The purpose of this note is to consider the way in which the NEC4 family of contracts manage and transfer the allocation of risk in typical project structures and to point to the key considerations when considering the drafting.
The question of managing risk is always raised from a context. Depending on where an organisation is in the supply chain, its concern to manage or transfer risk can be quite different. An organisation using the standard forms must consider the specific drafting and risk management principles of the NEC4 family of contracts, which are fundamental to their use and apply across the contracts.
The Client to some extent, and the tier 1 contractor will usually drive the documentation and so this note looks at the drafting from their perspective.
Subcontractors entering into these subcontracts have different issues to consider and that is dealt with in a separate note.
At the client level the important issues with regard to managing risk are first addressed in the choices that a client makes in relation to the form of contract that the client will enter into with its tier 1 contractors or supplier.
That choice starts with considering the family of contracts and the potential structures which are available to a client and the client has to choose what sort of contract from the NEC family is appropriate.
At the most strategic level this will involve an analysis of whether the client’s needs can be addressed through a single bilateral contract with a tier 1 supplier or whether the client’s needs must be addressed through a series of bilateral contracts and if so, whether those bilateral contracts stand in isolation or whether an overarching structure to the underlying works or services or supplies is required.
There are a number of options. A framework agreement can be used to bring structure to the underlying works or services or supplies that are required. Another alternative to providing an overarching structure can be to use a two-stage approach to the procurement and development of a project and its delivery. There is also an alliance contract using an alliancing structure to bring a group of suppliers, consultants and works contractors together in order to achieve defined client objectives. In addition at a more granular level the separate bilateral contracts that may make up the client team and the supply chain can be linked through the secondary option X 12. The possible structures and overarching or strategic considerations are the subject of the NEC 4 document “establishing a procurement and contract strategy “.
How do these differing structures permit a client to have a greater or lesser degree of control and management of the various inputs from the supply chain?
A full analysis of the strengths or weakness of the differing approaches is beyond the scope of this note. Instead what will be considered in this note is the traditional single stage procurement and how the bilateral agreements between the client and the tier one supplier and between the tier one supplier and its subcontractors are managed.
There is a strong tradition of single stage procurement of capital works using structures which provide the client with a single point of responsibility and a clear transfer of the risk of failure on the part of the supply chain to the tier 1 contractor.
The NEC family in the drafting of its contracts reflects that approach at the bilateral contract level and states in terms that the contractor is responsible for providing works or services as if it had not subcontracted the works or services. Clause 26.1
Once the client steps away from that structure then a number of consequences follow; either there are multiple points of responsibility and the complexity that creates in terms of overarching management and co-ordination or if a framework or alliancing context is chosen the single point of responsibility becomes diluted and the division of responsibility much more clearly includes the client. The client becomes more involved in performance and the outcomes of the contractual relationships.
In the traditional bilateral structures where a single point of responsibility is an important part of the risk allocation, the question then arises what interest or degree of control does a client wish to have over any part of the underlying work or services or the documents by which the contractor procures those works or services.
The client’s Interest in performance by the Subcontractor: the NEC approach
In terms of interest in the performance of the works or the delivery of the service, the NEC family is drafted on the basis that the client has a direct financial interest in the outcome.
This can be seen in the rigorous risk management procedures of programming / planning, early warnings and also in the approach to valuing change or the impact of risks through the use of “Defined Cost”. Valuing change and risk at the cost when it occurs and the generous allocation of risk through the compensation event procedure means that for the client the out-turn cost will be directly related to the management of the risks as opposed to any pre-contract priced risk transfer to the Tier 1 contractor. That is the case even in the Option A (lump sum) contract.
The foresight and collaborative early warning process is included in the contract for the benefit of the client to allow the client to potentially avoid or mitigate risk that, if it materialises, the client will pay for through the compensation event mechanism. In that sense the client is not disinterested in the performance of the contract (and the contractor’s supply chain) in the same way that under other traditional priced contracts the client is disinterested. Under a traditional commercial design and build contract apart from very direct client interventions much of the risk of meeting the contract sum is transferred to the contractor and it would be wholly inconsistent for the client to take a commercial interest in the underlying performance.
Where the NEC target or cost reimbursable options are used then the client is literally paying for the supply chain through the Defined Cost mechanism and management of cost is the primary purpose of the valuation and record keeping.
Control over subcontracting
While NEC contracts leave responsibility for performance with the tier 1 contractor this interest in the tier two arrangements is also reflected in the drafting which requires that subcontractors are approved by the Project Manager before they are appointed and the inclusion of drafting setting out what contract information must be provided.
In NEC 4 the conditions have been amended, although the degree of control that the Project Manager has not been extended. The Project Manager is limited to rejecting the appointment of a subcontractor to the reasons stated in the contract ( or that would create a compensation event).
The contract provides “A reason for not accepting the subcontractor is that the appointment will not allow the contractor to Provide the Works.”
From a client perspective if greater control is needed over the selection or procurement of subcontractors then the basis for rejection could addressed in the Scope or the drafting of the conditions could be changed.
In the Option A and B contracts it would be possible to include in the Scope a restraint. This would link to the standard drafting wording permitting the Project Manager to reject the appointment if “the appointment will not allow the contractor to Provide the Works”.
To Provide the Works is a defined term and means “ To Provide the Works means to do the work necessary to complete the works in accordance with the contract ( emphasis added) and all incidental, work, services and actions which the contract requires.”
If the appointment offended the restraint the Project Manager could rely on this reason.
In Options C, D, E and F a link is also made between recovery of Defined Cost and the contractor’s compliance with an acceptance or procurement procedure. The example Scope document at Volume 2 of the NEC4 Users Guide for the ECC sets out in the Section 1200 of the Scope the possibility of including such additional requirements.
The additional requirements in the form of compliance with the restraint being linked to Defined Cost also provide a powerful incentive. If the Project Manager points out to the contractor that the contractor won’t get paid for the subcontract works if the subcontractor is appointed in defiance of the restraint that might be sufficient to achieve the desired end.
In terms of the control over the conditions of contract which are used for subcontracting there is some standard drafting that refers to the conditions.
Again the control is through the approval process. The contractor may not appoint the subcontractor until the Project Manager has accepted the subcontractor and accepted the subcontract documents.
The contract requires that the contractor submits the proposed subcontract documents, except any pricing information for each subcontract to the Project Manager for acceptance unless the proposed subcontract is an NEC subcontract which has not been amended other than in accordance with the additional conditions of contract, which are the main contract Z clauses or the Project Manager has agreed that no submission is required.
The reasons for which the subcontract documents can be rejected are;
· “their use will not allow the contractor to Provide the Works or
· they do not include a statement that the parties to the subcontract act in a spirit of mutual trust and co-operation.”
The requirement to act in a spirit of mutual trust and co-operation is the statement set out in the NEC4 family at clause 10.2.
For the target and cost reimbursable contracts the contractor must also submit the pricing information for each subcontract. There are no additional reasons for rejecting the subcontract documents.
In order for the Project Manager to reject the subcontract documents it would not be sufficient to say that they included amendments beyond the additional conditions of contract or even that an NEC form of subcontract has not been used at all.
If the subcontract contains the required statement about acting in a spirit of mutual trust and co-operation and their use will allow the contractor to provide the works the subcontract documents cannot be rejected.
What sort of problem with the subcontract documents would offend against the drafting?
If the underlying subcontract Scope was very defective it might offend against the test “their use will not allow the contractor to Provide the Works”. It is not easy to think of how that test would be applied to the subcontract drafting. To the extent that drafting is regulated by law it might be that it could be argued that non-compliant drafting could have that effect. Harsh risk allocation form Tier 1 to Tier 2 of itself would not.
From the client perspective there is in the standard drafting little that is regulated in terms of the form or content of the subcontracts. A client would probably need to add Z clauses or carefully consider the drafting of the Scope to provide any tighter regulation of the subcontract or supply agreements.
The Tier 1 contractor’s perspective.
From the Tier 1 perspective the question of risk transfer is different.
There are a number of considerations;
1. How does the standard drafting provide a simple transfer of risk from the Tier 1 contractor to the subcontractor?
2. Do the procedures in the subcontract align with the requirements in terms of process under the main contract?
3. Does the standard subcontract allow for departures in risk allocation from the risk allocation at the main contract level?
4. How does the standard subcontract compare with other typical subcontract structures?
The ECS (Engineering and Construction subcontract)
The preparation of a subcontract is a significant task for the Tier 1 contractor. The subcontract follows the same principles as the main contract and requires the contractor to define its content, to programme the works and deal with completion and defects as issues in the contract data and Scope.
There is no separate guidance provided on preparing the subcontract but the guidance for the main contract includes the guidance needed. The content of the Scope must be defined and the same checklist that applies to the main contract applies.
Although reference is made to the Works in the main contract and the relevant parties and the Project Manager and the Supervisor in the main contract, little is done to transfer risk from the Tier 1 contractor to the subcontractor. The main contract documents do not form part of the subcontract.
The actions of the client & others and any fault on the part of the contractor rest with the contractor. The Project Manager does not have any control over the subcontractor and the contractor is responsible for issuing any instructions.
The list of compensation events includes events that arise from the conduct of the client or others (see 60.1 (5)) and 60.1 (14). The contractor is responsible for unnecessary delay caused by the Supervisor’s tests and inspections.
The programming requirements are extensive and the contractor becomes bound by the programme as a contract document in the same way as the client is in the main contract. Access dates and completions dates are defined in the subcontract and the much looser approach to drafting whereby the subcontractor is left to carry out its works by reference to progress and /or completion under the main contract is avoided.
Do the procedures in the subcontract align with the requirements in terms of process under the main contract?
The subcontract contains the same procedures as the main contract. The timescales are shortened or lengthened as appropriate to allow the contractor to comply with its process upstream. But the sanctions and obligations that apply to the processes in the main contract are also mirrored. The drafting is not just for the contractor’s benefit.
Does the standard subcontract allow for departures in risk allocation from the risk allocation at the main contract level?
The short answer is yes. Even without any other amendments the contractor could choose a different payment mechanism for its subcontract and the valuation at the main contract level. However the approach to the valuation of change using Defined Cost under the standard drafting does provide a consistent approach to pricing and management of cost to that taken in the main contract.
If Option A is chosen as the subcontract then even if the main contract is option CD or E the amount the contractor will receive for a compensation event is the amount of the payments to subcontractors for work which is subcontracted without taking into account any amounts paid to or retained from the subcontractor by the contractor, which would result in the client paying or retaining the amount twice.
The contractor should therefore be in no better or worse position as the result of a compensation event.
The compensation event procedure has shorter timescales for the subcontractor notify or provide quotations etc. and the contractor has longer timescales to respond than it has under the main contract.
Where timescales are being extended by agreement under the main contract there is also the possibility of agreeing to extend timescales under the subcontract
This approach to Defined Cost at the main contract level reduces the extent to which contractors can take the benefit of “ buying gains” where change occurs but does not prevent a contractor from using an option A subcontract to seek to achieve a buying gain at the point where the subcontract is entered into for the subcontract Scope.
The real downside for the Tier 1 contractor will be in those circumstances where any change at the subcontract level is not recoverable as a compensation event at the main contract level. This could occur through failure of the contractor to operate the compensation event system at the main contract level or for those events which are contractor held risks. In terms of those probably the most significant could be poor content in the subcontract Scope not reflecting the obligations being undertaken in the main contract.
Next in significance are the contractor liabilities which include;
· A fault on the part of the contractor
· A fault in design contained in the subcontract Scope provide by the contractor
· Loss of or damage to the subcontract works taken over by the contractor
Clause 35 – defines takeover as being “the contractor takes over the works when the client or contractor starts to use it except if the use is for a reason stated in the Scope or to suit the subcontractor’s method of working.
The next significant risk is the programme and programming and performance of works to be carried out by the contractor, the client or Others 9 see 60.1 (2) Access 60.1(3) 60.1(5)
Another significant risk would be a mismatch in the information that the subcontractor has in relation to or responsibility for the Site.
The approach in the standard subcontract is therefore to place significant responsibility on the contractor for giving very complete information about the subcontract and its relationship to other subcontracts and works at the contract date. If that is not done then, as in the main contract, the subcontractor is expected to price and programme against the information provided.
How does the standard subcontract compare with other typical subcontract structures?
The “stand- alone” features of the subcontract contrast sharply with a subcontract tradition that has been very much towards drafting that transfers risk to subcontractors which they are not able to price and which they accept because of competition in the market and poor risk management in the supply chain.
As consequence of this it is not untypical to see very extensive amendments to the standard subcontracts. Below are examples of typical changes;
1. Main contract documents – included “ in so far as they relate to the subcontract Works”
2. Main contract documents taking precedence
3. subcontractor deemed to have knowledge of the main contract and allowed for in its pricing
4. subcontractor will comply with the subcontract so as not place the contractor in breach of the main contract
5. Responsibility for design carried out by others given to subcontractor
6. Responsibility for all site conditions given to subcontractor and for it to have allowed for and will co-ordinate its subcontract works with others
7. Progress to be maintained in accordance with the main contract works
8. Rights for the contractor to instruct additional resources to be provided, in default of which works to be taken out of the hands of the subcontractor
9. Completion not clearly defined or linked to the main contract
10. Defects liability period linked to the main contract
11. Full indemnity against any loss suffered by the contractor
12. Limitation of subcontractor’s recovery to that recovered under the main contract.
13. Design liability not limited to reasonable skill and care.
14. All sanctions for contractor non-compliance with procedure deleted.
15. Timescales for notifying of compensation events reduced.
16. Compensation events reduced or modified to allow for time only
17. Planned completion removed as the base line for extensions
18. Concurrency and float treated differently
19. Long payment cycles.
Some of these amendments may be subject to challenge under the applicable law.
A contractor who extensively amends the subcontract in this way may unnecessarily transfer risk and change the behaviour of the subcontractor such that when risk materialises, at the main contract level, risk that could have been managed and shared with the client is now sitting squarely in the contractor’s price. If the subcontractor ultimately fails then the paper risk transfer may be counterproductive and ultimately futile.
It is perhaps for this reason and to encourage transparent risk management that the NEC4 family has begun to suggest that where significant amendments are made to a traditional NEC structure that that may be of concern to the Project Manager, albeit the controls in the existing drafting are limited.
Other amendments are made which are more a question of drafting issues in NEC such as
1. Compliance with applicable law
3. Flow down from main contract Z clauses and bespoke structures
4. Public sector or client specific legislative requirements
These are probably driven by the additional conditions of contract and to that extent are considered unobjectionable changes in NEC terms.