China: The new NEC3 engineering contract – Antidote to arbitration in Hong Kong?

Last Updated: 4 August 2015
Article by Julia Court, Paul Starr and Richard Lyons

The NEC3 Engineering and Construction Contract ("NEC3") is on a mission to reconstruct the way in which engineering and construction contracts are carried out. From its novel approach to language to the spirit of collaboration which is embedded throughout the contract – the NEC3 takes great leaps away from the adversarial culture of traditional contracts, such as the JCT or FIDIC suite of contracts and the standard forms typically used in Hong Kong in the public and private sectors.

One such leap is the effect that the NEC3 has on disputes arising out of the contract. Proponents of the NEC3 state that its anti-dispute nature is a large reason for its popularity, and point to the limited pool of relevant case law as support for the position that the NEC set of contracts discourage litigation.

It has been used extensively in the UK by London Underground and the Highways Agency and on major projects including Heathrow Terminal 5 and the London 2012 Olympic Stadium. Its use has also spread internationally and from April 2015 all Hong Kong Government works departments are required to tender new projects using the full suite of NEC3 contracts. Total public works expenditure is currently HK$70 billion a year.

Hong Kong Government has already completed three NEC3 pilot projects with 14 more in progress and 15 in planning. The Hong Kong permanent secretary for development (works), Wai Chi-sing, stated that the:

"...pain share/gain share mechanism [built into the NEC3] basically drives the contracting parties to the common goal of completing the works at the lowest cost and in the shortest possible construction period."

In addition, one of the biggest construction employer's in Hong Kong, the MTR Corporation, has begun its first NEC trial project valued at HK$600 million for the reprovisioning of a swimming pool associated with its West Island Line project.

This article considers some of the NEC3's key innovations and whether those innovations are likely to lead to dispute creation or dispute avoidance.

The innovations examined in this article are:

  • use of language;
  • encouraging collaborative relationships;
  • adaptability to project and parties'

needs; and

  • pro-active management.

They are considered by reference to the engineering and construction contract ("ECC"), the most frequently used contract in the suite.

Does the NEC3's language facilitate understanding or create misunderstanding?

The two features of the NEC3 that stand out with regards to language are (i) use of 'plain English' and (ii) use of the present tense. Strangely enough, construction contracts have not historically used either.

  1. Plain English

The NEC3 has wholesale done away with legalese and instead uses readily understandable terms throughout the contract. The benefit is evident – a dictionary, lawyer, legal research and tens of thousands of dollars in legal fees is unlikely to be required to determine the true meaning of a given word in the contract, for example, "impossible".

The disadvantage is that in the absence of disputes the terms used by the NEC have not been judicially considered. However the NEC has now been in use for over 20 years and various editions have provided an opportunity to refine some of the provisions.

  1. Present tense

The NEC3 uses the present tense throughout the contract, making it different from virtually every other contract – construction or otherwise. To the layman, the tense in a contract is unlikely to be something noteworthy at all. To anyone from a first-year law student reading contract law to experienced construction lawyers – the difference between "will", "shall", "is" and "are" could make all the difference to the strength of a case.

The following example illustrates the grammatical differences between the NEC3 and a traditional construction contract:

"The Contractor Provides the Works in accordance with the Works Information" (clause 20.1 of the NEC3);

"The Contractor shall, subject to the provisions of the Contract, execute the Works and provide all labour, materials, Constructional Plant, Temporary Works, transport to and from the Site or in and about the Works and everything whether of a temporary or permanent nature required in and for such execution so far as necessity for providing the same is specified in or reasonably inferred from the Contract." (clause 10 of the Government of Hong Kong General Conditions of Contract for Building Works ("HKGCC")).

Due to its brevity and grammar, the NEC3 clause could raise additional questions as to:

  • time of commencement of the obligations (were the Contractor's obligations present pre-contract as it sounds from the phrase "the Contractor Provides..."?);
  • nature of obligations (does the absence of the word "shall", which does appear in the HKGCC, mean the Contractor's obligations under the NEC3 are not mandatory?); and
  • scope of obligations (does the Contractor provide labour, materials, transport, etc?).

It appears that on its face, the HKGCC clause answers all of these questions. That clause itself is not without room for debate– an obvious point of contention being what inference is considered 'reasonable' under the HKGCC.

Indeed, the discomfort stemming from the NEC3's novel drafting language was highlighted in Anglian Water Services Ltd v Laing O'Rourke Utilities Ltd [2010] 131 Con LR 94 TCC where the Judge stated that:

"the task of construing the provisions in this form of contract is not made any easier by the widespread use of the present tense in its operative provisions. No doubt this approach to drafting has its adherents within the industry but, speaking for myself and from the point of view of a lawyer, it seems to me to represent a triumph of form over substance".

Having said that, the following example illustrates why the plain English, present tense approach is much simpler to digest for a layman, for instance, on-site personnel:

"The Employer may insure a risk which this contract requires the Contractor to insure if the Contractor does not submit a required certificate. The cost of insurance to the Employer is paid by the Contractor." (clause 86.1 of the NEC3)

"If the Contractor shall fail to effect and keep in force any insurance which he may be required to effect by any Special Condition of Contract then and in any such case the Employer may effect and keep in force any such insurance and pay such premiums as may be necessary for that purpose and such premiums shall be recoverable by the Employer from the Contractor." (clause 2 of the HKGCC)

On the whole, the intentionally broad language adopted in the NEC3 may be helpful for cooperating, collaborative parties during the execution of the contract but that 'less is more' approach may be less than ideal when relations have broken down and parties are at odds with each other.

Codifying collaboration: clause 10.1 of the NEC3/ECC contract

The ethos of collaboration is central to the NEC3 suite. This applies in two ways. First, adoption of collaborative processes is key to the management of the contract which encourages changes and other events to be dealt with as and when they arise. Second, the spirit of collaboration is expressly codified in clause 10.1 of the ECC which states that:

"The Employer, the Contractor, the Project Manager and the Supervisor shall act as stated in this contract and in a spirit of mutual trust and co-operation."

At its core, this clause requires the parties to carry out the contract in good faith. While such good faith clauses are not unknown to common law contracts, clause 10.1 of the NEC3 is drafted more broadly than similar clauses in traditional contracts. Practically put, the clause appears to require parties to act honestly and reasonably. The scope of the obligation of good faith however is broader than'honesty and reasonableness'.

The key issue arising out of presence of good faith clauses in contracts is whether or not such clauses are enforceable and the scope of obligations under such clauses.

Historically, English courts have been reluctant to find enforceable an obligation of exercising good faith due to the inherent uncertainty such an obligation contains. In the House of Lords case of Walford v Miles [1992] 2 AC 128, the court when considering the obligation to negotiate in good faith in the context of a lock-out agreement stated that:

"the concept of a duty to carry on negotiations in good faith is inherently repugnant to the adversarial position of the parties when involved in negotiations" and that such a duty is "unworkable in practice as it is inherently inconsistent with the position of a negotiating party".

More recently, the Supreme Court of Western Australia has held quite differently in the case of Automasters Australia Pty Ltd v Bruness Pty Ltd & Anor [2002] WASC 286, In that case, Hasluck J embarked upon an extensive review of case law dealing with the enforceability of good faith obligations, quoting with approval an editorial on the point of what an obligation of good faith contains:1

"It might be concluded that such an obligation [to act in good faith] would import notions of all the elements of reasonableness, honesty, fair play, lack of caprice and lack of arbitrariness. It is submitted that the motives of the party whose actions are the subject of an alleged breach of the implied obligation of good faith are very relevant."

Hasluck J also cited with approval Einstein J's judgment in Aiton Australia Pty Ltd v Transfield Pty Ltd [1999] 153 FLR 236 as follows:

"A party under such an obligation [of good faith] is obliged to subject himself to the process of negotiation or mediation (which must be sufficiently precisely defined by the agreement to be certain and hence enforceable). In subjecting himself to the process, he is obliged to have an open mind, in the sense of a willingness to consider such options for the resolution of the dispute as may be propounded by the opposing party. His Honour acknowledged that such a party is not required to act for or on behalf of or in the interests of the other party or to act otherwise than by having regard to self-interest. His Honour thought that the concept of good faith acquires substance from the particular events to which it is applied and is best determined on a case by case basis using the broad discretion of the trial court."

In Automasters Australia, the court concluded that:

"It is apparent from the decided cases and related discussion that an express term concerning good faith, either in negotiation or in performance, is likely to be considered certain and the term will be interpreted to give it meaning. What constitutes good faith will depend on the circumstances of the case and upon the context of the whole of the contract."

Returning to England, it appears that recent case law has found enforceable the obligation of good faith in situations where that obligation was limited to particular purposes. Lord Justice Jackson in Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (trading As Medirest) [2013] EWCA Civ 200, a Court of Appeal decision, found a good faith obligation enforceable, stating:

"the obligation to co-operate in good faith is specifically focused upon the two purposes stated in the second half of that sentence. Those purposes are: i) the efficient transmission of information and instructions; ii) enabling the Trust or any beneficiary to derive the full benefit of the contract."

It is yet to be seen how clause 10.1 of the ECC unedited, will be received by a court. The concern with general co-operation obligations as in the ECC is how they will operate when parties fall out. If trust has gone, a party would not want to find its ability to deduct damages or even terminate being limited by a co-operation provision. For the moment, the courts seem reluctant to apply co-operation provisions to absolute contractual rights or discretions but appear more willing to apply co-operation provisions in relation to procedural aspects of contracts particularly where those contracts are of a partnering nature. 2

Separately, in addition to the obligation to act in a spirit of mutual trust and cooperation, clause 10.1 of the NEC3 also requires parties to "act as stated in this contract". Arguably, that wording requires the parties to treat the remainder of the obligations in the contract as mandatory. That wording therefore clarifies the nature of the obligations under the contract, which, as identified above, is often unclear due to the use of the present tense.

How adaptable is NEC3? – Making use of the pricing options and Z clauses

One of the selling points of the ECC form has been the flexibility of its six pricing options which have been drafted so that they can slot into the core clauses. These are the Priced contract with activity schedule or bill of quantities (Options A and B), the Target contract with activity schedule or bill of quantities (Options C and D), the Cost reimbursable and the Management contract (Options E and F). Of these, the Target contract has attracted most interest because of the opportunities it offers for an incentive-based approach and pain/gain risk sharing.

A more sophisticated approach to pricing, which also provides a management tool for assessing pricing change to reflect risks as they occur, is an attractive element of the contracts. However, pricing under the ECC is complex and needs to be fully understood by those preparing and operating the contracts. For example, the form distinguishes between the "Prices" and the "Fee" which is a fee percentage for overheads and profit.

How the two are applied in practice will vary between the options. Employers and professional teams also need to try and keep pricing structures and any amendments to the pricing options simple. A temptation to over complicate pricing mechanisms can make the practical operation of the contract more challenging. Similarly where there is risk sharing the balance needs to be appropriate and targets realistic otherwise the benefits of the contract will be lost.

The route to amendment under the NEC is the Z clauses which are akin to 'special conditions' in traditional construction contracts. In the NEC3 contract, Z clauses can deal with a variety of issues and are particularly relevant in public sector contracts where parties are required to comply with government practice in construction and for providing sectorspecific requirements of construction contracts.

Z clauses most often seek to:

  • reallocate pre-set risk allocations under the contract;
  • ensure compliance with governing law of contract;
  • comply with project specific insurance requirements;
  • modify timeframes within which to carry out actions under the contract, (e.g. timeframes within which to provide early warning notification);
  • make provision for warranties;
  • modify notice requirements; and
  • enlarge or specify powers of project manager (e.g. to approve or reject subcontractors).

Of those issues, pre-set risk allocation is the most commonly varied and consequently, the most commonly disputed area under contracts. Z clauses can add, modify or delete clauses dealing with pre-set risk allocation. Often as a result, those additions, modifications or deletions cause inconsistencies with other clauses of the contract, or do not properly cater for allocation of risk.

Take for example, a Z clause which modifies the allocation of inclement weather risk – unless such Z clause also modifies appropriately the 'prevention' clause there could easily be disputes as to whether the risk of inclement weather is to be allocated as per the modified Z clause or in accordance with the prevention clause.

Other risk allocations that parties often try to modify and can lead to fatal inconsistencies if not managed carefully include:

  • the risks related to ground conditions which are typically Employer risks (although not in Hong Kong);
  • the scope of force majeure (clause 19); and
  • the scope of liability for works, in particular design (clause 20).

Most ECC contracts will require Z clauses but parties varying their NEC3 contract using Z clauses should ensure:

  • Z clauses do not conflict with any other provisions of contract and are workable with those provisions; and
  • if Z clauses also require other clauses to consequently be modified, that such modifications do not cause further provisions to become unworkable.

Proactive management – How does the NEC work in practice?

All contracts require diligent preparation and coordination of contract information with the legal terms but because of the flexible and simple way in which the NEC has been written, careful collation and completion of the "Contract Data" and of the "Works Information" is particularly crucial to the success of the contract.

For example, under the ECC, the contractor provides the works "in accordance with the Works Information" and the contractor designs the parts of the works "which the Works Information states he is to design". These and many other provisions of the ECC which refer to Works Information will be ineffective if relevant points have not been covered off in the Works Information. Inadequate completion of information can make operation of the contract procedures during the construction phase very difficult.

Project management is at the heart of the NEC and the effectiveness of the form relies on operation of the contract processes. There is therefore a high resource component required on the part of both employer and contractor with good project management a necessary component.

A key aspect of the management is the early warning system. The NEC3 puts great emphasis on ensuring that any events that may cause delays or changes in the price or quality are flagged up and dealt with as soon as possible. It does this through the following two step process:

Step 1: providing early warning notification to the Project Manager in writing. The notification does not have to be in a standard form but must clearly identify itself as an 'early warning'. This prevents parties from subsequently arguing that verbal communication in meetings and recorded in minutes constituted an early warning. Typically the Project Manager maintains a schedule of early warning notifications.

Step 2: the Project Manager holds a risk reduction meeting which all parties are obliged to attend. The purpose of such a meeting is to go through each early warning notice, determine its risk level and how to reduce that risk by considering various proposals. In putting forth and then considering proposals, all parties are required to bear in mind that the aim of the contract is to satisfy the goal of the contract (i.e. to get the job built, not the goals of individual parties).

Subsequently, the Project Manager considers whether to determine compensation events (traditionally known as 'variations') as a result of the early warning notifications.

In order to ensure the above procedure is stringently carried out by the parties, the Project Manager has the power to instruct that the contractor not be reimbursed for relevant additional expenditure arising from delays if an early warning regarding such delay is not communicated within eight weeks.

Another major aspect of the project management is programming. The programme is contractual and has to be continually updated to reflect progress and compensation events. The contract will usually therefore require a significant planning resource both on both the employer and the contractor teams. If properly managed, this can provide a useful tool for employer's in gaining a real understanding of the status of progress of the project.

The implications of not keeping records and operating procedures are considerable. Without these there is no basis for assessment and the contract will start to fail. This is not only a problem for the contractor but also for the employer. The employer could be faced with claims and no real way of assessing them. Similarly, the NEC should not be signed up on a letter of intent type basis. All the information has to be in place and the contract has to be properly operated from the start because it will not be possible to retrospectively capture what should have been there.

All this means is that there is a significant cost to running the NEC, hence why it has been most used on major projects. However, where it is used correctly it should enable costs to be managed and saved.

Familiarity with and understanding of the NEC forms is very important not just for the employer but also for the contractor. In a tender process, it is key to assess whether a contractor has this understanding. Where the NEC has failed it has often been not just failure to follow the contract procedures but a contractor who has not bought into the ethos of the NEC and allocated the necessary resource.

The NEC also needs to be consistently used across a project. For example, if the NEC forms are not used with subcontractors then the relevant financial and other information may not be available and inconsistencies in approach are likely to affect the supply chain.

Resolving disputes

The NEC3 sets out two options for dispute resolution:

  • option W1
  • option W2

The key difference between these two options is that option W2 provides for dispute resolution procedures that are in compliance with the Housing Grants, Construction & Regeneration Act of the UK ("HGCRA") and must therefore be used for projects where that Act applies. Specifically, option W2 ensures that the adjudication process is in line with those as required under the HGCRA.

Under both options, the dispute resolution process is multi-tiered. Parties in the first instance refer any disputes arising under or in connection with the contract to an adjudicator. If parties are dissatisfied with the decision of the adjudicator, the dispute can then be referred to the nominated tribunal under the contract. The nominated tribunal can be an arbitration tribunal or acourt.

The adjudicator's powers are as follows:

  • review and revise any action or inaction of the Project Manager or Supervisor related to the dispute and alter a quotation which has been treated as having been accepted;
  • take the initiative in ascertaining the facts and the law related to the dispute;
  • instruct a party to provide further information related to the dispute within a stated time; and
  • instruct a party to take any other action which he considers necessary to reach his decision and to do so within a stated time.

While adjudication is mandatory for certain construction disputes under the HGCRA, option W1 has the effect of making adjudication a contractual requirement for disputes outside of the UK as well.

Antidote to arbitration?

The intention of the NEC3 was to produce a contract which was simpler to operate and which forced parties to work collaboratively to resolve issues as they occurred in order to save costs with contemporaneous assessment of compensation events.

The limited number of reported cases under the form does not necessarily mean that disputes and issues have not arisen. Some will have been resolved in the way the contract envisages and other claims may have been settled because the information was not there to deal with the dispute in a conventional way. How can an adjudicator look back at what assessment should have been made if the information is not there to make the assessment?

Does NEC3 help to avoid disputes? The story from the UK is positive where the form has delivered on a number of major projects and the change management process is said to have achieved cost savings on projects such as the Olympic Stadium. Time will tell in Hong Kong but preparing the project information carefully, getting the pricing right, putting in place an appropriate set of Z clauses and then having the appropriate resource to operate the contract mechanism are all crucial steps if the NEC is to deliver a successful and efficient project.


1 "The Implication of a Term of Good Faith in Commercial Leases (2002) 9 Australian Property Law Journal 209.

2 See for example, Willmott Dixon Housing Ltd (formerly Inspace Partnerships Ltd) v Newlon Housing Trust [2013] EWHC 798 (TCC).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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