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Nottingham University Business School MBA Programme
Business and Commercial Law (N1DM19) Module Convenors : Chan Wen Li & Mohammed Rizal Salim
Assignment Title: Individual Coursework Question One:
Contractual Provisions On Change Management & Liability Limitations Within An Major Construction ‘EPC’ Contract
ZHIJING, EU (UNIMKL-004151) Date: 27.04.2009 COPY II
[Word Count : 2520 Words – Excluding Executive Summary, Table of Contents, In-Text References & Bibliography ] 1
This paper describes the contractual structure of an agreement between a private sector “owner” firm in the energy sector and an engineering and construction services firm that will provide design, engineering and project management services for the construction of a major capital asset in a EPC (Turnkey) style contracting arrangement.
The question of how, subject to English Law, the appropriate provisions within the agreement will provide the owner/purchaser with protection against liabilities and maximise their contractual rights is addressed. In particular, the subject of legal remedies available to the owner in the event of a purported dispute is discussed in detail. In conclusion, it is clear that the usage of effective caps and limitations of liabilities and clauses pertaining to change/variation management in a comprehensive and unambiguous manner will provide both the owner and contractor with certainty as to the placement of risk. When crafted appropriately, this certainty generally leads to more cost efficient contract pricing for all parties involved.
TABLE OF CONTENTS
Introduction ............................................................................................................4 Transaction Background.........................................................................................5 Risk Allocation In Capital Asset Construction .......................................................6 Change / Variation Management Clause................................................................8 Exclusions / Indemnity & Limitation Clauses........................................................11 Conclusion............................................................................................................15 ............................................................................................................................15 References :..........................................................................................................16 Table Of Cases :...................................................................................................18
Large private sector firms in the energy sector frequently make capital project investments involving either expanding or revamping existing facilities or constructing new production facilities. These investments often cost millions of dollars and require a wide range of engineering and construction expertise. Therefore it is normal that numerous separate contractors will be engaged to design & engineer, procure material/equipments and construct various sub-components of the new facilities. Due to the complexity of managing the interfaces between these contractors/vendor-suppliers, a “main contractor” is appointed to manage the interface and also to enter into contractual relationships with the various suppliers and sub-contractors.
Within the industry, there are a number of contractual configurations for segregating the overall scope of work into separate contracts as well as for varying the owner firm involvement in project managing the entire endeavour. ( McNair N. et al 2005 ) One common contract model is the EPC (Engineering Procurement Construction) approach. The EPC contractor is expected to take ownership of all the risks (Inclusive of legal risks of directly contracting for the work and financial risks in funding the work) and be the single party accountable to the owner for successfully executing the work. “EPC” contracts are often in the form of Lump Sum Fixed Price Turnkey arrangements with progressive payments issued against pre-agreed milestones. The phrase “turnkey” alludes to the fact that the EPC contractor is expected to perform all the necessary works to deliver a finished product to the owner firm who then only has to “turn the key” to operate the facility. This contract format allows the owner firms to obtain a degree of certainty as to time and costs required ( Loots & Henchie 2007 ). This is because the preagreed total price and completion date arrangement incentivize the contractor to manage the project to meet the promised cost, time and quality targets.
Risk Allocation In Capital Asset Construction
There is an abundance of “standard form” contracts developed by various global organizations. An example would be FIDIC’s (Federation Internationale des Ingenieurs Conseils) Conditions Of Contract For EPC/Turnkey Projects (Also known as the ‘Silver Book’ due to the colour of the guide’s front cover) ( Huse J. 2002 ). However most contracts tend to contain customized terms as owner firms often try to build in certain provisions and clauses covering some of the basic uncertainties associated with major capital projects. In capital project work, Cost, Schedule and Quality are pre-defined before the acceptance of the contract offer and these parameters are subsequently applied as measures of success. Any factor that could detrimentally affect the quality of the work, increase the estimated cost or result in an unplanned delay represents risks to the project. In a survey conducted in the recent years (KPMG International 2007), the top reasons for a project not meeting its targets were scope changes, poor forecasting/estimating, contract mismanagement and cost escalation. Therefore it is unsurprising that negotiations on the contractual terms and provisions within an EPC contract reflect the attempts by both parties to delineate and transfer the ownership of the above risks to either party. From an owner firm’s perspective, the key benefit of an EPC is that it removes the need to identify specific parties to attribute liabilities for defects as the responsibility for scope of works tend to be broad enough for the ultimate accountability to be with the single “main” contractor. (Chuah C. 2008)
As such, an owner firm’s priorities is to incorporate contractual terms that protect them against change orders from the contractor and to provide enforceable means of penalizing the contractor for late completion, cost over-runs and quality issues in the widest range of situations. The phrase “widest range of situations” is used here as delays or additional costs may sometimes be difficult to attribute directly to a single party or may be a consequence of circumstances outside the immediate influence of either the owner firm or the contractor. The crafting of EPC contract clauses is a wide topic but the proceeding sections will analyse some critical clauses that impact the project cost / schedule and the legal remedies available to either contractor or owner parties when things do not go as initially planned.
Change / Variation Management Clause
EPC contracts tend to have pre-negotiated lump sum fixed prices. Therefore, owner firms would seek to incorporate terms to avoid claims for situations where the performance of the work could be more onerous than initially assumed due to conditions such as labour shortages or price escalation. An example would be as follows :
“The Contractor shall be deemed to have satisfied himself as to the accuracy and completeness of the agreed Contract Price and shall not take into account any unforeseen difficulties or costs, except as otherwise stated in the contract”
However, change is an unfortunate fact of life and no contractor would knowingly bid on a job that does not allow them flexibility to manage subsequent changes. Hence, change variation clauses need to be included but to protect themselves, the owner firms should include terms to clearly distinguish between what constitutes a valid change request (I.e Which provides an entitlement for change order claims or extensions in pre-agreed milestones) and developmental ‘changes’ which do not. A sample of such a Management Of Change clause would be as below:
“Any modification or alteration of, amendment or addition to or deletion from the work, or changes in the method or sequence of the work resulting from any of the following shall not constitute a CHANGE IN THE WORK: (a) any changes to the WORK to the extent attributable to any default, breach or negligent act or omission of the CONTRACTOR, any AFFILIATE OF CONTRACTOR, any AGENCY PERSONNEL, any SUBCONTRACTOR and any other party for whom the CONTRACTOR is responsible under the CONTRACT or whose WORK is managed or supervised by the CONTRACTOR ; (c) work resulting from instructions, interpretations, decisions or acts of the COMPANY, aimed at: (i) compliance or avoiding failure to comply with the CONTRACT;
rectifying faulty workmanship; remedying any delay or default to the extent attributable to any default, breach or negligent act or omission of the CONTRACTOR, any AFFILIATE OF CONTRACTOR, any AGENCY PERSONNEL, any SUBCONTRACTOR and any other party for whom the CONTRACTOR is responsible under the CONTRACT or whose work is managed or supervised by the CONTRACTOR;
work required to avoid injury or death to persons or damage to property; and
(e) work necessary as a consequence of CONTRACTOR’S failure to comply with any of its obligations under the CONTRACT”
Conversely, contractors would want to include clauses that allow the contractor to determine the manner in which they will execute the work without undue influence from the owner firm. This is especially relevant for projects that involve work within an operating facility where the contractor’s workforce will require accessibility to the work location. In the end though, the final negotiations will have to strike a balance between detailing what constitutes a change without restricting the contractor from carrying out the work in an efficient manner. This has been exemplified in the case of Strachan and Henshaw v Stein Industries  where the Strachan was a contractor engaged by Stein to conduct work for National Power. Strachan had initially located some temporary accommodation for its workers adjacent to the work area but were later instructed by Stein to relocate to a more distant location. Strachan argued that this constituted a variation order due to the loss of productivity that they estimated ‘cost’ them 1.6 Mil GBP. However the Court of Appeal ruled that based on the phrasing of the contract, the “work to be done by 9
the contract under the contract” could not be re-interpreted to encompass the arrangement made by the contractor to bring it’s workforce to the work area. However it should also be noted that the exact manner in which the contractual terms are drafted could also expressly permit the contractor to claim that changes to sequence, timing or method of construction or temporary works could also constitute valid variations that entitle the contractor to additional time extensions or payments. This has some significance because a less restrictive definition of what constitutes a “claimable” change may lead to a better contract price from the contractors.
Exclusions / Indemnity & Limitation Clauses
It is the contractor’s interest to incorporate terms that limit their exposure to liabilities in the form of liquidated damages and to outline clearly the extent the owner can claim for consequential damages. An example of such a clause would be as follows :
“The total liability of the Contractor to the Company under or in connection with the Contract shall not exceed the sum stated in the Contract Price stated in the Contract Agreement”
While the above example pegs the liabilities to the contract price, the owner’s have other means in which to re-define the peg to suit their perceptions of the potential risks. Instead of the contract price, the below example limits the liabilities to a preagreed figure, X, ( A figure likely to be lower than the contract price) which is tied to a ‘per incident’ basis but without limiting the number of incidents :
The Contractor shall assume all liability for and shall defend, indemnify and hold COMPANY free and harmless from and against any and all claims, demands, actions or proceedings from third parties arising out of the execution of the WORK howsoever arising and whether or not caused or contributed to by negligence or breach of duty on the part of COMPANY up to an amount of X dollars per incident or event and unlimited as to the number of incidents.
An exhaustive definition is worthwhile because in the event of a dispute, contractors may attempt to argue that the liquidated damages clauses are invalid due to it constituting a penalty. English law will disallow the enforcement of liquidated damages clauses if the sum stipulated is meant to be a penalty rather than a genuine pre-estimate of the loss. This principle reference the case of Dunlop Pneumatic Car Co v New Garage Motor Co  which states that regardless of how a provision is described in the contract, it would be considered a penalty "if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest
loss which could conceivably be proved to have followed from the breach" ( Elliot C. & Quinn F. 2007 ) Liquidated damages clauses can also be rendered void due to vagueness of description and contractors can also argue invalidity due to contravention with the prevention principle, a situation where the contactor can be released from an obligation to complete works at the agreed target date if the owner is responsible for causing the delay unless there is an expressly stated extension of time clause to deal with delays (Bateson D. 2002). In the course of negotiations, owner firms may also formulate the limitation clause to provide some assurance to the contractor that their liability for loss of profit, loss of use and consequential losses are capped such as in the below :
“…the Contractor’s liability for loss of use, loss of profit or other consequential loss arising in respect of the liability of the Contractor shall be limited to the Contract Price..”
However a counter-strategy open to owner firms is to assert that the loss suffered was a reasonably foreseeable consequence of a breach at the time of contracting, thereby effectively circumventing the above limitation. (Salter S. 2007) The case of British Sugar Plc v NEI Power Projects Limited  exemplifies the application of this tactic. British Sugar Plc contracted NEI to perform design and installation work but suffered a power breakdown due to faulty electrical equipment supplied by NEI. Even though the contract had a limitation of liability clause with a cap of 0.225 Mil GBP, British Sugar Plc sued for 10.6 Mil GBP in damages. The Court of Appeal rejected that NEI’s defence that the loss suffered by British Sugar was too remote and fell under the terms of consequential loss.
The general principle in English law for testing of remoteness established in Hadley v Baxendale  are such that liability for loss caused by breach of contract would be only be valid if they arose naturally from the breach or may have been reasonably forseeable as a result of a breach at the time of contracting. In this particular instance the Court of Appeal ruled that the damages incurred had all arisen naturally / directly from the breach of contract and therefore the full amount of the 10.6 Mil GBP claim was not covered under the limitation of liability clause. Hence, in practice, wary contractors would insist on including specific details of the types of loss they are seeking to exclude rather than making a general distinction between consequential and direct damages. On the subject of exemption of liabilities, the Unfair Contract Terms Act invalids any clauses that exclude or restrict liability for death or personal injury resulting from negligence [Section 2(1) UCTA ]. However in Thomas v T Lohan (Plant Hire) Ltd , The Court found that it is possible to re-allocate the risks of injuries amongst commercial parties through exclusion/restriction clauses as long as these commercial parties do not seek to exclude or restrict their liabilities to the persons injured. This is certainly one area of contractual provisions worth reviewing considering the potential safety risks inherent in construction contracts. In short, a fair and balanced contract should be comprehensive enough to provide both parties with a certainty of the amount of insurance that needs to be taken against “worst-case” scenarios. Despite the conceptual separation between insurance and limitation of liabilities, both need to be aligned as liability
should not be assumed to be automatically capped at an agreed indemnity insurance limit unless the contract expressly provides for this (Murdoch I. 2003)
Contractors frequently build into EPC contract price a risk premium to cover liability for certain events. These risk premiums range between 5 - 15% compared to the situation where all risks are placed with the owner firms (Merrow E. 2006). The value of these premiums is subject to the contractor’s perceived ability to prevent or mitigate the consequences of these risks. The task of drafting an effective contract should NOT be treated as a zero sum game. Having effective caps, limitations of liabilities and comprehensive and unambiguous clauses pertaining to change/variation management will provide both parties with certainty as to the placement of risk. A well structured EPC contract where competing contractors can better estimate the price bids promotes contract price efficiency. It also smoothen the final contract terms negotiation thereby engendering a cooperative owner-contractor relationship critical to project success. Beyond the scope of this essay, there are many other clauses such as performance guarantees , definitions of negligence, dispute resolution, acceptance of work , force majeure, termination clauses , etc. that need to be jointly considered to determine the overall robustness of an EPC contract. However in conclusion, it is clear that the certainty gained from well crafted and mutually agreed contract terms is beneficial to all parties involved.
1. Bateson D. et al (2002) “Liability Caps & Liquidated Damages”, Mallesons Stephen Jaques Australia, Available From : <http://www.mallesons.com/publications/Asian_Projects_and_Construction_U pdate/Asian_Projects_and_Construction_Update_28_September_2002.pdf> Accessed 08th March 2009 2. Chuah C (2008), “Cost and Variation Management In EPC Contracts” Available From : <http://www.ebalawyers.com.au/system/files/download/o110/SIN116.pdf>, Accessed 10th March 2009 3. Elliot C. & Quinn F. (2007) , “Contract Law – 6th Edition ” , pp.337-338, Pearson Education 4. Huse J. (2002) , “Understanding and negotiating turnkey and EPC contracts” pp.24-26 , Thomson Sweet & Maxwell London 5. KPMG International (2007), “Construction Procurement For The 21st Century – Global Construction Survey 2007”, Available at : 6. <http://www.kpmg.lu/Download/Brochures/2007/Global%20Construction %20Survey%202007%20Final.pdf> , Accessed 09th March 2009 7. Loots P. & Henchie N. (2007) “Worlds Apart: EPC and EPCM Contracts: Risk issues and allocation”, Mayer Brown Article , November 2007 8. Merrow, E (2006). “Cost, Profit, and Risk Understanding the New Contracting Marketplace for Large Projects”, Construction Owners Association of Alberta
9. McNair D. , Webb S. & Tsirogiannis N. (2005) “EPC Contracts – Process Plants” , Mallesons Stephen Jaques Australia. Available From :<http://www.mallesons.com/publications/update-combine.cfm?id=481> Accessed 10th March 2009 10. Murdoch I. (2003) “ Limitations of Liability In Construction Contracts”, IHL Construction June 2003. 11. Salter S. 2007 , “Clauses Limiting Liability Must Specify Type Of Loss Parties Wish To Exclude” , The Lawyer’s Weekly Vol 27, No 22, p.p 8 ,
Table Of Cases :
o British Sugar v NEI Power Projects  87 BLR 42 o Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd  AC 79 o Hadley v Baxendale  9 Exch 341 o Strachan & Henshaw v Stein Industrie UK Ltd  87 BLR 52 o Thomas v T Lohan (Plant Hire) Ltd  1 WLR 649
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