Target cost contracts are popular in the construction industry. Their provisions set a target cost for the works and agree how costs coming in under or over that target will be dealt with – the so called “pain / gain” mechanism.  But what happens when those provisions are not followed?  Can either side argue that the contractual machinery has “broken down” and the target cost provisions fall away? A recent TCC decision has rejected such an attempt and noted how “onerous” it is to make these arguments work.

Secretary of State for Defence v Turner Estate Solutions

Turner Estate Solutions Limited (TES) was employed by the Secretary of State for Defence (SSD) to carry out design and construction works at Her Majesty’s Naval Base Clyde (aka “Faslane”) in 2003. The contract was a maximum price target cost contract.

The payment provisions were detailed. They provided for a target cost (which could be adjusted for example if there were “changes” to the works); open book accounting; payment based on TES’s actual costs plus profit; milestone payments; a final price payable being calculated by a pain / gain mechanism (comparing actual costs with the target cost); and a maximum price which could be adjusted but not exceeded.

A “breakdown of machinery”?

So what was the problem? The contract provisions were not followed in full. The parties stopped implementing the change proposal procedure and so the target cost adjustment process stopped.  

Fast forward to 2015 and TES’s actual costs were sitting at almost £70m above the maximum price in the contract – part of a long running dispute between TES and SSD. The question before the TCC was whether the target cost and maximum price provisions and the pain / gain mechanism had fallen away as a result of the parties’ failure to operate the target cost adjustment process in practice.

TES argued “yes”, the contractual machinery had broken down. The target cost, maximum price provisions and entire pain / gain mechanism could now be ignored. Plus, the adjustment of the target cost and the final price payable could not be operated after completion of the works and the pain / gain mechanism was therefore redundant. Instead, target cost should become cost plus i.e. TES was entitled to its actual costs and an allowance for profit without any restrictions, caps or loss sharing.

SSD argued this was an extreme position to take. There was nothing in the contract which meant that not following the change procedure resulted in the target cost and final price payable provisions falling away, nor any reason why the adjustment of the target cost and the final price payable could not be operated after completion of the works.

The decision

So what did the court say? Tellingly, that this was a “radical position” for TES to adopt. It involved ignoring parts of the contract and changing in a fundamental way the whole basis of the bargain between the parties because it replaced the original pain / gain agreement with a cost plus contract.

The court went back to the basics of contractual interpretation: business common sense; looking at contractual provisions in the context of the document as a whole; leaning towards an interpretation which validates the contract; and giving effect to all parts of it where possible.

The court went on to reject TES’s case. It said the payment provisions were still in effect and that target costs could still be adjusted in respect of changes. There was nothing to prevent that adjustment continuing following completion of the works.

Conclusions

This case provides a helpful real life example of the difficulties faced in construction contracts with a high degree of administrative complexity. Target cost mechanisms are one source of complexity, others arise in particular forms of contract. The NEC for example, with “real time” or prospective evaluation of Compensation Events and reliance on “Defined Cost” can pose a significantly higher administrative burden than others and one which should be adequately priced for in tenders.

In this case, the contractor was ambitious in saying a target cost contract should become a cost plus one. Arguments that the contractual machinery has “broken down” may be easy to make, but difficult to sustain and relying on them could well miss the mark.

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References: Secretary of State for Defence v Turner Estate Solutions Ltd [2015] EWHC 1150 (TCC)