Construction contracts, in infrastructure projects mainly refer to airports, structures, bridges, roads, dams, ports, and other civil engineering activities. Historical data suggests that in most government awarded contracts, particularly of high value, the bidders tend to underbid so as to achieve the status of “L-1” with an ultimate aim of subsequently claiming additional costs from the government.
The duration of such contracts may last for months or even years, and a midnight or overlooked clause, or an unanticipated, underestimated, or miscalculated aspect, can ensnare contracting parties in seemingly endless litigation involving time and costs.
Faced with such significant risks, and given that a contract is an agreement enforceable in law, both parties prefer to protect their interests by utilising all available means and procedures.
Since agreements may expose the employer to risks of time and costs, the procurement process is frequently guided by the employer’s policies and procedures. The procurement process begins with the employer’s team deciding the procurement route, after the project management team having determined the sections of the project work that will be awarded to the contractors and identified the kind of contractual obligations required from the contractors to successfully execute the project. The plan establishes the relationship between the employer, the main contractor, sub-contractors, etc., as well as, a procedure for resolving issues arising during the course of execution of the work to meet the project requirements.
This article, in two parts, focuses on the different procurement routes and factors that the employer and its advisers should consider while deciding on a particular route in issuing the tender or finalizing the contract conditions. First, the general concepts which broadly explains the principles for consideration while selecting a procurement route; and second, it deals with the practical application of a contract selection.
This part deals with commonly adopted procurement routes, standard form of construction contracts for use prescribed by International Organizations .
It is necessary that only after identifying and analyzing all the factors influencing the construction of a project viz. topography, weather and climate, altitude etc. and its requirements, the employer or its advisors/consultants should analyze the different procurement routes available, and the one that is found to be the most suitable and beneficial to the employer should be selected.
The different procurement routes available to the employers are briefly discussed as follows:
Under this method of procurement, a construction contractor is appointed by the employer who is given the responsibility of successful construction of works within the agreed scheduled timelines, in accordance with the designs provided by the employer’s team of design consultants, in consideration of the fixed amount of contract sum. The design development and supervising the performance of the main contractor is the responsibility and risk of the employer. As its name suggests, such contracts by their nature are founded on a ‘fixed price lump-sum’ basis, usually called the “Contract Sum”. The Contract Sum payable to the contractor upon successful completion of the project remains fixed, except for revisions upwards or downwards under certain circumstances that are also envisaged in the contract viz. change in the scope of work, or issue of variation orders necessitated for the benefit of the works. Such variation orders may be contractor’s suggested or employer’s instructed – in either ways, the contractor is duty bound to comply and execute the variations. The contractor would need to be compensated for the additional work that it is required to undertake due to a variation order, which increases his work; and correspondingly, if there is a saving for the contractor, then he would be required to share the savings due to reduced scope of work, with the employer after retaining his share of profits of such reduced scope of work. declared in his bid documents.
Although there is separation of the responsibility of the construction and design, at times the employer might ask the contractor to design a distinct element of a project then it would be known as ‘Contractor’s Designed Portion or CDP’.
Measure and Value’ or ‘Re-measurement
The major difference between this method and the ‘lump-sum’ method is the basis on which payments are made to the contractor for completing the works. A re-measurement contract is founded on the principle that each part or portion of the works that gets completed is measured and valued at the agreed rates. The contractor is paid for the completed work that is certified by the employer’s officials. Under this method, the bill of quantities (‘BOQ’) is essentially a rate schedule for each unit or item of work that becomes a part of the complete works or project. The main advantage of this method over the lump-sum method is that any change in the quantity of work is paid according to the pre-fixed rates, and does not require any variation order to be issued by the employer.
Design and build
In this method the contractor takes the responsibility of both construction as well as design development. To perform the combined roles of design and construction, it is necessary that a contractor who is equipped with the design development capabilities should be engaged. The contractor may either have its in-house design team or may engage a professional design development team. In order to ensure that the contractor fulfils the employer’s requirements, it is advisable for the employer to engage its own design consultant(s) to supervise the design submitted by the contractor till their finalization process is completed.
As the name suggests, the contractor is made responsible for executing the project’s design and construction work within the agreed-upon contract cost and time frame. Under this method, the employer’s team provides the contractor with a basic or concept design at the time of entering into the contract, or even at the tender stage. Thereafter, based on the concept design, the contractor develops the detailed design for approval of the employer. Till the basic design is finalized and labelled as ‘final design’ the employer may make changes to the design as per its needs. One of the most common point of discord that arises is when the employer does not provide its comments to the design/revised design within the period stipulated in the Contract, but initiates some change before the finalization of the design, the contractor demands that the change made by the employer to the design require issue of a ‘change order’ involving additional time and cost, since the employer failed to provide its comments on the design submitted within the requisite period, after which the said design had deemed to have attained the status of a final design, though not declared as such. It is possible that all disputes of such nature may not be resolved immediately, and the contractor makes its cost claims against the employer once the work is completed.
Construction and Management Contracting
The employer hires a design team (such as the architect, structural engineer, and building services engineer), and alongside, a fee-earning construction manager is hired to oversee, program, and coordinate the design and construction activities, as well as to foster collaboration.
The construction manager helps the employer in selection of specialized contractors (for example, for foundations, concrete, electrical work, or decorating). The construction manager is given the charge of managing the contractors, but he does not enter into any contracts on behalf of the employer, unless he has been specifically authorized by the employer. In this approach, the construction manager is answerable to the employer for the proper performance of its construction management services, and advises the employer on the design and/or construction activities of the project performed by the contractors. The construction manager is usually given the responsibility of supervising the contractor’s works by the employer, except to take decisions involving time or cost, which are reserved with the employer.
In contrast, management contracting entails a hundred percent sub-contracting by the employer. Every aspect of the construction project is subcontracted to the works contractors through the management contractor. It is the subcontracting element that sets management contracting apart from the construction contracting, in which all agreements are made directly between the employer and the contractors. The amount paid to the management contractor is the prime cost of the entire work under the management contract, along with the management contractor’s fee. The contract between the employer and the management contractor can be perceived as a ‘prime cost’ or as ‘cost reimbursement’ contract.
Partnering per-se is not a procurement route. It is a co-operative relationship formed between business partners to improve performance in delivering projects. The accurate meaning of partnering differs between parties, projects and contracts, however, it can be applied on project-specific basis or as a part of a multi-project relationship which would be for a longer time. Most common form of partnership is the Public Private Partnership which is used by Government agencies for construction of its projects. Salient features of such partnership are briefly described below.
Public Private Partnerships (PPP)
Although Public Private Partnerships is an umbrella term, it typically means when private entities enter into a partnership with a public sector/Govt. body for construction, providing or supporting a public service. A key feature of PPP is that the public sector transfers the development and financing risk and responsibility to the private entity. In exchange, after the asset is created, the public sector/Govt. body pays a regular service charge to the private entity for the duration of the contract term for the asset’s operation. Typically, the private entity is entrusted with the responsibility to develop/construct the asset out of its own finds, but as per the requirements of the public/Govt. body, and after a specified number of years, the possession of said asset is transferred back to the public/Govt. body. Ownership of the asset always remains with the public/ Govt. body. The estimated amount payable to the private entity over the period of defined term, known as the ‘operation period’ is sufficient to cover the construction & operation costs, lender’s charges, and profit of the private entity. The payment model to the private entity differs from project to project. It may be based on annual payment by the public sector or collection of revenue by the private entity from the users of the asset. The contract makes provisions for all contingencies – during the construction or the operation phase. In India, this mode of construction of assets, especially infrastructure assets which require money and time, is being preferred from 1990’s onwards particularly the roads and airports sector leading the pack.
STANDARD FORM CONSTRUCTION CONTRACTS
It is a normal practice for the construction contract to be based on a “standard form construction contract” when establishing a project, particularly in infrastructure development areas. These contracts are often developed by industry organizations with the object of providing a set of ready-made standard terms and conditions for employers and contractors to contract on.
Standard forms are mostly sector specific based on experience of entities in a particular sector of the construction industry. The complexities and risks involved in various construction and engineering sectors, as well as the difficulty, if not impossibility, of attempting to create a single standard form construction contract that could apply to the entire construction industry, have led to the development of these various types of standard form construction contracts. Other standard form construction contracts are created by specific industry bodies or trade associations, and the risk distribution in those contracts may be more favorable to those industry bodies or trade associations’ members.
Most standard form construction contracts aim to assign risk to the party most suited to handle it, but since this varies from industry to industry and sector to sector, each standard form construction contract takes a different approach to risk apportionment. As a result, just because a certain risk is treated one way in one standard form construction contract, it may not be treated in the same way in other standard form construction contract. Therefore, it becomes necessary for the people involved in selecting a contract for a project to be familiar with the risk allocation provisions of the different standard form construction contracts.
The most commonly used standard form construction contracts in the World and in India are developed by FIDIC, which was founded in 1915 by Belgium, France and Switzerland. FIDIC is the name given to the body of International Federation of Consulting Engineers, headquartered in Geneva, Switzerland.
With reference to the construction agreements, the main purpose of FIDIC was to create standard contracts that may be used for a variety of construction and installation projects, on the assumption that constructing any project around the world are based on similar principles governing the relationship of an employer and contractor. These standard form contracts have been developed after decades of experience in construction and installation projects, and take into account in a balanced manner, the interests of both employer and the contractor.
FIDIC contracts are widely used internationally, including by the World Bank for its projects. In 1999, first edition of the FIDIC ‘Rainbow Suite’ of New Contracts was published. The commonly referred FIDC suites briefly are described below.
Silver Book form of contract is mostly used for EPC (Engineering, Procurement and Construction) contracts and makes the contractor responsible to complete the works on a ‘turn of a key’ i.e., ‘turnkey’ arrangement.
The Silver Book approach is suitable for large construction projects as it provides a greater level of cost certainty in comparison with other forms. For achieving this high cost certainty, the contractor is required to accept a higher level of risk than what is attributed in other forms of contract. The employer transfers the risks of ground conditions to the contractor, with the force majeure conditions being the exception. The Contractor assumes the responsibility of the accuracy of requirements of the employer. Due to the presence of high level of risk for the contractor, the employer is required to give sufficient time to the Contractor for its procurement programme so that the contractor can obtain and consider all relevant information before entering into the contract. The employer assumes the risks for war, terrorism and other force majeure events. Other risks assumption by the contractor may be deviated before signing the contract through the use of Particular or Special Conditions.
Under this form of contract, the contractor has the freedom to conduct his activities in the manner he chooses, provided the work is in consonance with the criteria specified by the employer. Therefore, the employer has only a limited control over the work of the contractor.
In the Silver Book, there is no reference to an independent engineer as there is less influence of the employer on the engineering aspects, however, the employer may, for its own advisory engage a consultant to ensure that the contractor is adhering to the design and engineering requirements set out in the contract. The Silver Book provides for ‘Tests on Completion’ and ‘Taking Over’ only happens place after successful completion of the tests.
The documents that normally form part of the contract documents are Contract Agreement, Conditions of a Contract (Particular and General), Employer’s Requirements, Tender etc.
The industry name given to the Conditions of Contract for Plant & Design-Build for Electrical and Mechanical Plant and for Building and Engineering Works is the Yellow Book. This form of contract is a Design-Build contract in which the contractor has the responsibility of preparation of design as per the employer’s requirements as well as construction. The contractor has to fulfil his responsibility in adherence to the requirements of the employer which may involve any combination of civil, mechanical, electrical and/or construction works. This is a lump-sum price contract and contains the provision for progress payments based on the independent engineer’s certification. This form of contract is mostly used for electrical or mechanical plant projects and for projects where the design and build method is required.
The contractor, under the Yellow Book form of contract, undertakes a fitness-for-purpose obligation which covers design, along with material and workmanship in construction.
The independent engineer carries out the supervision of the work and administration of the project. He is responsible for the issue of instructions, certification of payments and determination of completion. The engineer also has the responsibility to consult with the parties in case of a dispute, and try to settle the same.
The documents in a Yellow Book form of contract, are the Contract Agreement, Letter of Acceptance, Tender, Addenda (if any), Conditions of Contract (Particular Conditions & General Conditions), Employer’s Requirements, Schedules, Contractor’s Proposal and any other documents that form part of the contract. The General Conditions and Particular Conditions collectively make the Conditions. Guidance is provided so that the Particular Conditions can be prepared/modified, if it becomes necessary to modify the General Conditions. The Guidance also provides different security options such as advance payment bond, parent company guarantee, or retention guarantee which may be selected by the employer as per the requirement.
This form of contract is intended for use in projects which are relatively small in value, have a short construction time or involve simple or repetitive work and where specialists’ sub-contracts are not needed. It is a flexible contract which contains all necessary administrative and commercial arrangements and it is possible to amend the same easily as well. The design responsibility may be undertaken by either the contractor or the employer. The nature of the project i.e., construction, electrical, mechanical, or other engineering work does not matter. An aspect of this form of contract is that there is no reference of an independent engineer in the contract. There is a provision for the nomination of a member by the employer to fulfil the duties typically carried out by the engineer. Since there is no provision of an engineer in the contract, the mechanism of payments is required to be mentioned in the Appendix.
All contract documents are intended to be added in the Appendices to the agreement. Therefore, the Appendices may include offer of the contractor, employer’s acceptance and all other relevant correspondences. The General Conditions are applicable on majority of the projects, however, there is a provision for Particular Conditions as well, in order to amend the General Conditions to provide for the project’s special circumstances.
This form of contract is intended to be used in projects where the employer retains the main responsibility of the design work. The work by the contractor is carried out in accordance with the employer’s design. There may, however, be certain aspects of the project which the contractor may be asked to carry out the duty of design. The work completed by the contractor is measured and the payment is made in accordance with the bill of quantities, however, the option for making payment on a lump-sum basis is also available. Supervision of the work carried out by the contractor is done by the engineer engaged by the employer. He is responsible for certifying payments, giving instructions etc. Payments to contractor are determined by the measurement of completed work and value method. However, there is an option for payment on a lump-sum basis. As in the Yellow Book form of contract, the engineer may be given the responsibility to settle a claim or determine a matter raised by any of the parties in consultation with both parties.
The documents forming such contract are the Contract Agreement, Letter of Acceptance, Letter of Tender, Addenda, if any, Conditions of Contract (Particular and General), Specifications, Drawings and any other documents that the parties may decide.
Type of contracts used by the following government agencies:
National Highway Authority of India (NHAI)
The National Highways Authority of India awards contracts for construction of national highway projects. NHAI uses the following types of contracts:
Public Private Partnership (PPP)
There are three types of PPP contracts that are used by NHAI.:
- BOT (build-operate-transfer) Toll or Annuity;
- Special Purpose Vehicles (SPVs); and
These projects have different duration terms and commercial risks that are borne by the contractor, who is called the concessionaire. The contract provides a fixed term for construction, and thereafter another term, usually around 17-18 years, is provided for the concessionaire to recoup its costs and earn profits. In this period, the concessionaire is also required to maintain the toll road.
A BOT-Toll contract gives the right to the concessionaire to levy toll from road users, however, SPV and the BOT-Annuity do not give such a right. In the BOT-Annuity contracts, the contractor is paid a fixed amount bi-annually, irrespective of the earnings on the toll plazas. The entire toll collection is retained by NHAI.
The common features of all types of PPP contracts is that the responsibilities of designing, financing, construction, operations and maintenance are borne by the concessionaire.
Item Rate contracts
Popularly called ‘item-rate’ (IR) contracts, the traditional contracts are another type of contracts commonly used for highway construction projects. Under this type of contract, the contractor is only responsible for the construction of the road and not its maintenance. The construction cost-related risks are shared between the contractor and NHAI, specifically which arise due to difference in quantities of items of work.
Government agencies, especially in the Energy Sector prefer the Engineering, Procurement and Construction (EPC) form of contracts. Such form of contracts are most prevalent utilized for large and complex infrastructure development projects. As discussed earlier, an EPC contract requires a contractor to provide a complete facility to a developer who simply has to turn a key to begin operating the facility, which is why EPC contracts are also known as turnkey construction contracts. Aside from providing a full facility, the contractor is also required to deliver it at a given price, by a promised date, and at the specified level of performance. Failure to meet any standard results in penalties on the contractor.
Some essential features of an EPC Contract are:
- The responsibility for design, procurement, engineering, construction, testing and commissioning activities lies with the contractor.
- The contract price is fixed.
- Liability is limited for the contractor.
- The contractor is generally supposed to provide performance security.
- The time period for completion of the project is fixed.
APPLICATION OF THE CONCEPTS
This part deals with the practical application of the concepts discussed above, such as inter-relationship between tendering, procurement and contract selection, factors influencing choice of contract etc.
Procurement and Tendering
Professional consultants advising an employer on contract selection must be clear that the choice of procurement channel and other criteria influences the selection of a form of the construction contract. A contract should not be “pre-selected” and then used to guide procurement decisions. Procurement being the general process of obtaining services or goods from external sources, includes the plan on how to acquire those goods and services with respect to time, cost and quantity, based on the requirements of the employer. Tendering, which is an important phase, is the bidding process and the actual process of appointing a contractor.
Additional factors to be considered for selecting a construction contract
Apart from the choice of procurement route, the other factors to be considered are:
- Types of work required and sector
- Size, value and complexity of the project
- The employer’s level of familiarity with the project
- Balance of Risk/ Risk Allocation
- Design Responsibility
- Method of contract sum and payment
- Control over sub-contractors
Selection of a suitable strategy for a project is a complex decision because it plays a major role in deciding the project’s cost and timeline. In recent years, many procurement systems have been created in addition to the existing methods, making this decision more complex. As discussed, there are many factors which should be considered before selecting the type of contract, such as procurement route, risk allocation, type of work and sector etc. Construction contracts mostly involve high stakes and hence they should be signed after making sure that all the factors have been considered and deliberated upon. The FIDIC standard form contracts are used internationally, and hence the parties while entering into one should take care that the contract that they are choosing, and its conditions are suitable for the jurisdiction in which the project works are situated and the law governing the contract. With time, the options for standard form contracts have increased with more industry specific structures providing a wide range to choose from. Hence, the employers and the consultants should benefit from this range by carefully analyzing their needs rather than getting confused by variety and making the wrong selection. The successful completion of a project depends upon the suitability and adjustability of the contract entered by an employer with a contractor.
Ravi Varma – Partner