Balance in construction contracts – the case for two-sided certainty

Construction Law International homepage  »  June 2020

 


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Joao Ascensao,
Acciona, Lison

 

When Paul pointed out in his first letter to the Corinthians that ‘we now are and have everything only provisionally, with reservations’,1 he was presaging the development in the 15th Century of the principle of clausula rebus sic stantibus. With few exceptions, this principle is unwelcome in the context of commercial dealings and jurisdictions worldwide have steered away from the clause. The binding force of contracts is a key assumption, as contracts ideally require a high degree of certainty.

In extremis, this results in contracting parties being bound to comply with their obligations no matter how burdensome they may become within the contractual framework, even in the context of agreements where uncertainty is high from the outset. Common law courts are not likely to rectify a bad bargain as in Bottoms v York Corporation,2 and, as described later in this paper, there could be unpleasant surprises in store for those who expect civil law courts to decide otherwise.

The FIDIC notes to the 2017 editions of the Red and Yellow Books indicate that the respective conditions of contract continue ‘FIDIC’s fundamental principles of balanced risk sharing’. But the quest for standard conditions of contract with balanced risk allocation is ineffective, for one individual’s view of balance is unlikely to match another’s. In reality, standard conditions have limited in?uence on the risk allocation of construction contracts as such allocation is often determined by ad hoc contractual documents, including the particular conditions, the scope annex or the technical specifications. Furthermore, the uniqueness of each construction project, combined with distinct idiosyncratic aspects of multiple stakeholders and speci?c external environments, result in different perceptions of risk that will inevitably have an in?uence on how balance is viewed.

This article draws a line between the concepts of balanced risk allocation in contracts and balanced standard conditions of contract in the context of the construction industry and proposes a mechanism to enhance the latter, focusing on the principle of certainty.

In pacta sunt servanda we trust

The binding force of contracts is a central principle both in the common law context and in civil law jurisdictions, albeit arguably less strictly in the latter. It is for the parties to agree on provisions that may limit their respective risks and responsibilities – and limitation-of-liability clauses are arguably the most prominent example of such provisions.

These clauses may have a considerable effect in reducing contractors’ overall risk in design-and-build agreements. However, the effect is only partial. Typically, contractors are expected to meet their contractual obligations even in cases where the associated cost becomes unreasonably high, with the result that contractors are exposed to unlimited cost overruns. In cases where uncertainty is high it is not commercially rational for contractors to enter into agreements that lack contractual protection for disproportionate cost overruns, in contrast to alliance contracts popular in many common law jurisdictions. But rationality fades when contractors need to secure jobs.

The standard conditions that design-and-build contractors typically take on imply that they are to deliver their end of the bargain, apart from limited exceptions, at a given price, no matter what the cost is.

Contractors may overestimate the extent of protection afforded by limitation of liability provisions. Given the prominence of these clauses, and their convenience by seemingly simplifying a complex subject by means of establishing caps and sub-caps, contractors can be drawn to confuse the concepts of limiting liability and limiting risk. However, the latter is a much wider concept.

Pacta sunt servanda and civil law

The prominence of the 13th-century concept of pacta sunt servanda in the common law context is unquestionable, but similar significance exists in civil law countries.

In Spain, ‘the debtor, despite the fact that it cannot and shall not deliver on an impossible obligation, will nevertheless be liable to the creditor for the effect of not satisfying his part of the bargain’.3 In Portugal, the public contract law imposes a contractual obligation on public entities to restore the economic equilibrium of contractors in certain exceptional circumstances. However, in addition to the exceptional character of the circumstances covered, contractors’ entitlements are limited to
situations where ‘the causing factor leading to the unbalance is not included in the normal business risk which the contractor should assume’.4

This topic is explored in a paper on the subject of the 2002 Brazilian Civil Code, in which the author reflects on how the principles of pacta sunt servanda and rebus sic stantibus coexist. Emphasis is given to the highly relevant role of risk allocation in contracts, indicating that

‘we are to associate this subject matter with that of risk. Being in the presence of the contract’s own risks shall not justify the contract’s termination or revision due to excessive onerosity’.5

Risk: a concept wider than liability

Having liability limited under contracts only partially deals with contractors’ overall risk in respect of contractual obligations and assumed responsibility. This is evident in design-and-build lump-sum contracts, where contractors assume the risk of completing work for a given price, regardless of the actual quantities needed. In the case of a significant increase in quantities for reasons not attributable to the employer, which result in the actual cost of the project to the contractor being 50 per cent more than the agreed price, the contractor would not be able to rely on a 25 per cent contractual liability cap, as such provision would not be relevant for cost overruns. The (ir)relevance of such a cap would come into play in a hypothetical case in which a contractor would take the decision to discontinue carrying out the work, in essence taking the commercial choice of not complying with its contractual obligations due to a disproportionate economic burden.


The binding force of contracts is a central principle both in the common law context and in civil law jurisdictions


If such a breach of contract took place, and as a result the employer terminated the contract and found an alternative contractor to perform the work, naive contractors could argue that their liability would be limited to 25 per cent of the contract price. Under this argument, the risk of quantities would be covered by the liability cap. However, limitation-of-liability clauses often have exclusions. One such exclusion may be – as in the case of the FIDIC rainbow suite – deliberate default. Not proceeding with the works in this scenario would be construed as the contractor’s deliberate default and there would be no contractual cap to liability. Arguably the contractor would be better off had it chosen to complete the work itself, incurring losses that would be, nevertheless, under its management.

Abraham Lincoln wrote in a letter: ‘My old father used to have a saying, that, “If you make a bad bargain, hug it all the tighter.”’6 This may be a good piece of advice.

Insurance, limitation of liability and then, no bounds

For contractors, the most critical exposure from such risks would be: liability to third parties, liability to the employer and, in a broad sense, cost overruns to be borne by the contractor.

Third-party liability is typically covered by insurance. Contractors’ liability to the employer may be capped, subject to certain exceptions, by limitation-of-liability clauses. Yet, a contractor’s risk for cost overruns is normally unlimited under typical contractual frameworks. Typically, cost and buildability risks rest with the contractor, especially in the common law context, as the approach in Thorn v Mayor and Commonalty of London7 demonstrates.


A contractor’s risk for cost overruns is normally unlimited under typical contractual frameworks


In addition to insurance and limitation-of-liability clauses, there are other common mechanisms that limit contractors’ risks, such as exclusion of indirect and consequential losses, liquidated damages (ascertained losses for delay and other events), defects liability periods (limiting the contractor’s mobilisation onsite) or force majeure provisions (a shared risk), to name a few. Nevertheless, while providing some protection, these do not change the fact that contractors typically face the risk of unlimited cost overruns. This is central to the concept of pacta sunt servanda as adopted in most standard forms.

Where balance is determined and risk is allocated

Standard conditions of contract will inevitably have an influence on risk allocation, but such influence may be neutralised by other contractual documents.

This article will not go into the debate of where risk should lie and who is the party best suited to deal with certain risks. This article is concerned with balance. So how is balance determined? There are two evident sources of balance. On the one hand, there is the job to be delivered by one party, added by the risk it assumes, versus the price to be paid by the other party. The greater the job and its risk profile, the greater the price should be. The right price affords balance. On the other hand, balance is determined by the nature of the clauses that apply to each party. For instance, where strict notification periods apply to one party but not the other, balance is absent. Also, when strict termination provisions apply to one party but not the other, balance is missing. The latter topic will be further explored later.

For standard conditions of contract, the discussion of which party is best suited to deal with a certain risk is less relevant as standards are designed for use in multiple contexts with significantly different parties involved depending on the project. One party may be better suited to deal with a certain risk than another. Conversely, one cannot expect to find the standard formula for balanced risk sharing – specific parties may find balance by negotiating the right price in each contract.

Balanced standard conditions should be about balanced provisions, not an exercise of imagining what the right formula for balanced risk sharing should be for unknown parties and circumstances. In some cases provisions should be mirrored rather than one-sided; for example, a time bar provision that results in a waiver of rights to one party should be matched by a symmetrical provision the other way around. Balance in other cases can only be achieved by recognising the lack of symmetry between the parties, as fundamentally the contractor brings buildability and supply-chain management to the table, where typically the employer has obligations for payment, provision of the site and a design brief. The balance will change on a project-by-project basis.

A two-sided termination provision

Employers in construction contracts typically have the ability to terminate contracts for convenience, such possibility normally being tied with the obligation, inter alia, to compensate contractors for costs already incurred or committed. Standard contracts with such a provision will arguably fail the balance test in case a similar right does not apply to contractors.

It would be naive to expect balance in the termination provision to be viewed favourably by employers. It is probable that their major concern would be that contractors could feel encouraged to walk away in cases where interim results fail to meet expectations. This is a fair concern at first sight, but does it pass the reasonableness test? In other words, is it reasonable that one party may terminate for convenience, while the other is barred from it?

Objectively, this results in an unbalanced relationship, so the question here really is whether an unbalanced contractual provision is reasonable and the answer is not clear cut. To assess the reasonableness of such a contractual provision, one must not only look at the provision itself, but also at the effect that such provision may have on the affected party. While the effect to contractors of a termination for convenience by employers may typically be assessed within the framework of the contract, the effect of contractors walking away is much more difficult to assess, as the effects suffered by employers will likely be exterior to the contract.

For an employer, the decision of whether or not to proceed with a project will be driven by matters external to the contract – a change in market forces or the commercial driver for the project. In that case, the accepted position is that the contractor is compensated for committed cost but not lost profit on the uncompleted balance of the project. For its part, the employer typically is constrained from engaging another contractor to complete the work.

This being the case, balanced contractual provisions would not necessarily result in a balanced contract.

Or would they?

Enter the principle of certainty. For any sensible allocation of risk, the reduction of uncertainty before finalising contractual responsibilities is critical. Some risks, however, can only be pushed off to be dealt with in the contract framework – force majeure, or for the purposes of this paper, termination either by agreement or at the will of either party.

Employers require the option to terminate where the job contracted ceases to make sense from its perspective, say because the price to build has become too high, because the final product is no longer needed or it has a better use for its resources. Further, contracts usually narrowly prescribe the effects of such termination for convenience of employers. This provides certainty to employers. To find balance, such certainty should be two-sided – that is, contractors should have a comparable right. In fact, a scenario where a contractor expected five per cent profit in a project and was faced with a five per cent loss is not shocking. But if the loss to be incurred was, say, 50 per cent of the contract price, corresponding to ten times the budgeted profit, the rationality of the bargain may start to fade.


Is it reasonable that one party may terminate for convenience, while the other is barred from it?


What about the effects of such right? In provisions of termination for convenience by employers, certainty is typically provided to contractors. Certainty shall also be afforded to employers in case a provision for termination for convenience of contractors is established.

However, balance here should not be measured alone by comparing the effects to each party. The risk–reward equation applicable to each individual party must also be considered and while contractors should not be released from their obligations lightly, balanced limits should be established. There are existing mechanisms that may be used for this purpose, which provide certainty to both parties. These include contractually capped delay liquidated damages that may apply to accrued deviations to the work programme for which the contractor is responsible, as well as liability for defects and third-party liabilities, which would not be waived in a termination for convenience scenario.

Contractors’ entitlement to be released from the obligation to proceed should not be abrupt. Employers should have the option of entering a negotiation process with the objective of finding alternatives to proceed with the work, possibly in the form of mediation, and there should be step-in clauses for key subcontracts. Any such clause should have a balanced nature – it would be no good to create a mechanism that would fail to reasonably provide employers with a safety net. Pragmatically, there is a mutual interest in engaging in such negotiation if a project is going off the rails for either party, whether the employer’s commercial drivers or ability to fund the work have changed, or the contractor has encountered a rampant cost overrun. Neither party has a long-term interest in holding the other’s feet to the fire.

As previously noted, in order for certainty to be two-sided, following termination for convenience by contractors, liquidated damages and liability responsibilities should kick in where applicable. In addition, a release fee may be appropriate, say, five per cent of the contract price. In the case of a contract with limitation of liability of 30 per cent of the contract price and a liquidated damages cap of 15 per cent, the contractor could find themselves having to disburse 50 per cent of the contract price in order to be released of its obligations (adding the five per cent release fee to the two caps).

A piece of two-sided rebus sic stantibus

Termination-for-convenience clauses provide certainty to the parties in the spirit of rebus sic stantibus. Such provisions mean that parties may be released of their contractual obligations in cases where the bargain ceases to make sense to either of them. This right will not prejudice the certainty of the other party in case the effects of the termination are appropriately set.

The advice by Lincoln’s father applies to construction contracts: Contractors should hug bad bargains all the tighter. But before getting into contracts, it should make sure it has a way out in case the contract becomes unreasonably burdensome. Certainty via rebus sic stantibus.

 

Notes

1 Karl Barth,Church Dogmatics, Volume III, The Doctrine of Creation, Part 4 (T&T Clark 1961).

Bottoms v York Corporation(1892) Hudson’s BC (4th Edition, vol 2) 208 at 225.

3 Luis Diez-Picazo et al, Sistema de derecho civil (Editorial Tecnos, 2001), author’s translation from the original.

4 Jorge Andrade da Silva, Código dos Contratos Públicos – Comentado e anotado (Almedina 2018), author’s translation from the original.

5 José de Oliveira Ascensão,Alteração das circunstâncias e justiça contratual no novo Código civil (Conselho da Justiça Federal, Centro de Estudos Judiciários 2004), author’s translation from the original.

6 Ward Hill Lamon, The Life of Abraham Lincoln (Applewood Books 2012).

Thorn v Mayor and Commonalty of London(1876) 1 App Cas 120 (HL).

 

Joao Ascensao is a deputy country manager for Acciona. He can be contacted at joao.ascensao@acciona.com.

 

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