The meaning and contestability of fair risk allocation in commercial contracting

This article focuses on fair risk allocation in the New Zealand construction industry.

The need for fair risk allocation in commercial construction contracts has become a hot topic. High-profile contractor insolvencies and financial losses – and an apparent inability to properly capitalise on the construction “bull market" – have led the construction industry to take a long, hard look at itself.

At the core of this introspection, a focus on contracting practices is emerging. Who is being asked to bear what risk under the contract and is this fair? Undeniably, principals have tended to shift as much risk as possible to contractors and up until recently a number of contractors have been willing to accept this. It would seem, for some contractors, the approach is to proceed on the basis that the risk can be scoped, priced and managed, and profits made, or they have not properly appraised the true nature and extent of the risk they are being asked to take on. In New Zealand's dynamic and varied contracting market, with differing approaches and risk appetites among contractors (at least until recently), the question of what constitutes fair risk allocation in the current market is not easily answered.

The theory of fair risk allocation

In the context of a construction project, a risk is an uncertain event or set of circumstances which, if it occurs, will have an effect on the achievement of one or more of the project's objectives. In other words, so long as there is uncertainty, there is risk. Common project risks include weather, ground conditions, labour markets, defective work or materials, inadequate design, incorrect estimating, incorrect programming and natural disasters. Inevitably, there are also additional project-specific risks. The consequences of such risks are realised in the contract works themselves (for example, through defects), the time for completion of the contract works and the amount payable for the contract works.

The current debate is about which party should bear responsibility for identifying, managing and mitigating such risks and which party should bear the consequences of those risks.

In 1973, internationally recognised construction law expert Max Abrahamson published what became known as the 'Abrahamson Principles'. The Abrahamson Principles state that to achieve a fair and equitable allocation of risk in a construction project, 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 economical to deal with the risk in this way;
• the main economic benefit of controlling the risk accrues to the party;
• it is in the interests of efficiency to place the risk on the party; and/or
• when the risk occurs, the loss falls on the party in the first instance and, applying the preceding principles, there is no basis to transfer the loss to the other party (or it is impractical to do so).

It is from these principles that the ubiquitous statement 'the risk should be borne by the party best placed to bear it' is derived. This statement is often held out as the barometer of fair risk allocation in a construction contract. Although many standard form construction contracts bear the hallmarks of the Abrahamson Principles, the Principles are only a theoretical framework which is not necessarily suited to each project or project participant. A party may be best placed to control and manage a risk, but this does not mean allocating the risk to that party is fair.

“This pure approach to risk allocation in relation to all risks in a contract can often be difficult in practice for contracting parties," says Krista Payne, partner at global law firm Ashurst. She notes “this difficulty can result from a variety of factors, including:

• the ability of parties to accurately price risk;
• questions regarding best value for money and how to achieve the best project outcomes;
• corporate policies regarding acceptable risk allocation;
• risk around setting market precedents;
• competition in procurements (or shortage of work) creating pressure to accept certain risks;
• the alignment between the scope or likelihood of the risks being taken and the pricing structure for a contract; and
• availability of expertise and capacity within principals to manage certain risks."

Achieving fair risk allocation in practice

Fairness is, by definition, an inherently personal concept. Glen Heath, CEO and general counsel of Mansons TCLM, says fairness is subjective and will mean different things to each party to the contract. “The only real, objective fairness is that each party considers that the contract is fair from their own respective perspective," he suggests. “Each party endeavours to achieve a balance of the various components of the contractual matrix that they consider is palatable and fair to them."

Glen makes the point that it is when the respective counterparty assessments of risk allocation are compatible that mutual benefits often flow. “The best outcomes are achieved when the parties' risk sensitivities are compatible, that is, each party places different levels of importance on different aspects, enabling them to each receive and provide what is important to them," he says. “For example, quality may be more important than price to the particular developer, and the contractor has confidence in its quality so is comfortable agreeing to more extensive warranties in return for higher margins."

Consistent with Glen's views, Craig Wheatley, head of legal at HEB Construction, believes that properly understanding the drivers and environment of the other party is key to achieving fair risk allocation. On the contractor side, this means recognising that the principal wants an asset built to a high-standard, on time and on budget, and so satisfying its stakeholders. On the principal side, this means recognising that the contractor is trying to make a reasonable profit. After all, deriving a fair profit in return for their services “is why construction companies exist", he points out.

So what does this realism look like in practice? According to Craig, it is predicated on not asking for more than what you know should be obtained. “If you're a principal, don't (for example) request 30-year guarantees on certain items when those are only given in certain niche markets overseas," he offers. “On the security side, don't include onerous requirements around performance bonds when you know that New Zealand banks (there aren't many) won't accept them. Don't throw around inflated liquidated damages figures that can't be backed up."

The same concept applies to contractors, says Craig. “Yes, you want to make a margin, but don't push for terms that you wouldn't entertain if you were on the other side of the table. Don't request months to lodge a variation or extension of time claim when you know that you have the resources available to comfortably prepare them in a couple of weeks. Be realistic around the defects periods you are proposing…".

As discussed in the next section of this article, there have been some positive changes in the industry in recent times. Of course, change takes time and we still often observe principals pressing for a full risk pass-through on a fixed price basis. Notably there is also increased resistance from contractors to take on certain risks, in some cases to such an extent that the contractor position is unlikely to ever be accepted by a prudent principal. In order to overcome these types of behaviours, and to embolden principals and contractors alike to adopt realism and pragmatism, a change in industry mind-set and approach is required.

Changing entrenched positions

At Bell Gully, we act on a range of infrastructure and construction projects for both public and private sector clients. This allows us a wide perspective on market behaviours and sentiment. As noted in the preceding section of this article, some conduct is still adversarial in nature, but it is clear that entrenched positional attitudes are beginning to soften at least in some quarters. Similar observations have been made by others in the market.

Part of this is no doubt due to increased and better quality contractor engagement in contractual negotiations. This includes more appropriate use of internal or external legal advice, better internal governance and an unwillingness (or indeed inability) to depart from board-imposed commercial rules of engagement. In turn, this has resulted in principals no longer being able to push the boat out on risk allocation if they want to receive tenders from reputable contractors or, in some cases, if they want to get their projects out of the ground at all.

Other initiatives, such as the 2018 Entwine Report and the industry-led Construction Sector Accord, are beginning to resonate in the market and will hopefully drive significant change in a range of ways. We are noticing evidence of the public sector's commitment to move away from lowest price procurement, in line with the Accord principles and consistent with the impending application of the new edition of the Government Procurement Rules from October 1.

David Jewell, director and owner of BondCM, considers such a change in approach critical to fair risk allocation. He says giving the contractor the opportunity to include a fair value for the risks it is carrying in the contract price is a very important part of the process. “Too often we see this process become part of a price competition, and it leads to under-valuation of risk, mostly due to over-optimism on the part of the contractor."

Constructive thinking around the prevalence and suitability of NZS3910:2013 and the use of special conditions is another indicator of growing market maturity and openness. Resolving the debate currently swirling around NZS3910 (including in the Infrastructure Transaction Unit's recent report on the use of NZS Conditions of Contract), is a condition precedent to achieving real harmony between contractors and principals and, therefore, fairer risk allocation and better project outcomes.

It is not within the scope of this article to delve into this debate, suffice to say that in our view any desire to throw the NZS3910 'baby out with the bathwater' needs to be tempered by the reality that a standard form contract can't be everything to everyone. A universally applicable standard form contract isn't realistic. Rather, we need a contract which is up-to-date, user-friendly, and principles-based so as to enable flexible application or additional prescription, where required, through the use of special conditions. Most importantly, we need a contract that facilitates better behaviour from project participants.

In the last 12 months we have been involved in a number of projects where the parties have engaged early and openly in conversation to try and appreciate different perspectives and risk sensitivity. This is the compatibility that Glen identifies as being key to fair risk allocation, and David agrees: “A fair risk allocation can only occur after the contracting parties are given the opportunity to have genuine conversations about the particular risks in a specific contract, and to also discuss the terms and conditions of the contract before they are finalised. This leads to agreed strategies to mitigate risks, and an open conversation about which party is best able to manage the residual risks."

David points out that these types of conversations happen in the infrastructure sector where the alliance model is used, or in negotiated Early Contractor Involvement (ECI) contracts. We have recently been involved in build-only contracts which, unusually, adopted a similar process.

From the foundations up

When we look at successful projects – in spite of everything, there are still quite a few out there – the common elements are alignment of objectives and intent, transparency in all dealings and appropriately tailored risk allocation which is properly understood. This is captured by one of the four key guiding principles of the Accord: 'build trusting relationships'. If the underlying relationship between principal and contractor is sound, then the prospects of achieving compatibility, and therefore a contractual risk allocation which each party considers fair, increase considerably. This applies equally at the project level and at an industry-wide level. Trust needs to be built by the industry as a collective.

Mansons TCLM has the unusual perspective of being both a commercial property developer and a main contractor, giving it deep insights into the subcontracting market which is the engine room of the industry. It is at this level that trust needs to be set, and fostered, in order to permeate the upper contracting tiers. Glen explains that Mansons' success is contingent on trusted relationships with its subcontractors, built up over multiple projects.

“We typically don't utilise retentions regimes, rarely have liquidated damages except for only the more substantial packages (for example façade), and have a rigorous policy of paying everyone on time with any disputes resolved before due date. Treating subcontractors fairly results in better performance and pricing for us as the head contractor" he says. Although the risks associated with a subcontract are different to that of a head contract, the fact that such an approach can work at any level in the current market suggests that there is value to be found in resetting the adversarial principal-contractor dialogue.

Where to from here?

Our view is that together we need to move away from the oft-quoted and poorly understood catch-phrase of 'the risk should be borne by the party best placed to bear it' and, as Krista says, acknowledge as an industry that “care should be taken before reaching this conclusion that a contract is unfair for an individual contract. Each contract and project is likely to have a complex factual context that impacts on whether this pure approach to fair risk allocation is appropriate and 'fair' in all circumstances".

Across the industry we have the experience and capability to be more nuanced, pragmatic and even innovative in the way we approach risk allocation, and we can do this efficiently. We should be prepared to consider bespoke solutions where appropriate, including amending standard form contracts if required to ensure the mutual intention of the parties is clearly articulated and understood.

As Craig opines, “It has been frustrating … (as a New Zealander as well as a construction lawyer) because if we got our approach to these contracts right we would be delivering better projects and enhancing our country's reputation both locally and internationally." There is certainly room for improvement.