Rob Horne
Head of Construction Risk at Osborne Clarke LLP, London, UK
When does the risk start to accumulate in a construction project? Is it once an unexpected problem has been encountered? Perhaps earlier, when processes are put in place for allocating responsibility for what happens on a project? Maybe before process, when an agreement is reached on what the project is and who will do what to complete it? Perhaps even earlier, when the project is first conceived? The reality is construction operations are inherently risky. To manage the inherent risk there needs to be a system or process in place. In a very general sense that is what the contract is there to achieve. The contract is therefore the first and primary risk management tool.
Most disputes in construction projects revolve around how well the contractual documentation, drafted at the outset before work has even begun on site, has reacted to the challenges and inherent risks of the project. Therefore, this chapter is not an explanation of what is ‘bad drafting’ in the sense of sentence structure and choice of words or what particular clauses should or shouldn't be included in a contract to make it effective. Rather, this chapter is going to consider the principles that should guide the drafting and do that from looking backwards from a dispute or issues occurring on a project to its root cause in a risk management sense.
Far too often in situations where dispute or conflict feels inevitable the apt, though overused, phrase ‘I wouldn't start from here’ can be heard. While this may be apt, and indeed is almost certainly a truism, it helps very little with the problem the parties to a project find themselves in. However, following the thread back through the life of the project can lead to some surprising insights into the root of the problem. What may have started as a simple, well intentioned, innocent looking piece of drafting in the Boardroom 1 can looking remarkably different midway through a project. Looked at from the project end of the telescope effective use of the contract as a risk management tool is often viewed very differently to how it was viewed while being prepared and agreed.
Equally, it is tempting, when considering contract drafting, to consider only the lead construction contract. However, as will become obvious on analysis, this is far too narrow a focus. The whole supply network needs to be considered from employer to designer, to subcontractor to supplier. Any break in the commonality of the risk management approach within the supply network will increase, rather than minimise, the chance of risks crystallising to form disputes 2 .
While it might be tempting to look just to the drafting of the words on the page, point the finger, and says ‘there's your problem; you wrote X in your agreement when you meant Y’ that is, regrettably, a vast over simplification. Who wrote those words? Why were they written that way? How do they fit in with the rest of the project documentation? 3 How are they understood at a project as well as at Boardroom level? Stopping at the words on the page, while certainly what a lawyer will do to reach a legal answer to a specific question, is not the route to solving the ‘don't start from here’ dilemma and neither is it the mechanism through which problems on future projects can be solved. Further, it will not of course even begin to deal with perhaps the greater evil, and almost always the ‘elephant in the room’, that nobody thought to look to the contract until there was a problem, by which time it was probably too late to minimise and avoid the problem, and the parties were forced to resolve it.
While this chapter may be an exploration of the idea of using the contract to actively manage project risks it is within a much larger context of considering and understanding the human dynamic that underpins and drives projects from inception, through drafting to delivery.
The written words are meaningless without human interaction to bring them to life and give them meaning. In particular, the words have to be operated and adhered to, otherwise, no matter how good (or indeed bad) the drafting, it will play no part in minimising the risk of a dispute. Therefore, while going through some common issues that arise, the human input driving the potential problem, dispute and solution should become apparent.
A good place to start is with a hypothesis; you may agree or not – the purpose is to shape the discussion and deepen the understanding. So the hypothesis here is that there are just six key or principle issues that drive problems using the contract as a risk management tool. Those six are like the ingredients of a cake, if one is missing or not quite right the cake as a whole won't be quite right, although it will still bear many of the qualities of the cake you were expecting. It can be difficult to identify what was missing unless you have significant expertise; however the result is plain to see.
The six principles, or ingredients, to creating a contract that can be used as an effective risk management tool are:
All of these principles, to a greater or lesser extent, can be guided by effective drafting of the contract. The contract is after all, the record of the agreed rights and obligations between the parties and therefore the ‘answer’ to most, if not all, questions should either be in the contract or capable of inference from the contract. Put simply, for the contract to be an effective risk management tool you have to get it right from the outset. Build the foundations correctly if you want what is built on top of them to last.
How do these key issues manifest themselves in projects? Unfortunately it is all too easy to identify examples of where one or more of the ingredients have been missed.
When, then, can parties take steps to improve the contract for use as a risk management tool? The most obvious starting point (although still lost on some projects) is before they start. If you have already commenced and then try to structure the contract around what you are already doing the risk exposure of the parties is markedly higher. There are, however, occasions when the drafting can be improved after the project has been started, but I will return to this shortly as it is easier, and more beneficial, to consider the opportunities in sequence.
Step 1 – Project Inception. This is the very earliest stage at which the kernel of an idea for a project is formed. You could think of it as a ‘light‐bulb’ moment where someone says ‘hey, I've got this great idea… ’. However, I prefer to think of it as a ‘big bang’ moment. The key difference being that in a ‘big bang’ moment, like the formation of the universe, everything about the project in fact crystallises at that moment. You may not realise it, understand it or deal with it yet, but all risks and opportunities coalesce in that ‘big bang’ moment. Soon after the initial big bang, ideas will start to be reduced to writing and this is the protean form of contract. It is at this stage that the first cut of opportunities and risks will be considered and it is at this stage that the first of the principles described above is at the fore. If unrealistic expectations are to be avoided, right at this very early stage, risks and opportunities need to be considered and how the intended contract is going to deal with them understood.
The common understanding will probably start from a set of outputs from the project: what is it we are trying to achieve from this project? Why is this particular formulation better than another? Even though the detail of how those objectives are to be carried into effect will change and develop, properly recording the original objectives is key. With the proper initial objectives recorded, development of implementation can be measured against something and there will be an ‘essential quality’ of the project around which a common understanding can grow and allow the other principles to be achieved.
As history has shown, from resultant disputes, particularly with regard to this second project example above, clarity, common understanding and all the other principles being in place at project inception is no guarantee that the project will be dispute free. Equally, the work done at project inception will not amount to effective drafting to manage risk and minimise disputes; it is just one step one the way to achieve that. There are, at project inception, still many stages at which the contract can become ineffective as a risk management tool or in fact can positively promote and encourage dispute.
The knowledge transfer and other drafting issues at this stage are focused on drawing in the professional team to the developer. Beyond project inception, the developer usually takes a step back from the project while the professional team start to add detail. Therefore, if the essential objectives of the project have not been properly recorded, or drafted, at project inception stage the detail of the project will be layered on top of an inadequate foundation and is therefore far more likely to lead to a misunderstanding of the inherent risks, preventing proper management of them and leading to disputes.
Step 2 – Procurement and Tender. Where the project inception step was all about initial ideas and recording them to ensure focus this step is focused on the initial contact with the team that will take the idea to reality. The key part of this step is that it will define the expectations of both parties. The principles at the forefront here are the creation of a common understanding, now between developer, professional team and constructor, and clarity of those documents that are going to be defining those expectations and requirements.
The temptation of many developers is to hurry through this stage, almost as if it is a necessary evil rather than an important part of the process. The rise, to dominance in many areas, of design and build construction has led to many developers seeing the tender stage as an expenditure to be minimised or avoided as the risk and requirements of bringing the project into reality are going to be passed to the constructor. The most often encountered problem with this is that, once in the build phase, the developer does not like some detail of what is being constructed and therefore seeks to change it. Many developers omit to consider or do not accept that such changes may well lead to unexpected consequences such as additional cost or time to complete.
This step in formulating the eventual contract should add to, strengthen and support the foundation stone laid during the project inception stage. Imagine two foundation blocks working in tandem to support a building; as long as they work in tandem everything that follows should be simple. However, if they are misaligned so they do not produce a single level starting point, or perhaps if they are made of different materials that will react differently when stress is applied to them, then the opportunity for a problem has been created. The further out of alignment they are the harder it is to recover, the more substantial the difference in material (even if both materials can be used as a proper foundation on their own) the more likely it is that additional and unexpected stresses will be applied during the project.
Step 3 – Contract Negotiations. The discussions and negotiations that occur around and during the tender period allow alternative views to be put and an opportunity is created for additional benefit to be added by the constructor. The increased use of two stage tendering, where one stage is competitive and then there is a second stage with a preferred bidder where more ideas and opportunities can be explored, certainly promotes the importance of this stage 6 .
The key principle at play during this stage is clarity with a healthy dose of knowledge transfer and a deepening of the common understanding. To achieve these three principles the discussions and drafting being produced at this stage needs to be done in as open a way as possible if disputes are to be avoided. Unfortunately, it is often at exactly this stage that the paths of constructor, developer and professional team can easily diverge.
During this step everything is starting to get quite ‘real’ and the tendency for many parties is to look to their own interests first. Indeed, why wouldn't that be the case? The developer will either have public accountability if it is public body or will be answerable to shareholders if private. Equally, the constructor, who will probably be working on a very tight margin, 7 is carrying out the works for reward, in other words he needs to make a profit. The professional team will have significant influence and control over the constructor but will not, generally, be answerable to the constructor. The natural instinct of all parties is to protect their own interests first. In doing so, that protection will often not be through an open dialogue until each party think they understand the risk they are taking and look for an opportunity to minimise the risk they carry and maximise the opportunity from risk carried by others.
It is rare for there to be a fully open joint examination of the risk inherent in the project as a whole, such discussions, when they occur, tend to focus on specific aspect of the project or particular issues which have arisen during the discussions to that point. If one were to look for a single point at which the preparation and drafting of contracts most often goes astray or stops being about minimising the chance of future problems, it is this step in the process.
Step 4 – Contract Execution. Although many would see this as not really a step in the drafting of a contract it is a crucial moment in terms of enabling the risk management aspects of the contract for a number of reasons. First, it is the last chance to get things right in the drafting before rights and responsibilities become locked. Second, this is the key point at which knowledge transfer comes to the fore as the lawyers (and often the entire Bid team for both parties) will step away from the contract at this point and leave it to the parties (and potentially an entirely different delivery team) to implement it. Finally, there is a real danger that this is the step at which the parties believe that the contract has been ‘locked’ and therefore they can put it away and not look at it again unless there is a problem, at which point they imagine it will, miraculously, provide an answer acceptable to everyone. Rather than a risk management tool it is reformulated to act as a disaster recovery manual. Prevention is always better than cure.
Most of the Private Finance Initiative (PFI) or Public Private Partnership (PPP) projects I have had any involvement with tend to run contract execution up to 11.50 p.m. or so on the day by which contracts must be signed or the funding arrangements will fall away or some equally dire consequences occur. In those last hours there is some very hard, close scrutiny of the project documentation. However, it is highly unlikely that the focus of attention in such projects is on the risky part of actually building something; far more often the key focus is the functioning of the financial model. That is not necessarily a bad thing, I raise the point because the financial model is the real driving force behind the whole project and yet it is being considered, in detail, right up to the last possible moment. When you compare and contrast that to the position in a normal, employer funded project it is unlikely that such focus is brought to bear on the relevant construction documents. Either they are agreed well in advance or, just as often, they are left, with work commencing under a letter of intent on the assumption that the construction contract will be entered into at some point. With such lack of attention one cannot blame the drafting if there is a problem later; it was never really given a chance.
Perhaps of greater significance however to the project outcome is what happens in the immediate aftermath of contract execution. Most of those involved with drafting the contract, preparing and submitting tender documents and negotiating on particular issues will step away. It is at this moment that many problems with the contract drafting will crystallise. Those problems are not necessarily manifest problems with the drafting itself, but simply that the way it has been considered and approached during the tender and up to execution is re‐reviewed as the implementation of the project starts and the theory of what, until then, has been a sterile contract is put into practice. The knowledge transfer that needs to occur at this point is critical to success. You may think this has little to do with the contract drafting and, in a traditional sense, that might be correct. However, challenging the traditional approach, why isn't the contract drafted properly in the expectation that it is to be implemented and applied by others 8 ?
Step 5 – Build Phase Implementation (stress testing). Once a contract has been entered into and fully executed, its function and importance as a risk management tool can be assessed under ‘live fire’ conditions. There are a further two key aspects to consider, and at this step the principles of adaptability and acceptance become key.
The first of the two key aspects is the stress testing of the words written into the contract, how they are used and followed, and how well they stand up to the scrutiny and challenge of a live project with changing facts and circumstances. The stress testing will focus significantly on the principles of adaptability and acceptance. However, this step can be crippled before it begins if common understanding, clarity, and knowledge transfer have not been put in place through earlier stages of the drafting process. In other words, for the contract to act as a proper risk management tool, all of the ground work must have been done, from project inception up to start of works on site.
The second key aspect is change. Practically every construction project will have a degree of change in it; it is an inherent part of the construction process. Whenever change occurs, how that change is recorded and managed should be approached with the same care and diligence as the original contract drafting. Certainly the same principles as outlined above in relation to the contract itself will be relevant.
Unfortunately, it is rare for the same care and attention to be given to change as to the original contract concept, even where the change itself is very significant. The key issue here is that a change in the nature of content of the works can alter the underlying risk and therefore the risk management tools of the contract may become less effective. In reality, while it may look and feel easier and quicker to implement change during the build phase of a project the risk management of the project as a whole must be considered when doing so. It may well be that new tools and new controls need to be brought in to help support the project where change has been needed. Is the change, for example, a symptom of some part of the contract not working properly? If it is, how do you trace back from the symptom to the cause? The only way is diagnosis, through good commercial intervention, and using the tool that the contract has given you to examine what didn't work properly. An answer, which is heard all too often, of ‘we just decided to…add works…change the sequence…alter the design…, etc.’ is not acceptable if one actually wants to learn to manage risk. If one is in the business of having disputes or perhaps playing roulette with millions at stake then perhaps it is fine.
These are the five steps or opportunities in which to create a risk management tool, in the form of a contract, to minimise the chances of dispute and the six principles to consider at each stage, as well as during the transition from one stage to the next. However, is that really enough to understand how to get an effective risk management tool in place? While it is tempting to say ‘no there are always more chances’ the reality is that it is and the contract must be resolved at the outset. There is little or no point trying to consider what exact form of words will work and what forms will not if the underlying principles have not been adequately considered and brought through the contract to be used by the parties. While examples can be given of specific instances in which certain terms were inadequate it is likely that there have been many occasions where the same, or very similar, terms have been used without a problem. Therefore, it is not so much the words and terms themselves but the underlying principles and their application that is key.
Returning to the main theme, it is not the particular words that are written down that give rise to the greatest problems. It is how those words are identified and then implemented. This then becomes the interface point between creating a principled risk management tool within the contract and the human dynamics of actually applying and utilising those tools.
There is no single right way to draft a contract to make it an effective risk management tool. There is no golden rule that if applied and obeyed will render a project devoid of disputes or allow risks to be identified early and answered in every conceivable circumstance. This is not surprising as, turning back to the start of this chapter, the proposition was that it is not the words themselves that create the problem and therefore it would be strange indeed if, not having caused a problem, those same words can act as a miraculous panacea.
The essence of using the contract as an effective risk management tool to avoid disputes then is in understanding the human dynamics driving the drafting. How is that interaction and knowledge transferred from the Boardroom and the legal and tender/procurement teams to the project team is key to identifying the risks and building relevant management tools around them. How those tools are then implemented at site to turn words on a page into a functioning project is the real test. The contract, whatever words are chosen, needs to reflect the requirements of the team implementing the project. The contract needs to be very carefully considered, usually taking the more time the better, but it needs to be in the context of six principles across five stages, which is as good a starting point as any. Utilising these tools and techniques gives you the best chance of putting in place risk management tools that will provide far more value than the cost expended in considering them and incorporating them into the contract.