Sterling collapse: how can developer institutions contractually limit their financial risk

The collapse in the value of the pound following Kwasi Kwarteng’s mini budget on 23 September is likely to create inflationary pressure on construction costs. With construction firms seeing reduced margins, this is likely to add pressure to what was an already challenging market.

In a volatile market, institutions that are carrying out developments should carefully consider the contracts they enter into to make sure they are fully protected.

Marie-Therese Groarke highlights three key contractual points that universities should consider to bolster their legal protections, with a particular focus on the themes of cost and contractual flexibility.

Fee controls (professional appointments)

In a volatile market, consultants will seek to protect themselves by giving as much flexibility as possible to pass on additional costs. Whilst some additional costs might be fairly justified, institutions will need a degree of cost certainty and control in order to stay within the parameters of their allocated budgets.

Most experienced developers seek to agree lump sum fees in order to give cost certainty. However, a lump sum fee will only fix the fee if the work remains in scope.

Typically, professional consultants will seek to recover additional fees if they undertake work that is out of scope. Useful provisions in these circumstances include notification requirements on the part of the consultant if they think they might have to undertake extra work. As a matter of principle, the consultant should have to demonstrate that the extra work has not been caused by their own negligence.

An institution carrying out development work does not necessarily have to accept the position that it should have to pay for all extra work incurred beyond the consultant’s control. This can be a point of discussion and negotiation. The agreed risk profile should then be clearly documented in the contract.

Consultants will typically seek to exclude expenses as part of the lump sum fee. Careful attention should be given to what expenses are reimbursable. Operational costs such as travel (within the UK), printing, telephone calls, postage etc might drafted in an open-ended way and so give a contractual basis to allow cost creep in the appointment. Ideally, operational costs should form part of the lump sum. In any event, expenses should be discussed and documented in a precise and meaningful way.

Some consultants may seek prolongation costs. Such costs should only be contractually recoverable if the consultant has had to undertake extra work as a result of the prolongation. The commercial basis for payment in such an event should also be agreed and documented.

Payment controls (building contract)

Most standard form contracts contain comprehensive payment provisions. For projects with specific needs and higher risk, these forms are typically amended to suit the needs of the project and give additional protection to the employer. There are a whole range of beneficial amendments to such forms, but this is beyond the scope of this article to consider.

Keeping focus on payment controls, the JCT (the most commonly used standard form contract), for example, provides for a retention. This is a sum of money that is deducted from each payment, held until the end of the project and fully released once all the outstanding snagging defects have been rectified. This clause should be properly utilised by universities acting as a developer and they should not be tempted to succumb to pressure to release the retention before it is contractually required of them to do so. The retention provides a useful incentive for the contractor to return to the site once practical completion has been achieved to rectify any snags or outstanding defects. If this right is given up by the developer, certain contractual provisions can be rendered somewhat toothless.

Some of the JCT standard form documents provide for the option to make an advanced payment to the contractor. Ideally, payment should be paid in arrears. Given the current market conditions, it is anticipated that more small to medium sized contractors will seek payment in advance. Their justification for doing so will be to maintain cash flow and secure orders with their sub-contractors and suppliers at the early stages of the project.

If an institution is inclined to agree to making an advance payment, it should do so with caution and seek additional protection in the form of an advanced payment bond, ie an agreement with an insurer to pay the advanced amount should the contractor default.

Some insurers can be reluctant to provide such bonds in terms that are sufficiently robust, and so advance enquires should be made to check that a suitable bond is available before agreeing advance payments. If the employer is not suitably protected, it risks having to pay for goods and works twice.  

For a more comprehensive overview on payment controls under a building contract, specific advice should be sought. The above seeks to highlight what is likely to be particularly pertinent in a volatile market.

Termination

Unfortunately, the economic viability of a project may be called into question for a variety of reasons. Budgets may not accommodate accumulating costs and deals may be put on hold to allow for a time for reflection. This leaves the thorny question of what to do if various consultants and contractors have already been appointed.

Consultants

To future-proof for this situation and allow for flexibility, institutions should ensure that professional appointments have a "termination for convenience" clause. Typically, in a business-to-business context, a termination for convenience clause will give an employer the option to terminate, usually following a short notice period.

The drafting of a termination for convenience clause is straightforward. However, parties can find themselves in adversarial territory if the cost consequences for termination have not been carefully considered and reflected in the appointment.

An employer can rarely walk away from a contract without some sort of cost consequence. However, a sensibly drafted clause can give the parties a clear basis for calculating what is owed and limit the employer’s exposure to open-ended claims for loss of profit and opportunity if such a clause is invoked.

It is unusual for consultants and contractors to be granted equivalent termination for convenience rights. If this is requested, institutions should robustly interrogate why this is needed and preferably decline to agree it. If a consultant or contractor sought to walk away from a project, this could have serious cost and liability consequences.

Contractors

The practical implications and consequences of termination for convenience means that it is less usual for building contracts to contain the right for the employer to walk away from a project without cause. Moreover, these are not a feature of the standard form building contracts generally available on the market.

If a contractor becomes insolvent, this gives the employer the right to terminate the building contract immediately. Before a contractor becomes technically "insolvent", there are usually warning signs that the contractor is financially in trouble. For example, there may be performance issues with the work, poor communication, poor attendance on site, low staff retention, and the contractor’s sub-contractors may start to walk off site (usually for non-payment).

Under the JCT forms of contract, if a contractor is under-performing it can be difficult for an employer to safely justify terminating the contract without running the risk of ending up in a dispute and defending a claim for direct loss and / or damage. By way of example, the JCT provides that if the contractor fails to proceed regularly and diligently with the works, the employer can (in accordance with the procedures under the contract) terminate the contractor’s employment. This sounds clear in terms of drafting, but in practice this is difficult to prove. The courts have taken a restrained interpretation of this clause and so employers typically exercise great caution before relying on such a clause. This can leave an employer with limited options where it really needs to galvanise a contractor or walk away from an under-performing contractor who has not quite met any of the contractual criteria to terminate safely.

Outlined above is a worst-case scenario, but not unusual in a challenging market. With that in mind, developers should go into contract with a view to preserving as much flexibility as possible. A contractor might be able to get comfortable with a termination for convenience provision if specifically negotiated. Some contractors are more willing to agree to such a provision if a pre-agreed sum is paid in the event of the clause being invoked (as well of course any outstanding payments being settled). Whilst the additional cost exposure might not be ideal, it might be useful further down the line to invoke a provision with a defined cost consequence then heading into the unknown territory of a dispute and all the associated costs.

The developer could also consider defining more precisely what constitutes a breach giving rise to an entitlement to terminate the building contract. These outcomes can be achieved through bespoke amendments to the standard forms.

In terms of negotiating strategy, developers should seek to tender their contracts on the basis of any bespoke drafting they wish to include in the contract. This means that early attention to the terms and conditions of the building contract should be given.

Conclusion

In a challenging market, it is sensible to act in a reasonable manner and be mindful of the commercial pressures and constraints that some businesses may find themselves under. Insisting on unduly onerous terms is unlikely serve either party well. This does not, however, mean an institution should accept a bad deal. A good and competent consultant and / or contractor should be able to perform under contracts that are robust, clear and protective of the developer’s position.

Of course, not every risk can be contracted for, but there are predictable consequences of a volatile market (as highlighted above) and these can and should be tailored for contractually in order to meet the needs of the project.  

If you require further information about anything covered in this briefing, please contact Marie-Thérèse Groarke, or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, October 2022