Malaysia Campus

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 ]

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Executive Summary

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.

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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

References :.....................................................................................................16

Table Of Cases :.............................................................................................18

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Introduction

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.

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Transaction Background

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 pre-

agreed total price and completion date arrangement incentivize the contractor to

manage the project to meet the promised cost, time and quality targets.

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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)

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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.

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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;

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(ii) rectifying faulty workmanship;

(iii) 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;

(d) 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 [1997] 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

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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.

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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 pre-

agreed 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 [1915] 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

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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 [1997] 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.

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The general principle in English law for testing of remoteness established in

Hadley v Baxendale [1854] 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 [1987], 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

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should not be assumed to be automatically capped at an agreed indemnity

insurance limit unless the contract expressly provides for this (Murdoch I. 2003)

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Conclusion

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.

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References :

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

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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 ,

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Table Of Cases :

o British Sugar v NEI Power Projects [1998] 87 BLR 42

o Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79

o Hadley v Baxendale [1854] 9 Exch 341

o Strachan & Henshaw v Stein Industrie UK Ltd [1997] 87 BLR 52

o Thomas v T Lohan (Plant Hire) Ltd [1987] 1 WLR 649

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