Risk allocation is a key purpose underlying commercial agreements between contracting parties.1

The process of risk allocation in the construction industry is determining which party will bear the responsibility of risks identified given the context (and often for contingencies that cannot be anticipated) of the construction contract.

The management and allocation of risk in a contract provides certainty to the contracting parties. However, imprecisely drafted clauses often negate the effectiveness of any such allocation.

Caps and Limitations on Liability

Limitation and exclusion of liability clauses are a valid means by which parties to a contract can expressly agree to cap, limit or exclude liability. Where a party is to be exposed to liability, it is not uncommon for a clause limiting that liability to be inserted into the contract. Liability capped at an amount equal to the value of the contract is industry standard and generally perceived as reasonable.

Liability caps are often determined by giving the words their natural and ordinary meaning, read in the light of the contract as a whole. Due weight is usually given to the contractual context and purpose in which clauses of this nature appear. Therefore, factors such as the respective bargaining power of the parties and the objective reasonableness of such a clause are significant. Ultimately, in interpreting the meaning, such clauses will be construed so as to avoid it "making commercial nonsense or working commercial inconvenience".2 Therefore, it is important that clauses relating to caps on liability are clearly drafted in order to be upheld.

However, parties must be careful that such clauses do not amount to a penalty, otherwise they may be unenforceable. Although the doctrine of penalty has seen considerable development in Australia since the High Court decision of Andrews v ANZ Banking Group, the High Court's latest decision in Paciocco v ANZ Banking Group3 shows that it will be rare for courts to find that the imposition of an additional liability for failing to observe a primary contractual obligation will be considered a penalty, if the clause protects a legitimate interest.

Proportionate Liability

Each of the Australian states and territories has enacted proportionate liability legislation, the focus of which is to regulate liability between:

a.Persons suffering economic loss or property damage and those responsible for causing such loss or damage

b.The wrongdoers themselves

But only in circumstances where the claim:

a.Includes a claim for damages whether in contract, tort or otherwise

b.Arises from a failure to take reasonable care

c.Does not concern relate to personal injury

Proportionate liability favors contractors and makes cost recovery by principals more difficult, not only because it requires joining all potential wrongdoers to the proceedings, but also as the principal bears the risk of any wrongdoer being unable to pay. This legislation also has the potential to offend against the key principle underpinning the allocation of risk in construction contracts namely, to the party or parties best able to manage it. By distributing liability proportionately across all wrongdoers and capping the liability of each wrongdoer to the extent of its responsibility, the legislation creates a default position that may not necessarily reflect the practical reality of the construction contract. Further, when a principal contracts with a party, it often expects that party to be a "one-stop shop" for responsibility service or work to be completed under the contract. There is not usually an expectation that the principal would be pursuing an unknown class of defendants for a remedy in the event that the bargain fails.

Exclusions of Liability

Parties, particularly contractors, rely on limitation or exclusion clauses to manage and confine potential exposure to damage arising out of their performance of a contract. This is particularly important in significant or long-term projects where the potential for loss over the life of the project is uncertain.

Despite the prevalence of exclusion or limitation clauses in building and construction contracts, Australian courts have had relatively few opportunities to consider the meaning and effect of clauses that purport to limit or exclude liability for consequential loss; it being likely that the uncertainty of the scope of such clauses encourages litigants to settle their disputes on commercial terms.

In the realm of consequential loss, the modern approach to the construction of a risk allocation clause appears to be broad, as asserted in the case of Environmental Systems Pty Limited v Peerless Holdings Pty Limited (Peerless)4 a case in which the Court of Appeal in Victoria considered the efficacy of an express term in a contract purporting to exclude consequential loss.

The decision in Peerless represented a fundamental shift in the way Australian courts approached the meaning of "consequential loss", moving away from the test for remoteness as laid down in the leading English contract law case of Hadley v Baxendale.5 That test for remoteness classifies losses into two limbs:

1.Losses such as may fairly and reasonably be considered as arising naturally (that is, according to the usual course of things) from the breach

2.Losses such as may reasonably be supposed to have been in the contemplation of the parties at the time when they made the contract as the probable result of the breach of it

Parties who included a term in a contract excluding liability for "consequential loss" can exclude liability for damages that fall under the aforementioned second limb.

Since Peerless, when assessing the scope of a contractual limitation or exclusion clause, invoking the remoteness of contractual damage dichotomy, as per Hadley v Baxendale,6 is no longer considered the correct constructional approach. Further the long held view that parties who included a term which excluded liability for "consequential loss" were excluding liability for damages within the second limb of Hadley v Baxendale no longer applies.

The new approach broadened the scope of the phrase "consequential loss" with the effect that categories of loss that may have previously been considered to be part of the liability regime in a contract (e.g. a clause excluding "consequential loss") may no longer be recoverable from a defaulting party. Before the Peerless decision, the trend in English and Australian decisions had been for courts to read down exclusion clauses, and allow claims for loss of profit under the first limb of Hadley v Baxendale, on the basis that such losses were a direct and natural consequence of the breach. Nettle JA stated that the loss of profit and expenses incurred through the breach (which may include costs of alternate suppliers or systems or costs in exercising step-in rights) are consequential losses.

In Western Australia, the case of Regional Power Corporation v Pacific Hydro Group Two Pty Limited (No 2)7 involved a Power Purchase Agreement (PPA) whereby Pacific Hydro agreed to construct and supply electricity to the State Energy Commission of Western Australia (now the Regional Power Corporation (Power Corporation)). As the power station was rendered inoperative due to an outage and subsequent flooding, Power Corporation was required to, at its own economic expense, arrange an alternative source of power to meet its supply obligations. The implementation of an alternative source of power was not a matter of discretion.

Pacific Hydro contended that the PPA contained a number of express terms which strictly constrained Power Corporation's rights of recovery for damages for a breach of the PPA. In his finding, Justice Kenneth Martin distinguished Power Corporation from a commodity trader in electricity that would lose profits in the event of Pacific Hydro's failure to supply. Power Corporation had suffered direct loss by its exposure to replacement energy replacement requirement obligations. In fact, the requirement for Power Corporation to outlay its own funds to secure replacement electricity was apparent from the express terms of the PPA, such that those outlays were properly assessed as direct damages or loss.

Justice Kenneth Martin considered that, at its widest, the word "consequential" might always be read as being responsive to something, thereby encapsulating almost every economic outlay following upon breach. His Honour's approach moves away from the artificial approach asserted in Hadley v Baxendale and Peerless, and instead focuses on the plain and ordinary meaning of the words used by the contracting parties, consistently with the principles of construction.

In arriving at the proper construction of the exclusion clause, Kenneth Martin J considered the principles of Darlington Futures, and adopted a commonsense view of the natural and ordinary meaning of the term "consequential loss" being the examination of the contract as a whole, and considering the context in which the exclusion clause appears (including the nature and object of the contract).

Subsequently, it appears that Peerless may not have the persuasive force that was initially perceived when the decision was handed down in 2008, particularly in light of the divergent approaches adopted by superior courts across various Australian jurisdictions. It remains to be seen which approach the High Court will take, with both the Australian and English position being upheld in lower Australia courts.

Use of Indemnities

Indemnities are essentially a promise that one party will hold the other harmless against loss. They are similar to exclusion clauses because they:

a.Operate to exclude, restrict or qualify the rights of a party to the contract in the event of a breach

b.Only operate for the benefit of one party to the contract

However, indemnities differ from an obligation to pay damages, as the obligation to indemnify is voluntarily assumed. Indemnities can also be distinguished from a guarantee in that an indemnity is a promise to make good a loss or to keep another party free from harm.8

Accordingly, indemnities can be classified as follows:

a.Against third party claims

b.Against loss suffered as a result of the indemnifier's conduct

c.Against loss suffered as a result of the indemnified party's conduct

Indemnities provide a strong means of allocating risk, as they are separate from the common law considerations of remoteness of damage or mitigation. Therefore, usual factors that need to be proved in a claim for damages do not need to be proved unless the indemnity clause expressly refers to those considerations. To this end, indemnities are often used in commercial contracts where it is agreed, in advance, that a party will be liable for certain conduct or losses, subject to the causation test provided for in the clause (rather than the common law tests).

An indemnity is enforceable, provided that it is unambiguous and does not offend some statutory prohibition. Historically, where an indemnity clause is ambiguous, it will be construed in a similar way to exclusion clauses or limitation of liability clauses; against the party relying on the indemnity.9 However, the more recent trend is that contracts should be construed in the context of the contract as a whole.10

Accordingly, the primary considerations when drafting unambiguous indemnity clauses ought to be:

a.The identity of the subjects of the indemnity who is providing the indemnity and who benefits from it?

b.The subject matter of the indemnity and what types of claims, demands, actions, liabilities, damages, losses, costs or expenses will apply?

c.What limits or exclusions should be placed on the indemnity to avoid "catch-all" wording designed to broaden the scope of the indemnity?

d.Is it possible to obtain insurance to cover the obligations in the indemnity?

Time-Bar Provisions

It is common for contracts on major projects to include detailed notice provisions that require a fully documented and supported claim to be submitted within a tight timeframe after an issue arises, failing which any claim is barred. These "time-bars" play an important role in ensuring that information vital to a successful project outcome is shared up the contracting chain via the prompt and comprehensive notification of issues as they arise. Time-bars provide the recipient of the notice with the opportunity to promptly investigate the substance of the claim.11 It also enables the recipient to monitor its position in relation to its contractual counterparties,12 as well as the likely impact of an event on the project. This, in turn, allows the principal to make its own assessment of whether to:

a.Direct the contractor to accelerate or re-sequence the work to recover the schedule

b.Adopt mitigating measures

c.Take steps in conjunction with third parties to mitigate the effects of the delay

The case of BMD Major Projects Pty Ltd v Victorian Urban Development Authority13 has said that a strict interpretation of notice provisions "would encourage, if not compel, contractors to be more concerned with anxiously satisfying a formal temporal requirement of notification rather than to explore the underlying needs and circumstances of the situation".

However, the case of CMA Assets Pty Ltd v John Holland Pty Ltd [No 6]14 illustrates the application of strictly interpreted notice provisions. CMA was subcontracted by John Holland to demolish and remove structures that formed part of a wharf on the Port Hedland Harbour. CMA's work was delayed, leading to numerous claims and counterclaims, including that CMA had been delayed by John Holland's failure to relocate machinery in time to allow work to proceed. However, the major question was whether CMA had complied with its obligations to notify and claim extensions of time in accordance with the subcontract, which specifically required CMA to notify John Holland, in writing, of:

a.The likelihood of delay as soon as becoming aware of the likelihood of delay

b.Its intention to claim an extension of time within 7 days after the occurrence of the cause of the delay

It was also required to submit a written claim for an extension of time within 14 days after the commencement of the delay.

CMA conceded that some of its notices were given out of time, but argued that, on its proper construction, the condition precedent to an extension of time required only that John Holland was aware of the likelihood of delay and, given the delay was wholly within John Holland's knowledge and control, there was no need for further notice from CMA.

This argument was rejected by the Supreme Court of Western Australia on that basis that, while John Holland may have been aware of the existence of the cause of delay and its likely effects, the detailed notice provisions in the contract required CMA to provide other specific information to John Holland. CMA's notices failed to comply with the conditions precedent set out in the contract and John Holland was entitled to reject the otherwise valid delay claim on that basis.

Evidently, the CMA case contained very detailed notice provisions that stipulated both timing and content of the relevant notice. As a consequence, the court held that CMA was obliged to comply strictly with these requirements, and a failure of which meant its claim was time barred.

Conclusion

Parties should be particularly careful before agreeing to terms in a construction contract that govern responsibility for risk. Courts will generally uphold a commercial bargain struck between parties, even if it means that one party takes on significantly more risk. Further, as risk is inevitable in any construction contract, it is imperative for parties to actively manage and mitigate any risk which is accepted by a contracting party, for instance, by the insertion of caps on liability or ensuring that robust contract administration is implemented in order to comply with contractual notice requirements.