Within the last few years, the unexpected introduction of Covid-19 and the Government lockdown mandates that followed has flushed out a plethora of issues within the building and construction industry.
Recent insolvency issues seen with big members within the building and construction industry has highlighted that construction contracts currently do not provide adequate flexibility in the face of unforeseen risks. This has exposed issues faced during the negotiations stages when drafting a project’s contract. The presence of bargaining power held by principals and developers has seen builders locked into long term fixed agreements without consideration to inflation hikes and other risk factors out of their control.
Due to this, a lack of ‘escape mechanisms’ in contracts and poorly planned projects has seen litigators unnecessarily involved in claims for moneys, or damages for breach of contract.
Within this article we will highlight our view on the key problems within the building and construction industry, and what we believe needs to be accomplished in order to address these issues.
Key Problems in the Building and Construction Industry
Insufficient ‘Escape’ Mechanisms within Fixed Price Contracts
The recent insolvency issues suffered by some of the biggest building and construction members is just the tip of the iceberg of problems within the building and construction industry. What we don’t see under the surface, is the underlying industry behavioral norms and contractual agreements that are the cause of these liquidity problems.
One such problem prevalent around different worksites in the last few years, was the material shortages and resulting increase in supplier prices caused directly by Covid-19. Many builders were left scratching heads on how to ‘escape’ liability for a rise in project cost and completion date delays, due to factors largely or completely out of their control.
Furthermore, with many work sites around the country having faced building delays due to Government enforced mandates, a lack of escape mechanisms during the project’s planning stage left many contractors paying liquidated damages for delays.
As a result of increased costs and expenses, many builders saw profits slashed, or worse even, began making overall losses to complete the project.
In order to avoid this, projects need to be better planned to capture all scenarios, (no matter how unlikely) that may eventuate during the performance of works. Many poorly drafted construction contracts were vulnerable during Covid-19’s lengthy delays, worker shortages and site access restrictions.
Whilst standard design and construct contracts may be an effective basis from a risk allocation perspective, not every standard contract will be best suited for every project.
A System of “Hot Potato” Risk Allocation
Risk allocation is a big consideration during the negotiation stage between principals and head contractors. During this stage it is common to see principals try to pass on as much risk as they can to the head contractors in an attempt to minimize their liability and responsibilities.
It is also common to see head contractors accept more risks from principals in order to make secure work. If a head contractor does not accept the risk and demands of the principal, they fear the principal will simply shop around until another developer comes along and meets their demands.
As a result of accepting liability to an overload of risk factors, head contractors will in turn attempt to pass on this risk to the sub-contractors they engage. This system of ‘hot potato’ risk allocation is considerably dangerous for sub-contractors, who hold liability for a majority of a project’s risk whilst having little or no control over many of those factors.
A study of major construction contracts has confirmed these trends around the industry that:
- Risk clauses are being varied from those in standard contracts;
- Risks are not being allocated to parties best able to manage the risk; and
- Disputes and claims are becoming common as a consequence of poor risk allocation.
These scenarios are causing projects to spiral out of control and litigators often see small contractors hit with the brunt of coughing up huge costs for issues they had little control in.
Cash flow to Subcontractors
The issue of payment has forever been a prominent issue within the building and construction Industry, with head contractors likely to neglect making on time payments to sub-contractors.
The introduction of the Security of Payment Act was designed and intended to improve payments made by contractors to their sub-contractors. Despite the introduction of this Act, litigators often see claims made by sub-contractors trying to recoup payments owed to them. Often it is developers and head contractors who neglect their contractual payment responsibilities, leading to payments made outside the maximum allowed payment times.
A huge reason for these late payments is a seeming culture within the industry, in which sub-contractors fear taking action against head contractors or developers in a view that any dispute and conflict will extinguish future working relationships. Sub-contractors will not take legal action against their contractors so as to not lose the chance for future engagements.
With the presence of this underlying cultural issue within the industry, head contractors and developers will always feel they have the power in any working relationship and disregard their obligations smaller sub-contractors.
How to Address these Issues:
In order to address risk allocation and cash flow issues developers and head contractors simply need to negotiate contracts and act with good faith. As outlined above, negotiations stages of construction contracts are not carried out in good faith and are used as an attempt to pass on as much liability as possible. In turn, a majority of liability falls to sub-contractors creating a pool of unmanageable risks and causing the involvement of litigators.
There is a lack of responsibility currently within the industry and principals, developers and head contractors will use contractual negotiations as a way to create agreements heavily in their favour without thinking of the long-term project ramifications this could cause.
These parties need to have more responsibility and negotiate contracts in good faith before any of the issues outlined earlier in the article can be fixed. Fairness should be the key consideration by all parties during contract negotiations in order to effectively avoid risks allocated to parties who cannot feasibly manage them.
We at Keystone believe there may soon be a reset in the building and construction industry regarding the way projects are negotiated and priced. With more awareness, builders will become more prudent in what projects they agree to take on and how to manage the associated risks.
In a way to navigate through insolvency and other risk management issues, we believe the following mechanisms can assist parties involved in the construction and building industry:
Cost Plus Contracts
This type of contract structure sees a contractor pass on the costs for materials and services to a principal as they become necessary throughout the scope of works within the building and construction contract.
The benefit of a Cost Plus Contract structure is in its flexibility. Whilst costs for supplies and labours obtained by the contractor are passed to the principal, it is common for an agreement to be reached as to the contractor’s hourly rates and for the margin to work in between for price fluctuations.
Entering into a Costs Plus Contract requires careful contract drafting and also good faith and trust between the principal and head contractor.
“Rise and Fall” Clauses
Similar to the idea of the Cost-Plus Contract, Rise and Fall clauses provide that a contractor is able to pass on to the principal the fluctuations costs that occur during performance of the scope of works. Including such a clause can be important to give the ability to contractors to pre-order and claim payment for important materials at the outset of a contract.
These types of clauses have recently almost been phased out of building and construction contracts due to a lack of party responsibility and fairness involved in negotiations.
Rethinking Tender Evaluations
When conducting a tender evaluation, it is common for contractors to look to price as the most important aspect before engaging a supplier.
In order to ensure a smooth sailing during your project, Contractors need to also consider criteria points such as:
- Can the supplier adequately resource throughout the entire project?
- Can the supplier meet deadlines in delivering supplies?
- Is the supplier financially stable and able to provide the required supplies throughout the engagement?
Whilst price should always be a factor considered during a tender evaluation, conducting a tender evaluation to find the lowest price may leave contractors finding themselves in deep water if material supplies suddenly cease.
Be aware about the lack of harmonisation of Building Laws across Australia
There is a lack of harmonisation of Work Health and Safety Laws and Security of Payment Laws across the states and all parties involved need to be aware of differing legal obligations depending on a project’s location.
Such an example includes the definitions of “Construction work” differs between each state’s Security of Payment Law and therefore what amounts can be claimed under the Act.
Other differences include specific exclusions to amounts that can be claimed, what party can make an adjudication application claim, timing for service of payment claims, if there is a right to suspend works for non-payment, how adjudicators are appointed and maximum payment terms just to name a few.
Knowing the difference of rights between each jurisdiction can be crucial in order to effectively negotiate the timing of payment within a project’s contract.
More Early Contractor Involvement Arrangements
These types of agreements allow for a builder to get involved in a project early, provide their input and help plan for a project long before all design elements have been finalised.
These arrangements provide the primary advantage of getting the contractor’s feedback regarding design, material and overhead costs, potential risks involved, completion dates and overall expected profit returns. It is a great mechanism for parties to find ways to save costs.
Involving contractors early during a project can help refine projects and provide opportunities for responsibility to be shared amongst parties through collaboration and innovation.
Better allocation of risks between Principals and Contractors
As has been the common theme throughout this article, principals and contractors need to reasonably plan for a project’s risks and then allocate risks between parties in a fair manner.
For example, planning for what is to occur when there are delays caused by factors outside the control of the builder have recently been absent from building and construction contracts. We see this as a crucial risk factor that must be accounted for within contracts and provides a fair split of liability away from a builder when delays occur from something completely outside their control.
Furthermore, most contracts have recently gone as far as to exclude any entitlements for extensions of time or delay costs except for in breaches, acts or omissions of the principal. The issue here is that all costs associated with delays from common risks such as wet weather delays, supply delays and other unforeseen events causing delay has been placed with the builder.
Common sense and reasonableness should drive risk allocation negotiations. Having a builder be responsible for risks they cannot control creates opportunities for unnecessary claims and disputes to arise.
Key Take Aways:
It is evident that good faith negotiations are crucial in ensuring risk allocation between parties to a Construction Contract is fair to any given scope of works.
Cost Plus Contracts and Rise and Fall Clauses are two effective mechanisms in ensuring the management of insolvency risks due to increased material prices.
Well drafted and more flexible contracts are key to avoiding unexpected expenses and other risks that may arise that could see contractor’s profit margins reduced.
However, getting to a point where risks are fairly allocated requires the good faith from all parties involved.