The majority of construction disputes proceeding to arbitration are commenced by contractors. This is not to suggest that it is only contractors that have claims on most projects, as that is clearly not the case. It goes without saying that employers have interests in the projects they are commissioning, in particular, the interest in having their project delivered on time, on budget and in accordance with the contractual specifications. The main difference between a contractor's position and that of an employer that causes a contractor to refer its claims to arbitration first is that, generally speaking, a contractor will feel financial pressure earlier than an employer in the form of non-payment of sums to which it considers it is entitled, and will turn to arbitration in order to recover such sums.
Nevertheless, employers often bring claims against contractors, sometimes as claimant, but more often by way of counterclaim after an arbitration has been commenced against them by a contractor. This chapter begins by considering the range of claims employers most frequently pursue in arbitration, which revolve around four issues:
- the time for delivery of a project;
- the quality of what is being delivered;
- termination; and
Other matters in respect of which an employer might, in theory, have a claim against a contractor are then briefly addressed.
Claims concerning the time for completion
In almost every construction contract, even for a simple project, there will be a specified date by which the project must be completed. On larger and more complex projects, the work may be divided into milestones and the contractor may be required to complete each milestone by the associated 'milestone date' specified in the contract. There may also be additional milestones and milestone dates for matters, such as testing and commissioning and handover of the whole project.
However, even if a contract specifies a completion date or one or more milestone dates, the question arises as to the nature of the remedies available to the employer if the contractor fails to complete part or all of the work by the associated milestone or completion date. As a matter of principle, the employer would have a claim against the contractor for damages for breach of contract. However, it is then necessary to consider the damage which it will have suffered as a result of the delay to the project, or part thereof, and how such delay can be quantified.
Consider the case of a construction project where the first milestone is the completion and approval of the design for the project. If the design is not completed or approved by the milestone date specified in the contract, has the employer suffered any loss? In most cases, the answer will probably be no. Even in a scenario where delay has occurred to a milestone that is capable of being used on its own (e.g., part of a shopping centre) or to a project as a whole (e.g., a new road), the monetary loss to an employer as a result of delay may be a relatively small sum or may be very difficult to quantify.
In light of this, the usual practice is for construction contracts to provide that the contractor will be liable for liquidated damages (that is, damages in a fixed monetary amount) for each day or some other period for which it is late in completing a milestone or the project as a whole. If the project has been divided into milestones, there may be different liquidated damages rates for each milestone. The liquidated damages payable in respect of each milestone and the project as a whole will also probably be capped.
An example of a liquidated damages provision is Clause 8.8 of the FIDIC Silver Book, which provides that:
If the Contractor fails to comply with Sub-Clause 8.2 [Time for Completion], the Employer shall be entitled subject to Sub-Clause 20.2 [Claims For Payment and/or EOT] to payment of Delay Damages by the Contractor for this default. Delay Damages shall be the amount stated in the Contract Data, which shall be paid for every day which shall elapse between the relevant Time for Completion and the relevant Date of Completion of the Works or Section. The total amount due under this Sub-Clause shall not exceed the maximum amount of Delay Damages (if any) stated in the Contract Data.
Clause 8.8 goes on to provide that liquidated damages are the employer's sole remedy for delay on the part of the contractor. Provisions of this nature are also commonly found in construction contracts containing liquidated damages provisions.
As is also illustrated by Clause 8.8, most liquidated damages provisions provide, in effect, that the contractor is, prima facie, liable to pay the employer liquidated damages for all delays in completing the project (up to the value of any caps). In other words, the employer is not required to establish that the contractor is at fault before being entitled to recover liquidated damages. Put another way, in an arbitration, an employer's claim for liquidated damages would, at least in the first instance, simply be a mathematical calculation of the number of days (or other period for calculating liquidated damages) from the scheduled milestone or completion date to the date on which the milestone or completion was actually achieved multiplied by the applicable liquidated damages rate.
However, the fact that liquidated damages provisions prima facie make contractors liable for delay, however caused, gives rise to two questions: first, how does the contractor obtain relief from this liability for liquidated damages when it has not been responsible for the delay to the project; and second, what are the legal implications of a clause that provides that the contractor is liable for liquidated damages even if the employer is at fault?
In relation to the first question, a contractor would be extremely unlikely to sign up to a contract that would make it contractually responsible for all delays, even delays outside its control. While there may be some risks that a contractor is prepared to accept (e.g., risks associated with bad weather), most contractors would refuse to assume responsibility for force majeure events and delay events caused by the employer's acts or omissions. For these reasons, most construction contracts contain terms that provide that the contractor will be entitled to an extension of a milestone date or the completion date if it establishes that it has been delayed in achieving the milestone or completion of the project by certain events. In the FIDIC Silver Book, such a provision is found in Clause 8.5.
Claims concerning extensions of time in construction arbitrations can be very complex. In most jurisdictions, the contractor carries the burden of establishing that it is entitled to an extension of time and associated relief from the employer's claim for liquidated damages – that is, that the project was delayed by matters that the construction contract specifies are the employer's responsibility. Strictly speaking, an employer is not obliged to positively demonstrate that the contractor was the cause of delay in order to be able to recover liquidated damages. However, when faced with a claim by a contractor for an extension of time, many employers will proceed to seek to do so as it is the best means of defeating the contractor's claim for an extension of time.
In relation to the second question noted above, the risk associated with a liquidated damages clause that does not provide relief for the contractor when the employer is at fault is that, if the employer causes delay to the project, the employer will not be permitted, under the law governing the contract, to hold the contractor to the contractually agreed milestone dates or completion date as it has prevented the contractor from achieving them. Under English law, the principle is known as the 'prevention principle'. Similar principles exist in most legal systems. If the prevention principle (or equivalent principle) applies because an employer has caused a contractor delay in achieving a milestone or project completion, the consequence generally is that time will be 'at large'. The effects of time being at large are that the contractor is no longer obliged to complete the milestones or the project by the associated milestone dates or completion date, but only in a reasonable time, and that the employer will no longer be able to claim liquidated damages if the milestone dates or completion date are not met. In theory, an employer might still have a claim for general damages if the contractor does not achieve a milestone or completion within a reasonable time, but, as discussed above, the employer is likely to have difficulty in establishing or quantifying its actual losses in such circumstances. However, the risk of the prevention principle coming into play is limited if a contract provides that a contractor is entitled to an extension of time and associated relief from the employer's claim for liquidated damages for matters for which the employer is responsible. Liquidated damages clauses that provide no relief when the employer is responsible for delay are extremely rare.
Nevertheless, because of the potential advantage of time being set at large, contractors often attempt to argue that time is at large because of alleged failures on the part of the employer in awarding extensions of time as and when they are due as a project is progressing. However, the mere failure to administer an extension of time clause is generally insufficient to set time at large, and arguments by contractors based on any such failings causing time to be at large almost inevitably fail.
In summary, where there has been delay to a construction project, an employer will generally have a claim against the contractor for liquidated damages. Such a claim is likely to form a significant part of any claims which an employer brings against a contractor in a construction arbitration. However, any such claim will almost certainly be met with a counterclaim by a contractor for an extension of time, and the employer will need to be prepared to meet the contractor's counterclaim with evidence showing why the employer is not contractually responsible for the delay. An employer may also want to lead evidence demonstrating that the contractor has caused the delay, although this may not be necessary if the contract provides that the contractor is only entitled to an extension of time in specific circumstances (as is generally the case) as in such circumstances the contractor is prima facie responsible for all delay, and the employer would only obliged to prove that it has no responsibility for any delay.
Assuming that a contractor's claim for an extension of time has failed in whole or in part and the contractor is contractually liable for liquidated damages, it is often thought that in some civil law jurisdictions, the contractor will not be liable for liquidated damages if the employer has suffered no loss as a result of the contractor's delays or its actual losses are less than the value of the liquidated damages that would be payable under the contract. However, such arguments are based on a misunderstanding of the treatment of liquidated damages clauses under civil law systems. The circumstances in which contractors are able to persuade arbitral tribunals to exercise any power to reduce the contractually agreed amount of liquidated damages are, in practice, extremely rare.
Finally, it is also worth noting that many construction contracts provide that if a contractor has not been proceeding with the works with reasonable diligence or some other measure required by the contract, or is otherwise in delay, the employer may instruct the contractor to accelerate the works or take other steps to recover the delay. In practice, however, employers are generally hesitant about exercising such powers as there is a risk that, if the contractor is subsequently found not to have been in breach of contract or not responsible for the delay, the employer's instruction would be found to amount to a variation and the employer would then be liable to the contractor for the additional costs of the acceleration or other steps it has directed.
Claims concerning the quality of the works
Under most construction contracts, the contractor's primary obligation is to deliver the project in accordance with the employer's specifications by a specified date. On a strict reading of such contracts, it might be argued that the quality of the works as they are being undertaken is irrelevant, as all that matters is that, when the project is handed over to the employer, everything is in accordance with the contractual specifications. This gives rise to a question as to whether there can be defects in a contractor's works prior to handover. This question has been debated by commentators in several jurisdictions, and the legal position is, perhaps surprisingly, generally unclear.
From a practical perspective, it would be unsatisfactory to an employer if, in circumstances in which it has observed a deficiency in the manner in which the contractor is carrying out the works or has identified a serious defect in part of the works, it has no remedy against the contractor until handover. In order to overcome this in circumstances where it may be unclear whether the employer would have a legal remedy against the contractor prior to completion, many construction contracts contain provisions that entitle the employer to inspect the works as they are proceeding (e.g., Clause 7.3 of the FIDIC Silver Book) and to issue a notice to the contractor prior to completion requiring the contractor to remedy a deficiency in the works (e.g., Clauses 7.5 and 7.6 of the FIDIC Silver Book). Clause 7.6 of the FIDIC Silver Book provides that, should the contractor fail to remedy the work following such a notice from the employer, the employer may instruct others to remedy the work at the contractor's cost.
In addition, the generally worded Clause 15.1 of the FIDIC Silver Book provides that:
If the Contractor fails to carry out any obligation under the Contract the Employer may, by giving a Notice to the Contractor, require the Contractor to make good the failure and to remedy it within a specified time ('Notice to Correct' in these Conditions).
This has the potential to be a powerful remedy for an employer while construction works are progressing. However, it needs to be accompanied by a provision expressly giving the employer a remedy if the contractor does not comply with the employer's notice as the employer may not otherwise have a claim against the contractor in such circumstances, particularly if the contractor's failure to comply with the notice does not cause the employer any immediate financial loss.
The employer may also have a right to withhold a portion of the payments otherwise due to the contractor until the deficiency in the work is rectified, even before the project is complete. In such circumstances, the amount that the employer will be entitled to withhold will generally be limited to the cost of rectifying the defect (see, e.g., Clause 14.6 of the FIDIC Silver Book).
Insofar as the quality of the works at completion is concerned, construction contracts for large projects will generally contain a structured regime concerning completion and handover of a project.
Typically, when the contractor considers that it has completed (or, if applicable, substantially completed) the works:
- the contractor issues a written notice to that effect (under the FIDIC Red Book, this notice is to be issued to the engineer appointed by the employer);
- the works are inspected (by the engineer, in the case of a project governed by the FIDIC Red Book);
- if the works are complete (or substantially complete as the case may be), a Taking-Over Certificate is issued (again, this is the responsibility of the engineer under the FIDIC Red Book); and
- if not, the contractor is notified (by the engineer, under the FIDIC Red Book) of the works it must complete or correct before the Taking-Over Certificate can be issued (see, e.g., Clause 10.1 of the FIDIC Red Book).
Similar mechanisms are found in other standard form contracts.
Pursuant to Clause 10.1 of the FIDIC Red Book, the Taking-Over Certificate may identify minor aspects of the work that are outstanding or need to be corrected by the contractor, although they do not affect the handing over of the project to the employer. In such circumstances, the contractor will generally be required to complete all snagging items and remedy any outstanding defects at its own cost within a specified period of time, known as the defects liability period, after completion (see Clause 11 of the FIDIC Red Book). Should any other defects be identified during that period, the contractor will also be obliged to remedy them by the end of the defects liability period.
The rectification of defects during the defects liability period is the contractor's right. Unless the contract specifically provides to the contrary, where a contract provides for a defects liability period, the employer is unlikely to have any right to sue the contractor for damages for breach of contract until the end of this period, unless the contractor has failed to carry out any rectification work it is required to carry out during the defects liability period within a reasonable time. If a contract does not provide for a defects liability period, or if defects remain unremedied or other works remain incomplete within a reasonable time of them being identified during the defects liability period or, in the worst case, at the end of the defects liability period, or if the employer subsequently identifies further defects, the employer will have a claim against the contractor for breach of contract. The measure of damages recoverable by the employer will be the costs of rectifying the defects.
Depending upon the number and complexity of defects on a project after completion and the costs of rectifying them, a defects claim may not be so significant as to warrant an employer commencing an arbitration against a contractor bearing in mind the costs of arbitration. Of course, there will be exceptions to this. In any event, a defects claim is likely to form a reasonably substantial part of an employer's counterclaim if an arbitration is commenced against it by a contractor.
In order to succeed in a defects claim, the employer will need to identify the relevant contractual specification (which may be a specification relating to the particular works in question, a specification concerning the quality of the works generally or a general fitness for purpose warranty), the reasons why the contractor's works fail to meet the specification and the costs of rectifying the defect. An employer is not limited to recovering the costs of rectifying the defect in the cheapest manner possible, but would be expected to act reasonably in engaging a third party to undertake the rectification works.
The most powerful remedy that an employer has against a contractor is the right to terminate its contract, particularly when the contractor is in default.
An employer will always be well advised to check carefully that it is contractually and legally entitled to terminate a contract before doing so, and that it complies with any notice or other procedures set out in the contract before serving a termination notice. The consequences of a wrongful termination of a contract can be serious and can expose the employer to a substantial claim for damages from the contractor, extending to the profit that it claims to have lost as a result of the wrongful termination. In addition, from a practical perspective, termination of a partially completed project may cause disruption to the overall completion of the project, bearing in mind the time required to identify and engage a replacement contractor, and will almost inevitably lead to increased costs because a contractor will charge a premium for taking over a project and accepting liability for another contractor's partially completed works (although the additional costs of completing should be recoverable from the original contractor if it was properly terminated for default).
At the same time, termination is a remedy that is perhaps considered too infrequently by employers. Although it may appear surprising, many construction contracts, even contracts for large projects, provide the employer with broad scope to terminate the contract for any default on the part of the contractor. If a contract provides that it may be terminated for any default, such a provision should be given effect by an arbitral tribunal. Even in jurisdictions in which the parties may be obliged to carry out their contractual obligations in good faith, there is no reason why a clause permitting termination for any default should not be construed according to the ordinary meaning of the words used in the clause so long as the employer is not acting maliciously or capriciously in exercising its termination right.
Contracts based on standard forms, however, may not be so favourable to the employer. For example, the FIDIC series of contracts effectively requires the contractor to be in serious breach of the contract before the employer will be entitled to terminate their contract. Nevertheless, the proof required to satisfy the termination provisions of such contracts is not insurmountable. Depending upon the precise wording used in the termination provision, multiple breaches of a smaller scale may together amount to a serious breach justifying termination.
If it validly terminates a contract for default on the part of its contractor, an employer will generally be entitled to recover from the contractor the additional costs of completing the contract with another contractor (that is, the costs over and above those it would have incurred if the original contractor had completed the project in accordance with its contractual obligations), which are likely to be substantial, plus any other amounts it would have been entitled to irrespective of the termination, such as liquidated damages for the delays that had occurred up to the time of termination.
However, termination will have a significant financial impact upon a contractor. If an employer does not promptly commence an arbitration against a contractor following termination, the employer is likely to find that the aggrieved contractor will institute arbitral proceedings very shortly after termination. In either case, the employer will bear the burden of establishing that the termination was valid under the contract. In some jurisdictions, local law may impose additional preconditions to termination, which must also be satisfied if the termination is to be upheld by an arbitral tribunal.
Another remedy available to employers, which has some conceptual overlap with termination, is descoping – that is, removing part of the original scope of works from the contractor. The wording of variation provisions in most contracts will permit an employer to add to or omit from the contractor's scope of works, effectively at its discretion. On the face of such provisions, it may appear that an employer would have the right to omit substantial portions of the contractor's works for any reason (e.g., if the employer is dissatisfied with the contractor's performance generally). However, this may be prohibited by the express terms of the variation provisions. Even if it is not, most legal systems limit the ability of an employer to make substantial omissions from a contractor's scope of works. In common law systems, it is generally held that an employer cannot take work from the original contractor in order to give it to another contractor unless the variation provision of the original contract permits the employer to do so. In some civil law jurisdictions, particularly those in the Middle East, local law prevents government employers from changing a contractor's scope of works by more than 10 per cent without retendering the works. In practice, this has the effect of preventing a government employer from reducing the contractor's scope of works by more than 10 per cent.
As noted earlier, an employer will be concerned to see that its project is delivered on budget. Disputes about price often arise as a result of claims made by contractors for additional payment, as considered in Chapter 6. Insofar as such claims are concerned, the employer will generally be the respondent – that is, it will be defending claims made by the contractor and arguing that the contractor is not entitled to the extra costs it is claiming.
Leaving contractors' claims aside, an employer will otherwise generally be required to pay the contractor pursuant to the contract as the contractor is carrying out its works in accordance with the terms of the contract. There are three main exceptions to this. First, an employer may be entitled to withhold amounts claimed by the contractor where the corresponding work has not been completed or has not been carried out in accordance with the contract. Second, many contracts will provide that the employer is entitled to retain a percentage of all payments (usually around 5 per cent) until the project is complete, at which point it must return half of this retention, and that it may continue to hold the remainder of the retention until the defects liability period has come to an end and all outstanding works have been rectified, at which point the remainder of the retention must be paid to the contractor (see, e.g., Clause 14.9 of the FIDIC Red Book). Third, the employer will generally be entitled to set off amounts it is owed by the contractor against payments it would otherwise be required to make to the contractor. If a project is in delay and the contractor has a substantial liability to the employer for liquidated damages, this can significantly reduce the net amounts actually payable by the employer to the contractor. Set-off provisions are therefore a powerful remedy available to employers.
Other potential claims and remedies
The difficulties that an employer will often face in establishing that it has suffered actual losses as a result of delay to a project have been discussed above. The same difficulties may arise in other circumstances as well. Consider the scenario where a contractor abandons a project and removes all of its staff and perhaps even materials and equipment the employer has paid for from the site. The loss and damage to an employer in such a scenario is likely to be viewed by a court or arbitral tribunal as (at best) purely economic such that the employer will have virtually no prospects of obtaining an order for specific performance or the like requiring the contractor to resume the works, even if the contractor is in serious default. For this reason, it is uncommon for employers to obtain injunctive relief in connection with construction projects where the dispute relates to time, quality of the works or money.
A contractor's breach of other provisions may also leave an employer without any practical remedy. For example, if a contractor fails to employ a specific subcontractor or key personnel named in the contract or identified by the employer, or if it does not make project documents available when an employer exercises its audit rights, the employer is unlikely to be able to do anything about this. A claim against the contractor for damages for breach of contract will fail unless the employer is able to identify a quantifiable financial loss from the contractor's breach.
The final remedy potentially available to an employer that is worth noting is an employer's right to call on the bank guarantees or other forms of security that a contractor will often be required to provide, particularly on larger projects. Although the practice of providing such security has been questioned by some commentators, it is not uncommon for contractors to be required to provide a bank guarantee, bond or similar security for somewhere between 10 and 20 per cent of the contract price at the beginning of a project. The provision of such security may be as a quid pro quo for the employer making an advance payment of a corresponding amount to the contractor. However, the terms of the construction contract or the security may permit the employer to call on the security if the contractor is in default. In addition, or alternatively, a contractor may be required to post a bond as a form of security against its performance of the contract. The value of such bonds is generally also between 10 and 20 per cent of the contract price.
In some contracts, particularly government contracts in the Middle East, an employer has an absolute right to call on the full amount of the contractor's securities on demand and for any default, and without proving that the contractor is in default. In other jurisdictions, the employer's right may be limited to making a call for an amount equivalent to the cost of remedying the contractor's default and after the employer has established that the contractor is in default (e.g., by way of a court judgment or arbitral award). In any case, it is important for employers to bear in mind that the right to call on a contractor's security is not a right to obtain extra compensation from the contractor even if the contractor is in default. The employer will ultimately need to account for the amount it has recovered from calling on a contractor's security in any subsequent arbitration and establish that it has suffered losses equal to or exceeding the amount recovered, otherwise it will have to return the excess part of the proceeds of calling on the contractor's security.
1 James Bremen is a partner and Mark Grasso is of counsel at Quinn Emanuel Urquhart & Sullivan LLP.