Who will pay for rise in cost during construction?

Who will pay for rise in cost during construction?Sachin Kerur

There is evidence that we are facing inflationary pressures in many aspects of regional construction and real estate. While not as violent as back in 2006, there are concerns about rising input prices locally. For contractors and suppliers working in today's volatile materials market, estimating, bidding and financing major construction projects have become a challenge. Many face significant losses or erosion of anticipated profits because the majority are locked into fixed-price construction contracts where they bear the risk of increases in material price and supplier cost.

Without a clearly drafted price escalation clause that allows for an adjustment to the contract price if there is an unexpected rise in the market prices of key construction materials, a contractor will generally have a difficult if not impossible task in getting some form of respite from such increases. Even if the contract has become economically burdensome, that will not generally be sufficient legal grounds for performance to be excused. However, legal doctrines such as impossibility, commercial impracticability, frustration of purpose, and force majeure, all of which have much in common, require the facts to satisfy well established criteria.

For example, under most legal systems, a party may be excused from performing an obligation under a contract if performance becomes impossible because of an unexpected event. But legal casebooks are full of examples of the courts finding that the doctrine of impossibility will not apply simply because performance of the contract will be much more expensive than previously anticipated.

Buy time

A number of contractors wrongly believe in the ability of the force majeure clause in a contract to come to their rescue. This clause is inserted as a means to protect parties if part of the contract cannot be performed because of some exceptional event, which is outside the control of the parties and could not have been prevented by the exercise of reasonable care.

However, generally such clauses only allow a contractor additional time to perform. Therefore while a force majeure clause may give a contractor extra time to obtain materials that are in short supply, it is unlikely to assist him if he is forced to pay much higher material prices than he originally estimated in the contract.

Assuming owners are receptive to the idea of price escalation provisions, what considerations should the person drafting such provisions have in mind? The clause should identify the specific materials considered to be volatile and the unit prices for such materials at the date the contract is executed. Typically, the clause should provide that the developer will become liable for any price increases in those materials that cause the total contract price to be increased by a percentage agreed by both parties.

A sensible clause will set out notice periods for identification of price increases of materials. To avoid arguments later on, it will identify the class of documentation evidencing the increase, what events trigger an increase in contract price, what is the appropriate measure of market price, how many times the contract price can be increased, and what are the time periods covered.

If developers fail to respond to industry concerns and refuse to include price escalation clauses in bid documents and negotiations, contractors need to take steps to limit their exposure. It makes sense for them to deal with reliable and reputable suppliers.

When prices and availability become an issue, established suppliers are likely to be more accommodating in sourcing material at an economic price. Even when reliable supply chains have been established, contractors must ensure that commitments received from their suppliers mirror their obligations to the owners. Supplier quotes should be vetted carefully as they may have provided bids on materials that are now unavailable or have increased significantly in cost and contractors will not wish to be left picking up the tab.

Tune into the market

It is also important for contractors to tune into the local market. This way they will be more alert to developments that could impact future prices. Such market knowledge may suggest the need to buy materials in advance, which can bring its own problems such as draining cash flow and increasing storage and security costs. It may be a good idea to buy price-volatile material on getting the contract, perhaps negotiating delayed delivery times to avoid storage costs.

The business strategy of contractors may have to change. For example, it may be prudent to only bid on projects with short construction programmes that give prices less time to increase.

Where owner-developers insist on fixed-price contracts, it makes sense to instigate thorough design review processes aimed at encouraging value engineering, procuring reliable cost projections and complete engineering plans and specifications to limit excessive contingencies. Design and build procurement may also keep costs manageable as the contractor is likely to adopt design options that help minimise exposure to volatile materials markets. If the developer has established subcontractor and trade contractor relationships, these could be nominated to the contract. Developers may also wish to procure materials themselves directly and as early as possible, thereby limiting the contingencies that may otherwise arise.

Finally, for those contractors who have been successful in negotiating price escalation clauses into their contract, the story does not end there. Such a clause will typically have a series of notice and documentation protocols and these must be followed to the letter to be effective and to avoid accusations that bad purchasing practices by the contractor are to blame for price hikes.

Share risks

The truth is that courts generally do not like to allow someone to escape a contractual obligation. Fixed price construction contracts allocate risk and without a specific clause allowing for changes in prices, courts are generally insistent that a contractor must execute the work contracted at the price agreed. In the UAE, for example, the local courts are required by Federal Law to uphold agreements on price, provided they are not contrary to public morals or order.

If the current Gulf economic climate continues, tender prices for EPC contracts may soar and contractors will argue that the only way developers will get more competitive bids is to share more risk. That would mean adjustments in price for changes in cost where it would be unfair for a contractor to bear the risk of inflationary costs.

Read more: Legal hurdles turn onerous in stalled projects in Dubai

Source: Sachin Kerur, Special to Property Weekly

The writer is Head of the Middle East office at Pinsent Masons. He advises the government and private sector on procured infrastructure and development works, particularly across the region and India. In 2012 Kerur was listed among the 50 most influential figures in the Middle East construction industry by the region's construction publication, Construction Week. He is also listed in the Who's Who Legal's Global Construction Lawyers

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