"Ensuring that risks are owned or jointly owned by the party or parties best able to manage and bear them, and understanding how they intend to handle them, is key to delivering value for money and successful outcomes."
Construction Playbook, September 2022
The benefits of getting the allocation of risk correct in a construction contract are invaluable.
In the context of any commercial contract for work in which the external (and sometimes internal) influences pose considerable risk in themselves, proceeding without a proper consideration of the allocation of risk at the outset can spell cost and confusion (and costly confusion) when those influences rear their heads.
Types of risk
Construction is well known for hefty associated risks and there are a great many factors that create uncertainty throughout a project. Force majeure, unforeseen ground conditions, adverse weather, inflation, political events, consents, economic conditions, changes in law and compliance, design defects and discrepancies can all entail considerable shifts in cost and time after the date that work begins under the contract. It is for the parties to determine between them how those risks will be both allocated and managed, and to document the same effectively in the contract terms.
Principles of risk allocation
In deciding on the party with whom the risk should lie (or where the needle falls between), a key consideration is which party is most capable of managing the risk and/or dealing with the consequences.
The following principles are helpful guidance:
- 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?*
All risks under the contract should be taken into account when drawing up or responding to the contract terms to ensure that the risk is balanced – the effort put in at the start can offset a considerable amount of grief later on.
In the case of Clin v Walter Lilly & Co Ltd [2021] EWCA Civ 136, the Court of Appeal held that the obtaining of a conservation area consent fell to the employer as an implied contractual obligation to use all due diligence to obtain such consent; and that such contractual term was breached. The employer's contention that such implied term a. did not exist and b. that the consent was not actually lawfully required points to the lack of understanding on the employer's part as to the risk that he was bearing.
A simple redraft of risk-bearing provisions (such as the obtaining of consents) may be insufficient to fully offset a party's risk thereunder; and in any case, why attempt to push the risk onto one party alone, when such offsetting threatens the risk-bearing party's solvency or capacity? The decision in Clin v Walter Lilly & Co Ltd [2021] EWCA Civ 136 indicates the courts' inclination to redress an inequitable risk balance.
Who bears the risk?
Generally speaking, most standard form construction contracts in an unamended form will aim to distribute the risk fairly between the parties. This is not to say that each standard form will accurately set the right balance in every context. There can be a temptation from the employer's (the party procuring the works) perspective to load risk onto the supply chain by way of contract amendments without consideration of the potential outcome.
During the tender process, it is generally the employer that is on the front foot when determining how risk will be allocated throughout the contract, because it is the employer that habitually sets out the contract terms. Prospective contractors (the party carrying out the works) must ensure that the contract terms are scrutinised and assessed to determine the balance of risk therein, and any items which swing that balance too far must be identified in the tender queries. Case law has determined that clearly worded qualifications which are appended to the contract will, in some circumstances, be held to trump contractual provisions (Clancy Docwra Ltd v E.ON Energy Solutions Ltd [2018] EWHC 3124 (TCC)).
The price of the risk
A common feature of a properly agreed allocation of risk is an effect on the contract price. This manifests in many ways; additions by way of management fees to lump sums, unit costs per collateral warranty and "pain versus gain" mechanisms are common signs of contracting parties' efforts to capture risk in contractual pricing methods.
It is always preferable to consider the pricing model at the outset, in parallel to selecting the form and content of the contract. There are considerable options in terms of pricing to parties wishing to balance risk in a contract, which are usually dependent on the type of project and economic circumstances of each party.
For example, if the project is taking place in a volatile economy, this can be tackled by agreeing adequate fluctuations in price or an indexation mechanism to manage the risk of inflation. Where the parties are comfortable with the predicted cost, a cost reimbursable contract might be suitable for effective cost transparency and fluidity in cash flow.
Regardless of how the parties strike the eventual balance, the pricing strategy for the contract should always be considered at the outset and should always form part of the invitation to tender.
Comments
It is clear from the case law and the "starting" position as set out in industry standard forms that the best option is a fair and equitable balance. It is also clear that the best balanced contracts are those that are scrutinised and discussed at the beginning of commercial relations between the parties; while it may be an awkward conversation at first, it makes for a long and happy working relationship.
In drafting, it is important to remember that risk allocation should not be administered just in terms of the two big hitters of cost and delay. The common mechanics of the construction contract should provide for adequate processes to be followed when a risk rears its head (e.g. retention of title, who insures what, notifications process of delays or discrepancies). Where the correct balance of allocation or risk has been struck, failure to adhere to the managing processes should not let contractual risk management fall at the last hurdle.
*Extracted from Nael Bunni, "The Four Criteria of Risk Allocation in Construction Contracts", International Construction Law Review Vol20 Part 1, p.6 (2009).
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.
