This article has been written by Bhavya Shah, pursuing a Diploma in Advance Contract Drafting, Negotiation, Dispute Resolution from LawSikho. It has been edited by Ojuswi (Associate, LawSikho).

It has been published by Rachit Garg.

Introduction

According to Collins Dictionary, Escalation is explained as a Soar in Premiums or policy benefits in line with agreed factors such as Standard of living, inflation, and Prices of Raw Materials.  In a commercial contract, a bid is obtained after estimating the costs of labour and material that will be incurred in the future. These costs might, however, fluctuate for causes outside the control of either party. Unexpected pricing changes like this have the potential to undermine the entire basis of the agreement that the parties agreed to, which might result in contract dissatisfaction and eventual contract termination. An escalation provision is inserted into the contract to prevent this from happening and accounts for any potential future changes in labour and material costs.

What is an escalation clause

Escalation Clause or Escalator Clause is a Clause of the contract defining an alteration in Costs, and remuneration in the occurrence of specified changes in circumstances such as a great rise in the prices of Raw Materials, fossil fuels, or the increasing cost of standard of living. The Escalation Clause is a Clause in a Contract provision that vouch for any specified reversal in the agreed price that has been determined by the two consenting parties on a particular factor beyond the control of either party that is in turn affecting the agreement value. Because of fluctuating prices, it has become a standard practice to insert an escalation Clause in the Contract in Sectors that largely depends on Specified raw Materials. 

If the price of Equipment, Raw materials, plant and Machinery, work Force and labour, increases beyond the point of 5% or 10%. The Clause authorizes the contractor to yield higher returns for the contract. An Escalation Clause is recommended when a Settled price is quoted for the contract and also when a cost-plus contract is entered into. Escalator Clauses or as commonly used as Price Escalation Clause when dealing with inflation or price rise or Material Escalation Clause when dealing with Raw Materials, fossil fuel are frequently common in sectors of construction and Real Estate wherein unexpected costs are secured due to Fluctuations in the prices for raw materials, fuel, workforce, and labour during the course of the Contract. 

Purpose of an escalation clause

Allow Buyers or Sellers to Commit to Long term Contracts 

The escalation Clause allows People to commit to long-term contracts, without being Concerned about the changes in external circumstances that could interfere with their long-term goals. 

The escalation Clause will ensure that contracts remain fair

Escalation Clause is made between parties of the contracts so that the contract remains fair and updated based on the external Criteria. 

Key elements of an escalation clause

The Typical Escalation Clause has the following Basic Elements:

  • The amount one is willing to increase the offer to compete with other bids;
  • The original amount one offered to pay for the property; and
  • The most one is willing to spend.

Issues addressed by an escalation clause

An Escalation Clause looks straightforward, but the devil is in the details. Regardless of the details worked out between the parties, practically all escalation provisions handle the following issues:

  • What is the Contract’s original agreed value?
  • How much will the price be escalated above or De-escalated below any other costs or competing bids?
  • In the event of numerous offers, what is the highest price that the original party will agree to or be compelled to pay?

Escalator clause in real estate sector

An escalator provision in a purchase agreement is expected in real estate contracts. The condition in this application states that if any further offers are received, the potential buyer will boost their first offer. This provision would frequently include a limit on how high the rise may go.

Illustration: a potential home buyer offers to purchase a house at a price of Rs.3,00,000 but includes an escalator clause that they will increase their offer to beat out any other higher offers by Rs.50,000. The clause also outlines the cap of Rs.6,50,000, which means that buyers will only increase their offer up to Rs.6,50,000. If another offer came in at Rs.6,48,000, the terms of the clause wouldn’t allow the buyer to add even Rs.5,000 because that would take the price beyond the cap of the escalator clause.

Escalation clause in construction business

Contract escalation provisions in the construction business refer to the cost of the project’s materials. Expenses that exceed what was initially agreed upon may be passed on to the project’s owner. It has been common practice in large-scale and long-term construction projects to use these types of provisions for many years. These sorts of provisions have been utilized for years in long-term and massive building projects. Because building material costs have been constantly rising in recent years, many contractors are increasing including escalation clauses in all sorts of projects. 

Commercial mixed-use complexes, single-family residences, and apartment buildings are examples of these.

  • One of the key causes driving up construction material prices is the global building boom, particularly in Asian Countries.
  • Another issue is connected to the environment since the loss of forest lands has driven up timber prices.
  • Transporting building supplies is extremely costly, especially when gasoline costs are high. With these possible price swings, escalation clauses are essential in the construction business.

Mitigating material price escalation

Before a contract has even been signed or agreed upon, material price escalation can be reduced. Contractors can reduce this risk by including language defining a deadline by which their bid proposal must be approved in order to be considered genuine. With this strategy, the contractor submitting a bid might revise it to reflect price changes after the allotted period of time has elapsed. Contractors should be wary of any bid instructions or RFP papers that explicitly forbid price increases or mandate that bids be valid for a predetermined amount of time. Furthermore, as soon as feasible, pricing can be locked in (or “bought out”) to prevent material price escalation, but owners must be ready to permit contractors to bill and be paid for these commitments when they are made. To that end, if the contractor can identify the commodities with the greatest price fluctuation, it could be an option to purchase and store those goods in advance, if the owner is ready to provide the necessary cash flow.

Benefits of incorporating an escalation clause

Escalation clauses provide benefits and drawbacks for parties looking to buy real estate. If for no other reason than to stay relevant, investors add an escalation clause in their initial offer. The power of an escalation clause to keep a prospective buyer in the race, however, is particularly significant. Escalation clauses are essentially rebuttals to the most recent offers, and choosing one over the other might be the difference between getting the property of one’s dreams and not.

In addition to the obvious advantages, including an escalation clause in real estate agreements has the following additional advantages:

  • Escalation clauses are common in real estate contracts, and when used properly, they may provide purchasers who are interested in the subject property piece of mind by preventing them from overpaying. 
  • If the language is adequate, the phrase ought to raise the offer just enough to close the sale without going overboard.
  • The sellers benefit greatly from this clause since, in the correct conditions, they are nearly always certain of receiving a better offer.
  • Escalation clause real estate contracts provide peace of mind for buyers who want the subject property.
  • Sellers may take bids with an escalation clause more seriously, offering the advantage to anybody prepared to include one. 
  • Prospective buyers won’t be excluded from discussions or neglected in the event they give one.

Pitfalls of incorporating an escalation clause

While an offer must have an escalation clause, it is not without drawbacks. In particular, an escalation clause compels potential purchasers to put all of their cards on the table; as an investor, it is by no means a good thing. Inserting an escalation clause or, more significantly, a limit in the offer like specifying the highest sum one is ready to pay.

In addition, while a seller could value the candour, it practically guarantees that it won’t be able to negotiate a lower price. Additionally, a badly thought-out escalation clause might harm the bottom line. Yes, it could aid in the ability to close a sale, but at what cost? If people are not attentive, this provision could force them to pay far more for a property than they ought to have.

There are a few drawbacks to escalation clauses in real estate contracts besides revealing the sum investors are ready to pay:

  • By including them, they minimize one of an investor’s biggest advantages: bargaining power. There is less flexibility to negotiate profit margins when a provision that exposes the amount someone is willing to pay is included.
  • Despite the progress the real estate sector has made, many individuals still don’t understand what an escalation clause is. This clause’s inclusion, for instance, can be unclear to a listing agent, which could lead to delays.
  • The presence of escalation clauses may deter certain sellers. They are typically created with the initial goal to undercut incoming bids, even if they are most likely accepting of the concept of investors paying more. The presence of an escalation clause can occasionally interfere with bank evaluations.
  • Although it’s uncommon, some sellers choose not to deal with an escalation clause.

When no  escalation clause is incorporated in a contract

It is a fundamental tenet of arbitration (under the Arbitration and Conciliation Act 1996) that the arbitrator gets his power from the terms of the contract and that an award passed in violation of those terms is invalid and subject to be set aside. There are, however, a number of situations when the contract does not contain an escalation provision and the contract is prolonged past the completion date for reasons that are not the contractor’s fault. As a result, the contract extension causes losses for the contractor, who is therefore entitled to damages, including an increase in the cost of labour and supplies. The issue that arises in such a case is whether the arbitrator can grant an increase in the cost of materials and labour in absence of any clause for escalation in the contract. 

In a recent case of Union of India (UOI) vs. Varindera Constructions Ltd. and Ors. The Apex Court, in a special leave petition, reversed the rulings of the division bench, Single Judge, and arbitral tribunal and held that an arbitrator cannot award escalation fees in the presence of a provision that forbids them. However, there are many factors to consider when expounding upon other situations dealing with the interpretation of escalation charges in contracts. If the delay is not the contractor’s fault and there is no escalation provision in the agreement, the arbitrator has the authority to award escalation fees. 

“Escalation, in our opinion, is a typical and usual occurrence coming out of the gap of time in this inflationary era in fulfilling any contract of any sort,” it was decided in this case. The arbitrator determined that there had been an escalation in this case through statutory wage revision, therefore he came to the judgment that allowing escalation under the claim was justified The Corporation was responsible for the delays’ effects, including an increase in statutory wages, once it was determined that the arbitrator had the authority to rule that the FCI’s actions caused a delay in the contract’s execution. Therefore, in our judgment, the arbitrator was qualified to consider this issue,”. The Supreme Court addressed this in the case of Food Corporation of India vs. A.M. Ahmed and Co. and Ors.,.

Without quoting Section 70 of the Contract Act specifically, it is evident that the Hon’ble Supreme Court has applied the principle enshrined in this provision of the Contract Act, which stipulates that when a party has worked for another party non-gratuitously, then the party who has received a benefit from such work must compensate the party that has done such work. Compensation, in this regard, would have to necessarily include price escalation.

The Hon’ble High Court of Delhi has laid down another connected principle in this regard in the case of National Highways Authority v. HCC Ltd., reported at (2014) 211 DLT 656, where the Hon’ble Court, while applying the principle of contra proferentem, held that a price escalation clause must be interpreted against the employer and unless there is a specific exclusion, the clause on price escalation must be interpreted to include all incidences of price escalation.

With the judicial precedents mentioned above in mind, as well as the legal principles they articulate, contractors must be aware of their rights concerning price escalation, even in cases where their contracts are silent on the subject or are vague as to what specific instances of price escalation they cover. The aforementioned principles will undoubtedly apply in most, if not all, situations as most government contracts are standard form contracts or are created by the government. Additionally, given that many project execution delays are invariably caused by problems that are not the contractors’ faults, the contractors should use their legal options to request price escalation 

Ethics of an escalation clause 

When an offer containing an escalation clause is received, sellers might take the following actions to safeguard their interests:

  • First, be aware that bids with escalation clauses are a possibility; the decision to accept or reject such an offer rests with the seller.
  • Understand the offer price, including the maximum amount it may be.
  • Select a course of action when there are several bids; sellers may decide to accept one, reject them all, or submit a counteroffer. The escalation clause may be waived by the seller if they decide to establish a fixed price for the property.
  • Be aware that accepting an offer with an escalation clause results in the creation of a buy and sale agreement. Before signing the agreement, confirm that the proper price is stated on it.
  • Even though purchasers can utilize the escalation clause to their advantage, they should be aware that this could lead to a bidding war and that their offer could not be withdrawn. 
  • Buyers will have to rely on the other agent since they won’t be able to examine rival bids to determine how much money is being offered.
  • If a buyer files an offer with an escalation clause, the buyer’s agent is responsible for informing the seller’s agent of the clause’s existence. Otherwise, it can go unnoticed. The buyer is not required to get confirmation of the second-best offer.

Judgements surrounding an escalation clause

Tarapore and Company vs. Cochin Shipyard Ltd., Cochin, and Ors., reported at AIR 1984 SC 1072 

FACTS OF THE CASE: The appellant and the respondents entered into a contract for the construction of Building DOCK of Contract entered into between the parties, any dispute shall be referred to the Sole Arbitrator. During the implementation of the works contract. disputes arose between the parties in respect of a claim for compensation on account of the increase in the cost of imported pile-driving equipment and technical know-how cost. The arbitrator held that the appellant was entitled to compensation for the increase in the cost of imported pile drawing equipment and technical know-how cost. 

ISSUE OF THE CASE: 

  • Does M/s Tarapore & Co.’s demand for payment from Cochin Shipyard Ltd. for increased costs of imported pile driving equipment and technical know-how fees fall under the provisions of the General Conditions of Contract that the two parties engaged in?
  • Are Messrs. Tarapore & Co. entitled to compensation for the increase in the price of imported pile driving equipment and technical know-how fees to be paid to them by Cochin Shipyard Ltd. if the answer to question 1 is yes under the terms of the relevant contract? If so, how much is it?

JUDGEMENT OF THE COURT: 

  • If rates initially given by the contractor become irrelevant as a result of future price inflation.
  • The Apex Court decided that the agreement would become odious to the degree that the factual circumstances upon which the agreement was established by the Parties cease to exist.
  • In this case, the contractors’ request for reimbursement for the additional costs incurred as a result of price increases could not be denied based only on the contract’s lack of a price escalation provision.

P. M. Paul vs. Union of India reported at AIR 1989 SC 1034 

FACTS OF THE CASE: The Contractor (Appellant) and the respondent entered into a contract for the building’s construction. A disagreement occurred about the transfer of site. The

Respondent claimed that the appellant had given up on the labour and violated the terms of the contract. Since the contract called for the resolution of disputes by Arbitration. An issue was raised in an appeal to this Court by an arbitrator, The Arbitrator made an award following a site inspection. The respondent who felt wronged by the decision filed a petition. And disputed the similarity. There was a claim that the arbitrator had gone above his authority by granting a sum of Rs. 2 lakhs as escalation fees and expenses

ISSUE OF THE CASE: 

  • Setting  aside Award
  • Whether the arbitrator has misconducted himself or proceeding
  • Adjudicating upon matter not subject matter of adjudication-Legal misconduct.

JUDGEMENT OF THE COURT: 

  • The Honourable Supreme Court awarded a contractor reimbursement for losses brought on by increases in the cost of labour, materials, and transportation throughout the course of the prolonged contract. 
  • Although there was no escalation provision in the parties’ agreement. The Supreme Court established the rule that, in the event of a price increase, the lack of a price escalation provision in the contract would not be fatal if the reason for the completion delay was unrelated to the contractor.

 K.N. Sathyapalan (Dead) by Lrs. vs. State of Kerala and Ors. As reported in 2007 (5) ALT 17 (SC) 

FACTS OF THE CASE: With regard to the building work, the appellant and the State of Kerala entered into a contract. Due to disagreements between the parties, arbitration was requested for this situation. Under Section 30 of the Act, the State of Kerala filed a petition asking for the award to be overturned. The State of Kerala filed an appeal with the Kerala High Court after its plea was denied, feeling vindicated. The appellant in this case presented claims under 12 distinct headings, yet the arbitrator only granted a small number of claims. Although the whole decision in the appellant’s favour had been contested in the memorandum of appeal, the objections were only raised in relation to a small number of claims. A preliminary objection was made in the appeal that the arbitrator chosen had been dismissed for severe misconduct, and Kerala State claimed that under the circumstances, the arbitrator’s decision lacked jurisdiction.

ISSUE OF THE CASE:

  • The arbitrator had  no authority to continue with the arbitration after his  suspension or retirement
  • whether the  claimant was entitled to compensation for the losses suffered  by him on account of price escalation of materials
  • relating to losses suffered by him  on account of  the non-availability of a suitable dumping yard for dumping  excess

JUDGEMENT OF THE COURT: 

  • The Apex Court observed that the parties would be bound by the terms agreed upon in the contract, but if one of the parties to the contract is unable to fulfil its obligations under the contract which has a direct bearing on the work to be executed by the other party.
  • The Arbitrator is vested with the authority to compensate the second party for the extra costs incurred by him as a result of the failure of the first party to live up to its obligations.”

The aforementioned are some of the important Supreme Court rulings that have altered the body of law surrounding price escalation in contracts without express clauses to that effect. When fulfilling their contractual duties, certain specialist contractors who were tied to fixed-price building contracts would incur significant losses, especially when delays occurred due to circumstances beyond their control. Through these cases, it can be seen that the courts have taken into account several factors when awarding compensation to the contractors, including the contract’s terms, the parties’ intentions, the inability to perform due to unavoidable circumstances, additional work completed by the party, and the contractor’s calculation of the claim.

Conclusion

When escalation clauses are employed by their customers, real estate brokers are required to abide by a certain code of ethics as well as other rules. The agent must, among other things, advance the interests of the client. They must also operate fairly and honestly toward everyone involved, gather all relevant information, and reveal it to the client. The interests of the buyer and the seller are obviously at odds with one another, therefore as long as their acts are just to the other party, the representatives of each party are responsible for safeguarding the interests of their own customers. It is crucial to realize that the right to determine whether or not there was a breach in the first place does not include the right to determine the number of damages resulting from the violation. It is a grave injustice to allow a contracting party to decide whether or not there was a breach of the contractual requirements. The number of damages that the defaulting party must pay might be deemed an exempted subject. Misinterpretation of such pertinent sections may result in serious unfairness to an aggrieved party and, eventually, may lead to abuse of powers by the authority holding such rights.

It is rather typical for parties to bring some claims during proceedings that may be outside the scope of their contract, notwithstanding the contractual limitations on arbitration proceedings. contract’s scope, despite the contractual limitations on arbitration. Among the most frequently asserted claims is the “escalation charge,” which is a financial Escalation cost/charge awards or rejections under an agreement that is frequently controlled by specific terms specified by the parties. But when the parties to a contract do not intend or foresee such a clause, issues might arise. However, despite these dangerous circumstances, courts have remained committed to dispelling doubt and providing essential clarification. The concept of “delay” is important, and the measurement of damages is dependent on the degree of delay. But if one of the contractual parties is granted the authority to assess the other contracting party’s violation, then immediately contravenes the dictum “Nemo judex in causa sua,” which states no person can be a judge in his own cause.

References

  1. https://www.upcounsel.com/escalation-clause
  2. https://contractnerds.com/material-escalation/
  3. https://www.realtor.com/advice/buy/what-is-an-escalation-clause-how-does-it-work-and-when-should-you-use-one/

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