Construction contracts: who bears the risk of cost overruns?

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16 February 2021

6 min read

Construction contracts may be priced in a number of ways. For most contracts, even those which are "fixed price", there is usually scope for cost/price variability. Four cases from December 2020 highlight some of the difficulties that can arise when parties agree that payment should be based on cost.

Case 1: Never Pay Retail

Alebrahim v BM Design London Ltd [2020] EWHC 3393 (TCC) concerned a contract for refurbishment of a residential property.

The employer sued the designer/contractor for alleged overpayments under the contract, arguing (among other things) that under the terms of the agreement she should not have to pay the designer/contractor more than the cost to the contractor (trade price) per item plus a fixed profit margin. The works under the contract were expressed to be priced on an "estimate of cost" basis.
The designer/contractor argued that the basis of remuneration should be the retail price of each item, and that this reflected normal industry practice.

The court held that on the proper interpretation of the contract the employer should pay only the trade price of each item plus profit, in particular construing the contractor's obligation to "procure" as indicative that remuneration should be based on the trade price.

Case 2: Blowing the Budget

In Optimus Build Ltd v Southall [2020] EWHC 3389 (TCC), a contractor claimed damages for repudiatory breach of contract by the employer, on the basis that the employer had wrongfully terminated the contract during a dispute over the contract payment mechanism.

The court held that the employer's acceptance of the contractor's "budget estimate" for the works gave rise to a lump sum pricing structure, and that the employer had been wrong to contend that the agreement was for a "cost plus" approach. The case was slightly unusual, as the court noted, in that employers rarely seek "cost plus" contracts due to the cost uncertainty inherent in them.
It was relevant that the budget estimate had been given in response to a request from the employer for a lump sum quotation, and that it was transmitted by an email referring to "price".
Even though the budget estimate was not offering a price "fixed in every respect", this was mainly because it referred to some items being potentially supplied by the employer, and suggested that there could be savings. There was no reference to wording such as ‘estimated costs', or to any mark-up for overhead and profit. The court found these features to be consistent with a lump sum offer.

Case 3: Paid for One's Own Breach?

ABC Electrification Ltd v Network Rail Infrastructure Ltd [2020] EWCA Civ 1645 involved a contract for the performance of power upgrade works for the West Coast Main Line railway in England. There was no dispute that payment under the contract was to be based on cost.

The contract in question was based on the Target Cost Version of the ICE Conditions of Contract. In this amended standard form, the contractor was not entitled to recover "Disallowed Cost" which included "any cost due to negligence or default".
The contractor sought a declaration that the use of the word "default" meant that it should be paid costs caused by its own breaches of contract; provided that there was no "blame or culpability" associated with such breaches.

The English Court of Appeal dismissed the application on the ground that the natural meaning of "default" is simply a breach of a contractual obligation. It was irrelevant that "default" had been added into the contract by amendment of the standard form.

Case 4: Reimbursement during Contractor Delay?

Santos Limited v Fluor Australia Pty Ltd & Anor (No 1) [2020] QSC 372 concerned an EPC contract for upstream facilities as part of an LNG project in Queensland, Australia.

The EPC contract allowed the contractor to recover its costs of performing the works on a reimbursable basis, subject to costs needing to be "properly" and "reasonably" incurred. The contractor had been reimbursed "on account" as the works were performed.
The employer subsequently sought to counterclaim from the contractor sums totalling around AUD$475m, which were invoiced and paid during the period between (a) the contractual completion date; and (b) the date when the contractor actually completed the works, in part because the contractor was in breach of its obligation to complete on time.

The Supreme Court of Queensland held that merely because costs had been incurred in a delayed period, it could not be said that they were outside the category of costs which the contractor was entitled to recover. Importantly, the contract included a clause making clear that the contractor was not precluded from recovering costs in the period after the contractual completion date.

Commercial Implications

The four cases above illustrate the general principle that parties are free to agree whatever payment terms they choose in their contracts. Courts will interpret payment provisions based on their plain words, even where the result may appear unusual or even uncommercial. Moreover, the cases highlight the following matters of importance to parties entering into construction and engineering contracts:

"Cost means cost": unless specifically defined, the word "cost" will usually refer to the cost to the contractor of performing works or procuring goods (Alebrahim). The cost of an item may be different (i.e. less than) its retail price. Similarly, payment on the basis of "cost" is different from payment of a "reasonable remuneration" (or quantum meruit), which usually refers to the market value of goods and services provided;
Budget estimates can give rise to a lump sum price: in less formal situations where contracts are not contained in a signed, agreed document, a "budget estimate" may amount to a "fixed price" if the parties' dealings indicate an agreement to this effect (Optimus). That may be a relatively rare situation, though, because most commonly an "estimate" denotes a provisional yet uncertain figure, where the final out-turn is usually based on actual cost;
The importance of "disallowed cost": where target cost or "cost plus"/cost reimbursable contracts are used, it is highly desirable for the contract to specify which types of cost may not be claimed by the contractor (as was the case in ABC Electrification). The usual expectation of an employer is that the "cost" it will pay for is something which has translated into "value" for the project. By providing that costs incurred due to the contractor's default or other breach of contract are irrecoverable, this ensures that the employer is not required to reimburse the contractor for its own inefficiencies or mistakes. Drafting to this effect may be found, for example, in NEC4 Option E clause 11.2(26) (definition of "Disallowed Cost"); and
Cost of the works vs prolongation costs: the fact that a contractor claims costs during a period of culpable delay does not mean that the costs are necessarily "unreasonable", or should be treated as "Disallowed Cost" (if such a definition is used). A distinction is usually made between (a) those costs that would always need to be incurred by the contractor in performing the works (which are reimbursable); and (b) costs arising purely due to culpable contractor delay (which are not). The distinction is not necessary where the contractor's delay is excusable, and the contract generally contemplates the contractor being reimbursed for all work properly performed.

_{White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities.}

_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}

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