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Back to basics law: how to balance risk and choose the right construction contract

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Barristers Kim Franklin and Sue Lindsey look at the balance of risk between employer and contractor in common construction contracts

English law has historically been very keen on parties contracting on whatever terms they want, and upholding whatever agreements they enter into. If they want to agree a peppercorn rent, that will be enforceable. Inequality of bargaining power is no cause for complaint (other than for consumers, thanks to relatively recent legislation). A small contractor contracting with a multinational employer will probably be obliged to do so on rather different terms from its larger contractor colleagues.

What contracting parties are actually doing is agreeing on how risks are to be allocated between them. The same is true in every contract. I pay a window cleaner to clean my windows. The payment includes an amount to reflect the risk he takes in climbing up a ladder with a bucket, which I happily pay someone else to do. The price and payment terms are dictated by the commercial balance between us. If there are lots of window cleaners where I live; the price goes down. If I failed to pay him for several months last year; he insists on cash before he sets foot on that ladder.

The concepts of allocation of risk and commercial balance are very useful tools for analysing building contracts and deciding which type to recommend. Some employers want control over the end result and time certainty for a reasonable fixed cost. That is not realistic, and an analysis of this type explains why.

Often exemplified by ‘the JCT standard form’, in traditional procurement the employer carries a lot of risk. The benefit to the employer of agreeing to carry those risks is that it retains the powers to get the building that it wants. What risks does the employer carry? While sometimes referred to a ‘lump sum’ or ‘fixed price’ contracts, this is something of a misnomer. The employer is responsible for procuring the design, and retains powers to vary the works. Those variations to the works change the price (almost invariably upwards), so the employer carries the risk of rising costs. There is some cost risk to the contractor insofar as it has to carry out the works that it has agreed to do for the lump sum, and as a result there is frequently tension over which elements of the works are in the lump sum and which are outside it. So with traditional procurement the employer can ensure it gets the building it wants, but has to pay for flexibility to achieve that.

The contractor bears the costs risk, as it contracts to provide a building for a fixed price. While there may be some provision for the employer to vary the works, this is often very limited. The benefit to the employer of allocating the cost risk to the contractor is cost certainty. What tends to be less certain, and that is a disbenefit to the employer, is the end result. The contractor agrees to a fixed price which it anticipates will allow it some profit. Plainly any cost savings the contractor can make along the way will increase that profit, but the end result may suffer. On the other hand if the contractor encounters unexpected difficulties, those will push the price up. So the contractor carries the risk of making a loss.

There is a theory of risk allocation that risk should be placed where it can best be coped with. Some risks are just too great to load on to a contractor, even if it is prepared to take them on. It is no good to anyone if one party takes on a risk it cannot bear. As a result large infrastructure projects such as tunnels, which tend to be procured by employers with deep pockets, are often done on a remeasurement basis. The contractor agrees to carry out certain activities for a fixed rate, and gets paid for how much of it it does. The cost risk lies with the employer, the benefit to the employer being certainty of getting the required end result.

As an aside, with a large-scale project it is easy to see that it is the employer that wants the works done, and so the risks of getting it built should rest with them. However this is true of any construction project large or small. If a householder wants to embark on building a conservatory that is their choice, and their risk. The contractor has not asked them to do it. The employer may allocate the risks of undertaking the works between them and the contractor in a sensible way that hopefully meets their needs, but in the final analysis the risk that is being carved up is all that of the employer.

Rather to one side of the balance between the end result and price is the risk of time. The last piece in this series (AJ 19.06.08) looked at the interrelationship of time and money in building contracts. Suffice to say here that delay can have cost consequences that most building contracts seek to legislate for those in advance, and that the cost consequences of delay can disrupt what might otherwise be costs certainty for the parties. But considering time as a standalone risk, there are some circumstances in which an employer must achieve a particular end date, such as is the case with procurement for the Olympics. Clearly if an employer seeks to place such an absolute time risk on the contractor, the contractor will want costs provisions that compensate it for undertaking such a risk.

There is perhaps a tendency to pick a contract because it is familiar or because it is recommended for a certain size of project. However it is important not to lose sight of the underlying allocation of risks that each form of contract uses. It is necessary to have an understanding of the commercial balance of a contract and the likely effect of its provisions on the end result and to match this to the parties’ needs.

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