract will not establish that time is of the essence solely by showing that a contract contained a time or date for completion and nothing more.16