Aisha Nadar, Advokatfirman Runeland AB

This is an extract from the third edition of GAR’s The Guide to Construction Arbitration. The whole publication is available here

An introduction through history

Construction is one of the oldest industries; it is a pivotal industry that has been entrusted throughout the generations with the task of transforming society’s ideas and needs into workable infrastructure solutions.

Prior to the Industrial Revolution, each construction project was undertaken by a master builder who was tasked with both design and construction; and as far back as Babylonian times, the relationship between the owner and the builder was governed by a detailed code.

The advent of specialisation and freedom of contract, brought about by the Industrial Revolution and documented by economists such as Adam Smith, resulted in owners no longer relying solely on the master builder to take their project from concept to completion, but rather on a cadre of specialists.

This development resulted in the owner having to enter into individual contracts with each of the project participants – contracts that governed the specific role each would play in relation to project execution.

This approach continues today, with the owner creating a mosaic of contracts that includes contracts with the financiers, designers, suppliers, insurance providers and, at the heart of this mosaic, the construction contract – the contract between the owner and the contractor.

The international construction contract

The terms ‘contract’ and ‘construction’ are defined in the United States Federal Acquisition Regulations (FAR):

  • ‘contract’ means a mutually binding legal relationship obligating the seller to furnish the supplies or services (including construction) and the buyer to pay for them; and
  • ‘construction’ means construction, alteration or repair of buildings, structures, or other real property.

Contracts for construction, alteration or repair of buildings, structure or other real property must clearly articulate both the technical aspects of the construction and the legal relationships between the parties.

Construction projects can be differentiated from other projects, such as manufacturing, in that they have unique attributes. Such attributes include the following:

  • construction projects are unique one-off projects that are often carried out on-site in remote locations, while being exposed to environmental hazards;
  • taking a construction project from conception to completion brings together a myriad of organisations and individual specialisations through ‘virtual teaming’; and
  • construction projects have a development and execution life cycle that is generally measured in years.

These unique characteristics were clearly noted by an English civil engineer and barrister, E.J. Rimmer, almost 80 years ago:

…contract works are to be constructed in or erected and fixed on to land, and cannot be rejected and sent back to the Contractor if they prove to be unsatisfactory; that the works are to be carried out in open air under unstable conditions with material and labour of varying quality; that the conditions of excavation and foundation cannot be entirely foreseen until the ground is opened up; that execution of the works may result in damage to property belonging to other persons; that works of specialists may have to be carried out concurrently with work done by the general contractor; that the period of the contract may extend over several years and the Employer may desire the use of completed parts of the work before final completion of the whole; and that the amount of money involved is often such as to imperil the financial resources of a contractor who has made an unwise tender.

These characteristics result in construction projects being particularly sensitive to an extremely large spectrum of risks; the spectrum is extended in the international arena.

Hence, successful project execution dictates that this risk must be managed and that parties settle the issues associated with project risk through contract provisions.

Management of project risk will require that the owner undertake a comprehensive and systematic approach to identifying, assessing and developing a risk mitigation strategy, which may include the transfer of risk to other parties.

There is a close relationship between risk management and the characteristics of a construction contract:

One of the main areas where risk management can be applied is in developing the conditions of contract. A clear definition for the risks and their allocation provides incentive for the efficient management of risks as they occur during the construction process. Each party to the contract has clear understanding of their rights, duties and liabilities. For this to occur conscious decision must be made in the drafting of any new contract to appraise each party of the consequences of each risk occurring.

As such, in a comparative look at other types of contracts, one will find that a construction contract contains more wording, provided to deal specifically with the risks that might arise.

Although it has been noted that, ideally, risks should be allocated to the party in the best position to handle this risk:

The ideal contract – the one that will be most cost effective – is one that assigns each risk to the party that is best equipped to manage and minimise the risk, recognizing the unique circumstances of the project…. This can be accomplished by assigning each risk addressed in the contract to the party that (1) has a comparative advantage in regard to the risk bearing ability; and (2) has control over the risk.

Nael Bunni states that, in addition to the general principles of control of the risk and ability to bear it, the allocation of the risks between the contracting parties should also consider: ‘(a) which party could best foresee that risk; and (b) which party most benefits or suffers when the risk eventuates’.

Thus, a construction contract will set the manner in which the project risks will be handled through provisions that allocate the project risks between the parties, and will offer specific remedies in the event of breach of contract or the occurrence of specified events. They also provide for procedures that must be followed by parties wishing to avail themselves of such remedies. In addition, in light of the possible change in design and technology, the construction contract may also provide the owner with the right to order changes and the mechanism for achieving them, in advance.

The owner then selects a project delivery method and a contract type that mirror the risk profile of the project and are congruent with the risk allocation strategy. The construction contract signed between the owner and the contractor will be a reflection of both the project delivery method and contract type (see below).

Project delivery methods and types of construction contract

In deciding on both the project delivery method and the contract type, the owner must consider who will undertake the essential functions required to take the project from concept to completion, and how the project risk, including the risk inherent in valuing and paying for the work, will be handled.

Construction projects are becoming increasingly complex, and this challenge is met with innovation, including a proliferation of project delivery strategies.

One distinguishing factor between various delivery methods is who will carry the design responsibility. This concerns the level of the contractor’s involvement during the design phase.

The traditional method of construction contracting (‘design-bid-build’) is the project delivery method in which design and construction are contracted for separately. The owner will carry out the design and only enter into a construction contract subsequent to the completion of the design. This type of project delivery typically involves a sequential process in which the contractor is selected by means of competitive tender that includes a fully detailed design. The resulting construction contract will only include the obligation for the contractor to construct the work designed by the owner in accordance with the owner’s detailed specifications and drawings.

Alternatively, the owner may allocate the design function to the contractor. This method of project delivery is commonly referred to as the ‘design-build’, when design and construction are combined in a single contract with a single contractor.

Design-build project delivery relies on a performance requirements-based contract – the intention is to tell the contractor what is needed, not how to achieve the desired product. The design is accomplished in accordance with performance requirements after the award of the construction contract, with the contractor given broad leeway to design the job in an efficient manner.

The design-build family of project delivery includes the engineering, procurement and construction (EPC)/Turnkey type of project delivery, which endeavours to transfer greater functions, project controls and risk to the contractor. EPC/Turnkey contracting seeks to establish a single point of responsibility, achieving the necessary engineering and design work, procuring the equipment and materials identified within those designs and constructing a facility that is ready to be used by the owner at the ‘turn of a key’.

Once the owner has determined the delivery method, they must turn their focus to determining the type of contract. The choice of type of contract is intimately linked to the overall payment and pricing structure that will govern the transaction.

Contract types are grouped into two broad categories: fixed-price contracts and cost-reimbursement contracts. When placed on a continuum, the contract types can range from firm-fixed-price to cost-plus-fixed-fee. In fixed-price contracts, the cost risk is transferred to the contractor, with the contractor assuming full responsibility for the performance costs and resulting profit (or loss) in firm-fixed-price contracts. However, in cost-plus-fixed-fee type contracts the owner retains the cost risk, with the contractor assuming minimal responsibility for the performance costs, and the negotiated fee (profit) is fixed. In between are various derivative types of contracts, including the re-measurement type contract.

The three basic types of contract that are most commonly encountered in construction are:

  • fixed-price/lump sum;
  • re-measurement; and
  • cost-plus.

Fixed-price or lump sum contracts

These are contracts where the contractor is paid a pre-agreed sum of money when he or she has successfully performed all of his or her obligations under the contract. The contract sum is determined and specified in the contract agreement. Payment is made in pre-determined stages and the contractor assumes the risk for both performance and price. Entering a fixed-price contract requires that the contractor commit to complete the whole of the work for a specific sum, which will require that the contractor fully understands all of his or her future obligations and is able to price them during the tender phase. Entering into a fixed-price contract with a high degree of uncertainty at the tender stage will require the contractor to build a significant premium into his or her tender pricing. Fixed-price contracts, while providing the owner with a higher degree of cost certainty, demand a greater investment in preparing a complete tender documentation.

Re-measurement

During the tendering phase, the contractor is required to give a fixed price for each item of work in accordance with the owner’s estimated quantities. During contract execution, the work completed by the contractor is measured and the amount that the contractor is paid is determined as a product of the measured quantities and the contractor’s price for each item. With this type of contract, the employer assumes the risk for the quantity and the contractor assumes the risk for the pricing.

Cost-plus

Under a cost-plus contract, the owner retains the cost risk and the contractor is paid his or her costs including overheads and profit. Cost-plus is more flexible in that it does not require full information at the time of tender, but this flexibility comes with greater price uncertainty for the owner. This type of contract is particularly useful in cases where the scope of the work is not well defined at tender stage, or where the kinds of labour, material and equipment needed to meet the owners requirements are uncertain. Administration of cost-plus type contracting also comes at a high cost because complete records of all time and materials spent by the contractor on the work must be maintained and must be verifiable.

Standard form contract

Globalisation requires optimisation in the allocation of resources and the facilitation of international trade.

Standard forms of contracts are used by every industry to aid in reducing costs, both by reducing costs that would result from the development of a contract and the cost of uncertainty as to what their bargain contains.

Standard forms of contract have a long history of use in the construction industry. They provide for lower transaction costs, and clarity and consistency of terms.

Standard form contracts, for use in the domestic construction market, have been published by professional institutions as far back as the 19th century. In 1888, the American Institute of Architects (AIA) published their first standard contract; this was followed in 1903 by the Royal Institute of British Architects. The first standard form of contract designed for use in international construction transactions was published by the International Federation of Consulting Engineers (FIDIC) in 1957.

Rameezdeen and Rodrigo identify the following as advantages of using a standard form of contract in construction:

  • it can be used for various types of projects and client requirements;
  • it embodies industry practices and customs;
  • parties can be comfortable with the fact that it has been tried and tested over a long period of time;
  • fair allocation of risks between parties;
  • in a competitive tendering environment, it provides a uniform basis for pricing without the fear of hidden costs;
  • the tendered price is likely to be lower as contractors do not have to price additional risks associated with interpretation of bespoke contracts or clauses;
  • the transaction cost involved in negotiating a contract is reduced; and
  • it looks at three dimensions together; namely, the wider legal context through statutes and case law, other documents forming the contract and areas of possible disagreement between parties.

Today, there is a wide spectrum of standard forms available for both domestic and international transactions that are published by national and international professional associations, including:

Standard contracts provide a risk allocation solution of general purpose for items such as differing site conditions, site investigations, unusually severe weather, permits and responsibilities, and changes. They assign responsibilities and liabilities to each contracting party regarding job performance, organisation, time frames, guarantees, insurance, errors and payment.

Each standard contract seeks to reflect a specific philosophy with regard to the allocation of project risk, and to capture best practice with regard to dealing with change, termination, payment and the contract administration role. 

Professional associations endeavour to update their standard forms of contract at fairly regular intervals in an attempt to keep pace with the developments in the industry, both in terms of best practice and legal concepts.

Underpinning the choice of standard form of contract are issues of project delivery method; risk allocation; cost, schedule and performance trade-offs; security arrangements; level of owner involvement in the design and construction process; liberty of owner to direct change during contract execution; approach to dispute management; and resolution and familiarity.

Essential elements of the construction contract

Regardless of the owner using standard or bespoke conditions of contract, construction contracts must include the principle documents that identify and allocate the project risk and describe the whole of the works. The principle documents in a construction contact will include:

The contract sets forth the basic terms under which the parties are doing business together – price and payment terms, commencement date, completion date, description of scope of work, allocation of risks of loss, insurance, change order procedure, suspension and abandonment of the project, termination, breach, liquidated damages, alternative dispute resolution and indemnification provisions.

The general conditions (including any supplemental conditions) are a set of rules that cover problems – such as claims, disputes, subcontracting, changes, time, warranties, protection of property, insurance, remedies and termination – that routinely arise in construction contracts.

Drawings

The drawings include the plans prepared by the architect, by the surveyor and by the consulting engineers (i.e., site plans, structural plans, mechanical plans and electrical plans), as well as more detailed drawings prepared by the contractor, subcontractor or supplier called ‘shop drawings’ that have been submitted to and approved by the owner or project design professional. A material deviation from these plans will constitute a ‘defect.’

Specifications

The specifications – typically written and supplied by the project design professional with the plans – provide even more detail as to the materials to be used, the performance requirements for aspects of the project and the methods or techniques of construction to be employed. The specifications fill in the necessary information that is not evident from the drawings and includes materials and workmanship clauses, schedules to provide positional information and prime cost and provisional sums if required.

‘Employer’s requirements’ is the term used by FIDIC to denote the document that defines the purpose, scope and design and technical criteria of the works in design-build contracts. As explained by Nael Bunni, the employer’s requirements are the main source of information for the general obligations of the contractor and should be drafted in a balanced manner so as to effectivly specify the employer’s needs, while not limiting the contractor’s flexibility in design to meet those needs, and must clearly state the purpose for which the works are intended.

Bill of quantities

The bill of quantities, as used in a remeasurement contract, is a list of the materials and their estimated quantities against which the contractors provide their rates during the tender phase. The agreed prices are then used for periodic valuation of the works that have been executed.

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