Top 10 Construction Contract Concerns
What are the clauses that can quietly make or break a construction project?
The reality of commercial construction contracts in Australia
Commercial construction contracts are long. Really long. Even the ones for small jobs. Perhaps it’s no wonder then that many principals and contractors don’t like reading them.
Actually, you might be surprised by how often parties don’t read their construction contract before they sign it (or at least, not properly). While doing so is, of course, very important for all parties, if you’re the contractor, it’s absolutely critical. If you don’t, then you really don’t know how much it’s likely to cost you to build the project and whether you’ll make any money in the process.
A construction contract isn’t just an agreement to perform construction work for a certain price, a certain quality and within a certain time. It’s also an agreement about who is going to foot the bill when things go wrong. All construction projects involve risks to one degree or another. Take the following, for example:
- delaying events, like weather;
- site conditions;
- defects in design, manufacture or workmanship;
- buildability issues;
- changes to the scope of the work (variations);
- damage to the construction works;
- price fluctuations;
- unforeseeable risks like natural disasters, pandemics, war and terrorism.
The parties (usually the principal in the first instance) work out who should take responsibility for various construction and project risks and record this in the construction contract. This process is called risk allocation.
Over the years, many industry experts have extolled the virtues of good risk allocation. Guiding principles have also been developed, with perhaps the most widely recognised being the ‘Abrahamson Principles’ developed by the late Professor Max Abrahamson in 1973 and later adopted in Australia by (among others) the Joint Working Party of the National Public Works Conference and the National Building and Construction Council in their 1990 report No Dispute: Strategies for Improvement in the Australian Building and Construction Industry.
A fundamental aspect underpinning principled risk allocation is that rarely, if ever, will it be appropriate for only one party to the construction contract to assume all of the project risks. A far more nuanced approach is required, which picks up on factors such as who is in control of the risk and whether there are good reasons to transfer the risk from one party to the other.
Despite this, it’s no secret that construction contracts in Australia have become more and more risky for contractors in recent decades. Principals almost always prepare the construction contract, and often believe that it is better for them to pass all the risk down to contractors and let them sort it out. Much of the time it doesn’t work, but it hasn’t stopped the practice, despite many in the industry believing that it’s a problem (see, e.g., the findings in The Health of the Australian Construction Industry – Research Report, University of Melbourne, September 2020).
It’s also a highly competitive contracting market out there. Price is still a significant – if not the most significant – factor influencing the tender selection process. It’s common for principals to make it clear that they won’t entertain ‘departures’ (requests to amend the contract – and in turn the risk allocation). Or they may tell a contractor that it has the job provided it drops the departures it has raised.
This means contractors can be faced with some unenviable options: increase their price to cover the risks, knowing that this may make their tender uncompetitive; or keep their price competitive but on the basis that changes must be made to the contract. There is also a third but much less desirable option: keep the price low and don’t change the contract at all. This may significantly enhance the contractor’s prospects of winning the job, but at what ultimate cost? If any of the risks arise, the contractor will almost certainly be out of pocket; it’s just a question of by how much. Not to mention the likelihood of a significant deterioration of the relationship between the principal and the contractor (because the contractor will feel compelled to bring claims for risks it agreed to bear but which the principal sees no good reason to entertain).
So, what’s a ‘Top 10’?
Thankfully, many of our contractor clients choose the first or second options. But there remains, understandably, a real apprehension about raising contract departures. It’s therefore not uncommon that we get asked to give contractors a ‘top 10’ (and sometimes even a top 5) – they don’t want to go in all guns blazing, but they do want to raise and try to fix the most important problems with the contract.
This is a difficult exercise, which requires a balancing between legal and commercial risks. As lawyers, we can only advise on the former of the two. But experience of construction disputes tells us where the pinch points tend to arise. We then combine this with our understanding of the client’s own commercial drivers and attitude to risk. This means that our top 10 will tend to differ from client to client and project to project. But if you had to ask for our typical top 10, it would be these:
1. Capping liability and excluding consequential loss
A limitation of liability clause (also known as a cap on liability) is a critical risk management tool for contractors and they are rarely included in construction contracts by default. Many construction risks can’t be insured (workmanship is a good example). Without a cap, the contractor may be exposed to losses and liabilities far exceeding the contract price and risk the ongoing financial viability of their business.
The cap is normally expressed as a percentage of the contract price and is a commercial decision for the client (but is often being heavily negotiated). We have seen values ranging from 50% to 150% in recent times. The cap should apply to all liabilities, including indemnities and third-party claims, to ensure comprehensive protection. There are plenty of other things to consider when preparing a limitation of liability clause, which is why we always recommend contractors seek legal advice to try to obtain the best protection possible. While these clauses tend to be quite heavily negotiated, there should not be much debate about whether the contractor is entitled to limit its liability.
Contractors should also consider capping their liability for delay liquidated damages to a reasonable percentage of the contract price, to act as a ‘sub-cap’ on its liability for delays.
Similarly, excluding liability for consequential loss – such as lost profits, revenue, goodwill, use or production – helps prevent exposure to expansive, indirect losses that in turn may vastly increase the contractor’s overall financial exposure.
In our view, if you are a contractor, adding these clauses to the construction contract should be a top priority.
2. Fitness for purpose
Construction contracts sometimes require the contractor to promise that the works will be fit for a stated (or worse, the nebulous ‘intended’) purpose, regardless of whether the design of the works was prepared by or on behalf of the principal instead of the contractor. In a construct-only contract, the contractor has no control of this risk because it won’t have prepared the design. This unreasonably increases the contractor’s potential liability for defects, especially those which could prove to be material (such as structural defects).
In design and construct contracts, where promising fitness for purpose of the completed works is typically expected, we also tend to see an additional promise that the designs themselves (rather than the completed works) will be fit for purpose, despite many professional indemnity insurance policies excluding cover for such ‘contractually assumed’ liabilities.
Contractors should therefore push to have promises (commonly called ‘warranties’) of this kind removed or expressly limited to design and materials that they have prepared or selected respectively.
3. Compliance with third party agreements, such as agreements for lease (AFLs)
Many projects don’t happen unless the developer has first secured third party commitments for the use or disposition of the completed asset. The one we see most often is the AFL, whereby the principal and a prospective tenant agree to a future lease of the development based on detailed conditions relating to the completion of the works, including scope, timing and performance standards. They are almost always prepared and negotiated without the contractor’s input.
AFL obligations are usually passed straight through from the principal to the contractor under the construction contract in addition to other, more typical risk allocation provisions. They introduce an additional layer of risk for contractors. If the contractor is required to comply with the AFL, it could become liable for delays, variations, or defects that impact the landlord-tenant relationship, even where such issues are outside the contractor’s reasonable control.
There is often a good case for removing AFL related obligations entirely from the construction contract, on the basis that the principal should be capable of reflecting any specific requirements within the contract prior to releasing it for tender, which can then be appropriately priced by the contractor. But if this cannot be achieved, it is still important to reduce the scope of the AFL related obligations and ensure that the scope of works required by the AFL properly aligns with that required by the construction contract. In addition, the contractor should thoroughly review the AFL to identify particular risks and seek to either to exclude them or incorporate appropriate qualifications and limitations in the construction contract.
4. Indemnities for breach of contract
Indemnity clauses create a contractual obligation to compensate the principal (and sometimes, related third parties) for losses, often extending beyond what a party would be liable for under general law. They can also make losses easier to recover for the principal. Another risk is that an indemnity for breach clause could potentially have the effect of extending the time limit for bringing actions against the contractor. For example, the period for claiming damages for breach of contract typically expires 6 years from the breach (in many jurisdictions this is now 10 years if the claim relates to defective building work), but if there is an indemnity for breach in the contract, the period may not start until the date the indemnity itself is breached. Insurers also don’t like indemnities for breach and sometimes do not agree to cover claims made on this basis.
Ideally, contractors should remove indemnity for breach clauses altogether. Failing that, they should try to narrow the extent of the indemnity, such as by reducing its scope to the extent others may have caused or contributed to the relevant loss or liability, and by requiring the principal to mitigate its loss. Liability under the indemnity should also be subject to the limitation of liability clause mentioned above.
5. Site conditions
Despite most standard form construction contracts containing provisions which entitle the contractor to a variation for unforeseen site conditions, many contracts are amended to shift the entire risk for site conditions onto the contractor. This can result in major cost overruns, especially if there is limited information regarding the site conditions or it is not practical to undertake proper investigations. Claims related to site conditions are one of the most common construction claims and also one of the most hotly contested.
While the contractor could price in this risk as part of its contingency, doing so can involve difficult risk prediction and so the contingency may turn out to be insufficient. Adding contingency may also render the contractor’s tender uncompetitive.
In all but the most exceptional of cases, contractors should therefore insist on a clause that provides for a variation (including time and cost) where latent site conditions arise. If the contractor has entirely excluded a particular site condition risk from its price, then there should also be an entitlement to a variation if that risk eventuates.
6. Risk of discrepancies and document precedence
Construction documents, particularly scope documents like drawings and specifications, often contain discrepancies or inconsistencies. Locating these at tender stage is often very difficult given the limited time available to tenderers, and sometimes the project is not yet fully documented.
Yet it is increasingly common for construction contracts to shift such risks (which are increasingly being expressed to include errors or omissions) entirely onto the contractor, forcing the contractor to absorb the resulting cost consequences even though the risks may well be outside of its control. The risk is even higher if the contractor is not permitted to rely on its own clarifications or exclusions submitted with its tender (or they are simply not carried into the executed construction contract).
Contractors should therefore be astute to the risk that such clauses may present and be prepared to seek changes to ensure that appropriate relief (including additional cost and time) can be obtained if necessary. Contractors should also consider seeking a discrepancy clause that enables resolution of discrepancies by way of an order of precedence that prioritises their clarifications and exclusions. Be aware that discrepancy clauses now commonly include an overriding provision stating that the more onerous obligation or higher standard will apply in the event of a discrepancy, regardless of document precedence. This effectively undermines any negotiated hierarchy, and such a provision should therefore be removed or amended to ensure it does not have this effect.
7. Unreasonable time bars and notification requirements
Time bar clauses require the contractor to notify claims (such as for delay or variations) within strict timeframes, failing which the claim is intended to be barred. If these timeframes are unreasonably short or difficult to comply with, the contractor may inadvertently lose its entitlement to time or cost relief. This can lead to significant financial loss for the contractor or exposure to liquidated damages.
Notification periods should be commercially reasonable and allow for real-world project constraints. Contractors should also request provisions that allow claims to be considered even if notice is late, where the principal has not suffered prejudice or the prejudice can be compensated.
8. Extension of time and delay cost entitlements
Extension of time (EOT) provisions are essential for protecting the contractor from liquidated damages when delays occur beyond its control. These may include variations or other preventative acts or omissions by the principal or the superintendent, site access issues, inclement weather, latent conditions or industrial action.
A reasonable contract will also provide for the payment of delay costs where the works are delayed or disrupted (although typically, ‘neutral’ events which neither party has caused (such as inclement weather) will not normally entitle the contractor to such costs).
Contractors should consider which delaying events are likely to be material to the project at hand and ensure that these are clearly provided for in the contract. Failure to adequately define or include relevant EOT and delay cost events is another common source of disputes that can significantly impact the contractor’s bottom line for the project.
9. Broad set-off rights
Set-off clauses allow the principal to deduct amounts from payments due to the contractor, including for alleged breaches or claims. Where these rights are broad and unfettered, they can be abused to withhold legitimate payments, causing cash flow problems for the contractor. If such provisions can’t be removed entirely, contractors should at least seek to limit set-off rights to debts due and payable or final determinations of liability (e.g., through dispute resolution).
10. Superintendent’s duties
The superintendent normally has two roles under a construction contract:
- administering the contract (generally as the principal’s agent); and
- assessing contractor’s entitlements.
In carrying out the latter assessment role, the law requires the principal to ensure that the superintendent acts reasonably and independently. Many standard form contracts go further than this and require the superintendent to carry out all functions reasonably and in good faith (see, e.g., clause 20 of AS 4000/4902).
Despite the many important reasons for ensuring superintendent independence, it has become increasingly common for construction contracts not to require the superintendent to act reasonably, independently or in good faith at all, regardless of whether it is acting as an assessor. This leaves the contractor exposed to assessments and valuations which serve only the interests of the principal and create a breeding ground for costly and complicated disputes between the parties (the financial consequences of which will usually rest with the contractor unless and until they are ultimately determined or commercially resolved).
When acting for a contractor, this is a non-negotiable for us.
Conclusion
While by no means the only issues of importance that we encounter when reviewing construction contracts for contractors, each of the ‘top 10’ outlined above directly affects a contractor’s ability to deliver a project on time, on budget, and within a manageable risk profile.
Even just by looking at those 10 issues, one can see that careful review of construction contract terms is more than a legal compliance exercise: it’s fundamental to protecting the business, maintaining profitability, and ensuring fair treatment throughout the construction process (which, by its very nature, is something that always requires a high degree of collaboration and cooperation between the parties).
In a highly competitive industry with continually tight margins, managing contractual risk effectively can therefore be the difference between success and costly failure.
So, what’s your top 10?
Related expertise: Construction & Infrastructure
This article is general information only and is not legal advice. Please contact us for advice about your particular circumstances.