Global construction update: The volatility issue- April 2023

Fragile” is a word being used to describe the global economy in 2023. The OECD has projected that global growth will remain at “below trend” rates in 2023 and 2024, at 2.6% and 2.9% and the World Bank has reported that nearly all the economic forces powering prosperity over the last thirty years are fading. In more positive news, some observers suggest that in Q2 2023 the global economy is modestly rebounding. In the construction industry, we do not need statistics or reports to know the outlook. Reed Smith’s clients around the globe are sharing their concerns. In a sign of the times, our construction arbitration and disputes practices are busy. Yet amidst the global pressures, our clients also see tremendous opportunities. In Europe, renewables projects (solar, onshore and offshore wind, and hydropower) are tipped to account for almost 84% of total power generation by 2050. In Saudi Arabia, the real estate construction market has been predicted to grow by 9% to a total of USD 324 billion by the end of 2023. And North America continues to dominate the global industrial construction project pipeline with spending on such projects to reach USD 194.8 billion in 2023, if all go ahead as planned. It is against this mixed economic backdrop that this edition of Reed Smith’s global construction update explores the theme of “boom or bust” and volatility. Across all our feature articles is a persistent message – the successful delivery of projects increasingly depends on rethinking risk allocation. Contractors and developers alike are advised to challenge the accepted wisdom of ‘standard market practice’ because the economic and political climate is anything but standard. In this edition: • Richard Ceeney and Laura Riddeck (London) offer practical legal tips to protect against risk and volatility, suggesting that complacency in due diligence and risk allocation on projects has led to a perfect storm for claims. • Michelle Nelson and Chris Edwards (Dubai) challenge the standard market practice of ‘on demand bonds’ in the UAE, asking whether developers should rethink security on construction projects. • Matthew Harley (Dubai) provides a civil law perspective on ‘economic hardship’ principles under the laws of GCC countries, which may provide legal respite in cases of unpredictable, exceptional circumstances that threaten exorbitant losses on a project. • James Willn and Finlay Donaldson (Dubai) consider how contracts can mitigate price fluctuations and labor shortages, while highlighting the increased importance of robust project investment appraisals to ensure the feasibility of projects. • In a spotlight on our US practice, James Doerfler and Gesue Staltari (Pittsburgh) offer five strategies for driving greater certainty in construction contracts, from a US market perspective, including innovations around expanded force majeure provisions, increased use of cost-plus and guaranteed maximum price contracts with contingency provisions, judicious use of liquidated damages clauses, and others. • In a Q&A session, Vanessa Thieffry (Paris) tells James Doerfler (Pittsburgh) about the challenges facing her clients in the current economic climate, including parties’ attempted use of force majeure claims to rebase or recalibrate a project. • To conclude, Nicolas Walker, Adrien Hall and Michaela Hanzelova (Paris) highlight new sustainability regulations in France that are expected to drive growth in the construction sector. We also celebrate the successes of our global construction team over the first half of 2023. Select examples include: • For the fifth consecutive year, leading publication Global Arbitration Review named Reed Smith’s international arbitration practice in its list of the world’s top 30 international arbitration law firms – the elite GAR 30. This year, our practice has risen 11 places to # 13 – a phenomenal ascension – and our global construction arbitration practice is a significant contributor to this ranking and recognition. Global construction update The volatility issue April 2023 Reed Smith 03 G• Reed Smith was shortlisted for ‘Diversity Initiative of the Year’ at the Middle East Legal Awards for the UAE offices’ webinar series ‘Maximising Female Talent in Construction’ delivered in collaboration with global consultancy HKA. • Turning to directories, Sachin Kerur and Michelle Nelson remain in the Legal 500 EMEA UAE 2023 Hall of Fame for construction. Also maintaining the top spot is our construction practice, holding fast at band 1. Separately, our international arbitration and dispute resolution practice write-ups and rankings in the Legal 500 EMEA 2023 France and UAE respectively credit construction and infrastructure projects as part of these practice group success stories. Looking to Chambers Global 2023, clients note that the construction team has “the exceptional ability to evaluate complex legal matters and provide out-ofthe-box solutions.” • Peter Rosher (Paris), Michelle Nelson and Sachin Kerur (Dubai) were ranked in the Who’s Who Legal “Global Leader” category for Construction 2023. Our construction lawyers have also been busy presenting and making connections: • Peter Rosher (Paris) co-chaired GAR Live Construction Disputes for the fifth consecutive year during Paris Arbitration Week. Alison Eslick (Dubai) was a panelist at the event on GAR’s ‘The Terminator 1’ panel, speaking on termination of construction contracts. • Sachin Kerur (Dubai) attended the ‘Leaders in Construction Qatar: Analysing The Legacy of Qatar Construction Post-FIFA’ in Doha. • Jarett Dillard (Houston) attended the 36th Annual Construction Law Conference – The Construction Law Foundation of Texas. • Richard Ceeney and Laura Riddeck (London) attended the Infrastructure Investment Event – Global Summit Berlin 2023. • James Willn and Chris Edwards (Dubai) presented alongside guest speakers Gurminder Singh Sagoo (Egis) and Christopher Seymour (Mott MacDonald) at a Reed Smith hosted Construction Breakfast Briefing, moderated by Sachin Kerur, on the topic ‘Outlook for the Middle East construction industry in 2023’. • Erwan Robert (Paris) moderated a panel session on “Inflation in the international construction sector” hosted by the association Young Professionals of Construction in Paris (YPCP). • Antonia Birt (Dubai) presented on ‘Unconscious Bias in the Legal Industry’ at an event hosted by CCi, A Rimkus Company to celebrate International Women’s Day and Women in Construction Week. • Liam Hart (London), Chris Edwards, James Willn and Finlay Donaldson (Dubai) all presented podcasts on nuclear power plant contracts and the complexities of nuclear disputes for Reed Smith’s ‘Energy Explored’ podcast series. • Sachin Kerur (Dubai) was a panelist at the prestigious Middle East Consultant C-Suite roundtable event, featuring CEOs and senior executives at the forefront of decision-making in the UAE and their response to the evolving economic factors of 2023. • Michelle Nelson (Dubai) moderated the first webinar in our ‘Maximising female talent in construction’ series, on the topic ‘Attracting and retaining female talent in the construction industry,’ with over 300 attendees registering for the event. We look forward to working with all our clients and construction industry colleagues throughout 2023. 04 Reed Smith Global construction update The volatility issue April 2023 Welcome Global construction update The volatility issue April 2023 Reed Smith 05 Editors: Alison Eslick Associate Dubai [email protected] James Doerfler Counsel Pittsburgh [email protected] 06 Reed Smith Global construction update The volatility issue April 2023 And, in an environment where projects are increasingly difficult to finance, will financiers be willing to provide development or project finance on a project that has limited capital expenditure (CapEx) certainty? Hybrid and cost-sharing clauses A hybrid system, either with a sharing of cost overruns or a guaranteed maximum price ceiling, may provide a workable compromise solution. Sophisticated developers may also be more open to exploring multi-contracting solutions to give greater flexibility when navigating a challenging market. Construction phase For projects already under contract, volatility is also causing significant complications. Most construction contracts will not allow for price adjustments, meaning the contractor needs to absorb any cost increases. Even where a party seeks to protect its supply chain by allowing for price adjustments in its contract, it may still be that commitments that its contractors, subcontractors and suppliers have given on their other fixed-price projects will lead to supply chain insolvencies, which can be highly problematic to a construction project, since they inevitably cause delays and duplication of expenditure, as well as continuity and quality concerns. Insolvency of subcontractors and suppliers and other downstream risks Ultimately a strong contract that passes substantial risk to the contractor is of little use to the developer if the contractor is forced into insolvency. During the last decade, a degree of complacency has developed over financial due diligence toward counterparties, over bonding for advance payments and insolvency, and over the passing of title (and vesting certificates establishing title before payment). Unsurprisingly, all of these factors are quickly becoming important. Following a sustained period of global economic stability, a number of market factors are now combining to create economic volatility. While the impact of COVID-19 is diminishing, other factors such as the war in Ukraine are driving up inflation generally, and particularly the cost of fuel and construction materials. This uncertain set of conditions is creating a number of challenges for all players in the construction industry. This article briefly addresses some strategies that developers are increasingly utilizing to address these current market. Pre-construction phase In the pre-construction phase, supply chain unpredictability is making it particularly difficult for contractors to price projects. For many years, the trend has been toward fixed pricing, with contractors (and subcontractors and suppliers down the supply chain) taking the risk of fluctuations in labor and materials costs. Price indexing and other price fluctuation clauses Every risk allocation, however, carries a cost, and the risk premium of covering new inflationary factors in these uncertain times may be prohibitive for contractors, particularly on substantial projects with long construction periods. Increasingly, developers are considering introducing price fluctuation mechanisms that allow contractors to adjust their prices, with reference to impartial indices (whether the official inflation index of the relevant country or an index that tracks changes in prices of steel or other materials or of local labor). These mechanisms provide certainty to contractors, but not to developers or financiers. So, how can a developer assess the profitability or even viability of a construction project when the capital expenditure cost is uncertain not only during the planning and design stage but also during construction? Global volatility drives uncertainty and risk Global volatility drives uncertainty and risk Laura Riddeck Partner London [email protected] Richard Ceeney Partner London [email protected] Global construction update The volatility issue April 2023 Reed Smith 07 Global volatility drives uncertainty and risk Authors: Common claim situations Inevitably, such uncertainties lead to claims. The construction contract may provide an entitlement to additional time and/or additional cost, depending upon the cause of the external factor. Most construction contracts, for example, would consider both COVID-19 and the war in Ukraine to be force majeure events, giving an entitlement at least to extensions of time. Any claim to give effect to this entitlement needs to be carefully managed, however, and many construction contracts contain pitfalls for both parties if claims procedures in the contracts are not followed. Similarly, claims received need careful handling, to avoid any acceptance of liability for excessive or invalid claims. Particular care is required when a contract allows no entitlement for the event that is causing delay and cost. In these circumstances, rather than simply absorbing this delay and cost, many contractors or subcontractors will seek to mitigate their losses by attributing their delay and cost exposure to other events which do legitimately give rise to an express entitlement. The importance of good project records During periods of extreme volatility, formal disputes may become inevitable. For this purpose, detailed recordkeeping is key, as it may be the only way to establish or disprove an alleged entitlement. Conclusion As we move away from COVID-19, with many regions keen to generate revenue back into their economies, and with an increasing focus on the energy transition following the invasion of Ukraine, construction deals will continue to be made. The market volatility that we are seeing will make those deals more complex. And contract terms that might have been considered acceptable even 12 months ago may now carry a dangerous level of risk. Developers, contractors and funders alike need to be wary. Takeaways • Exposure to fluctuating prices creates new risks for developers. • Developers must address potential contractor insolvency. • Effective and proactive claims management is crucial. • Keep clear and contemporaneous records. 08 Reed Smith Reed Smith Global construction update The volatility issue April 2023 Global construction update The volatility issue April 2023 Global construction update The volatility issue April 2023 Reed Smith 09 With difficult economic headwinds, rising interest rates and general pressure on liquidity, contractors are increasingly struggling to obtain customary financial and performance security instruments for projects, such as letters of credit, bonds or guarantees. Where such security instruments are available, they are often expensive, and this circumstance has a knock-on effect on bid pricing and, in some cases, may prevent contractors from bidding on projects at all. This difficulty in obtaining customary project security has a negative impact on not only contractors but also owners, who are finding that their resource contracting pool is dwindling and their project costs are rising. In this article, we consider the practice in the UAE in respect of project security and, particularly, how this sits alongside other jurisdictions such as the UK and U.S. We also discuss whether there might be alternative practices and whether taking a different approach might bring about positive change to the market, both for owners and contractors. Security practices on projects in the UAE In the UAE, a combination of unconditional/on-demand performance, advance payment, retention and defect bonds is customary. There is usually very little (if any) room for a contractor to negotiate with an owner in respect of security, in terms of either providing the instrument or the conditions in which it can be called upon by the owner. Likewise, the provision and maintenance of such security tends to be a condition precedent to payment under the contract. Furthermore, if the contractor fails to maintain or increase security in line with increases in the contract price, such a failure typically entitles the owner to encash the bonds and is often a contractual termination event. Contracts rarely provide for any form of notice or other requirements preceding a call on the bonds. The content of the bonds themselves varies depending on the issuer and the project but will typically include an unequivocal obligation on the issuer to pay the owner upon receipt of a written demand notice and expressly exclude any right to challenge a call. By way of example, standard form bonds typically include wording similar to the below: Rethinking security on projects in the UAE Rethinking security on projects in the UAE “Our obligations constitute direct primary, irrevocable and unconditional obligations and shall not require any previous notice to, or claim against, the Contractor.” “We agree that we shall have no right and not be under any duty or responsibility to enquire into the reason of any demand and/or the respective rights, obligations and/or liabilities of yourself and/or the Contractor under the Contract.” “Any demand made by you in accordance with this bond shall be conclusive evidence that the amount in demand is properly due and payable.” 10 Reed Smith Global construction update The volatility issue April 2023 Rethinking security on projects in the UAE In such circumstances, the owner is free to call on a bond at its discretion. This discretionary right makes the unconditional/on-demand bond a very safe and preferred form of security for the owner. However, bond calls in the region have become alarmingly common and, in some cases, are not always justified. The frequency and high risk of calls being made has significantly increased the costs of such bonds to contractors, and in some cases, banks are now refusing to provide them or are imposing extremely onerous terms on the contractor, such as including a requirement to provide a counter-guarantee from their “home” bank, in circumstances where the contractor is not based in the UAE. This increasingly challenging environment for contractors is exacerbated by the fact that UAE law offers little protection to contractors in respect of unconditional bonds. In particular, the Commercial Code explicitly provides that: a. a bank may not refuse payment to the beneficiary of an unconditional guarantee on grounds of the bank’s relationship with the person making the order or the relationship of the latter with the beneficiary;1 and b. a court may only intervene to place an attachment on an unconditional bond in “exceptional cases” where the person seeking the order relies on “serious and sure grounds.”2 While we have seen some recent examples of the courts granting attachments, preventing a bond call from being paid out, historically, the courts have been reluctant to intervene, which is perhaps unsurprising given the high legal threshold for such intervention. Accordingly, contractors are struggling to meet bonding requirements on projects in the UAE. Either the security is simply unavailable to them, or if it is available, their bids are inflated by the high financing costs of their banks. Ultimately, this situation is not in the interests of owners since they can no longer attract the right talent at the right price for their projects. A comparison with other jurisdictions While the unconditional bond has become the norm in the UAE, this is not the case elsewhere. For example, the position in the UK and U.S. in respect of guarantees and security is very different. On-demand bonds are occasionally used in the UK, particularly on large infrastructure or energy projects with an international contractor or where the employer is the UK government (which can leverage its position as a major consumer). However, default bonds (also known as conditional bonds) are far more common. Default bonds in the UK tend to adopt the standard Association of British Insurers (ABI) form of bond, which provides that a call can only be made when damages are crystallized under the contract. The key operative provision of the ABI form of bond states as follows: “The Guarantor guarantees to the Employer that in the event of a breach of the Contract by the Contractor, the Guarantor shall subject to the provisions of this Guarantee Bond satisfy and discharge the damages sustained by the Employer as established and ascertained pursuant to and in accordance with the provisions of or by reference to the Contract and taking into account all sums due or to become due to the Contractor.”3 This practice of using conditional bonds provides a layer of protection to contractors and banks, as a call can only be made in respect of damages that have been “established and ascertained” under the contract. Therefore, unlike the situation we often see in the UAE, bonds on projects in the UK typically cannot be called at the whim of the owner. In the U.S., if bonding is required, it will usually take the form of either: (i) a surety performance bond, where a surety promises to take over a contractor’s or subcontractor’s work if the contractor or subcontractor defaults or becomes insolvent; or (ii) a payment bond, which guarantees that all subcontractors and material suppliers on a project engaged by the main contractor 1 Article 417(1) of the Commercial Code are paid for their work. 2 Article 417(2) of the Commercial Code 3 Association of British Insurers (ABI) form of construction bond Global construction update The volatility issue April 2023 Reed Smith 11 Rethinking security on projects in the UAE The U.S.-style surety performance and payment bonds are quite different from the bonds provided on projects in the UAE. They are not simply a lump sum that can be drawn upon on demand. They meet specific projectdriven requirements, and can only be used/called in clearly defined circumstances outlined in the terms of the bonds. The use of UK or U.S.-style default bonds, surety bonds and/or payment bonds could all be attractive alternatives to the unconditional bonds used in the UAE. The owner’s interests would still be protected, but the risk and costs to the contractor could be greatly reduced. Other options? Various amendments to security provisions in contracts have been trialed and mooted in the region in an attempt to make them more equitable, such as introducing notice provisions or a stand-alone dispute process before a bond call. However, these possible amendments, while solving some problems, tend to come with their own sets of complications. Notice provisions A notice provision will usually require an owner to notify a contractor of its intention to call a bond unless a specified breach is rectified within a defined period. This advanced notice is often seen as a good compromise for a contractor. It ensures that a bond call is linked to a specific breach of the contract, and it allows the contractor some time to either rectify the breach or prepare for the consequences of the bond call. However, there is an inherent risk to the owner that, upon receiving such a notice, the contractor may seek an attachment in the court to prevent a call on the bond being made or take other measures to prevent a successful call (other than rectifying the alleged breach). Further, unless the notice provisions are clearly drafted and carefully followed, the contractor may challenge a call for failure to comply with the notice provisions. Stand-alone dispute resolution processes A stand-alone dispute resolution mechanism is another method used to prevent unjustified calls on bonds. These are also known as adjudication bonds. Adjudication bonds are not widely used. While at a high level, the concept may be appealing, when one delves into the details, the value of adding such a process often becomes questionable. In particular, the adjudicator is usually the guarantor (who would be unlikely to be fully impartial) and the process would likely be ad hoc, as adjudication is not a well-established forum in the construction industry in the Middle East. Given the lack of experience with adjudication bonds, banks may be reluctant to issue such a bond and there would be a significant risk of complications in implementing the process, and as a result, delays, more costs and, potentially, the call being rejected or the guarantee becoming invalid. Accordingly, while amen