Key Issues to note when seeking to resolve Construction disputes amicably
Real Estate & Construction and Hotels & Leisure
With the best of intentions? While hoping for the best, it is important to plan for the worst.
Law Update: Issue 359 - Real Estate
Euan LloydPartner,Construction & Infrastructure
Steven GrahamSenior Associate,Construction & Infrastructure
With the best of intentions? While hoping for the best, it is important to plan for the worst - in this article, we consider some key issues to note when seeking to amicable resolve disputes.
Construction project can be complicated things. Not simply because of engineering considerations, unexpected delays, obstruction and controlling costs but as a result of the complex relationship between contractor and employer. Managing that relationship when projects hit trouble is one of the most difficult aspects of any problem project and can be the difference between the parties walking away, if not happy, then satisfied and a protracted and costly dispute.
Contractually, there is almost inevitably tension between the contractor and employer.
The employer is keen to drive a hard bargain on cost and transfer of risk and then to hold the contractor to that bargain to deliver a project on time, on budget and at the best quality it can secure within the price agreed upon.
The contractor, often having been squeezed on price or having accepted too much risk (including on account of the competitive tendering environment), goes into the project keen to ensure that it does not take on additional risk or cost as the design develops and the works encounter the inevitable obstructions changes and other issues which occur on many projects.
However, alongside that contractual tension is a shared interest to get the project completed. The contractor to preserve its profit margin and the employer so that it can realise its investment in the project by commercially exploiting the finished works.
As the works progress that shared interest becomes increasingly important as it becomes more and more difficult for the employer to ‘cut its losses’ and terminate a struggling contractor. Termination/omission of works mid-way through construction is typically an adversarial step, can lead to significant delays and cost increases and can cause significant problems in coordinating works obtaining warranties and approvals and fragments liability when it comes to remedial works, maintenance and decennial liability.
In those circumstances, we often encounter employers who, despite growing concern about a contractor’s financial standing or ability to progress the works, decides to take steps to ‘assist’ the contractor to get the works to completion. The steps taken can range from direct financial assistance, paying subcontractors directly, waiving claims that the employer may have and settling ambiguous contractor claims with the intention of keeping the works moving and quelling or at least putting off disputes which could slow down or grind to a halt altogether.
However, taking such measures can lead to unexpected consequences for the employer further down the line if they are not taken in a considered manner which protects the employer’s position whilst enabling the contractor to complete the works. In particular, where the parties end up in dispute, employers who have sought, in good faith, to ‘keep the show on the road’ may discover that they have hamstrung themselves in subsequently defending a claim against them or seeking to assert rights against the contractor.
In practice therefore, what should an employer look out for when contemplating helping out a struggling contractor?
In recent disputes, we have seen a number of employers making payments either separate to the contract price or outside of the sequence of payments envisaged by the contract. These payments are often made to keep the contractor’s cash-flow positive so that the works can progress. In some cases, these payments are necessary as the contractor’s cash flow really is suffering from problems outside of the project which mean support is needed (in those circumstances it is worth considering whether the employer’s due diligence fell short when engaging the contractor).
However, it is often the case that the cash flow problems encountered may be the result of other issues in the project. Wherever possible, issues arising in the project should be resolved at the time (rather than being ‘parked’ until the end of the project) so as to avoid these cash flow problems. Whilst this is not a recommendation to simply accept questionable claims for variations or other additional payment; it is a suggestion that engaging with the contractor to establish whether there is any entitlement and basis for settlement ‘in real time’ might allow disputes to be resolved and payments to be certified within the contractual framework.
A classic example of this approach is engaging with the contractor to ensure they understand, in detail, what needs to be evidenced to allow a variation to be approved rather than simply denying claims at a high level as ‘unsubstantiated’ or ‘not understood’, without any explanation.
Resolving disputed items in ‘real time’ is good practice and is endorsed in multiple jurisdictions and forms a key objective of adjudication schemes in the UK, Australia, Singapore and Hong Kong. Similarly, a proactive ‘real time’ approach is endorsed by and built into the provisions of the NEC3 and NEC4 forms of contract, increasingly adopted in the UK.
Where ‘extra-contractual’ payments can be necessary to keep things moving, care should be taken to ensure that these are properly documented and accounted for within the contractual payment mechanisms or otherwise through an addendum.
Generally, it is better to structure any such payment as an additional advance payment (in respect of which we recommend that security is obtained) rather than over certifying (expressly or impliedly) the amount paid in respect of works carried out to date. Over certifying may be within the contractual mechanism but, if a dispute arises, then the overpayment can be used as evidence that the employer/engineer did consider progress had been made otherwise why would they have made corresponding payments? In short, it is harder to recover an overpayment than it is to recover an advance payment in the event of termination of dispute.
Where a payment is being made as an additional advance payment (i.e., it is to be recovered) then it should be clearly recorded that this is what is happening, ideally, by an amendment to the contract in writing which adds a further advance payment in the appendix to tender. Such an amendment should be compliant with the terms of the contract governing amendments, typically requiring such amendment to be express, in writing and signed by both parties as a minimum.
When agreeing additional advance payments, it is important to consider and record the terms on which the advance will be recovered. The amount will need to be stated to be recovered in tandem with or after recovery of the first advance payment. If a project is well advanced, it will also be necessary to consider how quickly the amount can be recovered and if it can all be recovered from interim payments or whether it will need to cut into the retention money. If there are insufficient interim payments remaining/not enough of the contract price remaining to recover the additional advance against then an alternative way of recovering may be required (for example through a bond).
It is also worth considering the impact of having a large part of each interim payment being deducted for recovery of the advance. Indeed, if the percentage is too high, then this arrangement may boost cash flow initially and then negatively impact it at the end of the job, thus inhibiting effective project close-out. Similarly, it is not advisable to rely on the retention amounts as a way to recover additional advance payments as this reduces the available amount of the retention to use to (a) cover the cost of defects and/or (b) to incentivise the contractor to return to carry out remedial works in order to recover the final tranche of the retention amount, which are the key purposes of a retention.
It is commonplace for arrangements between employers and contractors for additional sums to be called ‘loans’. However, it is not uncommon to find that no terms for the return of that ‘loan’ have been agreed.
As above, where it is possible to recover the sum in question within the exiting contractual mechanisms (i.e., the advance payment provisions) then that is preferable. Where a ‘loan’ is preferred then the terms of that loan should be expressly recorded including any interest and the terms for its recovery. A loan which cannot be recovered within the advance payment mechanism is inherently riskier than one which can – the fact that the contractor needs a loan in order to meet its contractual obligations should generally be seen as a warning sign that they may not be in good financial health and caution is therefore required.
A further consideration when agreeing to a loan or other agreements to advance money outside of the contract is to ensure that the additional agreement is covered by any arbitration agreement in the underlying contract. Care should be taken to ensure that the loan or other agreement expressly states that it is or is not (as may be required) covered by the arbitration agreement. This is considered further below.
It is increasingly common for employers to pay subcontractors directly either as a result of past failures to make payments by the contractor or because of concern that payment is not filtering down the chain. However, it is very risky to make direct payments to subcontractors without the employer have an expressly contractual right to do so. The FIDIC standard form contracts do contain a mechanism to allow for direct payment of subcontractors, but that mechanism is limited to nominated sub-contractors in situation where the contractor fails to evidence payment when requested. Where the employer considers it may wish to pay subcontractors directly (in our view a good option to have in all cases) amendments are necessary to ensure that the clause allows the mechanism at clause 5.4 of the Red Book FIDIC form (1999 edition) to be extended to domestic subcontractors and to widen the mechanism to allow payment of subcontractors going forwards. It is also recommended that the contract addresses the treatment of overhead and profit on subcontract costs otherwise payable to the contractor and the contractors ongoing liability for the subcontractors works expressly. Other issues include whether the employer has the right to instruct the subcontractors it is paying or whether control remains (as is usual) with the contractor. It is also a sensible precaution to require subcontracts to contain provisions allowing the relevant subcontractors to speak directly to the employer/engineer in the event of non-payment so that there is no breach of subcontract should they need to make the employer aware of a non-payment.
When paying subcontractors directly one point of caution should be noted. It is still necessary to engage with the contractor to avoid overpaying subcontractors and prejudicing the contractor’s position in respect of sums due from subcontractors back to the contractor in respect of sums withheld pursuant to the contract or disputed works/sums.
Employers should also take care when accepting, even if stated to be interim or preliminary, claims which are made by the contractor but are not actually agreed in order to resolve commercial deadlocks between the parties.
As above, it is generally not good practice to ‘put off’ claims until the end of the project. They rarely go away and often the delay will make the situation worse as this tends to (a) entrench disputes (b) impact cash-flow (c) may result in suspension of termination. Generally, best practice is to address claims as they arise in the project to avoid the above problems. This approach is endorsed by the Society of Construction Law in its Delay & Disruption Protocol and others in the industry such as the NEC in its forms of contract. FIDIC also endorses this approach providing timescales for notification, particularisation and determination of claims as well as the DAAB process which aims to resolve disputes during the construction phase is necessary.
Notwithstanding the above, it is not unusual for employers to delay applying deductions (including liquidated delay damages) until the end of the construction phase in order to avoid impacting cash flow in the hope that this will get the project to completion. When making such concessions, it is important that employers ensure that they reserve their rights to make those claims in the future and avoid language which expressly or impliedly (or could be argued to imply in the event of dispute) waive the right to make claims at a later date. Whilst the FIDIC provisions (other than the 2017 suite) do not provide a time bar for employers claims in the same way as clause 20 does for contractor’s claims it is still good practice to notify any employer’s claims promptly to ensure that the right to claim is not waived.
Employers should also take care when accepting, even if stated to be interim or preliminary, claims which are made by the contractor but are not actually agreed in order to resolve commercial deadlocks between the parties. Where a party makes such an acceptance it may be difficult to withdraw it later – any indulgence granted should be clearly framed in writing as not being an acceptance of claims made along with a reservation of rights to pursue any counterclaims/review decisions made on an interim basis in future.
A further, although less common, decision made by employers who, as a result of delays, need to urgently begin using the project is to certify partial completion or full completion before the works are fully complete.
The FIDIC contracts permit partial taking over. However, it is important to only use this mechanism when it can practically be used. The partial taking over mechanism in the FIDIC contracts allows for partial taking over of a distinct part of the building for use only. It does not allow an employer to use all of the building for a limited purpose or to use all of the building save for areas where the contractor need to work. This mechanism should only be used where it is practically possible for the employer to identify and use in isolation a particular geographical area of the building. If this is not possible the building should not be taken over at all. This is because one the employer has the use of the building or parts thereof; they are deemed to be taken over. So, if an employer says in writing it is taking certain floors of a building but in practice begins using other parts of the building to access those floors/use services on those floors then they will be deemed to have taken over all areas actually used.
There is also risk in taking over the whole of the works/sections before they are actually completed. Whilst the FIDIC contracts do allow for taking over subject to a snagging list that process is only intended for relatively minor issues which can be made good in the DLP, that process is not suitable for taking over with large parts or critical elements of the works outstanding. The granting of the taking over certificate (in FIDIC and other forms of contract) is a key milestone which changes the obligations of the parties from that point (for example in relation to retention release, insurance, the obligation to carry out the works and remedy defects and so on) and in certifying completion the employer loses a number of key negotiating tools under the contract (as it takes on risk for the works, releases payments to the contractor etc). In a dispute scenario a contractor will (notwithstanding ‘no approval’ wording in contracts) point to the issue of the taking over certificate to suggest that it had completed its obligations but for snagging as ‘why else would the employer issue the certificate’. For those reasons taking over should not be done early without compelling reasons and should never be done without substantial and unambiguous evidence of the employer’s position as to outstanding works and extensive records (and photographic evidence) of the status of the works/tests on completion at that time.
Another mechanism which employers may reach for when a project is in difficulty is the option to omit works from the contract and complete them directly or by a third party.
Before doing so it is important to check whether the contract permits omissions. It is common for contracts to allow for omissions to be made as a variation but usually with the caveat that they cannot be awarded to third parties or carried out directly. Where that is the case, absent agreement from the contractor concerned, omitting the works and having them carried out by third parties would be a breach of contract by the employer and the employer would likely be required, as a minimum, to pay the contractor the amounts it would have made as overhead and profit on those omitted works (in effect paying that OHP allowance twice). If employers consider that they might make omissions from the scope of works should things become difficult in future, then they should expressly allow for this when negotiating the contract. In doing so issues such as coordination, interface of works and liability for defects should all be expressly addressed.
There are other factors to consider when omitting such as how risk in the omitted works and their interface with the rest of the works will be managed. This is particularly the case in a design and build project where fragmenting the single point responsibility could give both the existing and new contractors defences against claims made at a later date as each could point to the other as the true culprit.
Whatever the agreement between the parties for the benefit of the project a key takeaway is to ensure that what is agreed is understood by the parties and is clearly recorded in writing so that there is a clear reference point should a dispute as to the nature of the arrangement between the parties become the subject of dispute.
In recording that agreement, it is important to consider a few key points:
The form of the written agreement matters. If the agreement is intended to operate within the contracts mechanisms it should comply with the requirements of the relevant provisions of the contract. The contractual requirements for a variation or engineer’s determination or instruction are likely to differ from those for an amendment to the agreed terms of the contract. Care should be taken to ensure the correct set of requirements are identified and complied with.
Similarly, the parties should consider whether the employer or engineer should (and can contractually) give the relevant instruction/agreement – in some cases only the engineer will have the power to give a particular notice whereas the power to vary the contract itself is generally reserved to the employer.
Where a contract contains an arbitration agreement this will not necessarily include separate agreements (for example for a loan or settlement) which are not obviously part of the contract, this is the case even where the subject matter is related to the contract. If the parties agree to a loan in a separate agreement for example, then that agreement should expressly state that it is (or is not) subject to the arbitration agreement in the underlying contract – if it does not, the employer may find that it cannot recover sums due under the loan agreement in any later arbitration and might need to rely on the local courts to do so in separate proceedings. Of course, in some cases, for example if a settlement agreement is being entered into then it may be preferable for the local courts to have jurisdiction (to allow faster enforcement of the agreement) in which case this should be expressly stated to ensure that the intention of the parties is clear.
The lack of a ‘without prejudice’ principle in Gulf jurisdictions should also be kept in mind. Parties should take care not to make admissions they might later not want on the record in litigation/arbitration proceedings. For example, allowing the contractor to make statements about the status of the works in a memorandum of agreement relating to an agreement as to advance/interim payments might placate the contractor at the time but by agreeing to the terms of the document the employer is making/accepting representations as to the status of the works which may prevent it arguing (or credibly arguing) the opposite at a later date. Generally, such statements should be omitted, and only factual/neutral statements should be included in written agreements or where that is not possible any admissions should be clearly stated to be on a commercial basis only without implying any approval/acceptance by the parties. NDAs can also be used to provide an added degree of comfort.
For further information,please contact Steve Graham.
Published in June 2023
