New Zealand Engineering 1999 September

Practice - Legal

Project Contracts - Planning for the unplanned

What if?
Liquidated damages
Balance is essential
Benefits of careful planning

Delays at two high profile New Zealand energy projects have highlighted the importance of project contracts.

When a new project is in its formative planning stages and all participants are brimming with enthusiasm and confident that it will proceed smoothly, the possibility that something could go wrong hardly merits consideration. It is sometimes assumed that the project participants will sort things out amicably if and when a problem arises. Were that always the case, project contracts could be drafted on the back of an envelope.

Unfortunately, the reality, particularly with complex projects, is that unplanned difficulties do occur and, as a result, the relationships between the participants can become severely strained.

As much as thorough planning is important from an engineering perspective, so too, from a legal perspective, it is essential to plan for unwanted contingencies.

Project contracts set out the relationship of the parties, their respective responsibilities and obligations and allocation of risk. When unplanned contingencies arise these contracts can be sorely tested and found wanting if not prepared carefully.

What if?
It is crucial, at the project’s inception, for each participant to make provision in the contracts for what should happen if difficulties arise.

For participants who refuse to plan for contingencies at the outset and adopt a "she’ll be right" attitude, the occurrence of unplanned events can be costly and result in drawn out court disputes or arbitrations. In many cases these may have been avoided or, at least, mitigated by a relatively small amount of forethought and sound advice.

Things the project contractor/engineer should think about include: What happens if the project encounters delays through the non-delivery of materials from a supplier? What if a component of the facility under construction is defective due to faulty workmanship of a sub-contractor? What if the facility, when completed did not meet the agreed performance specifications? What if completion was delayed due to some other unforeseen difficulty, such as atypical weather patterns? What if the site reports or geographical surveys were inaccurate? What if the cost estimates were grossly inaccurate? And, generally, who is responsible and to what extent in each of these circumstances?

Project contracts that expressly provide for unplanned contingencies and clearly allocate risk and responsibility stand a far greater chance of achieving successful completion without undue delay or major additional cost.

Liquidated damages
Two such contingencies are typically dealt with through liquidated damages provisions. Typically, a project contract will provide for liquidated damages (LDs) to be paid by the contractor to the project owner to compensate the owner for costs resulting from a delay in project completion or delays in the achievement of agreed milestones caused by the contractor. LDs can also be used to compensate the project owner for failure of the completed facility to meet agreed performance standards.

If the liquidated damages represent a genuine pre-estimate of the loss the owner expected to suffer as a result of the failure, the Courts will not interfere with the amount set. However, if a Court found that the LDs constituted a penalty for non-performance or were being used to force the offending party into performing the contract, they will be unenforceable.

For example, LDs for delay in achieving the contracted completion date may reflect the owner’s finance costs. The project owner and its lenders will have assumed, and funded on the basis of, repayments from the cashflow generated by the project commencing on or by the agreed completion date. The parties may also factor in loss of profit and other costs caused by delays in the commencement of input contracts, such as take or pay obligations under contracts for the supply of fuel to the facility, or output contracts, such as power sale agreements.

Balance is essential
The project contractor should not simply agree to LDs without attempting to strike a balance in terms of the extent of the obligations assumed, and the payment to be received, by it in return for acceptance of these risks. This balance can be pursued in a number of ways, including the following:

1. Contractor’s responsibilities should be clearly set out in the project contract
The scope of work for the project should be sufficiently detailed to operate as a list of responsibilities so that events which fall outside that scope of work are not matters for which the contractor should be responsible. The contractor should not be responsible for delays caused by the owner or which are otherwise outside the contractor’s control, for example, changes to project specifications by the owner and force majeure events.

2. Milestone payments
The contractor should be induced to keep to an agreed schedule through scheduled "milestone" payments payable prior to the final completion date.

3. Cap on LDs
LDs should be capped to an agreed percentage of the contract price.

4. Bonus payments
It may be appropriate to include in the contract an incentive for the contractor to accept such risks in the form of a bonus payment should the facility be completed ahead of schedule or perform better than agreed standards. This is a reasonable quid pro quo for the contractor. If delays would mean lost revenue and additional costs to the owner for which the contractor must compensate the owner, then early completion which results in revenues from the project and cost savings to the owner should be shared with the contractor in return for the contractor’s acceptance of risk and expeditious work.

Benefits of careful planning
Careful thought and planning and a thorough knowledge and understanding of the contractual relationships that exist in projects has two major benefits. First, planning for contingences at an early stage of the process can lessen the risk of problems occurring. Secondly, if and when problems occur, they are more likely to be dealt with in an expeditious and cost-effective manner with minimal strain on the project participants.

Chris Gordon is a partner in the Wellington office of law firm, Bell Gully and a member of the Construction and Energy team.