Julie Scott-Gilroy: Future-proofing your construction contract
SCN is delighted to introduce a three-part series taking place over the next month that will take a closer look at inflation and other challenges currently facing construction companies as well as what the industry can do to be best prepared. The series is compiled by Julie Scott-Gilroy, legal director in the commercial litigation team at Morton Fraser, who is an accredited specialist in Construction Law. The first article explores one vital step that businesses can take to ensure they are prepared for fluctuations in the market: future-proofing the construction contract.
It is fair to say that the construction industry is facing several challenges: higher interest rates, labour shortages and inflation - all of which look likely to continue through 2023.
As a result of these factors, companies operating within the construction industry can be particularly susceptible to downturns in the market, as they typically operate on low margins and can be more sensitive to higher borrowing costs.
To protect themselves, construction companies must think ahead to ensure that they are safeguarded from fluctuations within the market. Failing to do so can cause significant problems on any project, which can ultimately lead to delays and uncertainty over completion dates.
The first step companies can take is to make their construction contracts future-proof; a contract must be able to manage the fluctuations of inflation.
For those that have not yet entered into a contract, it is vital to take into account increased labour and material costs, as there is always a risk of costs fluctuating for both parties during a project.
Before entering an agreement, an assessment of the current state of prices within the industry should be carried out to properly inform contract clauses. A bespoke set of clauses can then be introduced to the construction contract. For example, under an NEC form of contract, four out of its six forms of contracts (options A, B, C and D) allow for a secondary Option X1 “price adjustment for inflation”. This optional Clause X1 provides a formula under which the parties can agree on which products are to be subject to adjustment (for example, equipment, plant, fuel etc). The parties are also free to agree on the type of indices they wish to apply for calculating a “Price Adjustment Factor”. For any products not included in the X1 clause, the contractor carries the inflation risk.
The NEC also dictates that parties should be given an “Early Warning Notice” as soon as they become aware of any matter which could increase the price of the contract or the contractor’s total cost. This will help protect companies from fluctuations in the market and prevent unexpected additional costs. Compensation Events should then be notified timeously in accordance with the contract.
Another example is under the Scottish Building Contract Committee’s (SBCC) Standard Building Contract, where there is a choice of three optional clauses to address fluctuations.
The first optional clause under this contract allows for fluctuations in relation to contributions, taxes and levies payable by the contractor as an employer. Therefore, if inflation drives up wages, the associated contributions, taxes and levies will also increase, and that element of inflation risk is addressed. This option automatically applies unless deleted.
The second option relates to fluctuations in labour and materials costs and tax. This covers scenarios where there is price fluidity for key elements of work eg oil. Under this optional clause, the Contract Sum is said to be calculated based on market rates for materials, goods, electricity and fuels at the base date. Most importantly, if these costs increase, the contractor can claim the difference from the employer.
The third and final optional clause provides a formula to adjust the Contract Sum in agreement with the Formula Rules issued by the Joint Contracts Tribunal (JCT) or the SBCC. This option takes account of items manufactured overseas, allowing the contractor to claim for any price difference between the market rate, when the item was bought, and the rate at the base date. In addition to inflation increases, this could also see the cost of Brexit tariffs being passed on to the employer.
Recent economic challenges imposed on the construction industry means companies cannot be complacent when it comes to safeguarding their construction contracts. By assessing the ever-changing climate of the industry and creating contracts with terms that address the issues of inflation, construction companies can better protect themselves against fluctuation and ensure that they are thoroughly prepared for undertaking a new project.
In our second article, Julie will discuss how construction companies can manage their supply chain to mitigate and minimise disruption.