A five-point action plan
In a two-part article, Shourav Lahiri, a partner in the international law firm Pinsent Masons LLP, looks at the measures that can be adopted by both employers and contractors to shepherd projects through the credit crunch. This first part deals with five strategies available to employers.
The drying-up of funds has started to affect a number of privately funded projects. Even on infrastructure projects, contractors with long outflow-to-inflow payment lags are experiencing difficulties in financing the lag, causing pressures on the supply chain.
Terminating and even suspending projects is a drastic remedy which may not ultimately benefit any of the participants in the projects. It is therefore worth considering what other options may be available under the contract to help ameliorate this situation.
Though usually a preserve of contractors seeking to reduce cost or to accelerate completion of the works, value engineering also offers employers an attractive option in these times. The increase in price of steel earlier in 2008 led to a number of employers looking to value engineer parts of their works. While the economic circumstances are somewhat different now, value engineering remains a valuable tool to reduce cost.
Reducing the direct cost of the works, while continuing to contribute to the contractor’s overheads and profits, may therefore be an optimal solution. If there are no contractual mechanisms that entitle the employer to require the contractor to submit a value engineering proposal at the contractor’s own cost, the submission of a proposal can be ordered as a variation, followed by an appropriate valuation to cover the cost of abortive work if the proposal is not implemented.
Omission of works
While value engineering is conceptually the same as omission of work and its replacement with varied work, employers may also consider a simple omission of works. Past events on a project – such as contractor default – may give the employer a right to remove works from the contractor’s scope of works.
These rights are often exercisable only as an alternative to termination; accordingly, the right to terminate will need to have accrued before part of the contractor’s works can be removed. As a proper exercise of these rights is likely to have a low cost exposure for the employer, they should be investigated.
Alternatively, the variations procedure under the contract can be used to omit works. Under increasing cost pressure, a number of employers are tempted to omit works and award them to an alternative, cheaper, contractor. Care should be taken if this option is being considered; contracts usually prohibit the omission of works and a subsequent award of those works to a third party.
A negotiated omission of the works with a pre-agreed valuation for that omission brings more certainty and therefore may be more attractive than an ordered omission for both the employer and the contractor.
Extending time for completion
Employers may be tempted at this time to levy damages on contractors and use the cash released from such damages against payment due to the contractor to ease its cash flow. This is a risky step and is not to be recommended.
Nothing gets contractors more heated than an unfair levying of liquidated damages. Most disputes are prompted by a feeling of unfair treatment. Instead, employers may wish to take this opportunity to grant extensions of time if applications are pending, preferably on grounds that do not automatically entitle the contractor to prolongation costs. Often, relief from liquidated damages as a result of grant of extensions of time is more valuable to a contractor than prolongation costs, and this is the time to negotiate such solutions.
A negotiated extension to the time for completion may be attractive. A contractor can avoid having to accelerate at its own cost to catch up on delayed progress. An extension to the time for completion, coupled with an agreement as to maximum limits on the sums that can be claimed in interim payment applications, can spread out an employer’s obligations.
Bonds or post-dated cheques in lieu of payment
On residential construction projects, where stage payments from purchasers are released on the meeting of milestones (either directly from purchasers or from an escrow account), developers could look to structuring their cash outflow so that payments are made to contractors only after such milestones have been reached.
If payments to the contractors are not linked to similar milestones, and if the contractor is in a stronger financial position than the employer, the contractor may well be open to an offer by the employer to provide on-demand bonds or post-dated cheques in lieu of immediate payment.
These instruments can be returned upon future payment and they provide security in the meantime. While bonds provide greater security than post-dated cheques, as their effectiveness is not dependant on the employer’s solvency, there is a cost associated with bonds which may dictate the viability of this option.
Asset purchase instead of payment
On developments that have not been sold off-plan, or have not been completely sold prior to construction, a developer can find himself holding unsold units but exposed to a continuing obligation to make payment to contractors.
Offering these unsold units to the contractor in lieu of payment, priced at an undervalue to the market price, may turn out to be an attractive financing option for both parties. A variant of this option is a sale and buy-back agreement where the contractor takes on the property at an undervalue and the employer agrees to buy-back the property in the future at a premium, with the premium being secured in the interim by a bond.
This financing structure has enabled developers to complete construction in a recessionary economy. Singapore and Japan are pertinent examples. There is no reason why this model cannot be applied in India.