Constructive Notes ®
The last few years have been unforeseen periods of uncertainty in the construction industry in terms of consistency and pricing. Not only has there been the usual fluctuations in labour costs, but also significant variation in material supply cost and availability. There are anecdotes of bidding wars for certain items such as timber roof trusses where there is limited supply, and the highest bidder gets the materials.
In the Australian construction market where, lump sum fixed pricing is the norm, this has led to significant cost blowouts, resultant difficulties and even insolvencies for many contractors and subcontractors.
What is the solution moving forward?
Somewhat like the concept of force majeure, the pricing mechanisms are not a subject to legal maxims or principles that provide how issues are resolved – you get what you bargain for in the contract. There is no automatic right of rise and fall or magic common law solution for cost adjustment. Unless the contract allows for a mechanism of price adjustment, then you are stuck with the price you agreed.
What are the options to cater for rise and fall?
Cost-plus contracts
The simplest way around this is to price on a cost-plus basis. This has never been particularly popular in the Australian marketplace and in some jurisdictions, cost-plus pricing is banned with respect to pricing of domestic or residential building work. Cost-plus pricing is never as simple as just being paid what you spend plus a nice margin. The process is always constrained by parameters as to reporting, accountability, and overall capping and is, when used effectively, a time consuming and technical process. It usually involves an independent quantity surveyor or cost manager to make decisions on which subcontractors to engage and the assessment of actual and necessarily incurred costs each month. This comes with its own costs, delays, and complexities, not to mention that most financiers will not agree to financing a project where there is no certainty as to final cost. Government projects are more likely to utilise a format of cost plus. However, this is usually only on very large-scale projects and through collaborative processes where there is a reasonably complex development of costs and cost reimbursement, with target out turn cost versus final out turn, financial KPIs and pain/gain mechanisms. For most commercial projects, this is not on the table and for most contractors, cost-plus arrangements are generally not an option.
What are the other methods we can consider?
There is the ability to include a rise and fall provision. There will be more on this later in the article, as it is not generally as simple as a one paragraph clause.
Provisional sums
There are several other ways in which some allowance for cost increases can be catered for. The most common is the sensible utilisation of provisional sums clauses. This relies somewhat on the parties identifying areas that are genuinely at risk of cost fluctuation and then agreeing to processes to manage provisional sums. It is not possible to put everything in the provisional sums basket or that would effectively be a cost-plus arrangement. Typically, provisional sums have not been utilised so much to cater for rise and fall but more for uncertain grounds. For example, long lead items that are not going to be purchased until later in a project and where the price is simply not known until the time that they are purchased e.g., lifts, elevators and other complex machinery. However, there is no reason why provisional sums cannot be utilised with sensible parameters for items that are generally at risk of cost escalation. The process is key – considerations include whether it is necessary to obtain three quotes, how long before the items are to be ordered, what if the price changes in the interim, what happens with margin and so on.
Another means is to consider who is best placed to manage the overall price risk. Principals generally like to place price risk on contractors. However, there are potential cost savings to be made if price risk items are to be principal supplied items. Think of it as cost, without the plus. The principal pays only the price without the contractor applying a separate margin. In this way, the principal themselves must look at the market and understand the real price because they are paying it. It can also sometimes involve other economies – if a principal is developing several projects, it may get a better price for bulk or sequential purchases. It can also help foster a better understanding of cost management pressures. When a principal sees significant market price fluctuations, they can better understand and potentially work more collaboratively with contractors on overall project pricing.
Price adjustment clauses
Then, there are specific price adjustment clauses. There is no one hard and fast rule on how these clauses are structured. One common method is to have targeted clauses that deal with specific cost sensitive elements. For example, in a road construction contract bitumen costs are recognised as variable and may be subject to a rise and fall regime – this is a concession that has been made in numerous state government contracts for road construction.
Another approach is not to target specific items but to look at time constraints. The contractor will not have a claim in the first 12 or 24 months but will have price resetting mechanisms for cost changes after the initial period. Depending on the nature of the contract, this may be an annual reset (for ongoing services) or a review and assessment at the time the product or service is to be provided. For more traditional construction contracts or where there are separable portions of stages delivered over a significant period.
Although it is possible to have general and unconstrained price adjustment mechanism within the contract, these are understandably uncommon. If including an unconstrained price adjustment mechanism, why not just have a cost plus and avoid having a separate valuation methodology?
Primary considerations when formulating any price adjustment mechanism
Irrespective, whenever there is a rise and fall or cost adjustment clause, there are several elements to get right, all of which come back to one key issue: certainty. An agreement to negotiate or act reasonably to consider price adjustment is often an agreement to agree and potentially unenforceable. Even if it is linked to dispute resolution as a fallback, it has missed the point – if you must enter to formal dispute, it will usually end in a compromise and full cost recovery has gone out the window. The primary requirements are to agree:
- What elements of the works are subject to adjustment and is it relevant cost of materials and labour for that element of the works or just one or the other?
- When does cost adjustment apply? Both the date from which you utilise the clause and the date from which the adjustment will apply. For example, if you can apply the cost adjustment mechanism in the new year and you do the calculation on 25 January, does it backdate to 1 January?
- What is the formula or process to be applied and is it clear and certain?
- If the formula relies upon and external measure, such as a commercial or consumer index then which index, at what date, and is there an alternative if the index is discontinued or merged with another index?
- Is there any cap or limit on increases?
All of this may seem like common sense, but it is surprising how often price adjustment clauses are written as more of a wish list than a process, and ultimately as an agreement to agree which may be unenforceable.
As an aside to this, these clauses are called rise and fall for a reason. While it is low risk today, the markets do turn and it must always be remembered if prices drop, then the contract sum may also be adjusted.
Lastly, there is nothing stopping parties negotiating new terms even after the contract has been executed. Sadly, when money is tight for contractors it is usually also tight for principals, so unless one party has a large contingency to draw on or is a public entity that has flexibility on pricing, then usually this is not a genuine option.
Implications of walking away from a contract
If price increases are making a project uneconomic and you have no contractual mechanism to deal with it, can you just walk away?
The short answer is no, certainly not without penalty. It is not frustration (the contract can still be performed, albeit at a higher cost) and unless you can point to a genuine significant breach by the other party there is unlikely to be a contractual or even common law right to terminate. Further, if you elect to walk away then there is strong chance that in addition to a breach of contract claim, that you will have a claim of repudiation against you. In the recent decision of Addinos Pty Ltd v OJ Pippin Homes Pty Ltd [2022] QDC 205, the District Court considered a scenario where, irrespective of other arguments (found ultimately to be without sufficient substance) the builder OJ Pippin Homes Pty Ltd walked away from the project on the basis that “construction costs…increased significantly since the project was priced” along with problems in retaining experienced senior staff which meant that the builder told the owner that they just could not build the project anymore.
The court found that without a contractual basis to terminate, this amounted to a repudiation (an unwillingness to meet contractual obligations). The result was that the builder was liable for the increased costs of engaging an alternative contractor to complete the works, additional intertest that Addinos incurred with respect to two loans for the project and various other costs associated with the ownership of the land. Liquidated damages were not relevant as the contract had already been terminated so they failed to apply and could not be seen as a sole remedy. In short, the builder by repudiating remained liable and exposed itself to potentially greater costs incurred by the owner in having the works completed.
In summary:
- If you do not have a clear mechanism for cost increases in a construction contract, then unless you can negotiate something with the counterparty, there is no general entitlement to rise and fall. To the contrary most contracts will specifically exclude rise and fall).
- If you are negotiating, then consider both the specific types of costs that are likely to increase (having a targeted cost item may be easier to negotiate and a more palatable risk to the party paying).
- Ensure that you have clear and certain terms for rise and fall to avoid unenforceability for uncertainty.
- If you cannot negotiate an actual rise and fall clause, consider if costs fluctuations could be managed by other contractual means such as provisional sums or principal supplied items.
- If you do not have any mechanisms in place under the contract, consider negotiation but remember that walking away is unlikely to be the solution and is likely to be a breach of contract or repudiation with potentially significant cost consequences.
This article may provide CPD/CLE/CIP points through your relevant industry organisation.
The material contained in this publication is in the nature of general comment only, and neither purports nor is intended to be advice on any particular matter. No reader should act on the basis of any matter contained in this publication without considering, and if necessary, taking appropriate professional advice upon their own particular circumstances.
