Risk in construction contracts
'Risk', in a project delivery context, can be defined as 'an uncertain event or set of circumstances that, should it occur, will have an effect on the achievement of one or more of the project's objectives'.1 Risk exists as a consequence of uncertainty, and, in any project, the exposure to risk produced by uncertainty must be managed.2
Construction projects are often complex, highly technical and of high value, and can have construction periods that may span a number of years. Common risks prevalent in construction projects include weather, unexpected job conditions, personnel problems, errors in cost estimating and scheduling, delays, financial difficulties, strikes, faulty materials, faulty workmanship, operational problems, inadequate plans and specifications, and natural disasters.3 Projects will also have additional specific risks, dependent on the nature of the project and its surrounding circumstances.
Although the volume and nature of contractual documentation for a construction project will vary as a consequence of the nature of the project, its scale and the procurement methodology adopted,4 a construction contract may be simply described as a contract between a contractor and an employer whereby one person (the contractor) agrees to construct a building or a facility for another person (the employer) for agreed remuneration by an agreed time.5 A construction contract will include a compact of rights and obligations6 between the parties by which the parties pre-allocate responsibilities between themselves in respect of certain risks that may transpire during the contract's execution. In doing so, the parties define the impact of such risks on the three key elements of the construction: the product or facility that is to be constructed by the contractor, the time at which the product or facility must be completed by the contractor and the amount the employer is obliged to pay the contractor. The collective allocation of such risks in a construction contract represents its 'risk allocation'.
Pursuit of a 'fair and equitable' allocation of risk
Typically, in preparing the contract document bid package, the employer will be in a position to decide on its intended risk allocation. While there may be, in such circumstances, a temptation to allocate major risks to the contractor, this must be tempered by an understanding of the adverse consequences of unilaterally assigning risk where doing so may preclude the submission of bids or result in such an increase in cost that the project is no longer financially viable.7 Improper risk allocation may also result in prolongation of construction completion times, wastage of resources and increased likelihood of disputes. As Shapiro states, ‘proper risk identification and equitable distribution of risk is the essential ingredient to increasing the effective, timely and efficient design and construction of projects. If the parties to the construction process can stop thinking in an adversarial manner and work in a cooperative effort towards obtaining an equitable sharing of risks based upon realistic expectations, the incidence of construction disputes will be significantly reduced.’8
While it is possible for parties to negotiate the terms of a construction contract individually, the possibility of unwanted variance and scope for abuse of bargaining power on both sides has led to a number of standard form contracts being developed by various entities, and it is now common in major projects for one of these standard forms to be used as the basis for the final construction contract.9 One of the pervasive features of standard form contracts is an attempt to produce a ‘fair and balanced’ allocation of risk.10 The rationale for pursuing this is that doing so will provide the best chance of successful project delivery. Echoing Shapiro, Lane notes that, ‘[a] contract which balances the risks fairly between a contractor and an employer will generally, in the absence of bad faith, lead to a reasonable price, qualitative performance and the minimisation of disputes.’11
Abrahamson suggests that to achieve a fair and equitable allocation of the risks inherent in construction projects, a risk should be allocated to a party if:
- the risk is within the party’s control;
- the party can transfer the risk, for example, through insurance, and it is most economically beneficial to deal with the risk in this fashion;
- the preponderant economic benefit of controlling the risk lies with the party in question;
- to place the risk upon the party in question is in the interests of efficiency, including planning, incentive and innovation; and/or
- the risk eventuates, the loss falls on that party in the first instance and if it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by attempting to transfer the loss to another.12
Commenting on this, Bunni notes that, while the principle of control of a risk is a powerful method in the determination of risk allocation, it is not comprehensive and other principles must be utilised to address adequately the allocation of risk in a construction contract.13 For example, ‘acts of God’ or ‘force majeure’ cannot be controlled by either party, and, instead, the consequences of such risks must be assessed and managed. Consequently, Bunni proposes that the following four principles are used for allocating risks in construction contracts:
- Which party can best control the risk and/or its associated consequences?
- Which party can best foresee the risk?
- Which party can best bear that risk?
- Which party ultimately most benefits or suffers when the risk eventuates?
The question of what is a ‘fair’ risk allocation is, ultimately, a subjective one; in deciding how it wishes to procure a project and the way it seeks to allocate risks, an employer will need to weigh up the theoretical efficiency of the risk allocation with political and market dynamics and the needs of the particular project.
Click here to download PDF.
1 Peter Simon, David Hillson and Ken Newland, Project Risk Analysis and Management Guide, The Association for Project Management, p. 17 (1997).
2 See Catriona Norris, John Perry and Peter Simon, Project Risk Analysis and Management, The Association for Project Management, p. 3 (2000).
3 See Samuel Laryea and Will Hughes, The Price of Risk in Construction Projects, p. 553 (2006).
4 See Julian Bailey, Construction Law, Volume 1, 2nd ed., p. 49 (2016).
5 Peter Simon, David Hillson and Ken Newland (op. cit.), p. 17 (1997).
6 Julian Bailey (op. cit.), p. 1512.
7 Bryan Shapiro QC, ‘Transferring Risks in Construction Contracts’, p. 5 (2010).
8 Ibid, p. 17.
9 See Graham Vinter, Project Finance, 4th ed., Sweet and Maxwell, p. 1 (2013).
10 In relation to FIDIC, see Ellis Baker, Ben Mellors, Scott Chalmers and Anthony Lavers, FIDIC Contracts: Law and Practice, Informa, p. 6 (2009).
11 Patrick Lane SC, ‘The Apportionment of Risk in Construction Contracts’, International Conference on Arbitration and ADR in the Construction Industry, Dubai, (2005).
12 See article by Max Abrahamson, Journal of the British Tunnelling Society, Vols 5 and 6, November 1973 and March 1974; and CIRIA Report R 79 ‘Tunnelling – improved contract practices’ (1978).
13 Nael Bunni, ‘The Four Criteria of Risk Allocation in Construction Contracts’, International Construction Law Review, Vol 20, Part 1, p. 6 (2009).
This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2018 White & Case LLP