Authors
Read time: 8 minutes
Given the significant risks associated with supply chain impacts to major construction contracts, a toolbox of legal and project risk mitigation strategies, presented here, should be considered to cover each major stage of a construction project: pre-construction/bidding/tender, contract negotiation, procurement and construction. In addition, when impacts do occur and disputes arise, the dispute resolution clause in contracts can become an important factor in resolving the disputes efficiently and effectively. This is especially important in construction contracts that have an international dimension and where oversight of the non-performing party may engage several legal systems.
Operational and logistical challenges
Pre-construction phase: Key contractual provisions and planning
The preferred way to mitigate supply chain-related risks is to plan for them by allocating the risks in the construction contract. Often, a force majeure clause addresses such risks. Such clauses are commonly incorporated into turnkey-style engineering, procurement and construction (EPC) contracts that are widely used in international projects. However, force majeure clauses are absent from many industry-standard form building contracts in domestic or regional projects, such as the American Institute of Architects (AIA) and ConsensusDOCs templates widely used in the U.S. If a construction contract lacks a force majeure provision, construction contractors should consider adding one and clearly defining its scope to reflect the profile of the project. This process may include drafting express language describing events that would be considered force majeure where no universal judicial approach exists. For instance, the post-COVID contractual environment demonstrates parties specifically addressing risk in the context of a pandemic event. The absence of such a provision altogether would very likely be viewed as precluding relief. Owners cannot presume that mere silence in a construction contract is equivalent to a party’s reliance on force majeure provisions available under the operative law, thus limiting important protections for the owners. Further, owners should consider expressly allocating the contingent risk of supply chain impacts on major projects to avoid the risk of possible contractor cost claims based on the assertion that such risks were not contemplated at the time of contract formation, which could lead to claims of mutual mistake or commercial impracticability to seek recovery of additional costs.
When drafting such provisions in a construction agreement, careful consideration must be given to whether supply chain disruptions constitute a “force majeure event.” Drafters need to be careful about both the specific and general language used. For example, owners who unthinkingly agree to a definition of “force majeure event” that includes broad “catch-all” language such as “any other event outside the reasonable control of the contractor” may be unwittingly exposing themselves to potential additional cost claims.
Assuming that the definitions in a force majeure provision are appropriately drafted to address supply chain risk, the next issue to address is what relief will be available: Will the remedy for the force majeure event be limited to additional time for performance (and corresponding remission of liquidated damages risk that might be included in the contract for delayed performance) or will it result in an increase of the contract price? If it is the latter, then the parties must address the quantification of such price increases and the extent to which the increases will be compensable. Use of cost indices and material escalation clauses, such as “Day One,” “Threshold” or “Delay” clauses, might be considered, along with whether one party should bear the entire risk or the parties should establish a risk-sharing scheme.
Many commercial building contracts employ a cost-plus methodology, which is typically subject to a guaranteed maximum price (GMP) cap and includes an allocation of some level of financial contingency for unforeseen project impacts. On projects using this approach, the parties will normally enumerate unforeseen market price increases as an item of permissible contingency usage. Other contracts may classify materials subject to price volatility as contractual allowances, with negotiations then occurring over whether such items should be included in or should remain outside the GMP cap and/or any shared savings provisions. Contractors should be wary of any unit price provisions that would lock in amounts allowed for increased costs resulting from supply chain impacts. Finally, the parties should carefully consider the termination and suspension provisions of the contract. For example, the parties might consider whether a termination provision would allow a contractor to terminate an agreement because of materially changed conditions brought about by supply chain disruptions, as well as how these conditions are defined.
The procurement phase
Once the construction contract has been signed, the parties can take additional steps during the procurement phase to further minimize risks. For big-ticket items, such as structural steel or long-lead and major equipment, such as electrical switchgear, contractors and owners should work collaboratively to mitigate risks and consider appropriate contractual structures. For example, to reduce the risk of volatile pricing for structural steel and long lead times from switchgear equipment suppliers, the prime contractor should seek to obtain advanced commitments from fabricators and equipment suppliers as soon as possible, and the owner will need to plan for and agree to pay deposits associated with securing a place in line with those long-lead fabricators and equipment vendors. One market response to the risk of supply chain disruption has been the increased use of limited notices to proceed and the creation of standard early release procurement mechanisms (such as the AIA G735-2021, Authorization to Proceed with Early Release Work). While such procurement measures can and should be employed, they may be only partially successful in mitigating the impact of significant supply chain disruptions.
The construction phase
If potential supply chain impacts have not been allocated in the construction contract itself or during the procurement phase, then those impacts will typically manifest themselves during the construction phase in the form of contractor claims for equitable adjustment or change orders. In contracts that incorporate some level of contingency allowance, the first-level response from owners and developers will typically be to push for use of available contingency funds in order to prevent any increase in the contract sum or GMP. In cases where recourse to contingency is unavailable or insufficient, claims disputes will inevitably arise. In such claims, where contractual remedies are not readily available, and in projects to which common law applies, theories of mutual mistake or commercial impracticability will often be invoked. Recourse to these theories depends on the applicable law to the contract, as well as considerations of foreseeability and fault by the party seeking relief, and whether the parties contractually allocated the risk in question. Finally, in addition to these legal requirements, technical allocation issues will need to be addressed, such as proof of the impact and quantum of material prices, impact to the critical path of the project, and the like. At that point, it may be difficult for the project participants to resolve the claims without commencing a dispute resolution process that could be protracted and expensive. This only underscores the need for contracting parties to proactively anticipate and plan for the risk of supply chain impacts during the pre-construction and planning phases.
Dispute resolution mechanism considerations
In addition to the substantive contractual provisions outlined above, the contracting parties should carefully consider their dispute resolution provisions. For a purely domestic construction project, a party’s preferred standard arbitration and/or litigation clause may suffice. However, for projects involving international or cross-border participants, or even for largely domestic projects that involve significant material or equipment items coming from overseas, proactive management of the dispute resolution forum and applicable arbitral rules is essential. The risk of international supply chain disruptions may be better addressed by incorporating appropriate international arbitration clauses.
For international projects, an appropriate international arbitration clause has distinct advantages, such as allowing parties to seek urgent protective relief in support of the arbitral process rather than engage in a lengthy court process seeking to bring foreign parties into domestic court proceedings. Thus, parties often seek a “pro-arbitration” place to hold the arbitration, referred to as the arbitration “seat,” where courts will reliably facilitate the arbitration process. Furthermore, parties choosing international arbitration can specify criteria for arbitrators with specialized expertise in supply chain management or in the specific technology or products involved. This expertise can often ensure that complex issues are adjudicated by knowledgeable arbitrators rather than commercial judges. Finally, international arbitration clauses can also help avoid the pitfalls of multi-jurisdictional litigation by minimizing the risk of inconsistent decisions, reducing foreign enforcement concerns, and ensuring that disputes are handled efficiently and fairly. In sum, parties should evaluate not only risks associated with the project execution but the legal landscape in which any dispute might arise, and choose a forum which will yield an effective and expedient outcome.
Finally, while many companies often opt for litigation because of the perceived advantage of possible access to injunctive relief, sophisticated practitioners can structure international arbitration clauses to offer a similar ability to seek urgent interim or provisional relief from courts in time-sensitive situations or choose arbitral rules that allow for such relief before the constitution of a tribunal. Such choice could enable parties to obtain emergency remedies, such as securing delivery of critical components, without waiting for a final award.