Each construction contract has its own different areas of risk.
In this commercial law update, we consider only the general areas in which risks can arise and need to be managed in a construction contract.
Some common areas of risk in construction contracts are:
- Advance payment
- Performance bond
- Manufactured goods
- Shipping and Transit
- Customs clearance
- Payment and Tax
- Unforeseen conditions
- Engineer’s role and authority
- Testing and Completion / Handover
- Liquidated Damages / Delay
- Design Risk
- Warranty / Defects Liability
- Final Completion / Handover
- Dispute Resolution
Risk arises at each of these stages and needs to be managed in each of those stages.
In different contracts, different areas of risk will have different weightings and will need to be dealt with accordingly on each contract document. The “weighting” of the risk and the remedies sought in relation thereto can be tied directly to the financial impact of the risk occuring.
Example: Design Risk – Specialised one-off design versus Off-the-shelf machinery.
For “Specialised” design will want a big design warranty and PI insurance cover. For “off-the-shelf” will only get a manufacuturer’s warranty of fitness for purpose. No design warranty.
The intention of this article is to assist with a better understanding and a checklist of some of the common areas of risk in a construction contract, and an outline on how you might manage each of these common areas of risk.
The purpose is to provide a number of “red flags” that may be used when next considering a construction contract and identifying areas of risk contained in it and how to deal with these.
I set each of these points out in bullet point format, with some brief explanatory notes, below.
1. Advance Payment
- Secured by advance payment guarantee
- Need to look carefully at form of guarantee
- Clear mechanism for claim on guarantee
- Clear mechanism for expiry of guarantee
“form of guarantee” – conditions for claim, expiry of guarantee, amount of guarantee.
“clear mechanism” – means clear mechanism in contract for both making a claim and for expiry of guarantee. Usually linked to progress of project and amount of money contract has been paid under the contract.
2. Performance Bond
- Need to clearly specify the terms of bond
- Total amount of money required for the performance bond
- Effective length of bond and expiry
- Clear method for making claim on bond
Role of performance bond in risk management. Performance bond is a financial tool used to ensure that in the event of a developer or contractor's default, funds are available to finish the construction project. It is common to require contractors to provide a bond from an independent bank or insurance company so that the employer can recover damages it may sustain as a result of the contractor's default up to a stipulated limit.
The idea is that, if the contractor defaults, funds are available to finish the project.
Total amount usually specified as a percentage of the total cost
Usually valid until final completion of a project
3. Manufactured Goods
- Attend factory test
- Manufacturer’s / Third Party Warranties
- Effective date of warranties
- Lifetime of Engine
- Spares (available for lifetime of engine)
Attending factory tests. Usually just a right to attend and observe tests, etc. undertaken by manufacturer to ensure engine meets the specifications / requirements.
Manufacturer’s Warranties. Employer should ensure that contractor (if the contractor purchases the machines) passes on the benefit of the warranties to the employer and manages any warranty claims in relation to those goods in the event that the employer does make a warranty claim.
Effective date of warranties – when do they start (relative to handover of project)
How much risk (and correspondingly the amount and structure of remedies) involved in this process depends on the role of the manufactured goods / machine in the project.
Example: Hotel development versus Power House.
Hotel development machines are more likely to be air conditioning units, lifts, etc. These are minor in nature compared to the overall project and their role in the overall completion and success of the project.
On the other hand, generators in a power house are the most vital component. Without them, the powerhouse is just an empty house.
Lifetime. In terms of the lifetime of the engines and the spares, a lot of issues that may arise could be potentially resolved by ensuring that any engines (which are intended to last for any length of time such as in a powerhouse) are bought from reputable firms producing high quality engines and who are of a sufficiently substantial nature so as to ensure that the vendor will be, in one form or another, able to continue to supply spares for the useful life of the engine (and meet warranty obligations). The other choice of course is to find a suitable alternative source of supply of parts (highly unlikely) or to stockpile spares right from the outset (huge up-front cost and money tied up in stock. Also only covers consumables and other parts likely to fail, won’t necessarily cover all parts).
4. Shipping and Transit
- INCO terms
- Passing of Risk and Title
- Conflict between passing of risk and title under INCO terms and passing of risk and title under terms of contract
- Must ensure no “gap” in risk
- Notify Insurer
Must understand INCO terms and their implications. Especially in terms of passing of title and risk.
For example: compare EXW terms with DDP
Applicable to plant and equipment. Not only INCO terms but also whatever the terms of shipping may be under the contract.
Vital component to be considered (especially depending on how “vital” the plant and machinery is to the successful completion and running of the project).
5. Customs Clearance
- Taking advantage of customs exemption
- Named owner of equipment – passing of title but NOT risk
- Responsibility for customs clearance – potential impact on delay claim
- Contractor’s equipment versus Plant and Material to be part of Works
Must keep customs abreast of any plant and equipment being imported.
6. Payment and Tax
- Pay careful attention to tax obligations
- Withholding tax (might need to split contract into goods and services)
- Double taxation agreements
- Offshore payment timing and RBF consent process
- Exchange rate risk
Highly recommend that each party must get own tax advice.
Misunderstanding or wrong calculation of tax impact can throw a business case “off” entirely.
Example: A client entered into negotiations with a firm from Singapore. Now this matter had been put out to tender, client received conforming tenders, and the firm from Singapore had been sent a letter of intent. Upon negotiation of the terms of contract, it suddenly came to the contractor’s attention that our client would be deducting withholding tax of 15% from all payments for services made to the contractor. The contractor further realised that they most likely would not be able to take advantage of any double taxation treaty between Fiji and Singapore. Basically the contractor had 15% wiped off their bottom line just like that.
Fortunately the parties negotiated and agreed a compromise and the project went ahead.
Most companies have now started doing two things in light of the tax issues.
1. Made it very clear in all invitations to tender that the tenderers should take tax advice on the tax structure in Fiji when preparing tenders; and
2. Structured the pricing provisions of each contract so that it clearly separates the “goods” and “services” components and then further separates the “goods” supplied overseas from the “goods” supplied in Fiji and the “services” supplied overseas from the “services” supplied in Fiji. This way, it made it much clearer what sort of tax would be charged on what area of payment under the contract and the parties could see quite clearly and quickly the impact of tax on the charges under the contract and whether, in light of this, the parties should change the structure of the contract to lessen the tax burden.
Offshore payment timing (factor in time it takes to get RBF consent to make offshore payments when considering time period for payment of invoices overseas.
Exchange rate risk – what currency will the payments be made in and who will bear the exchange rate risks?
Payment structure allocates risk between the parties. On a continuum from Entire Contract to Cost plus percentage fee. The risk at the former end is minimised for the Employer and maximised for the Contractor and vice versa at the latter end.
• Lump Sum – minimum risk for Employer, Maximum risk for Contractor
• Value and Measurement Contracts (Bill of Quantities)
• Schedule of Rates and target cost
• Cost plus fixed fee
• Cost plus percentage fee – maximum risk for Employer, minimum risk for Contractor
Of course in construction contracts we can have different payment structures for different areas of the project depending on the risks arising in the particular area.
7. Unforeseen Conditions
- Especially relevant where sub-surface excavations are involved
- Need clear initial definition and outline of characteristics within contract scope
- Need clear process and quantities and costs for work outside contract scope
- Very important. Can involve large amount of extra work and money and very susceptible therefore to dispute
Whoever is drafting the legal agreement must at this point consult clearly with the engineers involved in the project to ensure the risks are understood and the method for dealing with the risks as they may arise are properly documented in the agreement.
We recently acted for client who had a dispute with international contractor. Part of the dispute arose over the requirements for excavation under the contract and in the end it just came down to one number. “4m” under contract. The standard design required “2m” depth of subsurface excavation. Luckily the provisions of the contract were clear and initial provision for the characteristics or requirements for sub-surface excavations obligated the contractor to dig down to at least 4m before it could pass the risk (and hence the associated costs) on to our client.
8. Testing and Completion / Handover
- Must have clear completion process
- Clear testing process and criteria to be met
- Provision for deemed completion
- Very important as completion is linked to payment, passing of risk, reduction of bonds and beginning of warranty / defects liability timeline – likely area for dispute
Clear completion process: Who has to do what and when and to what standard? How is the other side to react once this is done?
Cannot stress enough that this has to be a clearly documented process. This is a likely area for disputes to arise due to the consequential events linked to a “handover” or completion.
9. Engineer’s Role and Authority
- Engineer’s authority must be clearly defined and understood by both sides
- Power to bind employer
- Power to order variations
- Power to make determinations at first instance on a wide variety of issues
- Must keep clear communication channels and control communications between the parties
- MUST have a clear understanding of the contract and the parties’ obligations under the contract
- Must keep a record of everything
“Engineer” In the Fiji Standard Building Contract – this role is taken by the Architect. In FIDIC this role is taken by the “Engineer” – appointed by the Employer.
If you are using the standard form contracts these roles will already be quite well understood between the parties, but if you sign a different form of contract of for some reason want to change the provisions of the standard form, then you must keep a close eye on these things.
Clear communications channels. Word of caution here about communication between parties in a contract. Must ensure that you have internal controls about who is to communicate with the other side and how the communications are channeled before being sent to the other side.
Also caution about content – could amount to a changing of the terms of the contract or a new contract being found.
CAUTION ABOUT EMAILS! – email strings can contain some very interesting (and damning evidence). Be very careful when sending emails, especially those including an internal email chain.
- Must have clear process
- Must have clear statement of authority required to approve variation
- High potential for dispute/conflict
- Need to be careful not to “undo” contract
If you look at role of “variation” in context of risk management for entire project, it is meant to be a “catch all” to cater for the inevitable changes in circumstances, conditions, requirements, specifications, etc. that arise during the course of a project which has not been specifically catered for or foreseen in the contract.
The process itself is meant to be a practical way to manage the risk involved with such and must itself be very clear and flexible.
Must involve both parties in agreement.
When agreeing variations, parties need to be aware of how it impacts on the contract document and rights and obligations under the contract document.
Under case law, there are 4 things that have to be shown by the contractor if it were to prove variation:
- Extra Work not included in the work for which the contract sum is payable
- Any agent of the Employer that ordered the Extra Work was “authorised” to order it
- He was actually “ordered” to do the Extra Work?
- There is a binding promise (express or implied) by the Employer to pay for this Extra Work
Basically, any process contained in a construction contract must ensure that all these 4 areas are covered in the process. As we keep repeating, if you are using a standard form contract, and if you correctly follow the process contained therein, you should meet these requirements. However if you were to stray from or change the standard form in the course of negotiations then you should ensure that whatever process or changed process you adopt covers at least these 4 areas.
“Undo”. Have to be very careful not to “undo” what has already been agreed aside from what is necessary in light of the variation at hand.
11. Liquidated Damages / Delay
- Genuine pre-estimate of loss
- How many days / limit of LDs
- Can be used as an effective deterrent / motivator for timely completion of work
- Bonus Incentive
- Likely area for dispute
- Project manager must keep very clear notes of delays, reasons, etc. in writing
Idea here is not only to be compensated for actual losses suffered but the very practical side of this is to also get the project completed.
Neither side wins when the project is not properly completed.
Bonus incentive –a question can arise about “who owns the float” in a project timetable. And essentially as between the contractor and the employer, the float in any project timeline is owned and can be utilised by the contractor as he considers best. However, depending on the commercial benefits the employer may receive for early completion, the employer may want to in some instances pay a bonus for early completion.
Must keep clear records – keep a diary. Very important. Also not enough just that there was a cause of delay. The cause of delay must have actually affected the project timeline.
For example: If there was rainfall which affected excavation, but contractor continued to do assembly work or something similar.
Also be careful of “double claiming” for extension of time. For instance, late delivery of machine (contractor’s responsibility). On a couple of those days the employer wasn’t able to supply electricity to site due to a fault in the supply line. The contractor claimed for extension of time to try shift some of the days of delay from their responsibility to the employer.
12. Design Risk
- Effective date and length of design risk
- Amount of design risk
- Evidence of PI Insurance for design risk
- Care needed regarding “acceptance” of design
What are you designing for?
When the designer gives you that design, what function do you want it to perform and to what standards?
If something goes wrong, where will that show up? How will it show up? Make it clear what, physically, will be the result of a design fault or what the level of care is that is expected from the designer and then tie this in with a breach of the designer’s obligations to you under the contract.
If something goes wrong with the design (that is, it is not an equipment failure, not a workmanship standard issue, but a design fault) what will the consequences be?
Usually, with design the risk is quite large. If there is a design default it could result in any part, or in the extreme cases, the whole of the project being unusable or not being able to be used for the purpose for which it was intended.
Due to the potential financial impact of a design defect, usually then the amount of compensation payable for breach of the design obligations is stated to be a factor of the total contract price (2 to 3 times the contract price for design). Where we have dealt with design build contracts we have provided design risk to be the accepted price of the contract. Basically if there is a fault in the design, we want to be covered for the entire cost of project. This is the amount of risk we are talking about with design.
Be careful when negotiating design contracts because of this seemingly “disproportionate” exposure that the designer is subjected to. Quite easy to think that the designer is only getting paid say $100,000 but he is being exposed to a potential risk of $1m. But this is the nature of the professional services being provided by the designer.
Must have PI insurance and must produce copy of insurance terms and certificate of currency as part of contract.
Be careful with “acceptance”. Always advise my clients not to even use the word “accept” but to use the words “no objection”.
13. Warranty / Defects Liability
- Length of warranty / Defects liability
- Amount of retention sum, security bond to cover warranty
Note: length of warranty of completed project could be different from length of warranty on the installed equipment which are a part of the project.
Retention sum: we find it is becoming more and more common now that contractors ask that retention sum be replaced by bank guarantee or other form of security.
14. Final Completion / Handover
- Clear process and criteria to be met
- Very important as linked to final payment, passing of risk, and expiry of bonds/security – likely area for dispute
This is the final act and just like the Completion / handover, must be very clearly drafted.
15. Dispute Resolution
- Not a “boiler plate” clause
- The clearer the risk allocation and management terms of contract the less potential uncertainty, dispute and conflict
- Clear process to genuinely resolve disputes
- Place to conduct dispute resolution process
- Both parties involved
- Consider practical options
- Keep away from Courts if possible
- Will be based on records – very important to keep clear written records
“clear process” consider the dispute resolution rules. Tempting to just “overlook” this as it is not an “important” part of the commercial substance of the contract. However, can have a major commercial impact (in terms of unresolved disputes and all the time, money and resources this consumes) if not done properly and no clear process provided for resolving disputes. If you think about the role that dispute resolution has in the context of risk management as a whole, it is a final “catch all” where the risks under dispute has not been specifically provided for. The quicker and more effective this process, the less “risk” of disputes “blowing up” and unnecessarily consuming further time, money and resources.
“Clear risk allocation” means less disputes and “clear process” means easier/quicker dispute resolution.
“genuinely resolve disputes” Must have the confidence of both parties and not be perceived to be “window dressing”. Both parties should be engaged and involved. Perceived independence of dispute resolution “board” or “adjudicators”.
“Keep away from courts”. The truth is going to litigation takes time, money and diverts management resources which could be more profitably engaged elsewhere in the business. Also not guaranteed of a “suitable” outcome.
Need to keep very clear written records. Can’t stress this enough. The lack of records can be fatal to any case and it will be too late when the parties enter into arbitration to bemoan the fact that you should have kept better records.
Can you change the standard form? Yes, you can change the standard form by agreement. If you understand what you want and the legal principles which you may be subject to (depending on the changes made), the parties can simply re-draft the relevant clauses of the standard form agreement and agree it.
It is useful to keep this checklist of common areas of risk in a construction contract and to “check off” each point as they may arise in your next construction contract negotiation.
We also leave you with three main points to keep in mind when entering into a construction contract:
1. You must take time at the negotiation stage to consider the project in full, consider the risks involved and then consider how you want to apportion this risk.
Every stage of a construction contract involves risk and the relative weighting of each risk will change depending on the subject matter of the contract but the principle remains the same. Spend the time and effort up-front to go through all these considerations.
Then, record the result of these deliberations, how you want to deal with the risks arising in each area, in the contract. We think that this is where a lawyer can add the most value to the process.
If you do this, and keep to the processes set up under the contract, you can save yourself from having to deal with the issues at the end. It is much harder discussing and agreeing disputed issues with the other side when they are the subject of an actual dispute with a real monetary impact and all the background surrounding it.
Deal with this issue up-front!
2. Stick to the contract – do not stray from it (“follow the yellow brick road”).
3. Keep clear, concise and complete written records.
For more information in relation to construction law or for any other commercial law enquiry please contact Atu Siwatibau: email@example.com
This commercial law update is provided for general information purposes only and it is not, and should not be relied on as, legal advice.