Ellis Baker, Ibaad Hakim and Richard Hill | White & Case
Risk in construction contracts
‘Risk’, in a project delivery context, can be defined as ‘an uncertain event or set of circumstances that, should it occur, will have an effect on the achievement of one or more of the project’s objectives’.1 Risk exists as a consequence of uncertainty, and, in any project, the exposure to risk produced by uncertainty must be managed.2
Common risks prevalent in construction projects include weather, unexpected conditions, errors in cost estimating and/or scheduling, delays, financial difficulties, strikes, faulty materials, faulty workmanship, operational problems, inadequate plans and/or specifications, and natural disasters.3 Projects will also have additional specific risks, dependent on their nature and surrounding circumstances.
Although the volume and nature of contractual documentation for a construction project will vary as a consequence of the nature of the project, its scale and the procurement methodology adopted,4 a construction contract may be simply described as a contract between a contractor and an employer whereby one person (the contractor) agrees to construct an asset for another person (the employer) for agreed remuneration by an agreed time.5 A construction contract will include a compact of rights and obligations6 between the parties by which the parties allocate responsibilities between themselves in respect of risks that may transpire during the contract’s execution. In doing so, the parties define the impact of the occurrence of risks on three key elements, namely: the asset that is to be constructed by the contractor, the time at which the asset must be completed by the contractor and the amount the employer is obliged to pay the contractor. The collective allocation of such risks in a construction contract represents its ‘risk allocation’.
Pursuit of a ‘fair and equitable’ allocation of risk
Typically, in preparing the contract document bid package, the employer will be in a position to decide on its intended risk allocation. While there may be a temptation to allocate all or most major risks to the contractor, this must be tempered by an understanding of the potentially adverse consequences of allocating risk where doing so may preclude the submission of bids or result in an increase in cost such that the project is no longer financially viable.7 Improper risk allocation may also result in prolongation of construction completion times, wastage of resources and/or increased likelihood of disputes. As Shapiro states, ‘proper risk identification and equitable distribution of risk is the essential ingredient to increasing the effective, timely and efficient design and construction of projects.’8
While it is of course possible for parties to negotiate all the terms of any construction contract, a number of standard form contracts have been developed and it is common for one of these standard forms to be used as the basis for the final construction contract.9 One of the features of standard form contracts is the intent to produce a ‘fair and balanced’ allocation of risk.10 The rationale for pursuing this is that doing so will provide the best chance of successful project delivery. Echoing Shapiro, Lane notes that, ‘[a] contract which balances the risks fairly between a contractor and an employer will generally, in the absence of bad faith, lead to a reasonable price, qualitative performance and the minimisation of disputes.’11 Abrahamson suggests that in order to achieve a fair and equitable allocation of the risks inherent in construction projects, a risk should be allocated to a party if:
- the risk is within the party’s control;
- the party can transfer the risk, for example, through insurance, and it is most economically beneficial to deal with the risk in this fashion;
- the preponderant economic benefit of controlling the risk lies with the party in question;
- to place the risk upon the party in question is in the interests of efficiency, including planning, incentive and innovation; and/or
- the risk eventuates, the loss falls on that party in the first instance and if it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another.12
While the principle of control of a risk is a powerful factor in the determination of risk allocation, it is not comprehensive and other principles should be utilised to address adequately the allocation of risk in a construction contract.13 For example, events of ‘force majeure’ by their nature cannot be controlled by either party but the consequences of such risks must be assessed and allocated. Bunni proposes that the following four principles are used for allocating risks in construction contracts:
- Which party can best control the risk and/or its associated consequences?
- Which party can best foresee the risk?
- Which party can best bear that risk?
- Which party ultimately most benefits or suffers when the risk eventuates?
The question of what is a ‘fair and equitable’ risk allocation is, ultimately, a subjective one albeit using objective tests mentioned above by way of assistance; in deciding how to procure a project and to allocate risks, an employer will need to weigh up the theoretical efficiency of the risk allocation with political and market dynamics and the needs of the particular project and its financiers (if any).
Allocating risk in a construction contract
There are various procurement methodologies or ‘routes’ by which an employer may wish to procure a construction project. The methodology selected will necessarily have an impact on the allocation of risk in certain respects in the construction contract. A summary of the major methodologies and their primary impacts on risk allocation is set out below:
Traditional procurement
In traditional ‘construct only’ procurement, the employer will engage a design consultant or team to prepare the design for a project and then bid and award a construction contract to a contractor to construct the project in accordance with that design. The employer will take responsibility for the design provided by the design consultant or team and the contractor will be entitled to relief (which may be in the form of an of the time for completion and/or increase in the agreed remuneration) if there are defects or deficiencies in such design. (See the section on the FIDIC Red Book in Chapter 4, ‘Introduction to the FIDIC Suite of Contracts’ and below.)
Design and build
In a design and build contract, the contractor will be responsible for both the design and construction to meet the contractual specification. This offers the employer ‘single point responsibility’ and is an advantage relative to traditional procurement where for example it may be difficult to establish whether a defect was caused by defect(s) in design (and therefore the responsibility of the design consultant) or construction (and therefore the responsibility of the contractor). (See the section on the FIDIC Yellow Book in Chapter 4, ‘Introduction to the FIDIC Suite of Contracts’ and below.)
EPC/turnkey
In engineering, procurement and construction (EPC) contracts, a single contractor takes responsibility for all elements of design (engineering), construction and procurement of a project on a ‘turn-key’ basis. While similar to design and build contracts, in such EPC contracts the contractor will normally have significant discretion to design the project as it sees fit (so long as requirements of the output based or functional specification are satisfied) and such contracts also typically involve a heavier transfer of risk from the employer to the contractor. (See the section on the FIDIC Silver Book in Chapter 4, ‘Introduction to the FIDIC Suite of Contracts’ and below.)
Allocating specific risks
Risks that are typically allocated between the parties in construction contracts include:
Quantities
The volume of resources required for a construction project can be a source of uncertainty at the outset of any project. In contracts for a lump sum remuneration, the contractor is paid a fixed amount, regardless of the quantity of resources used. The risk of volumes of resources required therefore sits with the contractor and must be accounted for in the formulation of its bid.14 Conversely, under a re-measurement contract, the parties agree unit rates for the resources required for some or all of the works and remuneration is calculated based on the actual quantities used. In such an arrangement, in effect the employer bears the volume or quantity risk.
Errors in employer-provided information
In construction projects, it is common for the employer to provide the contractor with a range of information, including requirements for what is to be constructed (for example, the specification for the works), the location and condition of the site on which the works are to be constructed and other factors related to how the works will be undertaken (for example, the permits required for the works, the means of accessing the site and prevailing weather conditions at the site). Such information may be provided to the contractor for ‘information only’ on a ‘non-reliance’ basis. In such cases, the risk of errors or inaccuracies in such information will sit with the contractor. Alternatively, the employer may assume some or all of such risk, by allowing the contractor time and/or cost relief in circumstances where the information provided by the employer proves to be incomplete or incorrect.
Unforeseen ground conditions
The risk of unforeseen ground conditions is well known to the construction industry: ‘It frequently occurs in practice, particularly in engineering contracts, that unexpected difficulties are encountered during construction which may not only necessitate a change from the expected method of working, but in extreme cases may mean that completion of the work, at least in accordance with the original design, is impossible.’15
The effects can be felt in terms of time and money: ‘unforeseen site conditions…have an obvious capacity to cause delay and disruption to the performance of works on a construction or engineering project, and to cause an escalation in the contractor’s costs.’16
Certain types of work have a greater propensity for being affected by ground conditions, but most structures have subsoil foundations of some kind so the phenomenon of unforeseen ground conditions is widely applicable. Accordingly, the potential time and cost consequences should be provided for and taken into account in the parties’ forward planning, which includes tender pricing.
In the FIDIC suite of contracts, the Red and Yellow Books have traditionally sought a balanced allocation of risk in Unforeseeable Physical Conditions and related provisions, both as to time and cost. Unforeseen ground conditions are dealt with in a radically different way by the Unforeseeable Difficulties provisions of the Silver Book. (See the section on ‘Unforeseen ground conditions’ below.)
On 7 May 2019, FIDIC published a new Tunnelling and Underground Works Contract (to be known as the Emerald Book) which was a joint initiative of FIDIC and the International Tunnelling and Underground Space Association. The Emerald Book uses the Yellow Book as a base, but incorporates risk allocation recognising the nature of the works to be undertaken (in particular in relation to subsurface conditions).
Force majeure
In the course of a construction project, performance of the parties’ obligations can be delayed, impaired or altogether prevented by events outside the parties’ control. All major legal systems have rules governing the impossibility or inhibition of performance of contractual obligations. The underlying law of the contract selected by the parties, or that which applies in the absence of such selection, is capable of providing remedies and other outcomes to some extent but there is often a significant difference between civil law and common law traditions in this respect.
The concept of imprévision has long formed a part of systems deriving from French law and the doctrine of rebus sic stantibus is expressly incorporated into the German Civil Code.17
In the common law systems and notably in English law, there is no general theory of force majeure, which is not a term of art. The effect is that ‘performance of the relevant obligation must have been prevented by an event of force majeure and not merely hindered or rendered more onerous.’18
The difference in approaches between jurisdictions explains why parties to construction contracts routinely make their own express provision for force majeure. The treatment of Force Majeure (and now Exceptional Events) under the FIDIC suite of contracts and some other standard forms of contract is discussed further below.
Change in law
The starting or default position under a construction contract is that, in performing its obligations under the contract, each party will do so in compliance with and so as not to cause any breach of the laws applying to such obligations. In the absence of a specific provision dealing with the consequences of a change in law
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1 Peter Simon, David Hillson and Ken Newland, Project Risk Analysis and Management Guide, Association for Project Management, p.17 (1997).
2 See Catriona Norris, John Perry and Peter Simon, Project Risk Analysis and Management Mini-Guide, Association for Project Management, p.4 (2018).
3 See Samuel Laryea and Will Hughes, The Price of Risk in Construction Projects, p.553 (2006).
4 See Julian Bailey, Construction Law, Volume 1, 2nd ed., p.49 (2016).
5 Peter Simon, David Hillson and Ken Newland (op.cit.), p.17 (1997).
6 Julian Bailey (op.cit.), p.1512.
7 Bryan Shapiro QC, ‘Transferring Risks in Construction Contracts’, p.5 (2010)
8 Ibid, p. 17.
9 See Graham Vinter, Project Finance, 4th ed., Sweet and Maxwell, p.1 (2013).
10 In relation to FIDIC, see Ellis Baker, Ben Mellors, Scott Chalmers and Anthony Lavers, FIDIC Contracts: Law and Practice, Informa, p.6 (2009).
11 Patrick Lane SC, ‘The Apportionment of Risk in Construction Contracts’, International Conference on Arbitration and ADR in the Construction Industry, Dubai (2005).
12 See article by Max Abrahamson, Journal of the British Tunnelling Society, Vols 5 and 6, November 1973 and March 1974; and CIRIA Report R 79 ‘Tunnelling – improved contract practices’ (1978).
13 Nael Bunni, ‘The Four Criteria of Risk Allocation in Construction Contracts’, International Construction Law Review, Vol 20, Part 1, p.6 (2009).
14 This would not apply to a contract based on a full bill of quantities, such as the JCT Standard Building Contract With Quantities 2016.
15 Nicholas Dennys QC and Robert Clay (eds), Hudson’s Building and Engineering Contracts, 13th ed., Sweet & Maxwell, p.402, (2015).
16 Julian Bailey (op.cit.), p.697.
17 Axel-Volkmar Jaeger and Götz-Sebastian Hök, FIDIC – A Guide for Practitioners, Springer, pp.329-330 (2010).
18 Hugh Beale, Chitty on Contracts, 33rd ed., Sweet & Maxwell, p.1236 (2018).