UNDERSTANDING AND NEGOTIATING
SWEEr" MAXWELL
Published in 1997 by Thomson Reuters (Legal) Limited
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© Joseph A. Huse
1997
ACKNOWLEDGMENTS
The author would like to thank all the partners, managers and staff at the various offices of Freshfields for their assistance. In particular, he would like to thank Matthew Turner and Claire Skrinda for their invaluable efforts with respect to the preparation of the second edition of this book.
v
FOREWORD
When the first edition of "Understanding and Negotiating Turnkey Contracts" was written by Mr. Huse, the Orange Book ("Conditions of Contract for Design-Build and Turnkey"), issued in 1995, was the only FIOIC form of contract intended for use in a design and build context. FIDIC being well known for the quality of its prior documents, it was certainly only natural for him to use the Orange Book as a basis for discussing turnkey con­ tracts and proposing negotiation points for the parties.
In 1999, three new Books were issued by FIDIC, with their basic structure and wording harmonised around the previous Orange Book format. These Books were the Conditions of Contract for Construction, for Plant and Design-Build, and for EPCffurnkey Projects. The first one is intended for construction works where the employer is responsible for the design, similar to the old Red Book, and with an important role for the Engineer. The two latter ones are intended for cases when the contractor supplies the design. The Plant and Design-Build Book has the traditional Engineer while the EPCffurnkey Projects Book has a two-party only arrangement.
With further development, the new (1999) "Conditions of Contract for Plant and Design/Build" retain the essential elements of the earlier Orange Book. It had been noted, however, that new trends in project financing and management, especially related to PFI and BOT, required a different set of conditions, and the "Conditions of Contract for EPCffurnkey Projects" were drafted to cater for this. They complement but do not replace the "Conditions of Contract for Plant and Design/Build", in that they are intended to be used in a rather specific context, e.g.:
• when greater certainty is sought that price and time will not be exceeded;
• when the Contractor is required to take total responsibility for the design and construction of the infrastructure or other facility;
• when the Employer is willing to pay more in return for the Contractor bearing the extra risks associated with this; and
• when uncertain or difficult ground conditions or other largely unforeseeable risks are unlikely to be encountered.
They should rather not be used for design-build work in other circum­ stances. The decision which Book to use should, therefore, always be taken in full consideration of the particular characteristics of the project at hand.
In a similar way, depending on the project context, the first edition of "Understanding and Negotiating Turnkey Contracts" very much retains its merits for a better understanding and appreciation of FIDIC's new "Conditions of Contract for Plant and Design/Build", while the new, second edition is equally valuable with respect to the "Conditions of Contract for EPCffurnkey Projects".
vii
FOREWORD
In the very detailed discussion of the context and of the operation of the various clauses, the author pays special attention to the operation of the con­ tract in a BOT project. This will certainly be much appreciated by the many employers and contractors who do not yet have much first-hand experience of such projects but are eager to make the best possible use of this approach to project financing and execution. Other interesting features are the tables summarising the employer's and the contractor's obligations under the various clauses of the contract, and comparisons with other standard forms of turnkey contracts.
For FIDIC, its own "FIDIC Contracts Guide", with detailed guidance to the new contracts, remains the main reference work, especially since it was written by the principal drafter of the three 1999 Books. However, Mr. Huse's work is still the major commentary coming from an independent con­ struction lawyer and will therefore certainly receive much positive attention from employers, contractors, lenders and other interested parties.
Daniel Ivarsson Managing Director FIDIC
viii
INTRODUCTION
When drafting international construction contracts, practitioners often use standard form contracts as a basis for their documents. The form contract provides a familiar starting point to ease the drafting burden and facilitate negotiation.
The Federation Internationale des Ingenieurs-Conseils (FIOIC) has recently published a new form contract for use with the design and con­ struction of works using the engineer, procure, construct or turnkey con­ tracting method. This contract, the FIOlC Conditions of EPCffurnkey Projects (the Silver Book), is aimed at situations where bids are invited on an international basis; with some modification the contract could be used, in certain countries, for domestic contracts as well.
The purpose of this book is twofold: (i) to provide a comparison of the terms of the principle design-buildlEPClturnkey contracts; and (ii) to assist contract drafters in their analysis of the Silver Book and in the modification of its provisions to meet the specific needs of the project in question. The final chapter gives drafting suggestions for selected contract provisions of the Silver Book from the perspective of both the contractor and the employer.
Turnkey contracts
In a design-bid build contract, the employer supplies the design, which often includes the designation of materials and other key construction parameters. Under an EPC agreement, the contractor provides all of the engineering, pro­ curement and construction. Under a turnkey contract, the contractor sup­ plies the final design of the project. From the perspective of the author, these three terms are largely interchangeable and the drafting of this book reflects this position.
These contracts place the design and construction duties in the same hands, providing in theory a more easily co-ordinated project with potential for increased speed of completion and decreased cost, due to tighter project organisation. They also place primary liability on the contractor for any defect in the design, construction or performance of the works. Therefore, as a general proposition, where a defect arises in the works, the employer need not prove to what extent resultant damage was caused by faulty design or by faulty construction, as may be the case under a design-bid-build con­ tract.
As the contractor is allocated design, co-ordination and construction responsibilities for the whole of the work, the employer need not provide the same level of technical expertise required under the traditional contract, e.g. he need not provide detailed design preparation capabilities.
In complex EPC and turnkey contracts parties often use the lump-sum
IX
TYPES OF CONTRACT
appropriate contracting method are the design function and co-ordination of the works. The employer can himself provide one or both of these func­ tions, or he can allocate them to one or more third parties.
1-04 Methods of contracting available to the employer can be split into two broad categories: design-bid-build, which separates the design and construc­ tion functions, and design-build, or turnkey, which places the entire project, including design and construction, in the hands of the contractor. The turnkey method is often referred to as "engineering, procurement and con­ struction" (or "EPC"), especially in the context of project financing. With respect to the first category, a distinction should be made between a design­ bid-build project using a single construction contract and a design-bid-build project using several construction contracts.
Design-bid-build
1-05 The design-bid-build method is the traditional approach to construction contracts (see Figure 1.1). First the employer provides for the design of the project in accordance with his requirements. The designer chosen by the employer then provides a set of drawings sufficient for construction. How far advanced these designs are when used for the tendering process may vary
1-06 Figure 1.1 The design-bid-build method
I EMPLOYER I
I CONSTRUCTION I CONTRACT
CONTRACTING METHODS
in relation to the origin and experience of the employer. In France, for example, the contractor will usually be responsible for detailed design.
In a design-bid-build project the employer provides the design and co-ordi­ nation of the project; thus he will be responsible for the interface between the design and construction aspects of the project. The designer often acts on behalf of the employer as the supervisor or engineer for the project, guiding the contractor in the progress of the works and supervising the interface between the design and construction. Where the project requires extensive financing, this may not be acceptable to lenders (as discussed below).
There are a number of potential disadvantages associated with the design­ bid-build form of contracting. It tends to delay the overall completion date due to the use of distinct design and construction phases (as opposed to the turnkey method). The employer-provided designs will not necessarily corre­ spond with the technical capacities of the contractor. There may be added delay while the contractor familiarises himself with the designs provided and the technology used in the designs.
Single versus multiple construction contracts
When choosing the design-bid-build method of contracting, the employer 1-07 will need to decide whether he wants a number of contractors to fulfil the various construction tasks of the project, or whether to place all of these tasks into the hands of one contractor. When using a number of contractors, the employer may also need to decide which tasks to contract out and which tasks can be provided by his own in-house staff.
The employer may choose the multiple-contract approach when he wishes to establish individual construction packages in order to achieve the lowest price. If multiple construction contracts are used, the employer will need to provide co-ordination of the various contractors and, under certain circum­ stances, subcontractors.2 Therefore, the employer will be responsible not only for the interfaces between the designs used and the work methods of the various contractors and suppliers, but also the co-ordination of each of the construction packages assigned to such contractors and suppliers. This necessitates either that the employer has the skills and experience to under­ take such co-ordination (and understands the construction methods and technology to be used by the various contractors and suppliers), or that he contracts with a competent third party to undertake such co-ordination.
The employer's first step in implementing the construction component of 1-08 such an approach to design-bid-build is to define the individual construction work packages. Construction packages are sometimes defined on the basis of electrical/mechanical works and works of civil engineering. Subject to rel- evant procurement requirements, the employer will then be able to allocate the individual work packages to the contractor or supplier of his choosing.
2 I.N.D. Wallace, Construction Contracts: Principles and Policies in Tort and Contract (Sweet & Maxwell, London, 1986), p. 401 (hereinafter Construction Contracts).
3
TYPES OF CONTRACT
Since the employer chooses the individual contractors and suppliers for each construction package, the employer has greater control over the quality of contractors used and materials chosen. By using this contracting method, the employer may also achieve a lower price for the works. The use of several contractors may enable the employer to use local contractors, possibly under the supervision of experienced foreign contractors, particularly where it is in the employer's interest to effect a transfer of technical and managerial skills to the site country. This same goal can, however, be achieved in a single con­ struction contract by mandating the use of local subcontractors for a certain percentage of the works.
When using the multiple contract method, properly defining the interfaces among each of the work packages may be problematic. Any ambiguity, or the failure of any such definition, is the responsibility of the employer and may result in contractor claims. For the employer this constitutes one of the major risks of the multiple contractor method.
1-09 Under the single or prime construction contract method, the employer places the responsibility for all of the construction of the works with one contractor. This relieves the employer of the need to co-ordinate the inter­ faces among the construction packages. It also reduces the risk of contrac­ tor claims in respect of such interfaces. However, it removes from the employer a certain amount of his control over the construction of the works. The use of this method may also result in a higher cost for the construction of the works (as mentioned above).
In a design-bid-build project with a single construction contract, the employer will still be required to manage the design/construction interface. However, the employer will be able to pass on to the contractor the respon­ sibility for the interfaces between the various construction packages.
1-10 Design-bid-build with multiple contractors provides the employer with extensive control over the design and construction process. Not surprisingly, this method also requires the greatest degree of intervention on the part of the employer. He will be responsible for interfaces between the multiple contractors and co-ordination of their work.
The design-bid-build model can prove to be disappointing. The designer employed by the employer is often removed from the actual field experience of contracting; thus his designs may be distanced from the realities of con­ struction. This distance could result in inaccurate cost and scheduling esti­ mates, impractical or outdated designs and failure to implement new construction methods. 3
Management contracting
1-11 Management contracting is a less traditional approach which involves hiring a contractor whose role is the co-ordination and management of the project.
J Brown, "Opportunities and Risks of Design Build Projects~, The Construction Superconference, San Francisco, U.S., December 7-8, 1995.
4
CONTRACTING METHODS
This management contractor organises time, cost and quality control. He engages a number of other contractors to do the actual construction work. The management contract provides the employer with the control of the project typical of a traditional design-bid-build contract, while reducing the requirements on the employer (a feature similar to the turnkey contract). The primary difference between the management contract and the turnkey model is that the management contractor generally assumes no responsibility for the work of the other contractors or for the performance of the design.4 He acts purely as a management intermediary.
The management contractor can be given any number of different man­ dates, with greater or lesser powers of intervention in the construction process. He can be involved from the very outset of the project, inviting tenders, negotiating for the employer and selecting contractors, through to the completion of the works. The management contractor's fee can be tied to the completion time or the overall price of the contract, or both, using a target price. The management contractor's fees will decrease where the actual price surpasses the target price, and increase where costs are less than those targeted. Under this system by using target pricing the management contractor has an incentive to control the price of the contract in the employer's favour. Similarly, the management contractor can be required to assume some of the liability for the performance of the works or the quality of construction to provide an incentive to supervise closely the quality of the workmanship and materials that go into the works.
Design-build, turnkey and EPC
The "turnkey" arrangement, (also known as the "package deal", "design 1-12 and build", "cle-en-main " , "design and construct" or "EPC") places the duty to design and construct solely on the contractor. There is no accepted definition for each of these terms in the construction field. The term "turnkey" tends to mean the most extreme form of placing design and con­ struction responsibility on the contractor, such that after completion the employer need only turn the key to commence operation of the constructed facility. Notwithstanding this, the term "turnkey" will be used here to describe the more general global arrangement of placing all design, pro­ curement and construction responsibilities on one contractor.
In recent years, design-build projects have seen rapid growth in some parts of the world. For example, use of the design-build method increased from an $18 billion (in the mid-1980s) to a $69 billion (in the mid-1990s) indus­ try and now represents roughly 25 per cent of the United States construction industry.s
4 For a detailed analysis of the management contracting method, see generally Freshfields' Construction & Engineering Group, Freshfields Guide to Management Contracting: Law and Practice (1994). .
5 M.L. McAlpine, "Construction Law: Will Design·Build Contracting Really Solve All of the Problems?" (1997) 76 MI Bar Jnl. 522, online: LEXIS at 533.
5
TYPES OF CONTRACT
Where the contractor takes responsibility for the design of the works, the employer's advisers find their involvement limited primarily to the tender process and supervision of the contractor's work. The definition of supervi­ sion is likely to be the subject of extensive negotiation between the parties, as the employer will want to maintain control over the construction process.
The turnkey system generally uses the lump-sum pricing method. Certain practitioners believe that it is ill-suited to interim payment based on the cost of work done, due to the difficulty of verification by outside experts of the figures submitted by the contractor.6
The turnkey contract places the responsibility for the entire project in the hands of the contractor. Thus, there is no need to identify whether a defect has been caused by defective design or defective construction of the works. As a general rule, any defect falling within the scope of works will be the respon­ sibility of the contractor. Contractor liability makes design-build contracts particularly attractive for employers.7 The potential liability of the employer under other construction contracts (where, for example, he provides any design specification) has led to a dramatic growth of design-build contracting.8
1-13 The use of the turnkey method of construction results in a considerable reduction of intervention by the employer in the design and construction process, as compared with other contracting methods. The role of the employer will consist primarily of contract administration. His role may also include, depending upon the terms of the turnkey contract, review and/or approval of designs. Further, the design used ought to be consistent with the technical capacities of the contractor, resulting in a more efficient and cost­ effective application of the design to the construction of the works.
The combination of the design and construction responsibilities should also decrease the overall time for completion. This phenomenon is known as "fast track" construction. Efficiencies in the design and construction process may potentially reduce the price of the project. However, certain construc­ tion professionals maintain that the claims of earlier completion with design­ build construction are exaggerated and that design-bid-build projects achieve similar completion times.
1-14 As the responsibility for co-ordination of the project passes from the employer to the contractor, so does some of the control. The employer will experience a decrease in his day-to-day control of the construction of the works. As the contractor's control of the construction increases, so does his need to be experienced in the management of large-scale projects. This may include handling interfaces between multiple methods of construction, inter­ faces between different industries, and the various designs used by sub­ contractors and suppliers.
Under the turnkey method of contracting, the tender stage takes on greater importance. Given the short time period available, it may be difficult for the
6 Construction Contracts, op. cit. n. 2 above, p. 365. ? M.L. McAlpine, op. cit. n. 5 above, 522, online: LEXIS at 555. 8 C.G. Hammond, "Dealing with Defects: Defective Owner· Provided Preliminary Design in
Design-Build Contracting" (1998) 15 1.C.L.R. 193 at 196.
6
CONTRACTING METHODS
employer to analyse properly each design at tender.9 Therefore, he will need to be extremely precise in his "request for tender" as to the performance and capacities desired from the works, (known, in the Silver Book, as the Employer's Requirements). The employer will need to spend a greater amount of resources on the tender stage to ensure the contractor and his pro­ posed design are of the requisite quality. Similarly, the contractor may need to expend heavily on bid preparation to ensure the buildability of the project and the profitability of his bid price. to
The employer may choose to use a turnkey model for only part of the project 1-15 (called "part-turnkey" or "semi-turnkey"). The co-ordination responsibility for the entire project will then either fall on the employer's consultants or the turnkey contractor. The contractor will, therefore, bear design responsibility for only a part of the works. ll Thus, for example, the turnkey contractor can provide certain aspects of the works such as heavy civil facilities which require specialised design and attention, while the employer can contract on a design­ bid-build basis for the finishing of the works and equipment systems.
This method decreases necessary interfaces, thus simplifying the co-ordi­ nation of the project. It may also separate the responsibility for differing types of work, for example equipment systems work and heavy civil work, thus reducing contact between various industries not necessarily familiar with each other's working methods. The advantages and disadvantages of the part-turnkey model are generally the same as those for the turnkey and design-bid-build models, including considerations related to the combina­ tion of the two contract models.
Reference should also be made to a variant of the EPC construction methodology referred to as "EPCM" or "engineering, procurement and con­ struction management". The essential difference between EPC and EPCM methodology is that the contractor under an EPCM contract assumes responsiblity for supervision/management of construction but does not assume responsibility for the construction itself.
BOT (Build Operate Transfer)12
The typical BOT (along with its variants such as BOO (Build Own Operate), 1-16 BLT (Build Lease Transfer) and others) contract encapsulates the process whereby a government grants a concession or similar right to a project devel­ opment company to develop and operate what would normally be a public sector project, for a given period of time known as the concession period. The project development company obtains financing for the project, and then designs and constructs the facility; it then operates the facility during the agreed period and thereafter turns the plant over to the government. The
9 M.L. McAlpine, op. cit. n. 5 above, 522, online: LEX IS at 554; I.N.D. Wallace, "Design­ and-Build: a No-No for Owners" (1999) 4 Const. & Eng. L. 7 at 8 (hereinafter "No-No").
10 For an outline of how this process might look under the Silver Book, see the applicable sec­ tions of the FIDIC Guide.
11 Construction Contracts, op. cit. n. 2 above. . 12 For further analysis of this concept, in relation to the Silver Book, see Chap. 4.
7
TYPES OF CONTRACT
parties generally intend that the income received by the project development company during the concession period (including, in certain circumstances, subsidies) will pay for the cost of financing and running the plant with an ade­ quate return for the investors. These investors often include the contractor. 13
Any BOT project involves a potentially complex contractual structure. However, in most cases, the BOT project will use a turnkey or EPC contract for the actual design and construction. Thus the BOT is not really a separ­ ate method of construction contracting, but rather a method of financing the project. Indeed, the lenders of the BOT projects have significant influence on the terms of the underlying construction contract, including the requirement that such a contract be turnkey and, often, in the form of an EPC contract. 14
In a BOT project, the operation period between completion and transfer also gives the transferee an opportunity to verify the quality and quantity of output of the works. The contractor can be required to provide the trans­ feree's personnel with training prior to the transfer, thereby easing transition. The transferee will need to take care to maintain the operator's incentive to maintain properly the works, in order to avoid deterioration in the final period before transfer to the transferee (the operator, in an attempt to save on costs, may towards the end of the operating period decrease maintenance and operating expenditures resulting in accelerated deterioration of the works). In certain BOT projects, the operator is required to assume defects liability for a limited period of time subsequent to the transfer.
l-17 A BOT project, in practice, is often not as simple as its definition implies. There may be a large number of parties. For example, in a recent hydroelectric project, the project development company (granted a concession by the govern­ ment), entered into various contracts for the building of the facility, its opera­ tion and maintenance during the concession period and a power purchase agreement with an electrical utility. The construction of the facility was pro­ vided through a turnkey contract with a consortium of contractors. Each of the turnkey contractors was also an investor in the project development company. A subsidiary of one of these turnkey contractors also acted as the operator of the facility after completion. This complex structure is typical of power plant BOT projects in developing nations, as developing economies struggle to meet the dramatic increase in demand for energy (see Chapter 4 BOT)Y
The increasing popularity of the BOT project is largely due to a shortage of public funding and the opinion that the facility will be more efficiently managed by a private entity.16 In theory, the BOT scheme provides develop­ ing countries with much-needed infrastructure at a reduced direct cost to the government. I? However, BOT projects are high-cost and high-risk ventures for private entities operating in a traditionally public domain.
IJ j. Scriven, "A Banking Perspective on Construction Risks in BOT Schemes" (1994) 11 I.C.L.R. 313 at 314.
14 C. Wade, "History and Scope of the Three Major Books" (1998) online: FIDIC http://www.fidic.comldocumentsllaunchlwade1.html(date accessed: November 19, 1999).
IS D. Blumental, "Sources of Funds and Risk Management for International Energy Projects" (1998) 16 Berk. J. Int'J Law 267, online: LEXIS at 270.
16 j. Scriven, op. cit. n. 13 above, 313. 17 S.W. Stein, "Build-Own-Transfer (BOT) ARe-Evaluation" (1994) 2I.C.L.R. 101.
8
CONTRACTING METHODS
The cost of tender being high, the project company members should take great care to examine the risks associated with the project prior to tender­ ing. The project company will prefer an exclusive and specific mandate from a host country interested in the project and supportive of it. 18 Project company members should have experience not only in constructing large projects but also in investing in and operating such projects. 19
Where the grantor of a concession for a project is a political entity, it takes 1-18 on a further political risk in that the project is placed in the hands of an entity not necessarily affected by the political repercussions of its actions. The public may not understand that the grantor is removed from the day-to-day operations of the public service subject of a BOT project (e.g., an under- ground railway) and thus any mismanagement or politically unpopular deci- sion may be imputed to the grantor. Although the contract may provide for grantor influence in the selection of personnel in order to ensure proper oper- ation, the effectiveness of such influence may be practically minimal. The grantor will, thus, want to consider the independent status of the project development company and the potential effect the company's actions may have on the grantor's political position and the public welfare.
Banks and other financing institutions will make it a condition of their financing of a project that there is implementation of a contractual scheme that provides them with some certainty as to their financial risk. By using a lump-sum price and placing much of the completion risk on the contractor, the turnkey contract can provide the lenders with a significant amount of cer­ tainty and thereby confidence in the project. (A more detailed discussion of the issues can be found in Chapter 4 BOT.) Some authors assert that the "contractor and employer are very likely to rely on the Silver Book as a good compromise approach». 20
Pricing Methods
Some of the most common methods of pricing a construction project are: 1-19
(a) lump-sum; (b) cost-reimbursable; and (c) unit price.
T.hey can be used alone or in combination. The selection of a pricing method directly affects the distribution of certain risks, such as changes in the cost of labour and materials.
18 Gurun, . " Build-Own-Tran.sfer Projects: The Contractor's Role in Risk Management", 19 InternatIOnal Ba~ ASSOCIation Conference in Tokyo, japan, February 1993, at 11.
S.W. Stem, op. CIt. n. 17 above, 101. 20 C. Pedamon, "~ow is Convergence Best Achieved in International Project Finance?" (2001)
24 Fordham Int J L.}. 1272, online: LEXIS at 1300.
9
Lump-sum method
L-20 The lump-sum method gives a price for the whole of the contract, irrespec­ tive of the contractor's as-built cost. The difference between the price and the actual cost of the works to the contractor will constitute the contractor's profit or loss. The contractor assumes substantial risk, including the risk of most changes of circumstances (for example, a change in the price of mate­ rials or labour). Although most lump-sum contracts provide for modifica­ tion of the price in certain limited circumstances, such contracts usually provide that the contractor may not claim additional payment for work indispensably necessary to completion, even where omitted from the specifi­ cations of the contract. The employer is therefore given a figure representing his global exposure, although this figure may be subject to adjustment as provided by the contract.
The contractor will usually be paid the lump-sum price in instalments. The instalments will be based on a schedule of payments or payable at specified stages of completion. In certain cases the lump-sum price may only be payable by the employer to the contractor upon completion, i.e. where com­ pletion is a condition precedent to payment.21
1-21 The lump-sum is generally easier and less expensive to administer than the other pricing methods, as the price is clearly specified (although variations and other alterations to the contract and its price are still possible). Rather than having to calculate the pricing of completion based on the amount of construction units required or the extent of materials, equipment and ser­ vices used (e.g. a calculation of the cost of construction), the parties need only refer to the lump-sum price.
The employer will need to provide for compilation and transfer of infor­ mation concerning the site in order to enable the contractor to formulate a realistic lump-sum price. Construction contracts often provide that the contractor will not be required to go through the expense of verifying employer-supplied information. However, the contractor will almost invar­ iably be required to investigate, or be deemed to have investigated, the site and the conditions present at the site. The time and cost associated with lump-sum tendering required of both parties may exceed the cost of tender­ ing in contracts priced in accordance with actual cost.22
The employer may require the contractor to provide him with a break­ down of the lump-sum price into specific amounts payable for different activities or portions of the works. In a tender process, this information will enable the employer to obtain a better understanding of the basis of the con­ tractor's price. This breakdown will facilitate adjustment or revision of the contract price where provided for in the contract. It may also be used for the pricing of variations.
2\ A. Burns ed., Construction Disputes: Liability and the Expert Witness (Butterworths, London, 1989) p. 26 (hereinafter Construction Disputes). ,
22 P.O. Marsh, Contracting for Engineering and Construction Proiects (Institute of Purchasmg & Supply, 1988), p. 164.
10
PRICING METHODS
The lump-sum price regime does not allow for adjustment or revision of the contract price, unless specifically provided for in the contract. There may be adjustment for incorrect data provided by the employer, unforeseeable adverse sub-surface conditions, or changes in the works required by the employer. The employer may also decide to assume the risk of inflation and exchange rate risk. The parties should specify with clarity the situations in which adjustment is available.
Cost-reimbursable or cost-plus
Under cost-reimbursable conditions the employer pays the contractor for 1-22 costs incurred plus a predetermined margin of profit. The margin or fee can be fixed, fluctuating or determined as a percentage of actual costs. For example, the margin for building a tunnel may be a flat fee on completion, a percentage of the actual costs incurred in building the tunnel, or a fee that will fluctuate in accordance with some external measure such as the rate of inflation or the base rate of the central bank of the country in which the tunnel is built. This form of payment may create no incentive to work eco­ nomically or rapidly, since, for example, the greater the cost, the greater the profit, irrespective of progress. In order to compensate for this lack of incen- tive the parties can include, as part of the pricing provisions of the contract, an incentive mechanism.
One example of an incentive mechanism is target cost. This mechanism may be implemented in a number of ways. One possibility is that any cost above a maximum "upset" or "target" cost will not receive any profit or "fee", and may incur a decrease in "fees" already earned.23 To increase the incentive to finish within a given time period, the contract could also increase or decrease the fee in relation to the completion date of the project.24
The cost-plus system is generally only used as a last resort, where it is 1-23 impossible to calculate construction costs, such as tunnelling works. For example, the Eurotunnel project used a target cost mechanism for the tun- nelling works. The construction contract awarded the contractor 50 per cent of the savings should the actual price be les:; than the target price. Where the actual price exceeded the target price then the contractor was liable for 30 per cent of the difference. The contractor's liability was limited to half of the fee, or 12.36 per cent of the contract price for such works.25
Another method of reducing the employer's risk in respect of the cost reimbursement price is to apply a reasonableness standard. The contractor is then only compensated for costs reasonably expended. However, it may
23 "Contracts", op. cit. n. 1 above at 345. Z4 P.O. Marsh, Contracting for Engineering and Construction Projects (Institute of Purchasing
& Supply, 1988), p. 167. IS Huse, Kirkland and Shumway, "The Use of the Target Concept for Tunnelling Projects in
Light of the Eurotunnel Experience", Options for Tunnelling Conference of the International Tunnelling Association, Amsterdam, the Netherlands, April 19-22, 1993, at 6.
11
TYPES OF CONTRACT
be difficult to determine the reasonableness of a given cost.26 This difficulty arises in the pricing mechanism of any cost-reimbursable contract, requir­ ing detailed provisions regarding verification and administration of the con­ tractor's costs, detailed schedules and care in eliminating the possibility that the contractor could make a profit at the costs level before the fee element has been calculatedP An employer becomes dependent on the reliability and efficiency of the contractor, despite protection placed in the body of the contract.28
The contract may also provide that the employer pay to the contractor only the amount paid for materials and services actually used by the contrac­ tor (to take into account any over-ordering by the contractor and sub­ contractors). The definition of costs may also take into consideration any discounts offered by suppliers. The obligation of the contractor to keep extensive records will provide some measure of protection for the employer in calculating costs.
Unit price or bill of quantities
1-24 According to the unit pricing method, the price of the project is calculated in accordance with the amount of work done. The price is established per unit of quantity with reference to a bill of quantities or a schedule included in the contract which specifies the amount of materials and labour needed for a particular task. This method places the risk of the number of units used on the employer but transfers risk of change in the cost or rate of each unit to the contractor.29 Thus, if the cost of a unit of excavation in a tunnelling contract is provided at 100, the employer will pay where more units are excavated than expected. However, in the absence of unforeseeable adverse sub-surface conditions (assuming the contract provides a changed conditions clause), the contractor is responsible for added cost where the unit of exca­ vation costs more than 100.
The unit pricing method is common in construction contracts. Employers have traditionally used this method where the quantity of construction inputs is not ascertained at the time of contracting. Thus, for example, where the amount of concrete to be used for the construction of a building is not yet ascertained, the employer can price the contract in accordance with the cost of a unit of concrete. The contractor will then be compensated for the actual amount of concrete required, while the employer will be assured a fixed price per unit of concrete.
This method continues to be used extensively today, even in projects where the quantity of materials is certain. Certain publications, such as the
26 ibid. at 3. 21 "Contracts", op. cit. n. 1 above at 345-346. 28 Construction Disputes, op. cit. n. 21 above, p. 26. 29 Huse, Kirkland and Shumway, op. cit. n. 25 above, at 3.
12
PRICING METHODS
Standard Methods of Measurement in England, provide forms of schedules as a pricing method.
As with the lump-sum pricing mechanism, the parties may provide for a 1-25 system of adjusting the unit price. The pricing mechanism may provide for changes beyond the parties' control, such as unforeseeable sub-surface con­ ditions, or changes in law or regulations that affect some aspect of the con- tract. The contract may even provide for adjustment on the basis of changes in the cost of materials or labour. The ability of the contractor to obtain an adjustment to the contract price in respect of certain defined circumstances shifts the risk in respect of such circumstances from the contractor to the employer. The parties should, of course, define carefully any such circum- stances and their potential impact on the unit price.
The parties will need to agree on a precise method of calculating the quan­ tities used. Although the costs of valuation and measurement associated with a project carried out under a unit-priced contract are not as high as those of a similar project under a cost-reimbursable contract, they are still higher than those necessary under a lump-sum contract.
While a good idea in theory, and often in practice, parties should be wary of the potential for the bills of quantities system to be abused. After the Second World War, widespread usage of contracts of this type "rapidly pro­ duced a whole science of upward price manipulation bearing no relation to the site realities which lasted for decades due to the apathy of clients' legal advisors and ~he collusion of architects, engineers, etc".30 Eventual disillu­ sionment with the bill of quantities method is perhaps one of the reasons for the growing interest in, and popularity of, the turnkey (and therefore lump­ sum) contracting method.
Bonus schemes and currency of the price
In addition to the pricing mechanism, the parties may want to add a bonus 1-26 scheme to create an incentive for early completion. Such a bonus can be cal- culated in a manner similar to the calculation of liquidated damages, provid- ing for a fixed amount or percentage of the contract price for each day of early completion. The employer may wish to defer payment of the bonus to the contractor until after the works have been operational for a period of time, such as after the defects liability period, to ensure proper performance of the works. Further, it is not normally advisable to use the bonus system in a cost-reimbursable contract without including a mechanism designed to eliminate any incentive that the contractor might have to construct using more costly methods in order to achieve early completion.
The parties will also need to consider the currency in which the price is 1-27 paid. If the price is to be paid in the currency of the costs incurred by the contractor and such currency is different from the currency of the employer's
30 "No-No" op. cit. n. 9 above at 7.
13
TYPES OF CONTRACT
country, then the employer carries the risk of a change in the exchange rate between the currency of the employer's country and the currency of the price. Where the currency of the price is the currency of the employer's country then the contractor bears the risk of a change in the exchange rates. If the currency of the contract is a third currency, not that of the employer's country and not that of the costs incurred, then both parties will bear a portion of the risk of a change in exchange rates. In certain countries, the parties may also have to consider exchange control regulations, including restrictions on the currency of payment of a contract and restrictions on indexation tied to a currency other than the currency of the locale of the project.
Currency ledging may also be available to layoff part or all of the cur­ rency risk onto one or more financial institutions.
Payment Methods
1-28 When considering the payment provisions of the contract, the parties must agree upon the methods of payment. The contract may provide for a certain portion of the price to be payable upon commencement of the works, through advance payments, in order to provide the contractor with sufficient cash flow to cover the substantial expenditures which may be required at the early stages of construction. For example, in a power plant project, advance payments may be provided for the purchase of certain equipment and machinery such as the generator and the turbines. This advance payment would then be repaid through reduction of future payments. The employer may also want a security to be provided for the amount of the advance payment. An advance payment guarantee for the amount can be provided by a third party much in the same way as a performance security, with the employer giving his consent to the guarantor chosen or a guarantor being indicated in the contract itself. The cost of the guarantee will lessen the benefit of the advance payment to the contractor, but may allow the employer to provide a larger sum than he would otherwise have supplied without the protection of the guarantee.
Where funds must be transferred to different locations the parties must consider risks relating to exchange rate fluctuation during transfer, and the tax regulations concerning such transfers. The form of payment may also incorporate some guarantee of payment, such as the use of a letter of credit.
There exist a number of methods of payment, three of which are discussed below. The second and third methods are the most commonly used.
Payment after completion
1-29 The first is rare in large construction contracts, involving the payment of the contract price only after completion of the works involved. This method is more common for smaller subcontracts or simple task-oriented contracts but
14
PAYMENT METHODS
it is not unknown on larger projects. When used on such large projects the payment after completion provides a form of contractor financing of the project, requiring the contractor to obtain outside financing himself or to auto-finance the construction. Sometimes this method will be used to finance a portion of the construction with payments extending well beyond comple­ tion of the construction.
Milestone payments
Under milestone payments the parties set up a schedule of tasks for the 1-30 contractor to perform. For each milestone achieved, the contractor is paid a portion of the lump-sum price or an amount in accordance with rate sched- ules, bills of quantities or cost-plus pricing. Payment occurs only after com- pletion of the tasks required. Milestone payments at specified stages of completion provide an incentive for rapid progress. 31 Milestone payments can occur either at the completion of each given milestone, or periodically, resulting in payment for all milestones completed within the period involved. Thus the greater the progress during a payment period the greater the value of the payment received.
Contractors may be tempted to carry out the more expensive tasks at the early stages of construction, resulting in less of an; incentive to progress at later stages of completion. Where combined with lump-sum pricing, mile­ stone payments can avoid such "front-loading" by the contractor.32
This approach may be combined with the progress payment method for certain portions of the works. For example, the parties may decide that the contract will be paid in accordance with milestones except for the price of the plant or certain materials for which the contractor will be compensated once they are in the employer's possession (such as upon delivery to the site).
Progress or scheduled payments
The contract can provide for payment for work completed during a given 1-31 period of time, calculating the value of the work done during the period, or simply setting a percentage of the contract price to be paid at the end of each period. The former method of payment is frequently used in connection with the unit-price method of pricing. The latter method of payment is not fre­ quently used. There is little incentive for efficient completion under this latter type of periodic payment since the contractor receives remuneration irre­ spective of the progress achieved by the work completed.
In order to balance the need for progress and timely completion with the use of progress payments, parties may institute different pricing or incentive
)1 Construction Contracts op. cit. n. 2 above, p. 380. J2 "Contracts" op. cit. n. 1 above at 345-349.
15
TYPES OF CONTRACT
programmes. The use of target costs, as described under cost-reimbursable pricing, will provide the contractor with an incentive to decrease the real cost of the project, while the use of unit pricing will define the value of work com­ pleted in order to avoid the effects of increases in costs of materials and labour.
16
Advantages and Disadvantages of Turnkey and EPC Contracts
In recent years the use of turnkey and EPC contracts for construction pro- 2-01 jects, and in particular infrastructure projects, ha~ become popular with employers and financing institutions. However, · although the turnkey approach is in fashion and it provides many benefits to these entities, it also has certain disadvantages.
Advantages
In traditional design-bid-build projects, responsibility for design and con- 2-02 struction is often spread between a number of parties. Design and construc- tion tasks are often performed by separate entities or pursuant to separate contracts.
Such projects are often split into different elements, or works packages. These packages will interact with one another (their "interface"). Interfaces exist between the design and all the construction packages but also between the individual construction packages themselves.
Generally, in design-bid-build projects the employer takes the responsibil­ ity for co-ordinating these various project elements and their respective inter­ facing. For example, in the construction of a hydroelectric project the employer will have to ensure that the design element and the civil and electri­ cal works interface correctly as well as between the civil and electrical works elements themselves- by seeing, for example, that the foundations can sustain vibration from turbines. Each contractor or participant will only have liability for the discrete project package for which he is responsible. This may lead to a number of problems. Contractors may make claims as a result of poor co-ordination between packages. One contractor may delay the work of others. Furthermore, it may be very difficult to allocate respon­ sibility for defects between a designer and a contractor.
By contrast, the turnkey or EPC contract makes the contractor entirely 2-03 responsible for both the design and construction of the works. The employer receives a completed project in accordance with his performance specifica- tions. When he looks for accountability as to the performance and quality of the works, he need look no further than the contractor.
17
TURNKEY AND EPC CONTRACTS
This means that the employer does not need to worry about co-ordinat­ ing contractors effectively (and avoids claims resulting from lack of interface definition). If he wishes to make a claim concerning a defect he can look to the contractor without the need to address whether it is a design or work­ manship problem.
In addition, single-point responsibility can also reduce the opportunity for claims by the contractor. Under more traditional contracting arrangements, these claims are often based on directions given by the engineer. Since the engineer is no longer a central co-ordinating figure in the turnkey contract and the contractor has taken on the responsibility for the design and con­ struction the turnkey contract may provide decreased opportunity for claims.
The contractor must deliver works that are fully operational to the spec­ ifications of the employer; any defect or fault is necessarily his responsibility except where the contract provides otherwise. Everything relating to the works can, thus, be concentrated in a single point of responsibility-the contractor.
2-04 This single point responsibility has two notable consequences: first, the role of performance criteria; secondly, the standard of performance expected from the contractor. The contractor must design and build the works in a manner such that the performance of the finished works satisfies the criteria set out in the contract (otherwise known as performance criteria). The employer will define these performance criteria in such a way as to ensure that the works provide at least the level of performance required for profit­ able production. The performance criteria may specify output, input, waste, and any other performances the employer may desire. For example, in the construction of a coal-fired power plant the employer will want to ensure that the plant produces sufficient power to satisfy his commercial needs, in particular where he has entered separately into an agreement for a third party to purchase a certain amount of the electricity produced. Thus, these criteria set out levels of performance the employer expects; it is then the responsibility of the contractor to produce works that are in conformity with them.
2-05 Under a traditional design-bid-build contract the construction contractor and the designer are held to different standards of performance for the com­ pletion of the works.
Designers in many jurisdictions traditionally have not been required to guarantee results, but rather method. They are held to have a superior base of knowledge, sufficient in competency and ability to complete the design with a reasonable degree of technical skill. For example, courts in the United States have held that the designer, in the preparation of designs and draw­ ings, must exercise his skill and ability, judgment and taste reasonably and without neglect.! This standard represents a professional duty of care. The contractor, on the other hand, often may be required to construct the works
I Stated in the U.S. case of Surf Realt)' Corp. v. Standing 78 S.E.2d 901 at 907 (1953) cited in Gravel), v. Providence Partnerships 549 F2d 958 (4th Cir. 1977).
18
ADVANTAGES AND DISADVANTAGES OF TURNKEY AND EPC CONTRACTS
with due care and diligence. The standards are often defined by the relevant legal system and in accordance with industry practice. The standard of per­ formance can 'vary from contract to contract, and construction contractors are required to complete the works in accordance with the contract. Therefore, the contractor will not generally be held responsible for design deficiencies.
Under a turnkey or EPe contract both the designer and contractor respon- 2-06 sibilities are placed on the contractor along with a :stricter standard of per­ formance. The standard of performance applied will be provided by the contract, or in the absence of a specific provision, by the applicable law. Under the Silver Book the standard is "fitness for purpose".2 According to English case law, a turnkey contractor is under strict liability to deliver a structure "fit for the purpose" for which it was made. 3
The "fitness for purpose" standard goes beyond a "professional" duty of care, placing on the contractor liability for any failure of the design to perform to the standards required. This provides the employer with works constructed and operational in accordance with the intended purpose or use of the works as provided in the contract. For example, in the construction of a thermal power plant the employer can set out in the employer's require­ ments the size and nature of the plant desired, as well as its operational output and the consumption necessary to reach such output. Therefore, if the employer's original conception of the works lacked some element neces­ sary for it to be fit for the purpose intended, the contractor would be respon­ sible for ensuring that the finished works contained the missing element.4
Lump-sum price. The lump-sum pricing method is often used for turnkey 2-07 and EPe contracts and enables the use of fixed payments by stages of com- pletion. Lump-sum pricing and fixed insta lment payments provide the employer with greater certainty in overall cost as well as in the timing of pay- ments.s This system reduces front-loading by the contractor and encourages rapid completion. It also facilitates financing, as lenders will have greater certainty of financial exposure and the timing of draw-downs.
However, even where the contract is priced on a lump-sum basis, the contractor will normally have the right, under certain limited circumstances, to claim an increase in the contract price (as discussed above).
The role and influence of project financing. Lending institutions, such as the 2-08 European Bank for Reconstruction and Development, often insist on lump- sum turnkey contracts for construction projects which they finance. Project lenders believe that lump-sum pricing and single-point completion respon- sibility reduce the completion risk to project lenders and provide greater
2 Silver Book sub-clause 4.1. J IBA v. EMI and BICC (1980), 14 B.L.R. 1. 4 For a more detailed discussion of the "fitness for purpose" obligation, see Chap. 8. 5 I.N.D. Wallace, Construction Contracts: Principles and Policies in Tort and Contract (Sweet
& Maxwell, London, 1986), p. 408 (hereinafter Constmction Contracts).
19
TURNKEY AND EPC CONTRACTS
certainty of overall financial exposure. This method of contracting is becom­ ing increasingly prevalent for international infrastructure projects. This is particularly true in BOT and similar projects, where limited recourse financ­ ing makes lenders wary of taking further risks when it comes to the pricing of the construction project.6
2-09 Speed of procurement. The traditional design-bid-build method of contract­ ing contemplates separate and distinct design and construction phases. The turnkey or EPC method combines these two phases and allows construction to proceed along a "fast-track"; in certain cases the contractor can even com­ mence construction prior to the completion of the design phase. Consequently, the turnkey method of contracting may result in earlier project completion.
2-10 Efficiency. Since the contractor both builds and designs the works, the contractor no longer needs to take the time to understand the employer's designs.7 The design should also take into consideration the contractor's methods of construction, providing more efficient and timely completion.8
The control given to the contractor should facilitate implementation of new and better approaches to design, developed through his experience and expertise. The contractor will have an incentive to implement such time­ saving changes under the turnkey structure, which may not be true under more traditional contracting methods.
Since the designer and the constructor work as a team, they are more likely to identify critical flaws in the design at an earlier stage, ensuring avoidance or mitigation of the flaw when such action is more effective. This team approach will help avoid many design and construction risks which a separate designer and constructor would not be able to identify.9 The joining of the design and construction task under one contractor may also reduce the number of disputes which arise between the contractor and employer.
Disadvantages
2-11 Loss of control. The overall design and construction supervision role of the engineer is absent from the turnkey contract. Under the Silver Book, the engineer's supervisory role has been replaced, but in part only, by that of the employer's representative. This new role is relatively flexible, allowing
6 D. Blumental, "Sources of Funds and Risk Management for International Energy Projects" (1998) 16 Berk. J. /nt'/ Law 267, online: LEXIS at 271, 288-289.
7 However, contractors operating under the terms of the Silver Book would be wise to take time to understand employer designs, as the contractor is strictly liable for any designs pro­ VIded by the employer under the Silver Book. See discussion in Chap. 9 (design)
• Construction Contracts, op. cit. n. 5 above, p. 407. 9 Brown, "Opportunities and Risks of Design Build Projects", The Construction
Superconference, San Francisco, U.S., December 7-8, 1995, p. 5.
20
ADVANTAGES AND DISADVANTAGES OF TURNKEY AND EPC CONTRACTS
input in and control of the design and construction of the works. However, the turnkey model generally contemplates less day-to-day intervention than is present under a traditional design-bid-build contract. Under the turnkey contract, it may be more difficult for the employer to exercise his variation power properly. He may be distanced from the design, reducing his understanding of the processes used and his ability to verify the need for a variation and whether the variation proposed will affect the perfor­ mance of the finished works. Where the engineer designs and co-ordinates the construction, the employer knows at each stage how the works may need to be altered. In the absence of the engineer, the employer's under­ standing of the process of the design and construction of the works may be diminished.
The contractor will want to execute the works within the parameters of the employer's requirements for the least cost possible. The contractor in a turnkey or EPC contract may be tempted to under-design the project in order to cut his costs and save on time. Therefore, under the turnkey or EPC model the employer will still need to provide supervision of the construc­ tion, to ensure that the contractor's performance satisfies the contract requirements.
Indeed, where the nature of the project is such that design changes are likely to be necessary (and yet where the contractor will not be entitled to an increase in the contract price) the employer should be aware that the ulti­ mate maintenance costs and long-term performance of the project's structure may be negatively affected.1o Some employers try to offset this risk by requir­ ing the successful bidder to operate and maintain the facility for a period of time after construction, thereby providing the contractor with incentive to produce an efficient, low-maintenance product. 11
Cost of tender.12 When tendering for a turnkey contract, the contractor 2-12 often must have a design in the advanced stages of completion, having made sufficient tests and studies to know the costs and the level of risk involved in the project. Under such circumstances, the cost of tendering a turnkey contract can be quite high. In order to counteract the expense of bidding, the World Bank has suggested limiting the number of bids to a maximum of six, based first on technical merit and secondly on price com­ petition. 13 The employer can also offer to make a payment to those contractors giving serious bids, but who are not chosen. This will decrease the cost of bidding to the contractor and increase the quality of the bidding pool. However, in practice, employers do not often provide for such payment.
10 M.L. McAlpine, "Construction Law: Will Design-Build Contracting Really Solve All of the Problems?" (1997) 76 M/ Bar Jnl. 522, online: LEXIS at 557; I.N.D. Wallace, "Design-and­ Build: a No-No for Owners" (1999) 4 Canst. & Eng. L. 7 at 8.
" M.L. McAlpine, op. cit. n. 10 above, online: LEXIS at 555. 12 For further discussion of issues relating to the tendering process, see Chap. 5. 13 G. Westring, "Turnkey Heavy Plant Contracts from the Owner's Point of View" (1990) 7
I.C.L.R. 234 at 235.
TURNKEY AND EPC CONTRACTS
The cost to the employer of verifying the design-if such verification is possible considering the time frame of the tender process-may prove to be quite high. As one construction expert has noted: " ... if a really detailed check of the design and specification is attempted, using consultants engaged for that purpose by the owner, the basic saving in costs by way of reduced fees of professionals is likely to prove illusory" .14 The temptation to under­ design, combined with the difficulty of verifying the quality and efficiency of the design tendered, could result in increased contract cost. Further, carry­ ing out an effective comparison between the various tenders (due to their individual design characteristics) will likely prove costly in both time and money to the employer. IS
In order to avoid the temptation to accept bids based on price rather than quality of design, the World Bank suggests a two-stage bidding process. During the first stage contractors submit unpriced technical proposals. It is only during the second stage that prices are considered. A legal counsel for the World Bank suggests five main steps: pre-feasibility, feasibility, bidding, evaluation of bids and award of contract, and negotiation. 16 Such staged bidding will allow the employer to look first to the quality of the design, then only secondly at the bid price.
Cost of risks,l7 Under the turnkey or EPC contract the employer benefits from an increased amount of the risk of the project being placed on the contractor. However, depending upon market forces, a contractor will attempt to increase the contract price in accordance with the increase in risk. IS Where there is little competition, the employer may have to assume the cost of the increased risk placed on the contractor. Thus the employer may end up paying a higher overall price for the project due to the degree of risk that is placed on the contractor and the need for the contractor to price such risk. Indeed, this is the idea behind the risk transfer and the justifica­ tion for such transfer.
Whether the advantages of the turnkey contracting method will outweigh the disadvantages will depend primarily on the nature of the project in ques­ tion and the identity of the parties involved. Naturally, the answer will also be influenced by the balance of power in the contracting relationship. The current employer-dominated market often results in greater risk being allo­ cated to the contractor, without a commensurate increase in the contract price to the contractor.
I~ Construction Contracts, op. cit. n. 5 above, p. 409. IS I.N.D. Wallace, "Design-and-Build: a No-No for Owners" (1999) 4 Const. & Eng. L. 7 at
8. 16 G. Westring, "Turnkey Heavy Plant Contracts from the Owner's Point of View", op. cit.
n. 13 above at 236-238. 11 For further discussion of risk allocation issues, see Chap. 21. 18 P.O. Marsh, Contracting for Engineering and Construction Projects (Institute of Purchasing
& Supply, 1988) at 252.
ISSUES IN CONNECTION WITH LUMP-SUM TURNKEY OR EPC CONTRACTS
Issues in Connection with Lump-Sum Turnkey or EPC Contracts
There are a number of key issues relating to the drafting and negotiation of lump-sum turnkey or EPe contracts which drafters will need to consider carefully, to ensure complete and effective allocation of risk. The key issues include the following:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
The definition of the scope of the works l9: the parties will need to specify carefully the scope of the works and the employer's require­ ments. in order to define the contractor's liability for design, con­ struction and performance.20
Use of an engineer or employer's representative: the parties will need to decide how to make use of an engineer and his role (or the role of the employer's representative) in the execution of the project. Increases in the contract price: the lump-sum price is fixed, except to the extent that the contract provides for price increases for certain events or modifications. Due to the contractor control over the works, the employer may want to limit the. ability of the contractor to obtain such increases. Extensions of time for completion: the time for completion of the works, otherwise fixed, can be extended under certain circum­ stances. The employer may want to limit the scope of the contrac­ tor's right to obtain such extensions. Resp~nsibilit.y for employer-supplied designs: the risk of employer­ supplied desIgns should be specifically allocated as between the parties.21
Employer's ris.ks: the contract will need to list the employer's risks, so as to proVIde a comprehensive allocation of such risk for the project. Performance guarantees: the parties will need to discuss the form and amount of the security provided by the contractor to the employer for performance of the contract. This security can take the form of ~ bank guarantee or other security and/or retention money. Completion: the contract should provide a definition of the extent and nature of completion required before the employer takes over the works. It should identify whether any performance tests are to be passed before or after such completion. Defects liability: the parties will need to decide the period of time
19 The definition of the scope of the works is found in the employer's requirements in the Silver Book.
20 Under the Silver Book, the contractor is responsible for almost the totality of the risk asso­ cIated WIth these phases of the process.
21 Under the Silver Bo~k, the contractor is deemed to have scrutinised the employer's require­ ments and therefore IS generally responsIble for the accuracy of any designs provided in such requIrements (SIlver Book sub-clause 5.1).
23
2-14
TURNKEY AND EPC CONTRACTS
during which the contractor will be responsible for remedying any defect that may arise in the works.
(j) Training of staff: to the extent training of staff is required, the parties will want to provide for a period of time during the contract period and before the employer takes possession of the works for the contractor to train the employer's staff.
(k) Use of a consortium or a joint venture by the contractor: a consor­ tium or joint venture of contractors may prove beneficial to the employer as they can provide more expertise as well as a broader base of liability for the completion of the works. However, the employer will need to ensure that the contractors agree to joint and several liability and elect a representative of the joint venture with sufficient decision-making power to facilitate interaction with the employer.
(I) Regulation of labour to be used on site: including origin of staff, facilities to be supplied and the skill and experience to be required of such employees.
(m) The organisation of the site: including the contractor's responsibil­ ities for safety and protection, as well as sanitation and services such as water and electricity.
(n) Effect of local law and regulations including allocation of the responsibility for obtaining permits and licences.
(0) Patent and know-how rights and licences of the technology neces­ sary for the completion of the works.
The drafter of a turnkey contract will need to consider each of these points, among others. Allocation of risk for these issues should follow a rea­ sonable assessment of the ability of the parties to bear the risk in question.
Standard Form Design-Build, Turnkey and EPC Contracts
2-15 Sectors that require a high degree of expertise and technicality, such as the construction sector, often engender the development of standard form con­ tracts.22 Such forms can be an important factor in reducing costs for the par­ ticipants, as they represent a predictable and stable basis upon which parties can begin negotiating.23 Indeed, some attribute the sophistication and exis­ tence of standard form contracts for design-build projects to be a measure of the popularity of this project delivery system.24 When using standard form contracts, however, parties should always keep in mind the specific­ ities of the project (which may make a particular contract less suitable) as well as the particularities of the governing law (which may denature, if not override, sometimes key provisions of the standard form contract).
22 C. Pedamon, "How is Convergence Best Achieved in International Project Finance?" (2001) 24 Fordham Int'/ L.}. 1272, online: LEXIS at 1294.
23 ibid. at 1298. 2~ M.L. McAlpine, op. cit. n. 10 above, online: LEXIS at 553.
24
STANDARD FORM DESIGN- BUILD AND TURNKEY CONTRACTS
Over the past few years a number of standard form design, build, turnkey and EPC contracts have been published. These include:
(a) the ENAA Model Form International Contract (1992); (b) the ICE Design and Construct Conditions of Contract 2nd Ed.
(2001); , (c) the DBIA (1998); (d) the AlA Contract Form A191 (1996); (e) the AGC 415 (1994); (f) the EIC Contract (1994); (g) the FIDIC Orange Book (1995); (h) the FIDIC Silver Book (1999); (i) the FIDIC Yellow Book (1999); (j) the FIDIC Red Book (1999).25
The above list is by no means exhaustive. A brief introduction to each of the listed contracts is set forth below.
The ~~AA Contract Model Form, The Engineering Advancement 2-16 Assocl~tlon of Japan (ENAA) is a non-profit organisation that was estab- lished 10 August 1978 and supported by the Ministry of Economy, Trade and I~dustry.of J~~an and by various other national and local government agen- Cies, UniverSIties and research organisations. The Association has the support of numerous specialists from member companies as well as various experts in their respective fields.26 ' . This book. refers .to the second edition of the ENAA model form published 10 1992, which reVised the first edition issued in October 1986. Volume 1 of the EN~A Model ~orm for Process Plant Construction is reproduced in the appendl~es of thiS book. The remaining four volumes, Samples of Appendices (Volume 2), Guide Notes (Volume 3), Work Procedures (Volume 4) and Alternative Form ~ithout Process Licence (Volume 5) are not repro­ duced. T~e form contract IS meant for use in connection with the design and construction .of process plants using the turnkey approach.27 In 1996 the ENAA published a standard form relating to Power Plant Turnkey Cont~a~ts. That edition consisted of three volumes: Agreement and General Condlt1ons (Volume 1), Samples of Appendices (Volume 2) and Guide Notes (Volume 3). It has not been reviewed for the purposes of this book.28
The ICE Design and Construct Conditions of Contract. This model contract 2-17 :-vas drafted by the Conditions of Contract Standing Joint Committee which IS the permanent joint committee of the Institute of Civil Engineers (ICE), the
25 l':I0te that, although not a turnkey contract, for comparison purposes this book will also con. SIder the terms of the Red Book.
~; jay~es, ".Turnkey Contracts: japan's Model Forms" (1993) 10 I.C.L.R. 251 at 253. Engmeermg Advancem~nt Association of japan, Model Form International Contract for
28 Process Plant ConstructIOn, Volume 3 Guide Notes (1992), p. 1. T~es~ fo~ms m~y ~ obtained by contacting the ENAA at GECIENAA, CYD Bldg. 1-4-6, NIshI Shmbashl,. Mmato-ku, Tokyo 105-0003, japan; telephone +81 35024441; fax +81 3502 5500; emaIl pdd422@enaa.or.jp.
25
I
TURNKEY AND EPC CONTRACTS
Association of Consulting Engineers and the Federation of Civil Engineering Contractors. This drafting body has a long history in and experience of tra­ ditional forms of contract, including, most recently, the ICE Minor Works 3rd edition (2001) and the ICE Conditions of Contract, 7th edition (2001).
The ICE Design and Construct Contract 2nd edition, referred to here as the ICE Contract, is based on the traditional form contracts of the ICE and adapted for use in connection with the design and construction of civil engineering works. The second edition of the ICE contract reflects certain changes made in light of "leg­ islative change and [ ... 1 evolution of working practice".29
2-18 The DBIA Agreement Between Owner and Design-Builder-Lump Sum. The Design-Build Institute of America (DBIA) was founded in 1993 in order to promote the design-build project delivery process throughout industry and government in the United States.30
In 1998 the DBIA published Document No. 525, Standard Form Agreement Between Owner and Design-Builder-Lump Sum. This form is examined in this book, along with Document No. 535, a Standard Form of General Conditions of Contract Between Owner and Design-Builder, which complements this document.
2-19 The AlA Form A191. The American Institute of Architects (AlA) is a national association of architects whose form contracts for design-build pro­ jects are a standard in the construction industry of the United States.3! AlA contracts are particularly well suited for architectural projects.32 The AlA A191 Standard Form of Agreement Between Owner and Design/Builder is for use where the employer contracts directly with one entity for both design and construction services. 33
The AlA A191 is a two-part agreement, developing the project and the design through two separate agreements, one for preliminary design and budgeting and one for final design and construction.34 This structure and the guiding concepts of this form are markedly different from the approaches of the other standard forms examined in this book.
2-20 The AGC Document 415 Standard Form of Design-Build Agreement­ Lump Sum. The Associated General Contractors of America was formed in 1918 with the intention, amongst others, to adopt standard form construc­ tion contracts "which would equitably divide responsibilities and risks and assure fair competition for works". 35 In response to a renewed interest in the
29 Online: The ICE http://www.ice.org.uklnavigationlindex_news.asp?page=/newsI pressarchive.asp
30 Online: The DBIA http://www.dbia.org/aulindex.html(date accessed: August 16, 2001); online: The DBIA hrrp:/lwww.dbia.org/aulmission.html(date accessed: August 16,2001).
31 R.J. Smith, "Risk Identification and Allocation: Saving Money by Improving Conrracts and Contracting Practices" (1995) 12 I.C.L.R. 40 at 58.
32 M.L. McAlpine, op. cit. n. 10 above, online: LEXIS at 558. 33 American Institute of Architects, Form A 191 Instruction Sheer at 1. 34 J.E Butler, "Protecting Owner with Conrract Clauses" in R.E Cushman & K.S. Taub (eds),
Design-Build Contracting Handbook (Wiley Law Publications, New York, 1992),253 at 255. 35 T.J. Stipanowich, "Reconstructing Construction Law: Reality and Reform in a Transactional
26
STANDARD FORM DESIGN-BUILD AND TURNKEY CONTRACTS
design-build method of contracting, the AGC first published a set of stan­ dardised design-build contracts in the early 1990s.36
In 1999 the AGC published the standard form contract AGC 415 to be used as a follow-on document to the 1999 edition of AGC 400. Unlike its predecessor, AGC 415 is not intended as a stand-alone agreement, but rather assumes that schematic design documents plus a preliminary esti­ mate and schedule (i.e. the work product of AGC 400) is part of the owner's program provided in AGC 415. The revision of AGC 415 was developed with the advice and cooperation of the AGC Private Industry Advisory Council which council is comprised of a number of Fortune 500 owners' design and construction managers who meet with AGC contrac­ tors to discuss issues of mutual concern.37
The European International Contractors Turnkey Contract. The European 2-21 International Contractors (EIC) is associated with the FIEC (Federation de l'Industrie Europeenne de la Construction) and the CICA (Confederation of International Contractors' Associations). Its membership includes 15 con­ struction industry federations in 15 different European countries.38
The FII~IC Design-Build and Turnkey (Orange Book). Created in 1913, the 2-22 Federation Internationale des Ingenieurs-Conseils (FIDIC) represents national associations of consulting engineers. It maintains its seat and secre- tariat in Lausanne, Switzerland. The first FIDIC conditions of contract were published in 1957 with the aid of the Federation lnternationale du Batiment et des Travaux Publics (FIBTP).
The (1995) Orange Book represents the fifth FIDIC form of contract. It is intended for use with international design and construct contracts.
The FIDIC Plant and Design-Build (Yellow Book). The (1999) Yellow Book 2-23 (first edition) is based both on its predecessor (the (old) Yellow Book) and on the Orange Book.39 The Yellow Book is intended "for plant and for build- ing and engineering works designed by (or on behalf of) the Contractor where, nonetheless, the Employer may have executed some design".4o
The FIDIC Construction (Red Book). The (1999) Red Book (first edition) is 2-24 based on its predecessor (the (old) Red Book) and is intended to be "suitable for building and civil or other engineering works designed by the Employer or by his representative, the Engineer" .4!
System" (1998) Wis. L. Rev. 463, online: LEXIS at 485 n. 74 citing in turn Booth Mooney Builders (or Progress 6 (1965). ' ,
~; M.L. McAlpine, op. cit. n. 10 above, online: LEXIS at 553. AGC Document 415 Instruction sheet.
38 Dr J.J. Goudsmit, . "The EIC (European International Contractors) Turnkey Contract 39 (Co?dltlons for DeSIgn and Construct Projects)" (1995) 12 I.C.L.R. 23.
Online: FIDIC http://www.fidlc.org/resources/contracts/courses.asp (date accessed, April 4 2001. . ,
41 ibid. at 2. ' .
TURNKEY AND EPC CONTRACTS
2-25 Due to significant changes between the two versions of the Yellow and Red Book contracts, FIDIC issued the new contracts as first editions.
The FIDIC EPC and Turnkey Projects (Silver Book), The Silver Book (1999 first edition) was issued for EPC Turnkey Projects and is suitable for BOT projects as well as process plant projects (such as E&M, or electrical and mechanical, projects).42 The Silver Book provisions arguably reflect industry practice at the expense of FIDIC's traditional even-handed approach.43
Under the Silver Book, the contractor takes a higher degree of risk and, therefore, the construction time and cost are more certain.44
42 ibid. at 5. 43 ibid. at 4; see generally C. Wade, "The Silver Book: The Reality" (2001) 18 (3) I.C.L.R. 497. 44 Online: FIDIC www.fidic.orglresources/contracts/courses.asp (date accessed: April 4, 2001).
28
Introduction
Over the past 40 years, the Federation Internationale des Ingenieurs- 3-01 Conseils (FIDIC) has developed an unparalleled reputation as the leading body for the development of model standard form contracts for use in the international construction industry.
In September 1998, FIDIC published four new or revised standard form contracts comprising new editions of two existing forms-the Red Book2 and the Yellow Book3-and two completely new forms-the Silver Book4 and the Green Book.s Definitive editions of these contracts were published in 1999.
Previously, FIDIC had in place two contracts that were based on the nature 3-02 of the works: broadly speaking, the Red Book (fourth edition)6 dealt with civil engineering works and the Yellow Book (third editionj7 with electrical and mechanical works (in both instances, the employer and/or the engineer either supplied the design or played a central role in producing it). FIDIC pre- pared the Orange Book (first edition)8 to provide a contract where the contractor supplied the design and took single-point completion responsibil- ity. The Orange Book, unlike the old Red and Yellow Books, contemplates the use of an employer's representative and does not use the term "Engineer".
The new Red and Yellow Books have shifted this perspective to contracts based on the relationship between the parties, particularly with reference to which party takes responsibility for the design.9 The revised Red Book is now primarily focused on those situations where the employer will supply
1 A previous version of this chapter (in anticipation of the publication of this edition) first appeared in (1999) I.C.L.R. 27 and was co-authored by Joseph A. Huse and Jonathan Kay Hoyle.
2 Conditions of Contract for Construction (for Building and Engineering Works Designed by the Employer) (1998).
J Conditions of Contract for Plant and Design-Build (for Electrical and Mechanical Plant and for Building and Engineering Works Designed by the Contractor) (1998).
• Conditions of Contract for EPC Turnkey Projects (1998). S The New Short Form of Contract (1998). 6 Conditions of Contract For Works of Civil Engineering Construction (1992). 7 Conditions of Contract for Electrical and Mechanical Works (1998). S Conditions of Contract for Design-Build and Turnkey (1995). • See also the comments of Christopher Wade in his paper "History and Scope of The Three
Major New Books" in FIDIC's New Standard Forms of Contract, IBC U.K. Conferences Limited.
29
FIDIC DESIGN-BUILD, TURNKEY AND EPC CONTRACTS
the design (and an engineer will be used) and the new Yellow Book on those situations where the contractor supplies the design (and an engineer will be used). By contrast, the Silver Book is intended to deal with something entirely new in FIOIC's scheme: an EPCIO turnkey contract where the contractor takes responsibility for design and the contract is on a strictly two-party basis (that is to say, there is no intermediary such as the engineer).
3-03 The new FIOIC contracts are harmonised around the same basic format: that of the Orange Book. Therefore, the new Red, Yellow and Silver Books are now all structured in the same way: the 20 clauses of the Orange Book taking account of the particulars of each contract. This harmonisation has extended to the language of the contracts. Much of the basic Orange Book language has been retained in the three contracts.
The author welcomes, for the most part, the specific drafting changes to, for example, the new Yellow Book (as comp