CONNECT SERIES: Renegotiating construction contracts
A guide to renegotiating contracts.
Legal considerations for contractors asked renegotiate construction contracts
As the economic impact of the Covid-19 pandemic spreads, some project paymasters are seeking to reduce their project costs by forcing their construction contractors and suppliers to renegotiate their contracts with lower prices.
How should construction companies respond to the pressure? Can they respond? After five challenging years in which contractors have faced constant pressure to reduce their costs, how much latitude is there to renegotiate contracts and push prices lower?
On 30 April, the second Connect Series webinar of the Mashreq Construction Club considered how contractors and suppliers can respond to a client that is seeking to renegotiate a contract, and it examined what the consequences of those actions might be.
With expert insights from DLA Piper construction partner Suzannah Newboult, and Christopher Seymour, Mena Market Advisory Panel Chair for the Royal Institution for Chartered Surveyors (RICS), and managing director of Mott MacDonald Middle East, Renegotiating contracts and scope for reduced costs set out the key legal and commercial considerations for construction companies being asked to renegotiate their contracts.
In the first of two reports, MEED summarises legal considerations highlighted by DLA Piper construction partner Suzannah Newboult in the webinar.
To renegotiate or not to renegotiate
“The contracting party must first decide if it is obliged to renegotiate the contract,” says Newboult. “This depends on whether a contract has been signed between both the parties”.
If a formal contract is in place, such as a FIDIC-based contract, both parties are bound by the agreed price in the contract.
It is common in the region however to start construction works with only a letter of intent in place, with the intention to sign a more formal contract at a later date.
“Such projects are more susceptible to renegotiations,” she says. “With no legal restrictions if the employer does decide to change the pricing.”
However, Newboult says that a letter of intent can be upheld as a contract if it contains essential contractual elements such as a scope of works, price, and time for completion, and if both parties were legally entitled to sign a contract.
“It can be treated as a binding agreement,” she says. ”Which nullifies the need for a contracted party to agree to renegotiation.”
Once the legal grounds for a contract have been established, the contracting party must then consider the commercial importance of renegotiating the contract before deciding whether to engage or not.
Terminating and descoping
In the event that the contractor chooses not to renegotiate, it runs certain risks.
“The client may believe that it can make substantial savings by engaging someone else to finish the works if the contracting party is not lowering its prices,“ says Newboult. “It may then seek to terminate or descope the remainder of the party’s works.”
The FIDIC Red Book does not allow for termination of a contract if the client is going to replace the originally contracted party with someone else to complete the works. But in the Middle East, this clause is often heavily amended to remove the limitation from contracts.
“Most contracts in the region have provisions for termination for convenience or “at will” by the clients,” says Newboult.
The contract will typically dictate what happens in the event of termination. FIDIC contracts, for example, say that a contractor is entitled to its costs incurred to date and those reasonable expenses that is has incurred in anticipation of completing works.
If a contract does not specify that a client is able to terminate for convenience or does not elaborate on what the termination entails, then a client is likely to have to pay the contractor its loss of profits.
If either party has served a force majeure notice, then it is usual for a contract to specify that after a certain period (84 days in FIDIC contracts) either party will be able to serve notice to terminate, if the works have not substantially progressed during that period.
The consequences of this are the same in FIDIC, says Newboult. The contractor is paid for the work done to date.
The descoping of a contract is another risk that the contractor will have to consider should it choose not to renegotiate with a client.
Standard FIDIC forms of contract do not allow descoping if the works are assigned to another party. But again, says Newboult, this is a clause that is typically amended in the region.
Descoping is instructed by employers as a variation omitting large parts of the works as an “easier” alternative to termination.
Essentials of renegotiation
“In the event that a party chooses to renegotiate the contract,” says Newboult. “The price should not be the only factor. There are other essentials that the party must absolutely deal with in that renegotiation.”
These ‘other essentials’ include:
- Revised time for completion and clarifying new deadlines
- Settle existing claims, which will be difficult to recover once renegotiation is complete
- Consider a health check of plant and materials left on site, and consider the duration of manufacturer warranties, deal with any issues in the renegotiation
- Ensure that the value of bonds is reduced if the contract price is reduced
- Delay damages are often expressed as a percentage of the contract price, with a 10 per cent cap on delay damages. Make sure the contract definitions provide for the percentage to apply to the renegotiated lower price
- Deal with Covid-19 second wave, which will not be an unforeseeable event. If the renegotiated price includes the impact of Covid-19, the clients could say that it also included the future effects of a second wave
Some additional points to consider include advance payment repayments and bill of quantities (BOQ) rates, though these may provide cashflow benefits to a contractor.
“Advance payments are a percentage of monthly applications but will have to be revised moving ahead or else the contractor will have a balance outstanding to the client,” says Newboult.
If left unaltered, BOQ rates will build up to the original contract price which will mean that the monthly applications will cumulatively amount to a total greater than the revised contract price.
“This essentially means that the contract price will be used up faster,” says Newboult.
Newboult says that contract renegotiations can offer unexpected opportunities for contractors such as changes to payment terms. For example, where the two sides can agree to shorter payment terms such as fortnightly applications instead of monthly ones.
Cash flow issues can also be eased if parties can agree upon a release of retentions, or that no further deduction of retention will take place going forward.
Additionally, while it may vary from contract-to-contract, the contractor could offer other solutions to reduce costs such as aggressive value engineering, descoping by agreement, or a cost reimbursable mechanism with agreed profit (on open book basis).
“It will help to try and understand the reasons behind a client’s request for renegotiation,” says Newboult.