Construction Industry - CMGuide

Flexible Arbitration Filing Fees Introduced by AAA

by Andrew Ness

While arbitration is often touted as being a less expensive alternative to litigation, the initial cost of initiating arbitration has always been considerably more expensive than filing in court. Typical filing fee in a U.S. court is a few hundred dollars, while administering authorities typically have filing fees in the thousands of dollars. The American Arbitration Association (AAA), self-described as “world’s leading provider of conflict management and dispute resolution services,” is known for its high filing fees that get progressively greater as the amount in dispute rises. But the AAA will now be providing claimants some relief on that front.

The AAA has initiated a new Flexible Fee Payment Schedule intended to provide cost-savings to claimants. The new option is a pilot program available on all cases filed under the AAA’s construction and international rules (as well as the commercial and employment rules) through May 30, 2010.

Here is how it works. Instead of paying a single initial filing fee, the claimant pays a smaller initial filing fee and then a “Proceed Fee” within 90 days. For example, for a construction claim of $1 million, the initial filing fee is $1,000 and the subsequent Proceed Fee is $5,600. The initial filing fee under the AAA’s standard fee schedule would be a single payment of $6,000. The Flexible Fee option is supposed to provide a cost savings, but the combination of the initial fee and the full Proceed Fee is higher than the single initial fee under the standard schedule. So, where is the cost savings? The answer is: the savings come only if the parties appoint their arbitrators without assistance from AAA. If the parties are able to agree on their arbitrators, there is a 50% discount on the Proceed Fee. So, in the example above, the combination of the initial fee and discounted Proceed Fee becomes $3,800 – a savings of $2,200 compared to the standard fee.

Procedurally, if the claimant elects to proceed under the Flexible Fee option, the AAA will notify the respondent of the demand and set the date for filing the answering statement and any counterclaim, but then does nothing more until the Proceed Fee is paid. The Proceed Fee must be paid within 90-days or the AAA will administratively close the file. This 90-day window is for the parties to agree on the appointment of the arbitrators. If they succeed, the claimant pays the discounted Proceed Fee, and the AAA proceeds with the arbitration. If not, the AAA will conduct its standard arbitrator appointment process once the full Proceed Fee is paid.

So the new option provides greater flexibility and offers the potential for cost-savings if the parties can appoint their own arbitrators. Where there is a high likelihood that the parties will not be able to mutually agree on the arbitrators and no immediate settlement is in prospect, the AAA’s standard fee schedule remains preferable. Complete details and a schedule of the fees under the standard and Flexible Fee options can be found at the end of the AAA’s construction industry arbitration rules on the AAA’s website (www.adr.org).

Todd Wagnon
Andrew Ness

Kluwer Construction Blog

Private works contract and the owner’s legal guarantee obligation

by Maxime Simonnet

Commentary on the decision rendered by the third civil chamber of the Cour de Cassation (French Supreme Court) on September 9, 2009

To protect the contractor from the risk of the owner’s insolvency, the law No. 94-475 of June 10, 1994 on the prevention and treatment of the difficulties encountered by contractors instituted the obligation for the owner to guarantee the contractor that the price of the ordered works would be paid.

This obligation, set out in Article 1799-1 of the Civil Code, concerns exclusively private works contracts, whose amount exceeds the minimum threshold fixed by the decree of July 30, 1999 at EUR 12,000.

It is mandatory, as Article 1799-1 of the Civil Code is public policy, and is materialized by a control mechanism of the payment of the loan financing the contractor’s contract, or, in the absence of a loan, by an obligation for the owner to provide to the contractor a specific guarantee.

In a decision rendered on September 9, 2009, the third civil chamber of the Cour de Cassation confirmed once again these various principles by recalling that the owner which enters into a private works contract must guarantee the contractor that the sums owed will be paid, no derogation being allowed.

Moreover and above all else, the Court recalled that the owner is liable for this payment guarantee obligation as from the execution of the works contract, the owner being unable to postpone it or make it conditional.

In this case, an owner had engaged a private contractor to renovate hotel rooms.

The owner had placed three service orders with its contractor, subject however to the latter providing to the owner a bank guarantee for the total amount of the works (considering its wish to subcontract the contract).

The contractor’s bank, for its part, agreed to provide it with this guarantee, but subject to the contractor obtaining from the owner a joint suretyship guaranteeing the payment of the contracts, in accordance with Article 1799-1 of the Civil Code.

Confronted with this request from the bank, the owner notified its contractor that the service orders were null and void on the grounds of the failure to meet the condition precedent to obtain the bank guarantee.

Having had its claims for the payment of various down payments and damages dismissed in first instance and in appeal, the contractor lodged an appeal before the Cour de Cassation.

Referring to paragraphs 1 and 3 of Article 1799-1 of the Civil Code, the Cour de Cassation quashed the decision of the Court of Appeal and granted the contractor’s claim.

Because, as from the execution of the contract, the owner was indeed liable, under Article 1799-1 of the Civil Code, for its legal guarantee obligation, without being able to condition it on the provision of a guarantee by the contractor.

By Maxime Simonnet and Chloé Niedermaier

Kluwer Construction Blog

Construction Industry, Construction Law, Contract Administration

Tales Of The Unexpected: Where Liability Lurks Unseen #3

by Melanie Grimmitt

Recap

After a diversion a fortnight ago to address the newsworthy events in Dubai, normal service resumes with this blog. The previous two blogs in this series considered decennial liability and liability for harmful acts under UAE law.

This blog will briefly consider whether it is possible to limit liability under your contract eg by including liquidated damages provisions, and whether the courts will give effect to such a provision.

Limiting liability

On the face of it there seems clear evidence that it is possible to limit liability under a contract – take a look at Article 390(1) of the Civil Code.

However, it is not so certain that such a limitation will be upheld. In fact, the very next provision of the Civil Code (Article 390(2)) suggests that a judge may vary a clause seeking to fix compensation in advance so as to make the compensation fit the amount of loss suffered in the particular circumstances. Not exactly what contract drafters from common law jurisdictions will have expected!

But our contract is commercial not “civil”!

Some commentators have argued that the Civil Code does not apply to commercial contracts, and that therefore parties to commercial contracts can afford to ignore this possibility. This view is based on previous court decisions where the court has declined to apply the Civil Code to commercial contracts. Such a position would accord with English law where additional protection is given to consumer contracts, but where commercial parties who have equal bargaining power have far greater freedom to determine the apportionment of risk and liability between them.

However there is also plenty of case law where the courts have applied the Civil Code to commercial contracts. So better to err on the safe side and assume that this provision is relevant to commercial contracts.

No excuse for fraud or gross negligence anyway

In addition, even were it to be found that the Civil Code did not apply to commercial contracts, the courts would still be likely to interfere with any purported limitation of liability for fraud or gross negligence on public policy grounds.

When will a judge interfere and how?

There is no express guidance in the Civil Code as to the circumstances in which the court will exercise its power under Article 390(2) to adjust the measure of damages to reflect the actual loss. So far as I am aware, even Egyptian law, on which UAE law is in large measure based, only provides guidance on when a fixed amount of compensation may be reduced, rather than when it may be exceeded. Interestingly a similar provision under Bahraini law (also based on Egyptian law in large measure) expressly only refers to a reduction in the amount of fixed compensation where it can be established that no loss has been suffered or the amount fixed was grossly exaggerated (not far from “genuine pre-estimate of loss” perhaps, albeit that the test for genuine pre-estimate of loss is applied at the time the damages are fixed rather than when the loss is suffered).

However, it is possible to draw conclusions as to the application of Article 390(2) from general principles inherent in UAE law that relate to the conduct of parties to a contract. On this basis the courts would be more likely to adjust (or ignore) a limit on liability if the harm results from, for example, conduct by a party which is contrary to good faith, or an act which is wrongful or deliberate.

What to do?

Perhaps the best advice is to adopt the usual methodology to liquidated damages clauses and other “fixing” of liability clauses which would be adopted in common law jurisdictions: make sure the fixed compensation is actually likely to reflect the loss which will be suffered, rather than a windfall gain. And if you receive a claim for what you perceive as a windfall gain, don’t assume you must pay it even though the sum is clearly due under the terms of a contract – there might be grounds for challenge.

Kluwer Construction Blog

Construction Industry, Construction Law, Contract Administration

Issues involved in Taxation of Construction contracts

by Sujjain Talwar

There is a lot of mystery regarding taxation of Construction activities in India. The mystery starts from the fact that a Construction contract involves both labour and material and hence, both Service tax and Value Added tax is levied on one transaction.

The process becomes more complex depending upon a number of factors such as the Scope of work, the nature of the contract, whether the contract includes any further sub-contracting, whether individual prices have been specified for each part of the scope of work and whether the contract involves off-shore and on-shore activities etc.
Let us first consider the Indirect taxes applicable on a Construction contract. As already stated above, a Construction contract involves both labour and materials. Hence, a Construction contract is liable to both Service tax and Value Added tax.

…

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Construction Industry, Procurement Management

Contractor risk in the Gulf’s ‘new wave’ of EPC contracting

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by Sachin Kerur

With global business headlines currently dominated by debt restructuring issues facing Dubai World, the Gulf region is again subject to the negative gaze of the West. Despite this, the UAE and the broader Gulf region is likely to be a fertile region for major international contractors over the coming years.
Imminent infrastructure projects in the Gulf, as well as the current one, will provide major contractors with opportunities when global pickings are slim. However, contractors are already facing, and will continue to face, an increased transfer of risk combined with compressed margins in respect of new infrastructure projects and EPC contracts. …

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Construction Industry, Contract Administration

The Foreign Project Consultant as Jian Li

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by Hew Kian Heong

Many years ago, I saw a Chinese construction contract for the first time, and there was mention of a person called a “Jian Li” in the contract. I asked myself – what strange creature is this Jian Li?

The literal meaning of Jian Li in Chinese is “project supervisor” and it refers to someone engaged by the owner to supervise the contractor on matters like construction quality, progress of works and cost control. The Jian Li’s main role is really to ensure that a project is constructed safely and to the quality standards as required under law. The appointment of a Jian Li is mandatory for certain types of construction projects in China, for example projects funded by international development agencies, infrastructure projects and public utilities projects.

The concept of a Jian Li in China originated in the 1980s, early years in China’s transition to market economy. In those days, it was common practice for employers to manage construction projects on their own without any external professional support. The obvious problem was that inexperienced employers often ended up with projects with quality problems because the contractors were not properly supervised or managed in their work. Poor quality buildings and works were a major headache for the industry. The introduction of a Jian Li was part of an effort by the government to resolve this problem. Although appointed by the employer, the Jian Li is primarily intended to play a statutory role similar to that of an independent checker of works which we see in many countries.

In the last three decades, we have seen a massive influx of foreign investors relocating their manufacturing operations to China. Factories were and continue to be put up all over the country at an amazing speed. Most of these factories were built and will continue to be built by local Chinese contractors. Foreign contractors have not been able to get a foothold in the Chinese construction market due to a variety of reasons including restrictions on market entry, the tough requirements to obtain and maintain a contractor’s license and most importantly the inability to compete with the local Chinese contractors on pricing.

However, many foreign investors who are new to China are not used to working with the local Chinese contractors. They do not know for sure if the local Chinese contractors will build their factories in China to the same standards as their factories elsewhere. They therefore often look to the foreign contractors or construction professionals that they have used elsewhere to build their factories for help in managing or supervising the construction of their projects in China.

Many foreign contractors and construction professionals have come to China with the objective of servicing the foreign investors. Many of them have in fact followed their clients to China. Most of these foreign contractors and construction professionals have chosen to set up “project consultancy” companies employing both foreign and Chinese construction professionals. The business that a project consultancy company is licensed to undertake is however fairly limited, but it is relatively easy and cheap to set up. Although not ideal, with the right contract structures, these project consultancy companies have been able to service their clients’ needs adequately. Many become involved from the very start of a project, helping their clients with site selection and due diligence, right up to the ultimate delivery of the completed project to the clients.

On many projects, one would often find the foreign owner appointing a Jian Li as well as a project consultant. The project consultant’s role is usually wider than that of the Jian Li but it would invariably also involve ensuring that the project is built to the correct standards and quality. The Jian Li is however primarily concerned with ensuring that statutory standards and quality are met andthe project consultant is concerned with ensuring that contractual standards and quality are met. Although statutory and contractual requirements often overlap, the former are often less stringent than the latter. This gives rise to a risk that the Jianli and the project consultant in performing their respective supervision duties on a project may give inconsistent messages to the contractor if they are not properly coordinated.

One would have thought that it would be more efficient for one party to perform the duties of both the Jian Li and the project consultant. Most owners would certainly prefer a single point of responsibility. It would at least avoid any inconsistency in performance of their respective duties. For a long time, this was not possible. To set up a Jian Li company, one has to be licensed by the construction authorities. Before 2007, foreigners were not allowed to set up or acquire interest in a Jian Li company.

On 26 March 2007, the Regulations on the Administration of Foreign-invested Construction Service Enterprises was introduced which allows foreigners to set up or acquire interest in Jian Li companies. This was part of China’s effort to fulfill its World Trade Organization commitment to open up the construction engineering services sector. However, despite the Regulations, the market has not seen the setting up of many foreign invested Jian Li companies. Why is this?

I can think of a few reasons. I suspect the main reason is the regulatory limitations. Similar to construction and design companies, Jian Li companies must obtain Skill Qualifications Certificates (SQCs) from the construction authority before they can carry out business. The SQCs are classified into several grades which determine the size and scope of the projects that the holder is permitted to work on. A newly set up Jian Li company is only allowed to apply for the lowest grade of SQC and has to wait for at least two years to apply for a higher grade. This is obviously not appealing to foreign investors as it will take too long before they are able to upgrade to a SQC that will allow them to undertake the bigger projects that they desire.

Local protectionism may also be a factor hindering the growth in numbers of foreign-invested Jian Li companies. One of my clients recently complained to me that his proposal to acquire a Chinese Jian Li company was rejected by the local construction authority. I asked him about the reasons for the rejection. My client said that he believed the real reason was that the authority is keen to protect the local Jian Li companies from foreign competition. The official response from the local construction authority was that the review of our client’s application could not take place because the central construction authority has not issued any detailed implementation rules for the Regulations yet. And so we wait…

Kluwer Construction Blog

Construction Industry, Contract Administration

Chinese Drywall Update – Chinese Manufacturer Waives Hague Convention

by Andrew Ness

Problems with drywall imported from China during the ill-fated U.S. housing boom continue to be front and center in the southeastern U.S., as complaints continue to roll in regarding health problems allegedly caused by the tainted wallboard, as well as damage to electrical and plumbing work. Naturally enough, a significant litigation boom has followed, including attempts to bring claims against the Chinese manufacturers who supplied the drywall. In a recent development, Knauf Plasterboard (Tianjin) Co., Ltd (“KPT”), a leading defendant in the consolidated federal court lawsuit against manufacturers of Chinese drywall, has agreed to accept service of process for homeowner plaintiffs who are named in an Omnibus Class Action Complaint, and to waive its right to demand service of process through the Hague Convention (saving plaintiffs the $15,000 service fee).

According to the November 2, 2009 Order of United States District Court Judge Eldon E. Fallon, KPT’s offer was only available for a limited time to those homeowners capable of providing the required documentation. Homeowners had to sign up for the class action by December 2, 2009 and provide photographs, inspection reports, or other proof of KPT drywall in their home to Plaintiffs’ Lead Counsel. Plaintiffs also have to submit a fully completed and executed Plaintiff Profile Form to Plaintiffs’ Liaison Counsel by December 14, 2009. The offer applies only to the consolidated federal litigation. KPT has not agreed to waive its right to effectuate service through the Hague Convention in any other civil action.

Kluwer Construction Blog

Construction Industry, Contract Administration, Sustainability

Ppp Projects In Brazil: 2) General Concepts And A Comparative Comparative View Between Ppp And Concession

by Júlio César Bueno

Continuing our last discussion on PPPs in Brazil, we should note that PPP LAW applies to government entities (including mixed-capital companies) directly or indirectly controlled by the Federal Government, States, Federal District and Municipalities. Article 2 of PPP LAW defines PPP as follows: “Public-Private Partnership is an administrative concession contract that may assume the form of either a sponsored or an administrative concession contract.” PPPs are expected to be implemented concurrently with existing concession contracts, focusing on infrastructure projects. PPP LAW provides for sponsored concession and administrative concession.

The administrative concession is defined in Article 2, paragraph 2 of PPP LAW as a “service agreement in which the government entity is the direct or indirect user, even if such agreement involves performance of works or supply and installation of assets.” This type of concession is governed by PPP LAW, by Articles 21, 23, 25 and 27 through 39, of Law No. 8987, 1995 [FED. LAW 8987], and by Article 31 of Law No. 9074, 1995 [FED. LAW 9074]. An administrative concession contract is that by which government entities delegate performance of a public service to a private company. Such private company will develop the activity for its own account and at its own risk for the period and on the conditions agreed in the respective contract. In administrative concessions, services are directly or indirectly provided to government entities. For instance, the government entity may open competitive bidding procedures for the construction and operation of hospitals and prisons.

The sponsored concession, as defined in Article 2, paragraph 1, is “the concession of public works or services as dealt with in FED. LAW 8987 when it involves, in addition to the fees charged to users, payment of a compensation from the public partner to the private partner.” A sponsored concession is actually an ordinary concession in which the State gives some type of consideration. This type of concession is governed by PPP LAW by FED. LAW 8987 and related legislation. A sponsored concession may be adopted, for instance, in the cases of railways and highways in general.

Article 2, paragraph 3, of PPP LAW expressly stipulates that “the ordinary concession, i.e. the concession of public works or services as dealt with in FED. LAW 8987, will not be considered a public-private partnership when it does not involve payment of compensation from the public partner to the private partner.” Reflecting a general concern about the manner in which PPPs are to be conducted, PPP LAW also lays down the following guidelines:
(a) Efficiency in complying with the State’s missions and in using the company’s funds (due care in the use of the public funds invested in the activity);
(b) Respect to the interests and rights of service users and of the private entities charged with performing the services;
(c) Non-transferability of regulatory and jurisdictional duties, the exercise of police power and other activities inherent to the State;
(d) Fiscal responsibility in the execution and performance of partnerships, as Article 10, I(b) of PPP LAW stipulates that the rules set out in FISCAL RESPONSIBILITY LAW must be observed;
(e) Transparency in procedures and decisions;
(f) Objective sharing of risks between the parties; and
(g) Financial sustainability and socioeconomic advantages of PPP projects.

These guidelines mirror the spirit of care the legislator wishes government entities to adopt when contracting PPPs, reminding them of certain principles and concepts already contemplated by the legislation applicable to contracting of works, services, and other items by government entities with companies of the private sector.

Generally speaking, PPPs operate as an arrangement between the public and private sectors for execution of works originally entrusted to public concerns, which lack funds and/or expertise. As far as this concept is concerned, PPPs and ordinary concessions may seem to be very similar this is not necessarily true.

Even though both PPPs and ordinary concessions are administrative contracts between the government authorities and a private entity, more specifically concession contracts in a broad sense – concession contracts, in their broad sense, comprise all those in which government entities delegate the provision or performance of services (whether or not preceded by public works) to a private entity, which will perform the activities inherent to the services and assume the business risk under the contractual conditions. Prevalence of the public interest and an assurance of the original economic and financial conditions also constitute essential characteristics of concession contracts – there is a substantial difference between them: while in ordinary concessions, regulated by FED. LAW 8987, the compensation obtained by the contracted concessionaire (private entity) always originates from the service users only, in PPPs the compensation is fully or partially paid by the public partner to the private partner. In sponsored PPPs, the compensation received by the concessionaire from service users is, in principle, supplemented by the compensation paid by the public entity to the private entity, whereas in administrative PPPs all the compensation is paid to the private partner by the contracting public entity itself – Article 2, paragraphs 1 and 2, and Article 6 of PPP LAW.

In other words, PPPs are slated for services and/or public works that do not generate sufficient compensation to the contractor (e.g. expansion and management of highways or railroads with few users) or that do not even involve payment of fees by their users (e.g. construction and management of penitentiaries or public hospitals). Therefore, in addition to dealing with cases requiring investments and/or specialization beyond the possibilities of the public entity, PPPs have another specific characteristic: the venture itself is unable to pay off. These are the basic differences between PPPs and ordinary concessions, and should serve as guiding principles in bidding procedures, analysis of proposals and, particularly, concession contracts regulating PPPs.

Unlike ordinary concession contracts, PPP contracts are subject to more extensive and complex regulations: in addition to traditional clauses such as contractual term (which is considerably longer), PPP contracts must provide for rather specific aspects difficult to be expressed in few general terms. Therefore, PPPs cannot adopt near-standard draft concession contracts, which are mostly adhesion contracts.

The methods of compensation and the guarantees tendered (guarantee fund, insurance, etc.) by the public entity to the contractor, the risk sharing between the parties, the possibility of transferring the special purpose company (a legal entity incorporated to enter into PPPs) to financiers in case of default, the definition of performance evaluation criteria in accordance with the contractual term, among others, will be a matter of concern of those involved in drafting and negotiating PPP contracts. Certainly, this will require a more active involvement of bidders in drafting the contracts, which might result in an ample and detailed document, very probably in similar terms of common law contracts. This obviously strengthens the importance – after the phase of comparative law examination – of studying in advance examples of successful PPP contracts abroad, particularly the pioneering PPP contracts in England.

Having described the fundamental differences between PPPs and ordinary concessions, it is worth dealing once again with their contractual similarities. Both are kinds of administrative concession contracts. For this reason, PPP LAW expressly provides that PPP contracts must meet the general requirements of FED. LAW 8987 for ordinary concession contracts, such as: tariff adjustment mechanisms; methods and standards for service evaluation, expansion and inspection; indemnity calculations; users’ rights and duties; and periodical rendering of accounts by the private party to the public party. As a consequence of this legal provision, the caution taken when drafting PPP contracts must be redoubled, i.e. FED. LAW 8987 must be observed, insofar as applicable, and PPP LAW must be fully observed.

Generally speaking, once this new channel of investments is opened, there are very positive prospects of its use and results. However, it is important to stress the relevant and specific features (which have only been outlined above) of PPPs vis-à-vis ordinary concessions, notably when it comes to the careful drafting of PPP contracts. Hopefully, publication of the PPP LAW will catch the spirit of such date, not only confirming the expectation for a successful future, but also contributing toward a solid and continuous growth cycle in Brazil.

Kluwer Construction Blog

Construction Industry, Contract Administration

A Convenient Ending

by Joel Heard

Recent examples illustrate clearly that cancelling a project can be very expensive. The City of Ottawa recently paid over C$36 million to settle claims from contractors arising from the cancellation of a light rail transit project. In Montréal, the termination of a contract to build an incinerator has resulted in years of costly litigation and a large court award against the municipal defendants (which they have appealed). …

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Construction Industry, Contract Administration

Dubai World restructuring and PPPs in the Gulf

by Melanie Grimmitt

The news of the requested standstill period for Dubai World debt repayments has left those of us who advise on Public Private Partnership (PPP) projects in the region wondering what it will mean for us……

Why is it relevant for PPPs?

As most readers of this blog will be aware, PPP projects are usually largely funded by debt borrowed by a Special Purpose Vehicle (SPV). The SPV uses the money to build an asset gets paid by the public sector for the provision of services or utilities connected to that asset over the long term. The payments to the SPV come from the relevant public authority to whom the services/utilities are provided eg the schools authority, or the power offtaker.

So you can see that for the lending banks and the shareholders in the SPV (Sponsors) it is important they are comfortable that the government entity responsible for the payments necessary to repay the debt will make those repayments.

PPPs have been planned in the region for rail projects, road projects, power projects, desalination projects, wastewater projects, schools projects…..The region is looking to PPP to fund urgently needed and critical infrastructure.

Tough times already

PPP projects in the region had already been hit hard by the global economic crisis, with a number of large projects being financed on an expensive short term basis until lending conditions improved.

However, at the regional gathering of the International Project Finance Association in Abu Dhabi on Wednesday afternoon, shortly before the Dubai World story broke, and a day after the successful financial close of the USD1 billion Zayed University project by Mubadala, it was generally thought that 2010 would be the start of the upturn. What a difference a day makes…

Or will it?

Can Banks and Sponsors draw a distinction between the Dubai World story and government debt? As the media in this part of the world is emphasising, Dubai World is a government related entity and not the Dubai government. In addition, in PPP transactions in the region it is very common for banks to insist on state guarantees anyway as they very keenly aware of the financial covenant of the ultimate re-payee of their debt. Therefore, perhaps theoretically, it should be business as usual.

However, there is concern already that it might not be that straightforward. Worries about the fragility of the Dubai economy have led to worries about repayment of debt from other countries, and Abu Dhabi may suffer if it doesn’t stand behind Dubai, as it may be argued it allowed investors to believe it would.

A rethink in the air

It may be for this reason that The National, a local newspaper based in Abu Dhabi, yesterday ran a story that actually Dubai World may still pay that Sukuk…..

Kluwer Construction Blog

Construction Industry, Construction Law, Contract Administration

Freedom of contract meets its match: Pay If Paid Clauses

by Andrew Ness

Cash-flow from lender to owner to construction manager to subcontractors is the lifeblood of any construction project. And maintaining a sufficient flow of funds is essential to every construction manager’s ability to manage the job. Contract provisions requiring a contractor or subcontractor to continue to work, even if the right to payment is disputed, mean little to the fate of the project if subcontractors cannot meet payroll.

As a consequence, who will bear the risk of non-payment has becomes a frequent negotiation point, particularly so during periods of economic uncertainty. Imagine that two sophisticated corporations spend thousands of dollars and hundreds of hours of the best legal talent available to negotiate a contract for the construction of a large project to be located in the United States. The negotiations are lengthy and contentious; they are the very definition of ‘arms-length’.

As with all negotiations, the give and take often involves an adjustment to the contract price in exchange for amendment of a certain risk allocation or other material term. At the end of the long process a final deal is struck and the contract is executed. Imagine further that as part of the negotiations, the contract price was increased in exchange for a “pay-if-paid” clause, i.e., a clause that says the construction manager has no obligation to pay the subcontractor for work, unless the owner first pays the construction manager for that work. Under these circumstances, where there is no reason to question the validity of the contract, it would be natural under general principles of U.S. contract law, where “freedom of contract” supposedly reigns, to expect that all of these contract provisions would be enforced as written.

But the aforementioned negotiations involved a third-party. A party that was silent during all of the negotiations, but who gets the final say regarding every provision she wants to influence: public policy. And in some states, public policy will invalidate a provision to share the risk of non-payment through a ‘pay-if-paid’ clause.

In New York, for example, the Court of Appeals (New York’s highest court) has held that a “provision which forces the subcontractor to assume the risk that the owner will fail to pay the general contractor is void and unenforceable as contrary to public policy.” West-Fair Electric Contr. v. AETNA, 87 N.Y.2d 148 (1995). The basis of the Court of Appeals decision was New York State’s mechanics’ lien law, which provides that subcontractors have the right to file a lien against real property to which they have contributed manpower or material to improve. Because a pay-if-paid clause threatened that right, such clauses were found to be contrary to public policy. So much for freedom of contract!

Kluwer Construction Blog

Construction Industry, Contract Administration

How “Fit” is your Contract?

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by Sarah Thomas

As lawyers, we want what is best for our client. We will fight for that additional clause or that tricksy wording that will give our client that added protection that may, someday, prove decisive in an argument with the contractor or the employer.

One issue that lawyers often fight quite savagely over (but in that overly courteous way beloved of lawyers) in construction contracts is the inclusion or exclusion of a fitness for purpose obligation on a contractor or architect. But do we know what we are fighting over? What will happen if fitness for purpose is not expressly included? And what is the real effect of including a fitness for purpose obligation? Will it be implied into your contract anyway? How does this affect insurance?

Reasonable skill and care

In English law, in the absence of an express or implied fitness for purpose obligation, designers are required to exercise reasonable skill and care in their design. This means that the design must meet the standard expected of a competent professional designer. So, why not rely on this standard of care? Why do employers spend many hours arguing with contractors, insisting that they accept a fitness for purpose obligation rather than a reasonable skill and care obligation?

The simple answer is that fitness for purpose is a stricter and tougher obligation for the designer to meet. A reasonable skill and care obligation essentially requires an employer to prove that the designer has been negligent. This requires the employer to show that the design fails to measure up to the standard of a competent professional designer.

But how does the court decide what the standard of a competent professional designer would have been? Well, as with a great deal of legal questions, the answer will, unhelpfully, depend on what a competent professional designer would have done in the circumstances. This question will need to be decided by a judge or arbitrator, taking into account evidence from expert witnesses. This subjective element of the standard of reasonable skill and care, and the need to prove that what has been designed is below that expected in the industry, is one of the principal reasons why many employers push for a express fitness for purpose obligation.

Fitness for purpose

The contractor’s acceptance of a fitness for purpose obligation effectively means that that it is guaranteeing that the design will meet the requirements (whatever they may be) of the employer. That being the case, the employer merely needs to prove that the completed building does not work as intended; there is no need to show that the design has been negligent. For example, if an architect were asked to design an office building, and within that building the suspended stair that was part of that design was found to shake when used, then the employer would only have to establish that the stair shakes when used. The onus would then be on the architect to demonstrate that its design was indeed fit for purpose but the stairs were not constructed as designed – e.g. the steel or glass used in the stair were not as specified. However any argument that a reasonable architect, exercising skill and care, could not have foreseen the failure of the stairs when used in this way would, where there is a fitness for purpose obligation, fall on deaf ears.

Similarly, where a fitness for purpose obligation is subsumed into a contract to design and build say, a desalination plant, then that contractor is normally guaranteeing that, once constructed, the plant will be able to produce, say, 10,000 litres of clean drinkable water per day. If it fails to do this, in that the plant can only produce 5,000 litres of clean water, or if it produces 10,000 litres of water that is not drinkable, then the contractor has failed to build a plant that is ‘fit for purpose’.

Of course I appreciate that in most design and build contracts of this nature the performance guarantees are spelt out anyway – so why the addition of express fitness for purpose? The employer is already effectively guaranteed that the end product will meet its needs by the inclusion of performance tests and guarantees.

What’s your purpose?

What both parties must be wary of is whether or not there is a clear indication in the contract as to what the employer’s purpose actually is. In the absence of a clear statement as to the employer’s purpose, the intended purpose will usually be assessed and determined by a court or arbitrator based on the facts. This places additional onus on the contractor to push for inclusion of a stated purpose or employer’s requirements and then to scrutinise them to ensure that the purposes are narrowly and specifically defined. For the employer such an “open-ended” clause gives him comfort that the contractor may still have to meet wider purposes of the building or plant that are not necessarily spelt out in the contract in the performance requirements. Thankfully for contractors, a number of those standard forms that still use express “fitness for purpose wording” nevertheless tie it to purposes expressly set out in the contract. For example, clause 4.1 of the FIDIC Silver, Yellow and Gold Books (Conditions of Contract for EPC/Turnkey Projects, Design and Build and Design Build Operate) contains the following provision:

“When completed, the Works shall be fit for the purposes for which the Works are intended as defined in the Contract.”

So, we have a clear and explicit fitness for purposes obligation placed on the contractor but tied to the purposes “as defined in the Contract”. The parties just need to be clear where these are in the Contract and (certainly for contractors) that they are narrowly and precisely defined.

Implied purpose

There is the potential (at least under English law) for a fitness for purpose obligation to be implied into a contract, absent an express fitness for purpose obligation. Where a contractor is tasked with carrying out all the design under a design and build contract, a fitness for purpose obligation will often be implied into the terms of the contract (George Hawkins v. Chrysler (U.K.) Ltd. (1986). Also see the Supply of Goods and Services Act 1982 (UK) which sets out that, when a customer indicates (expressly) that goods are wanted for a particular purpose, or where it is obvious (implied) that goods are suitable for a particular purpose, and a seller supplies them to meet that requirement, the goods should be fit for that specified purpose). Contractors unwilling or unable to take on a fitness for purpose obligation in their design and build contract should therefore look to include wording which expressly excludes fitness for purpose.

As to whether a particular Civil Law jurisdiction will imply a fitness for purpose or similar obligation on a contractor in a design and build contract will very much depend on the codified document setting out the law in that jurisdiction. For example, the German Civil Code includes a provision which implies that a contractor will provide a product that is fit for its intended purpose, while under UAE Civil Law there is no implied fitness for purpose requirement.

Fitness for purpose and insurance: The elephant in the room?

One of the main reasons why fitness for purpose obligations are often fought over so vehemently, is due to the impact that such an obligation has on the designer’s professional indemnity insurance. The vast majority of PI policies available to contractors and architects contain express exclusions such that any assumption of a fitness for purpose obligation will result in the designer not being covered under the PI policy.

So how do you deal with this issue of PI insurance dictating the risk allocation of your contract?

One technique that employers have used when faced with this scenario, is to remove any explicit reference to fitness for purpose from their contracts. For example an employer could amend clause 4.1 of FIDIC Yellow or Silver Books with something along the following lines:

“When completed, the Works shall comply in all respects with the requirements of the Employer as defined in the Contract.”

It is interesting that the more recent IChemE International Form of Contract (First Edition 2007) adopts this approach, recognising the problem with using explicit fitness for purpose wording – see for example clause 3.4 of “The International Red Book”.

The advantage of using the above wording from an employer’s point of view is that it has the same power and effect of a fitness for purpose clause, without the stark (and easily identifiable and word searched) term ‘fitness for purpose’. Contractors, on the other hand, should be wary of this type of ‘fit for purpose by stealth’ approach, particularly if their PI policy excludes cover for fitness for purpose. They may look at extending their PI policy in this instance, or alternatively they should look at counterbalancing the risk taken by seeking to limit their overall liability under the contract.

Your experience?

So, what has been your experience with fitness for purpose clauses? Do you push for their inclusion, or push for their exclusion? How have you balanced the competing forces of a fitness for purpose obligation with the strict terms of an insurance policy which excludes their use? All comments welcome.

Kluwer Construction Blog