Tony Dymond and Sophia Burton, Debevoise & Plimpton LLP
This is an extract from the third edition of GAR’s The Guide to Construction Arbitration. The whole publication is available here.
Price and payment are central to most commercial transactions. In the complex web of reciprocal obligations that comprise sophisticated modern construction contracts, the overarching significance of these matters may not immediately be apparent to the casual reader. However, notwithstanding the relative brevity with which it may be expressed, the principal obligation of an employer under a construction contract is to pay for the work. This chapter addresses how much, when and upon what conditions.
It is often said that one of the principal functions of a construction contract is to allocate risk. If a risk that has been allocated to the contractor occurs, the contractor will be obliged to execute the works without any additional payment to compensate it for costs incurred as a result of the occurrence. Conversely, if the risk is allocated to the employer, the contractor will typically receive additional payment if that risk eventuates. Commonly, the language of provisions in a construction contract is, explicitly, the language of risk. For example, a contract may provide for financial compensation or additional time for completion where a contractor is delayed by unforeseen ground conditions, exceptionally inclement weather and the like. By contrast, the choice of pricing model entails an implicit risk allocation between the parties to the contract. There is no conditional statement providing for payment upon the happening of an event, but the pricing mechanism itself does that work. A bricklayer who agrees a fixed price for building a wall will bear the risk that it requires more bricks (and therefore more labour) to complete than anticipated, whereas if the bricklayer agrees a rate per brick laid, the employer will bear that risk.
The risk allocation effected by the pricing model may not be immediately obvious because it is implicit, but it needs to be analysed and considered together with all of those risks that are expressly allocated to one or other party (or in some cases shared by the parties) if the risk profile of the contract is to be understood properly. Once the pricing model is seen as a risk allocation device, risk management techniques can be used to inform the choice. An employer choosing a pricing model should consider:
- which risks it allocates to the contractor;
- whether the contractor can accept those risks;
- whether it can manage and bear those risks;
- what premium it will charge for accepting the risks; and
- what behaviour the retention or transfer of those risks will incentivise.
Finally, while under most legal systems many risks can be allocated to either party, the risk of change of scope directed by the employer and the risk of the employer interfering in, delaying or hindering the progress of the works will usually rest with the employer. A high probability that such risks will frequently arise may militate in favour of a pricing model that automatically allocates that risk without the need for the engagement of the contractual mechanics of notices, variations, claims, complex valuation rules and the like, which can be cumbersome, time consuming and expensive to operate, and can promote adversarial behaviour.
Lump sum or fixed price contract
These are contracts in which the total contract price is pre-agreed. The price can be adjusted pursuant to the change or variation regime if the employer instructs variations to work scope. In addition, the contractor will be entitled to financial compensation for the employer’s interference with progress, and may be so entitled for other identified neutral risks that might include the ground and weather conditions examples referred to above.
This pricing method provides the employer with the greatest possible certainty as to cost and, correspondingly, exposes the contractor to the greatest possible risk. Subject to the price adjustment mechanism, the contractor takes on all pricing risks, such as quantities, labour efficiency, labour and material costs, plant costs as well as all neutral risks not specifically allocated to the employer under the price-changing mechanism.
Fixed price contracts have obvious attractions for employers valuing price certainty above other considerations, for example, where the employer is a project financed special purpose vehicle, or where a public sector employer is highly sensitive to the political repercussions of substantial cost overruns. In some jurisdictions, the fixed price model is the default, particularly for public procurement, while others including the United Kingdom have seen growing interest in models that apportion risks differently.
The prudent contractor will seek to identify and quantify the risks. The contractor may decide that the risks are too great or too uncertain to accept and decline to bid for the work. Similarly, an employer may conclude that the risks are too great for the contractor (or any of the potential tenderers) to bear. There are few contractors that can bear the pricing risk on a multibillion dollar fixed price contract. If a contractor accepts a risk that it is unable to bear, the risk transfer is illusory – it reverts to the employer as insolvency risk. The unavailability of contractors who are willing to accept or able to bear the risk of a fixed price may dictate using another pricing model.
Price certainty comes at a cost. A prudent contractor will include a contingency in its price to cover the risks it is accepting. That contingency will not always appear as a discrete line item in a tender but may be spread through the various items that make up the tender price. Further, a contractor will accept a risk only where there is a corresponding reward. The profit margin on a fixed price contract will, therefore, ordinarily be higher than it would be had the contract been let on some other basis. Where an employer has some flexibility as to the pricing model to be adopted, it will consider whether the risk premium that would have to be paid for the transfer of risks that may never arise represents good value for money.
Cost reimbursable contracts
Cost reimbursable contracts (sometimes called a cost plus contract) sit at the other end of the risk allocation spectrum. The contractor is reimbursed the actual costs they incur in carrying out the works, together with an additional fee that may be fixed, a percentage of the costs, or some combination of the two. The employer will bear all of the pricing risk: the number of man hours, the labour rate, the quantities and costs of materials and of plant and materials, etc. In all but the most straightforward of projects, this is likely to translate to considerable uncertainty as to outturn cost. Since the contractor is bearing very little risk, it will not need to include a substantial contingency in its fee and will ordinarily be prepared to tender on a lower margin than it would for a fixed price contract.
Cost reimbursable contracts are often employed where there is a high probability of risks arising that a contractor will not accept, for example, where the employer expects to have a very high degree of involvement in directing the execution of the works or otherwise interfacing with the contractor, or where the works comprise the refurbishment or upgrade of existing ‘grey’ assets, the condition of which is unknown. The principle of cost reimbursement means that it is not necessary to undertake a valuation on each occasion on which the employer gives a direction, or each time the condition of an existing asset differs from that assumed.
While the administrative burden is potentially reduced because of the elimination of valuation exercises, cost reimbursable contracts do need to be closely supervised and managed. The contractor’s costs records need to be updated, maintained and made available to the employer (or third-party certifier). Importantly, contractors operating under cost reimbursable contracts may not be commercially incentivised to manage the works to a budget, thus increasing the risks of cost overrun. Employers engaging contractors on this basis may therefore require an increased level of scrutiny of, and involvement in, management, scheduling, procurement and resourcing.
Unit price contracts
In a unit price contract, the price is derived from agreed rates and prices for units of work. This might include prices for cubic metres of excavation, casting tonnes of concrete, laying metres of pipe, pulling and terminating cables, etc. The initial price will be based on an approximate quantity of the units, with the actual payment determined by the number of units actually required and used on the project. Unit pricing allows for the direct comparison of tender prices and benchmark prices. The employer takes the quantities risk but the contractor takes other pricing risks including the efficiency risk, in other words, the risk that it has wrongly assessed the number of man-hours per unit of production and the risk of the unit cost of of the materials.
Target cost contracts
Target cost contracts use a mechanism in which a target will be agreed for the scope of works on the project, either for the entire project or for a portion of the works. The target price can be adjusted for changes instructed by the owner or other events using the contractual mechanisms. The contractor is paid on a cost reimbursable basis or according to agreed rates and prices. The difference between the costs incurred and the target cost is shared between the employer and contractor according to a formula that provides for their respective share of any cost saving (‘gain-share’) and their contribution to any cost over-run (‘pain-share’). The formulae can be quite sophisticated. In theory, it enables an employer to incentivise a contractor to control costs in circumstances in which a contractor is unable or unwilling to take the full pricing risk associated with a fixed price contract, or where the employer is unwilling to pay the premium a contractor would charge for accepting that risk. Often the formula is structured so as to provide the contractor with sufficient cash flow so as to complete the project if there is a cost overrun – effectively putting at risk only the contractor’s profit.
A guaranteed maximum contract is a variation of a target cost contracts where the contractor is compensated for actual costs incurred plus a fee, subject to a maximum price. The contractor is responsible for cost overruns above the guaranteed maximum price, unless that guaranteed maximum price has been increased via formal change orders using the contractual mechanisms. Any savings resulting from cost underruns may be retained by the employer or may be shared between the parties according to a formula. Again, the use of a gain share formula incentivises the contractor to manage costs.
Some contracts provide a mechanism to deal with the effects of inflation, exchange rate changes affecting the import of materials, changes in unionised labour rates, etc., all of which can be significant on larger projects that span several years. Where such mechanisms are incorporated, contractors base the tender on current prices, which are then subject to adjustment. The fluctuation provisions will identify the costs to which they apply. Typically they provide for changes in the cost of labour, transport and materials. Usually, the fluctuation provisions will provide for the price adjustments to be calculated from nationally published price indices rather than calculating actual cost increases. A fluctuations provision is intended to allocate to the employer the risk of potentially volatile costs that a contractor cannot control.
Hybrid models and price conversion
In practice, it is very common for a hybrid pricing model to be used. It is not unusual, particularly on large-scale projects, for a contract to be let in which some of the scope is fixed price while the remainder is cost reimbursable. The division may be by physical work scope or by activity: so the construction of a rail line might be fixed price while the construction of the associated stations might be undertaken on a target price; or the construction of a process plant might be fixed price while its commissioning, which entails a far greater degree of employer involvement, might be cost reimbursable. Where a pure pricing model is used, it may or may not be replicated further down the supply chain. So, for example, an employer may choose partially to de-risk a cost reimbursable contract by requiring the contractor to subcontract parts of the works on a fixed price basis (and may take a role in the procurement of the fixed price subcontracts).
Another common model is to convert from cost reimbursement to fixed price when the scope can be properly ascertained, for example once the design is fully or at least sufficiently developed, or the precise condition of grey assets is understood. The drawback of this approach is that no competitive tender is held for the fixed price scope, so the employer may not achieve the best price for the work.
Pricing and payment are linked. The pricing model will, to an extent, constrain the payment mechanism. But one theme runs through any discussion of payment, whatever the precise details of the mechanism: the management of cash flow. A contractor will generally wish to maintain a positive cash flow – that is to say for the payment received to exceed the costs incurred so that it can fund construction without drawing on its own cash reserves or third-party borrowing. Employers, too, have an interest in ensuring that the project is adequately funded. Failure to do so may result in the rate of progress being reduced or even the abandonment of the project. On the other hand, employers will want to ensure that the payments match the progress of the works, or that they have security for any overpayment or advance payment made early in the project delivery. Payment is almost always made on an instalment or interim basis as the works progress, using some kind of measurement, rather than for payment to be made in one lump sum at the end. Additionally, many contracts provide for the retention of sums as security for completion and the rectification of defects.
In this section, the payment clauses of the FIDIC Conditions of Contract for Works of Civil Engineering Construction (2017), commonly referred to as the ‘Red Book’, will be used a basis for discussion. The pricing under the FIDIC Red Book is on a re-measurement basis, although there is an option for the contract to be set up on a lump sum basis.
It is common for the employer to make advance payments to the contractor. The advance payments are usually used on preparatory activities such as site mobilisation or purchase of machinery or materials. Ordinarily, the advance payment is recovered by the employer through deductions to the interim payments. Typically, the contractor is required to provide a bond or bank guarantee known as an advance payment guarantee as security for the return of the advance payment. In the FIDIC Red Book, Clause 14.2 provides the mechanism for the advance payment, advance payment guarantee and repayment of the same. The example form of the advance payment guarantee is in the form of an on-demand security instrument.
Interim payments are typically made as the works progress, with payments being applied for on periodic basis, often monthly, or when certain stages or milestones of the project are met. The contract will require the contractor to make an application for a payment and will set out what specific information is to be included in the application, including the requirements to identify or demonstrate with specified documentary support the work done in the period or since the previous stage or milestone. If the employer is satisfied that the sum applied for is correct, it will make payment of the amount within a set time of receiving the payment application.
The mechanism of payment will be constrained by the pricing mechanism selected. For example, if the contract is cost reimbursable then the payment mechanism will very likely be cost based. Other pricing models will result in other payment mechanisms; for example, a unit price contract will be driven by quantities (using rates and prices) whereas a lump sum contract will likely have payment mechanisms that reflect the progress achieved by the contractor in accordance with progress measurement rules, or by achievement of payment milestones. Nevertheless, there is considerable flexibility in the timing and assessment of payments that parties are free to negotiate though there are practical and commercial limits. For example, payment on a quarterly basis may cause the contractor cash flow difficulties whereas payment on a weekly basis may become too burdensome for the employer to verify and administer effectively.
In the FIDIC Red Book, Clause 14.3 provides for periodic payment as agreed between the parties, or if not agreed, on a monthly basis and further sets out what information the payment application should include and what format the payment application should take. Clause 14.4 provides an option for the parties to use a schedule of payments specifying the instalments in which the contract price will be paid that is to be used as an estimate for the purposes of the interim payments.
Most construction contracts also provide for some kind of final account and subsequent payment once the works have been completed, and the FIDIC Red Book follows this practice. The purpose of the final account is to allow both parties to calculate and agree any adjustments to the contract sum that may need to be adjusted because of variations, liquidated damages, fluctuations or payments relating to testing of the works. Often, agreement of the final account will also be accompanied by (or is a precursor to) the issuing of a final certificate. The final certificate is usually treated as conclusive, demonstrating that all patent defects have been remedied, all adjustments to the contract sum have been agreed and all claims settled.
When drafting or negotiating the payment mechanisms in construction contracts, local law requirements or considerations have to be taken into account. For example, in the UK, there is a detailed payment scheme for all construction contracts under the Construction Act 1996. The Construction Act 1996 provides for a Scheme that takes effect as implied terms in a construction contract (as defined by the Construction Act 1996) where the construction contract does not include the necessary payment provisions under the Construction Act 1996. Those necessary provisions mandate that the construction contract must include or provide for:
- an adequate mechanism for determining what payments become due under the contract, when those payments become due and a final date for payment for any sum that becomes due; and
- a requirement for the paying party to make payment of the ‘notified sum’ by the final date for payment.
There are also other prohibitions imposed by the Construction Act 1996, such as the prohibition of pay-when-paid clauses and pay-when-certified or other conditional payments. The purpose of these requirements and prohibitions is to ensure that regular payments are maintained to, in turn, enable the contractor to maintain the cash flow that is vital to the success of projects.
In Australia, the rules governing payment in commercial construction contracts are the relevant Security of Payment legislation in each state and territory (SoPA). SoPA aims to ensure that contractors and subcontractors are paid for their work in a timely manner without the need for protracted legal disputes, recognising the importance of maintaining cash flow in the construction industry. The legislation in each jurisdiction differs slightly; however, common features include strict time frames in which an employer must respond to a contractor’s claim for progress payments as failing to do so entitles a contractor to the full amount claimed. The legislation also sets out the requirements for a proper or complete payment claim. If the parties disagree as to the amount owing, and provided the contractor’s claim is effective and the employer has responded in time, SoPA in each state and territory allows a contractor to swiftly proceed to adjudication and obtain a determination within a specified number of days (ranging from 10 to 15 days after the employer’s response is served). Recently, the state-by-state approach to SoPA has come under scrutiny, with many people advocating for a unified national approach.
In the United States, at federal level, the Prompt Payment Act 1999 ensures that all contractors on public construction projects receive payments from the government within 30 days, with specified interest rates applying thereafter. In line with the federal legislation, many states have now introduced Prompt Payment laws as a means of protecting payments owed to prime contractors and lower-tier subcontractors. Many of the state-based Prompt Payment laws also impose interest on late payments. In addition, the United States also has state based legislation that allows various parties involved in construction projects (owners, contractors, subcontractors, suppliers and lenders) to encumber real property that is part of the construction project by way of a lien as security for payment (often referred to as ‘mechanic’s lien’). Who can apply for a lien and under what circumstances differs in each state.
More often than not during a construction project, the scope of works will be varied. This might arise because the employer wants or needs to change the scope of works, the original scope of works can no longer be carried out, or the contractor may discover something that necessitates a change to the scope of works. Whether or not a change constitutes a variation and, therefore, which party bears the risk of that change, depends upon the terms of the contract. It is typically an issue that is bound up with the procurement methodology – who directed or is responsible for the matter that necessitated the change.
There is no requirement to have the same pricing mechanism for a variation as for the original contract price, and it is not uncommon for the pricing mechanism for the base contract to be different from the pricing mechanism for any variation. For example, a fixed price contract might provide for variations valued by reference to rates and prices, or reference to the cost of the variation works or cost plus a certain percentage for profit.
Variations are often contentious, in particular the valuation of the work done (or to be done). More sophisticated contracts will contain provisions that regulate how variations are to be valued, but even with those provisions, disputes often arise.
Under the FIDIC Red Book, variations are valued in accordance with Clause 12 using measured quantities of the varied work. Clause 12.3 sets out the procedures for the measurement and evaluation of the works, based on the net actual quantities of work that have been executed and variations are also valued in accordance with this clause. The basis for the appropriate rate or price is that which is specified in the Bill of Quantities or if there is no such item specified therein, the rate or price is based on that for ‘similar work’. Clause 12.3 also provides for instances where a new rate or price may be required.
Another contentious topic relates to the contractor’s costs and what a contractor can or cannot recover. In more sophisticated contracts, there will be a definition of the term ‘cost’ and when cost or cost plus a percentage profit is recoverable. For example, in the FIDIC Red Book, ‘cost’ is defined as:
all expenditure reasonably incurred (or to be incurred) by the Contractor in performing the Contract, whether on or off the Site, including taxes, overheads and similar charges, but does not include profit.
Another example is the NEC4 ECC form of contract using Option C, under which the contractor is entitled to be paid the defined cost of carrying out the works. Clauses 52.2 and 52.4 of Option C require the contractor to make its cost records available to the Project Manager on an open book basis. The definition of ‘defined cost’ comprises:
- the cost of components listed in the Schedule of Cost Components; and
- less ‘disallowed cost’, including costs not justified by the accounts and records, costs of correcting defects or cost incurred due to the contractor not following a procedure stated in the scope or not giving an early warning.
While the above examples of definitions are clearly aimed at trying to prevent disputes arising as to what the contractor can or cannot recover as ‘costs’, there is ambiguity in the provisions that will often lead to a dispute. For example, the FIDIC Red Book definition begs the question as to what is meant by a cost that is reasonably incurred, whereas the NEC4 definition of ‘disallowed cost’ might give rise to a dispute about what standard of justification is required by the contractor’s accounts and records.
A common issue is whether and to what extent the employer is entitled to withhold or deduct amounts from the contractor. Under the FIDIC Red Book, Clause 14.6.2 sets out how amounts can be withheld from an interim payment if the contractor has failed to perform any work, service or obligation under the contract. Local laws might set out statutory provisions in relation to withholding of payments or payment schemes. In the UK, if an employer wishes to withhold money it must serve a notice in a particular form, referred to as a ‘pay less notice’ to be entitled to do so.
Another recurring issue is entitlement to interest on late payment. Whether or not a contractor can claim interest or financing charges may depend on the jurisdiction and governing law of the contract. However, assuming that there is no prohibition or over-arching local law, it is common for a contract to contain a contractual rate of interest for late payments. Further, in some jurisdictions, there is also a statutory rate of interest. In the FIDIC Red Book, Clause 14.8 applies to delayed payments and the contractor is entitled to financing charges compounded monthly. The contactor is entitled to such amounts without the need to submit any formal notice.
Construction contracts typically allow the employer to retain a percentage of the value of the work carried out until completion of the works (or a section thereof) or until the making good of defects. This mechanism provides security to the employer against the risk that the contractor either does not complete the works or fails to remedy any defects. Usually the employer keeps the retained amount, the ‘retention’, either for a specified period or until a specified event has occurred, after which it is released to the contractor.
Under the payment terms of the FIDIC Red Book, the amount of retention is agreed upon by the parties. That agreed percentage will be deducted from each of the interim payments under Clause 14.3(iii). The FIDIC Red Book follows the usual practice of releasing the retention to the contractor in two equal portions as set out in Clause 14.9:
- half when the taking-over certificate has been issued for the whole of the works and the works have passed all specified tests (or if sectional completion is being used when the section is complete a relevant percentage based on the percentage value of that section); and
- half after the expiry of the defect notification period (or relevant percentage of the works for sectional completion).
The Guidance Notes accompanying the FIDIC Red Book address the option for the parties to include a special provision that allows for the early release of retention money to the contractor in exchange for some other kind of security. FIDIC is not alone in so doing; the Joint Contracts Tribunal standard forms also provide for a retention bond as an alternative to the retention of monies from the interim payments.
Payment on termination
Termination of a construction contract gives rise to potentially complex payment issues that may turn on which party terminated, for what reasons and whether or not the party terminated under the contract or at law. Sophisticated contracts set out the consequences for the different types of termination, and the FIDIC Red Book does so in Clauses 15 and 16.
Clause 15 addresses the consequences of termination by the employer and provides for two options: termination for contractor’s default and termination for employer’s convenience. Clause 15.4 sets out the payment consequences of a contractor’s default that allows the employer to withhold payment to the contractor of the amounts agreed or determined in line with Clause 15.3 until all the costs, losses and damages under Clause 15.4 have been established. While the specifics of these clauses are particular to the FIDIC Red Book, the principle underlying these clauses is quite common in that termination for default enables the employer to recoup any loss or damage it has suffered before making any payment to the contractor.
Termination for convenience provisions are common but are usually only available to the employer. Consideration must be given as to whether local laws prevent or restrict any express contractual right to terminate for convenience or otherwise. Clause 15.7 sets out the payment obligations following a termination for convenience: the employer must pay the amount certified in the payment certificate to the contractor within 112 days after the engineer received the contractor’s submission in accordance with Clause 15.6.
Clause 16 sets out the consequences for termination by the contractor and Clause 16.4 sets out the consequences for payment after termination by the contractor: The employer must pay the contractor:
- any loss of profit or other loss or damage suffered or incurred by the contractor as a result of the termination.
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