Tariff-related considerations when planning a data center project
High tariffs would significantly impact data center projects, through increased costs, supply chain disruptions and other problems. Reed Smith’s Matthew Houghton, John Simonis and James Doerfler explain how owners and developers can attenuate tariff risks throughout the planning, contract drafting, negotiation, procurement and construction phases. In this podcast, learn about risk allocation and other proactive measures to manage cost and schedule challenges in today’s uncertain regulatory environment.
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Intro: Hello, and welcome to Tech Law Talks, a podcast brought to you by Reed Smith's Emerging Technologies Group. In each episode of this podcast, we will discuss cutting-edge issues on technology, data, and the law. We will provide practical observations on a wide variety of technology and data topics to give you quick and actionable tips to address the issues you are dealing with every day.
Matt: Hey, everyone. Welcome to this episode of our Data Center series. My name is Matt Houghton, joined today by Jim Doerfler and John Simonis. And in today's episode, we will discuss our perspectives regarding key tariff-related issues impacting data center projects that owners and developers should consider during initial planning, contract drafting, and negotiation and procurement and construction. So a bit about who we have here today. I'm Matt Houghton, counsel at Reed Smith based out of our San Francisco office. I focus on projects and construction-related matters both on the litigation and transaction sides. I was very excited to receive the invitation to moderate this podcast from two of my colleagues and thought leaders at Reed Smith in the area of capital projects, Mr. John Simonis and Mr. Jim Doerfler. And with that, I'm pleased to introduce them. John, why don't you go ahead and give the audience a brief rundown of your background?
John: Hi, I'm John Simonis. I'm a partner in the Real Estate Group, practicing out of the Orange County, California office. I've been very active in the data center space for many years, going back to the early years of digital realty. Over the years, I've handled a variety of transactions in the data center space, including acquisitions and dispositions, joint ventures and private equity transactions, leasing, and of course, construction and development. While our podcast today is primarily focused on the impacts of tariffs and trade restrictions on data center construction projects, I should note that we are seeing a great deal of focus on tariffs and trade restrictions by private equity and M&A investors. Given the potential impacts on ROIs, it should not be surprising that investors, like owners and developers, are laser-focused on tariffs and tariff uncertainty, both through diligence and risk allocation provisions. This means that sponsors can expect sophisticated investors to carefully diligence and review data center construction contracts and often require changes if they believe the tariff-related provisions are suboptic. Jim?
Jim: Yes, my name is Jim Doerfler. I'm a partner in our Pittsburgh office. I've been with Reed Smith now for over 25 years and have been focused on the projects and construction space. I would refer to myself as what I would call a bricks and sticks construction lawyer in that I focus on how projects are actually planned and built. I come to that by way of background in the sense that I grew up in a contractor family and I worked for a period of time as a project manager and a corporate officer for a commercial electrical contractor. And data center projects are the types of projects that we would have loved. There are projects that are complex. They have high energy demands. They have expensive equipment and lots of copper and fiber optics. In my practice at Reed Smith, I advise clients on commercial and industrial projects and do both claims and transactional work. And data of projects are sort of the biggest thing that we've seen come down the pipeline in some time. And so we're excited to talk to you about them here today.
Matt: Excellent. Thank you both. Really glad to be here with both of you. I always enjoy our conversations. I'm pretty sure this is the kind of thing we would be talking about, even if a mic wasn't on. So happy to be here. I want to start briefly with the choice of topic for today's podcast. Obviously, tariffs are at the forefront of construction-based considerations currently here in the U.S., but why are tariffs so important to data center project considerations?
Jim: So, this is Jim, and what I would say is that Reed Smith is a global law firm, and one of the things that we do in our projects in construction group is we try and survey the marketplace. And data center projects are such a significant part of the growth in the construction industry. In the U.S., for example, when we surveyed the available construction data from the available sources and subject matter experts, what we found is that at least for the past year or two, construction industry growth has been relatively flat aside from data center growth. And when you look at the growth of data centers and the drive for their being built by the growth in AI and other areas, it's really a growth industry for the construction and project space. And so something like tariffs that have the potential to impact those projects are particularly of concern to us. And so we want to make sure for our owner and developer clients and industry friends that we provided our perspectives on how to do these projects right.
Matt: That makes a lot of sense. So we've sort of set the stage for the discussion today. I think we could go on for hours if we didn't give ourselves some guidelines, but there are really three critical phases of a project that a owner or developer should be thinking about how they're going to address tariffs. And those are the initial planning, the contract drafting and negotiation, and then the procurement and construction phase. Since planning comes first, and of course, of the Titleist podcast is tariff-related considerations when planning a data center project. Let's start with the planning phase and some of the considerations an owner or developer may have at that time. John, what do you see as some of the key portions of the planning process where an owner or developer needs to start addressing tariff-related issues?
John: Tariffs and trade restrictions are getting a great deal of focus in all construction contracts. Tariffs impact steel and aluminum, rare earth materials. Data centers are big, expensive projects and can be impacted greatly. We're obviously in a period of great uncertainty as it relates to these types of restrictions. So I think in the planning stage, it may be somewhat obvious to say that that may be the most important time to mitigate to the extent possible some of the impacts. I think it starts in the RFP process. The requirements you're going to put on your design team and on your contractor to cooperate, collaborate, to mitigate to the extent possible the impacts of tariffs and particularly increased tariffs. You identify the materials and equipment subject to material tariffs and tariff risk. It increases, particularly those that might increase in the future, and I'd address those as best possible. You expect your team to be proposing potential mitigation measures, such as early release, substitutes, and other value engineering exercises. So that should be a very proactive dialogue. And you should be getting the commitment from the parties early in the RFP process and throughout the planning and pricing stage to cooperate with the owner to mitigate negative impacts, both in terms of cost, timing, and other supply chain issues. Jim, there's also some things we're seeing in the procurement space, and maybe you can address that.
Jim: Sure. So, you know, as you're going through the RFP phase and sort of anticipating what you would ultimately want to build into your contract and how you're going to procure it, you want to be thinking ahead about procurement-related items. As John indicated, these projects that are big and complicated and that involve significant and expensive equipment. So you want to be thinking about essentially your pre-construction phase and your early release packages, your equipment or your major material items. And you want to be talking with your trade partners in terms of allowing that equipment to get there in a timely fashion and also trying to lock down pricing to mitigate against the risk of tariff-related or generally trade-related disruptions that could affect either price or delivery issues. So you want to be thinking about facilitating deposits for long lead or big ticket material or equipment items. And you want to identify what are those big equipment or material items that could make or break your project and identify the risk associated with those items early on and build that into your planning process.
John: And there's some difference between different contracting models. If you were looking at a fixed price contract versus a cost plus for the GDP or a cost plus contract, obviously the risk allocation as it relates to tariff and trade restrictions might be handled differently. But generally speaking, we're seeing tariff and trade restriction risk being addressed very specifically in contracts now. So sophisticated owners and contractors are very specifically focusing on provisions that specifically address these risks and how they might be mitigated and allocated.
Jim: Just to follow up on John's point I mean in theory there are you could you could have a fixed price contract versus at least in the in the US what we would describe as cost plus or cost reimbursable projects using a guaranteed maximum price or a not to exceed cap style agreement in our experience at least in the US they tend to be more of the latter type of project delivery system and even if you had a fixed price contract, one of the issues in the marketplace that we've been seeing really since COVID has been these force majeure or supply chain impacts. And the tariffs are really sort of almost an outgrowth of that or a different manifestation of the same types of effects that we would see. And so even if you had what was in theory a fixed price contract, one of the issues that you're going to quickly run into is that the contractors are going to want some carve-outs from that because of what we're seeing in the marketplace.
Matt: I think you guys are basically making the natural transition into our next topic, sort of talking about the contract drafting and negotiation phase. When you're putting those thoughts into practice, what sort of provisions do you guys see as sort of the key contract provisions that owners and developers should either be including and or carefully negotiating or crafting into their contracts that involve these tariff-related issues?
John: I think traditionally, the issue of tariff increases, tariff uncertainty, supply chain uncertainty, given the current political climate, would typically, you'd be looking to the force majeure provisions, you'd be looking to the change in law provisions that have traditionally been in construction contracts. As Jim mentioned, we are seeing a more direct focus on tariff-related issues in current contracts where the party very specifically discuss it, allocate risk, allocate commitments to collaborate. So we're seeing that as its own provision usually now and setting a baseline that any kind of a change order would be based on, giving commitments to work with each other. And if we're going to put those into separate provisions, then we need to make sure that as you look at your change in law, of course, with your provisions, that you don't also cover them in those provisions. You'd want to refer to the specific provision as opposed to picking them up in the more generic provisions.
Jim: And just to follow up on what John was saying, I think one of the things you need to do is you need to look at your existing contracts. If you're using certain, if you're in the U.S., for example, and you're using some of the standard commercial templates like the American Institute of Architects or the consensus docs type documents, as opposed to a bespoke agreement, some of those actually don't contain a force majeure or a change in law provision. So in all likelihood, the contractor is going to suggest that one needs to be included, but I think you need to proactively plan for that. And as it relates to the specific issue of tariffs, one of the things that you want to focus on is your definition of change in law and whether or not, for example, an executive order issued by the president qualifies as a change in law. The bottom line is you want to be specific and you want to allocate your risk specifically to eliminate uncertainty and the risk of claims that follows from uncertainty. You know, I guess the other thing along with sort of the big issues of force majeure and change in law is if you're doing something like a cost plus type arrangement, one of the additional provisions that is going to be heavily negotiated is something called contractual or construction contingency. And contingency is typically a term that is used for essentially an allocation of money that has been set aside to cover the risk of unforeseen contingencies or unforeseen events that would cause the cost of the project to increase. Now, tariffs would often be viewed as a contingency, but one of the things that we're seeing in the marketplace is that contractors have a certain amount of money that they're setting aside for contingency related to other risks associated with, for example, unforeseen price increases because of supply chain issues and that sort of thing. And so they're reluctant to give up what has been set aside for general construction contingency to cover tariff-related risks. So that's one of the areas that is going to be heavily negotiated in that type of project and to what extent the owner has approval over approving of the use of that contingency. So that's something for that particular type of contract. John, what other types of contractual provisions in your experience are going to be critical?
John: Following on your last point, Jim, first, I think contractors, at least in my experience, have been viewing the tariff risk as a very pure force majeure type risk that they can't control beyond collaborating on mitigation, but they cannot generally control it. So that if, you know, if they've done their pricing and bought out stuff and that changes, both they and their subcontractor are going to be looking for change orders if an additional cost is imposed on them. Now, we're seeing that contractors and some of the subcontractors sometimes absorb some of that risk, but it's almost always capped at, you know, some relatively low percentage of the cost increase. Jim, have you been seeing the same thing?
Jim: I have been seeing the same thing, that the contractors are pushing back, that basically they view tariffs and tariff-related risks as being a different animal, that you should have a different mechanism for dealing with that risk. And one of the ways, as you pointed out, they view that as being essentially sort of like a force majeure or a change in law type issues where they're entitled to a change order. And then the issue then becomes, from a negotiating standpoint, what sort of provisions or planning do you anticipate in your change order provisions? And we've seen some development in that area as well. John, do you want to talk about what you've seen in terms of how these change order provisions are being drafted to account for tariff-related risks?
John: Sure. One of the first items that's always addressed is a duty to mitigate. And that duty to mitigate, I think if it's properly drafted as both a covenant and a condition to recovery. It has more importance than the simple covenant, I believe, in that it precludes claims from a contractor that they just push forward and absorb what could be an exorbitant tariff. That the owner can say to them, we should be considering substitutes and value engineering and alternatives, and I want to pause to do so. So I think without crafting every possibility, the best way to do that is to have a collaboration clause. And we are not seeing much resistance with contractors.
Jim: And I'll just follow up on that. To the extent that there's agreement that the tariffs would represent sort of a change and that they're entitled to a change order, One of the things that we're seeing is essentially a bit of horse trading between owners and contractors in the sense that owners may be willing to grant a change order for the costs associated with tariffs that were not included in their original pricing, but they're asking essentially for the contractors not to seek fee or markup on the additional costs that they would be incurring. At least that's what I've been seeing. John, has that been your experience?
John: Yes. I think the tariffs, particularly if it's a substantial increase, I think there's more alignment and I don't think it's necessarily appropriate for a contractor to be profiting in that added cost to the project. And we see parties in general agreement on that.
Jim: I would say the other contract drafting and negotiation issue is that what I've seen is when they're trying to develop it, essentially you draw sort of a bright line at the time of contracting or the time that the pricing is agreed upon. And then going forward, then, if there is some new tariff that would come in, then it's very important to provide timely notice of claims so that it can be addressed very quickly. So that's one of the provisions that I think is important. And then finally, sort of the flip side of the contingency coin is oftentimes these cost plus agreements have a shared savings provision. And so I would say that if tariffs are considered to be a contingency item, then the flip side of that is that the contractor would be entitled to some level of shared savings if they are able to bring it in under the guaranteed maximum price or the not-to-exceed cap. By contrast, if tariffs are treated as being something set apart from contingency, then oftentimes what I'm seeing is that it gets treated as an owner allowance item. That if it's used, it's used, again, without markup. But if it's not used, then it reverts back to the owner in its entirety with no shared savings being paid out. At least that's what I'm seeing in my area.
John: Yeah, I think the one little twist on that, Jim, that I would throw out is if it's the contractors absorbing some of the risk of the tariff increases, in those instances, I have sometimes seen some of the sharing. But if they're not absorbing that risk, I think it's pretty appropriate for the owner to say you shouldn't be benefiting from the fact that the tariffs didn't come up and we had provided contingency for that. One last thing to think about, and I haven't seen a lot of changes in the provisions yet, but I've given a lot of thought to the fact that if you've got some extreme combative retaliatory tariffs that made a project uneconomic, you should be focusing on your right to pause and your right to terminate and making sure that those aren't penal to the owner. So I think that deserves some focus in this instance as well.
Matt: Just my takeaway from all of this is that there's really a lot for owners and developers to think about here. And to give credit where credit's due, I think John mentioned this during our preparation for this podcast. Owners and developers really need to make sure that they're considering these issues during the initial planning and address them carefully and deliberately during the initial drafting and negotiation. Your guys' thoughts and comments remind me of a remark I heard from a pilot in passing in response to passengers' frustration at certain delays when their plane wouldn't take off. He said it was better to address the problems with the plane on the ground than in the air. And I think that aptly applies here to these sorts of projects. Let's make sure we address them before the project has taken off. But to round out our discussion, I want to transition to the third and overall final area, procurement and construction. So once a project is ready to take off and get underway, what sort of issues should owners and developers anticipate and be prepared to address as the project heads into the procurement construction phase? Jim, if we want to start with you.
Jim: Yeah, so one of the things that I would say is planning is the best preparation for a successful project. And during, but you need to stay on top of the project as it moves forward. Some of our sophisticated clients, as they're building these projects, have developed things like tariff tracker spreadsheets, where they're identifying, they're breaking the project down into their different component parts and identifying specific equipment or material items that might be subject to tariffs, what the amount of those tariffs are, and who's bearing the risk of that. They are assiduously monitoring the windows for buyout packages to be completed so that once they get the go-ahead from the owner to lock in the guaranteed price or the capped price, it's very important that the prime contractor buy out those critical equipment and material and subcontractor packages to lock in that pricing and to lock in the best delivery schedules that they can get. And to monitor that as they're going forward to avoid any sort of slippage, either in terms of the project schedule or in terms of pricing.
John: Jim, I think a lot of it begins with the identification of the high-risk equipment being incorporated into a data center project. One thing I would comment on is that I've had a fair share of sensitivity from my clients to the issue of who's making the decision on early procurement versus wait and see if the tariff situation changes versus pausing a project. I think the owners should be focused on trying to keep as much control as possible of those decisions, since they will be bearing the brunt of the cost and the brunt of the delay.
Jim: One additional thought, and that is that during the course of the project, you may have situations where for various tariff or trade disruption type reasons, particular equipment, item of equipment or a particular material may not be available in the way that you want it. And so what we'll see is that there will be requests from the contractor to use alternates or substitutions that are designed either to control costs or to control schedule. And so that's going to be something also where you're going to have to work with your designer to evaluate those because sometimes the substitutions are not equal. But in other instances, if you can make a substitution and keep the project on track and on budget, it can be very helpful. So that's one of the things where, just from a procurement standpoint, handling of alternates and substitutions can be very important.
John: Following up on Jim's last comment, we've talked mostly about contractor-related issues in this podcast. But I do think the front-end focus from the design team may be even more critical. It's going to happen naturally, I believe. But I think it is incumbent upon owners to get their design team to be focusing heavily on helping them mitigate the risks to the extent possible. If they're speccing equipment or speccing supplies that are, you know, subject to substantial risk, that's going to exacerbate the problem. And you can only solve it to someone's degree, contractor. So I think it should be focused on early again in the process and with the design team and the contracting team from a pricing standpoint and value engineering standpoint.
Matt: Well, gentlemen, it's been a pleasure hosting this discussion with you today. Thank you very much for inviting me to be a part of it. Having worked with you both for some period of time, including, you know, basically living out of a hotel with Jim for a month at a time during arbitration. I know we could go for hours, but before we say goodbye, any final thoughts or key takeaways that you want to share with the audience in light of our conversation today?
Jim: What I would say is that many of the lessons that the industry has learned and the tools that have been developed during the COVID crisis and in the post-COVID supply chain disruptions apply equally or applicable, at least by analogy, to the current tariff issues that you'd be facing on data center projects. We've learned a lot from those, and they can be applied here. So in some ways, it's a new dispute, but it's sort of a variation on an existing theme. The second is that many of the contractors that we're seeing are facing a somewhat uncertain environment, especially in the United States, in terms of the pipeline of available work that they have coming in compared to years past. And so these contractors tend to be willing to trade off certain things like markup on change orders for security related to not having to assume what they view as being undue risk that would potentially cause them, you know, sort of an existential threat to their company. And as long as they can get some cooperation from the owner, they likely are willing to negotiate on things like fee and other areas in order to get that security.
John: I would add to Jim's comment just by saying that data center projects by their nature are fairly complex, fairly expensive projects. The contractors and subcontractors that you're dealing with are very sophisticated and understand the space very well. So I think there's an opportunity for the parties, assuming you can get alignment in your construction documents, there's opportunities for the party to work together to mitigate a risk that I think. Frankly, everyone would recognize as a force majeure type risk that nobody can anticipate what's going to happen politically in the near future. So the parties working together is important. Making sure the document creates alignment is important.
Matt: Fantastic. Well, thank you both. I look forward to hopefully doing this again with you guys. Thank you again for very much for inviting me in to host this with you today. This has been our data center series podcast on tariff-related considerations when planning a data center project. For more information on Jim, John, or myself, please visit our profiles on reedsmith.com. Thank you for listening, and goodbye.
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