Draft hybrid contract with care

By Martin Preston

TYPICALLY, the contract price under a construction contract will either be a lump sum or cost reimbursable.

Under a lump sum contract, the contractor is required to provide a fixed price for carrying out and completing the scope of work. The risk that the cost of completing the works is more than the lump sum price sits with the contractor, who will only be entitled to be paid more than the lump sum price if the employer varies the scope of the works or delays or obstructs the contractor in carrying out the works.

By contrast, under a cost reimbursable contract, the employer takes the risk of the cost of completing the works being higher than initially anticipated. This is because the contractor is paid its costs (either on the basis of rates or on an open book basis) plus an element of profit. If the cost of completing the works escalates because of, for example, unforeseen ground conditions the additional cost is borne by the employer.

From an employer’s perspective, it is clear that a lump sum contract will usually be preferable as this provides cost certainty (in the absence of variations and/or employer delays) and the risk that the scope of work costs more than the contract price to complete is with the contractor, who is likely to have more expertise than the employer in pricing jobs.

However, where the scope of works cannot be fully identified at the outset, it may not be possible to agree on a lump sum price before the contract is entered into and, even if a lump sum price is proposed by the contractor, it may not be in the employer’s best interests for a lump sum price to be agreed as the contractor will need to include a large contingency to cover the risk it is taking in relation to the as-yet unidentified scope. In these circumstances, a cost reimbursable contract is likely to be in the best interests of both parties.

Notwithstanding the fact that there may be circumstances in which a cost reimbursable contract may be preferable to a lump sum one, most employers are uneasy about the potential cost escalation under pure cost reimbursable contracts and may also be concerned that there is no incentive on the contractor to minimise and/or control costs to the extent reasonably possible. The solution to this is a hybrid of the two approaches, the guaranteed maximum price contract.

Under a guaranteed maximum price contract, the contractor is paid on a cost reimbursable basis up to the guaranteed maximum price. There is usually a sharing of any savings below the guaranteed maximum price, generally on a sliding scale so that the greater the saving the greater the proportion retained by the contractor, in order to incentivise the contractor to control costs.

One point that does need to be emphasised is that a guaranteed maximum price contract does not mean that there can be no adjustment to the contract price if, for example, variations are ordered by the employer or the employer delays the contractor. In these circumstances, there should be an adjustment to the guaranteed maximum price to prevent out of scope work being valued by a court or arbitrator rather than under the contract.

A recent case law from the English courts highlights the need to ensure that a guaranteed maximum price contract is adequately drafted. AMEC Group versus Secretary of State for Defence [2013] EWHC 10 (TCC) concerned the construction of a facility for nuclear submarines on the Clyde in Scotland. The contract was drafted on the basis that the parties would share cost savings and overruns up to the agreed maximum price, which was originally £89 million ($139.748 million). Changes to the scope of works had increased the agreed maximum price to £142 million ($223 million) and the guaranteed maximum price clause was drafted so that if costs exceeded that amount, they were borne by the contractor up to a cap of £50 million ($78.5 million). In the event, the cost overrun exceeded £50 million ($78.5 million) – something that had not been provided for in the contract – and the Disputes Review Board (whose decision was being challenged in this case) had to decide how costs in excess of the cap were to be allocated.

The contractor argued that once the £50 million ($78.5 million) cap was exceeded, it was entitled to all of the costs in excess of the cap, irrespective of how they were incurred. The employer’s position was that, once the cap was exceeded, it was not liable for the payment of any additional costs or, alternatively, that it was only liable to pay the contractor for any additional costs that were reasonably and properly incurred.

The Disputes Review Board determined, on a unanimous basis, that the employer was liable to pay costs once the £50 million ($78.5 million) cap was exceeded. On a majority basis, it was decided that the contractor could only recover costs that were reasonably and properly incurred. Entitling the contractor to recovery of all costs incurred above £50 million ($78.5 million) would, the majority decided, have enabled the contractor to seek recovery of costs arising out of its own breach of contract. The contractor sought leave to appeal the board’s decision under section 69 of the Arbitration Act 1996 on the basis that the board had erred in law in deciding that once the cap was exhausted the contractor was only entitled to additional costs that were reasonably and properly incurred. The contractor’s leave to appeal was refused as the Disputes Review Board’s decision was not “obviously wrong”.

The court criticised the guaranteed maximum price clause in this case as having been “badly worded” and this case demonstrates the need for the parties to a contract (be it a guaranteed maximum price contract or not) to ensure that the terms of the contract fully reflect what they have agreed. It may well be in this instance that the parties fully expected any cost overruns to come within the  £50 million ($78.5 million) cap but a good draughtsman would have realised that the contract did not identify who would be responsible for costs in excess of the cap and that the parties should have been consulted at the time of drawing up the contract as to how this would be addressed so that the contract fully reflected their wishes and did not leave any room for costly disputes as was the case here.


Gulf Construction

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