Keeping the construction industry healthy with a fair risk allocation. Which contract terms matter most for a project’s bottom line?

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Could the construction industry be hurting itself with contracts that go too far?

Some argue that you can only have a sustainable industry in good health if you keep the contracts fair and balanced. If you start shifting risk around inappropriately, history shows that the industry ends up in trouble.

But how much use of special conditions is too much?

Not all special conditions result in unfair transfer of risk. Some special conditions will always be required to address matters specific to the project or the site.

In my experience advising on projects in trouble, there are certain contract conditions that will create more of a squeeze on project margins - or create that squeeze by their absence - than any others.

Consider these common special conditions:

Time bars

A condition-precedent time bar clause can provide that a contractor loses the right to make any claim if the required notice is not given within the specified time period.

Construction contracts allocate risk by identifying certain matters which the contractor is entitled to claim for, if those risks eventuate. The trade-off is that the principal does not have to pay for risks that do not arise, as it would be too expensive for all risks to be priced by the contractor at the outset. However, it is so common on even the largest projects to find poor compliance with time bars and for contractual entitlements to be inadvertently lost.

The consequences can be significant. In some cases they can be highly inequitable, particularly where the principal has instructed the contractor to change the scope or has asked for additional items and the contractor is not entitled to be paid for that work, simply because it did not get its notice in on time.

The stated justification for time bars is that:

  • The contractor should not be able to hold on to claims and then lump the principal with a huge claim at the end of the project. This makes it difficult or impossible to manage budgeting and cash flow, including for Government.

  • Principals need to know how much a Variation will cost, to allow them to change their mind about whether to instruct it and/or mitigate the impact of it.

This all sounds reasonable. But that is not how it is working in practice. In my view, time bars are one of the most significant contributors to a contractor’s inability to recover on its claims.

At tender time, it can be hard for contractors to push-back on time bars because the justification for them is reasonable and the theory is that with proper resourcing they should be able to be managed. But we are not seeing these being managed well at all levels of the industry.

What’s the solution? Probably a combination of:

  • Actually using the mechanism that is already there in clause 5.21 which allows for a proportionate reduction of the contractor’s claim if the principal can demonstrate the matter would have been avoided or reduced if notice had been received earlier.

  • Ensuring time periods are reasonable.

  • Limiting condition precedent provisions to the initial notice only, and not the full substantiation of the claim, which can take time to put together and require inputs from third parties, such as subcontractors or forensic programmers.

  • Contractors stepping up their game in giving notices. This requires acceptance from the principal and its project managers that giving notice is not an ‘act of war’, but a necessary step to preserve contractual entitlements.

Concurrent delay

NZS3910 is silent on concurrent delay, which means the common law position as outlined in the Society of Construction Law Delay and Disruption Protocol applies. That is to say: where a contractor’s own delay event is running in parallel or concurrently with a principal’s delay event, the contractor is entitled to an extension of time, but no cost. This position recognises that the contractor should not be required to pay liquidated damages in respect of its own delay, when it could not have avoided the delay in any event, because the principal caused delay was happening at the same time. The contractor is not entitled to recover time-related costs, however, due to the fact of its own delays. An entirely fair position.

Many contracts now include special conditions which alter this position and prevent the contractor from accessing an extension of time at any time when there is a concurrent cause of delay attributable to the contractor. The contractor is generally only entitled to an extension of time, to the extent that the principal’s delay event exceeds the contractor’s delay event. In effect, this means that the contractor is required to pay liquidated damages to the principal at a time when the principal is itself also in delay.

When a project is significantly late, it is rare for there to be a single cause of delay, or a single responsible party, for the entire period of delay. Possibly because of the absence of any provision in NZS3910 dealing with concurrent delay, many contractors do not understand the significance of these special conditions and how much impact they can have on its ability to claim an extension of time. If time bars are the greatest cause of project entitlements being lost, I would suggest that concurrent delay clauses may be the next greatest in terms of the contractor being deprived of entitlement to an extension of time.

The consequences of a failure to secure an extension of time is, of course, payment of liquidated damages.

Cap on liquidated damages

There is a big focus on the uncapped liability in NZS3910 putting NZ out of step with international market standard. This is definitely important, but possibly more important for a contractor is a cap on liquidated damages, because this is where project margin can erode fast. If the wider industry is serious about ensuring the industry remains healthy and sustainable and makes enough margin to retain and invest in its staff, making a cap on liquidated damages market standard is an important step.

Principals may argue that capping liquidated damages deprives them of the ‘stick’ they need to ensure the contractor is incentivised to complete the work as quickly as possible. That ignores the commercial reality that time is money. Every day a contractor spends on site on a delayed project is a day that it is not spending earning money on the next project.

Contractually this concern is sometimes dealt with by providing that the principal may terminate the contract if the contractor exceeds the cap on liquidated damages. This is a huge stick. With the threat of termination, a contractor will most definitely be incentivised to complete. This should be sufficient protection for the principal too, although termination should not be considered lightly. It will be rare for the project to be completed more quickly if the principal has to engage an entirely new contractor and that contractor is unlikely to be prepared to give a warranty on sign-off in respect of the previous contractor’s work.

Procurement of subcontractors

The role of a head contractor is to plan and manage the works, engage any necessary specialist subcontractors and sometimes self-perform certain portions of the works. It’s a complex and multi-layered role. In a fixed price environment the head contractor takes the risk of cost overruns by sub-trades and is also generally required to provide overarching warranties and sign-off for the whole of the works - even those parts of the works that it has subcontracted to others.

It’s critical, then, that head contractors retain control of the subcontractor procurement process to ensure they can control time, cost and quality.

Many contracts now contain special conditions requiring the principal or the Engineer to have a greater role in overseeing the subcontractor procurement process and in some cases the final decision on procurement is made by the Engineer or the principal.

However, these parties may not choose the same subcontractor as the head contractor might. A head contractor is not incentivised by more than cost alone as it may not be prepared to accept the lowest price tender, if it has not worked with that subcontractor before, or if it does not have a proven track record of performance.

Principals who have contracted the risk of cost overruns and quality management to the head contractor are more incentivised to make procurement decisions on cost alone.

I am unable to think of an example where a principal or engineer-led procurement process has ended well. The driver for including special conditions to this effect, seems to be a suspicion that contractors are making super-profits on subcontract margins and principals naturally do not want to pay for excessive margin on margin. Clearly, events of recent years have shown that these provisions are unnecessary as very few contractors are making super-profits, particularly on projects which are heavily subcontracted not self-performed.

Conclusion

Balance and fair risk sharing are a state that most in the industry would surely hope for. But absent the prudent use of these special conditions it's not hard to foresee real and serious risk for the industry of being tilted out of balance. Sometimes you have to tilt the scales as you go.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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