Is it fair to share the pain? Rectifying defects on a project

The NEC4, and its predecessor, NEC3, continue to be the preferred procurement model for high-value public sector contracts. Many of these are let under Options C and D of the standard form. These are target cost contracts used respectively with an activity schedule or bills of quantities. Recently, the UK government stated that contracts for the HS2 rail project will be let under NEC3 Option C. This follows from contracts also let under this contract form relating to the Crossrail project with Transport for London. 

Should a design defect be discovered during construction, the contractor will still have a liability to remedy it. But this will inevitably increase the construction costs, which will increase the final price…

Target cost contracts are often used where the extent of the work to be performed is not fully defined or where anticipated risks are greater. The financial risk is shared as part of the defined “pain/gain” formula. Its intention is to incentivise efficiencies and good behaviours. The contract identifies a target price using the activity schedule to which is to be added the contractor’s “defined cost” plus other costs or overheads and profit to be covered by its “fee”. The fee is usually expressed as a percentage of the defined cost. During the course of the contract, the contractor is paid the defined cost plus the fee: this is defined as the “price for work done to date” (PWDD). The price will be adjusted to allow for the effect of compensation events. 

…the consequence is that the employer will take its share of this pain in accordance with the agreed formula as set out in the contract data. this may seem unfair

The mechanism of the contract provides that, on completion, the contractor is paid (or pays) its share of the difference between final total of the prices and the final PWDD according to the formula stated in the contract data. If the final PWDD is greater than the final total of the prices, the contractor pays its share of the difference. If the final PWDD is less than the final total of the prices, the contractor will receive a payment based on its share of the saving.

The contractor often assumes a design liability. It retains a liability for remedying design errors, but the Options C and D forms distinguish the contractor’s liabilities that arise pre-completion as opposed to post-completion. Post-completion, there will be a liability on the part of the contractor for any design defects that may emerge. The contract may even be amended to impose a more onerous fitness for purpose requirement. Should a design defect be present and be discovered during the course of the construction process, the contractor will still have a liability to remedy it. But this will inevitably increase the construction costs, which will increase the final price. The consequence is that the employer will take its share of this pain in accordance with the agreed formula as set out in the contract data. 

This may, on one view, seem unfair. Ordinarily, the responsibility rests with the contractor to make good any works, be they due to design errors or poor workmanship. Should these be discovered while work is under way, Option C and D provide that this increased cost is to be shared. This should not, however, give rise to a compensation event. Thus any time consequences and critical delays caused by the defects will be a liability to be retained by the contractor.

Policies insuring against design liabilities will usually allow recovery of costs which insurers agree to have been reasonably incurred as they mitigate or extinguish the loss that would otherwise arise. If, for example, there is found to be a deficiency in the design which requires more steel reinforcement, insurers should be content to incur these additional costs so as to avoid a greater liability should the building become distressed at a later stage, requiring the expenditure of greater cost. However, the insurance policies will not respond in situations (such as under Options C and D) where there would never be a third-party claim, the employer and the contractor having already agreed the manner in which they will deal with the total costs and the share thereof to be borne by each. 

How then should the employer respond?

One response is to accept that as a partnering contract, there is no iniquity if the employer, having accepted the use of the target contract, takes a share of the pain. The longer-term relationship is more important. If employers retain the benefits they should accept the burdens as well. However, the more common practice for employers, by the inclusion of a “Z” clause, is to render the contractor liable. Despite criticism from the drafters of the NEC3 contracts, the use of “Z” clauses is prevalent. This could be achieved by extending the definition of disallowed cost within the contract. The effect is to exclude the cost of the remedial work from the final total of the prices. To protect itself against this risk, the contractor should, if possible, extend its insurance policy coverage. This will compel the insurers to indemnify against this liability even in the absence of a third-party claim.

Jeffrey Brown is a partner at Howard Kennedy