The Saudi Construction Law Saga; a Tap in the Current Trends and Developments – Pt. 1
Euan LloydPartner,Construction & Infrastructure
Muhammad El HagganSenior Associate,Dispute Resolution
Saudi Vision 2030 is a strategic framework that has three key pillars – to make the Kingdom of Saudi Arabia (the KSA):
“the heart of the Arab and Islamic world”;
a global investment powerhouse; and
a “hub of connectivity, connecting Afro-Eurasia”.
At the heart of this hugely impressive objective is the intention to reduce the dependency of the KSA on oil, diversify the KSA’s economy and to develop the public services sector, including in respect of health, education, infrastructure, entertainment and tourism.
Saudi Vision 2030 has inevitably resulted in the KSA entering a period of rapid and dramatic transformation and has triggered the inception and development of many multibillion dollar and highly complicated projects. These projects supplement the various oil and oil-related projects that continue to be procured with regularity, particularly in the eastern provinces.
While the booming construction market in the KSA offers many opportunities and rewards, there are inevitably accompanying risks and challenges.
Al Tamimi & Company has been advising stakeholders from all sectors of the construction industry in the KSA for many years. In this article, we provide a snapshot of the legal framework in the KSA and discuss some key, and often interconnected issues in respect of which stakeholders in this incredibly exciting chapter of the KSA’s development should be aware.
Islamic Shari’ah is the main source of law, supplemented by laws enacted from time to time, including by the King and government departments.
The KSA legal system is uncodified.
Although the courts are not bound by precedent, decisions of the higher courts tend to be followed.
From a contractual perspective, the principle of freedom of contract prevails and, as such, parties are fundamentally bound by their contractual bargains, provided that the agreed contractual provisions do not offend Shari’ah principles or any relevant legislation.
A topical piece of legislation is the Government Tenders and Procurement Law (the “Procurement Law”).
The Procurement Law applies to procurement activities by government bodies (as well as by companies that are majority-owned by the government). It is particularly significant given that the overwhelming majority of projects that comprise Saudi Vision 2030 are government-sponsored and the Procurement Law was enacted with this in mind.
Although construction projects in the KSA have, until now, mostly been procured on a traditional construction-only basis, procurement is becoming increasingly diverse.
For example, there is a growing appetite in commercial developments as well as infrastructure projects procured on a design-build basis. Additionally, Engineering, Procurement and Construction (EPC) (as well as Engineering, Procurement and Construction Management or EPCM) contracting is prevalent in the context of industrial facilities, while PPPs (Public-Private Partnerships) continue to gain momentum, particularly in the areas of health, education, water and transport.
Although the discussion below is of general application, the majority of the issues raised probably resonate most strongly with "traditional"/design and build forms of procurement.
Despite the buoyant construction market in the KSA, some participants in the construction sector are experiencing significant financial difficulties, particularly in the form of restricted cash flow.
While such liquidity issues are often most acutely experienced at a contractor and subcontractor level, employers (especially commercial developers) are certainly not immune from having financial difficulties.
Although, in our experience, this action is seldom taken, we recommend that contractors take proactive steps to satisfy themselves as to the financial arrangements that the employer has in place to ensure that it can pay for the works that are being performed (this point is amplified as works are invariably paid for in arrears). Contracting with a financially unstable employer is a recipe for disaster and we are aware of several major players in the industry that have been left financially scarred due to the failure by employers to comply with their payment obligations. Employers, for their part, need to ensure that they have committed streams of revenue before committing to projects.
However, a further (and perhaps the predominant) cause of liquidity issues in the market originates from the prevalence of "back-to-back" contracting and specifically "pay-when-paid" payment terms, which are legal and enforceable in the KSA and can significantly impact suppliers and subcontractors.
An additional significant issue is that conditional payment/”pay-when-paid” regimes are often opaquely drafted and can therefore be abused. For example, it is relatively straightforward for an unscrupulous main contractor to contend that it has not received any payment under the main contract (or payment for a particular subcontractor’s scope) and to therefore stall on its obligation to make payment to its supply chain.
The main contractor’s position in this regard can be strengthened as subcontracts often contain a prohibition against subcontractors liaising with the employer, meaning that the subcontractor is unlikely to have any certainty regarding whether or not the employer has actually paid the main contractor. Even if such a prohibition has been omitted, it is unusual for employers to concern themselves with supply chain issues (other than when it is in their interest to do so).
An added risk to a subcontractor engaged on a pay-when-paid basis is that the employer may not be making payments to the main contractor on account of a dispute that has nothing to do with the subcontracted works or services in question.
Notwithstanding the competitive contracting environment (and while we accept that such mitigants can be challenging to negotiate), we nevertheless recommend that stakeholders who are subject to conditional payment regimes seek to qualify the absolute nature of this risk allocation by building in certain safeguards.
Such safeguards may include requiring the main contractor to: (i) substantiate its position regarding receipt of payments from the employer under the main contract; and (ii) demonstrate the actions that the main contractor has actually deployed in an effort to recover payment.
Further approaches may include seeking to implement certain thresholds that apply to the pay-when-paid mechanism. For example, it could be commercially agreed that payments of less than (or over) a certain threshold amount will fall outside of a pay-when-paid mechanism or that the pay-when-paid structure shall be subject to a longstop date. In other words, it could be agreed that outstanding payments shall become due (even if they have not been received by the main contractor) by a certain date.
Another issue encountered with increasing frequency in the KSA construction market is that of payments made by the employer to the main contractor being diverted by the main contractor from the project in question and allocated to other purposes that are not connected with the project in respect of which the payment was made.
This situation typically manifests itself in subcontractors and suppliers not being properly paid and, in turn, sub-subcontractors (and so on) not being paid.
This creates fertile ground for disputes, as it is highly likely that a project that is starved of liquidity will experience significant delays and that the work performed will be substandard.
As a partial solution to this situation, the employer can include a clearly drafted right of audit in the main construction contract that provides transparency regarding how payments from the employer have been distributed by the main contractor.
Allied to this, the employer may also wish to reserve the right (but not the obligation) to make direct payments to subcontractors, if the employer reasonably considers that amounts due have not been paid by the main contractor to its subcontractors.
It should be clearly documented that any such direct payments are made on the basis of necessity (and without creating any contractual relationship between the employer and the subcontractor), while the employer should reserve the right to set-off such direct payments from future payments that are due to the main contractor.
An added consideration where pay-when-paid structures are invoked, sub-contractors and suppliers may consider a facility line to account for delayed payments as a result of delayed payments under a pay-when-paid mechanism. However, this should be treaded carefully since it would uplift the cost of finance and thus, the overheads on a specific project; a matter that could impede commercial viability in a competitive market like the KSA.
The above discussion provides a brief overview of liquidity, a vital and prevailing issue in the buoyant KSA construction market.
In conclusion, it is recommended that all project participants carefully consider and negotiate liquidity risks under the contracts they are contemplating their execution, so as to properly protect their position.
For further information,please contact Euan Lloyd and Muhammad El Haggan
Published in March 2023