Third Party Arrangements

Introduction

The primary objective in all construction projects is successful completion, at the required quality, on time and for a reasonable cost.  Things can go awry, with issues of solvency, breach of contract and dispute.  When that happens, a multitude of people are affected.  The challenge is to maintain progress on site, with as little disruption as possible.

The loss of any party with an interest in completion has its own complications.  The owner is typically the central party, with contracting parties leading out from there.  

In rough chronological order, those participants include:

• owner - promotes the project, provides property rights and engages the other project participants
• the project engineer - engaged for design, consenting and contract management
• financiers - with general oversight of the project
• insurers - covering construction, third party damage, professional indemnity and business interruption
• the contractor - carrying out the works and engaging subcontractors and suppliers
• the off-take beneficiary - whether on-purchaser, lessee, utility provider or other party with a commercial interest in the project

Each has its own interests to protect, and with the exception of the insurer, the loss of any one of them will make keeping the rest of them engaged in the project critical.

Project risks

The risk profile for most major projects classically shows risk climbing as design and construction starts, peaking once construction has been largely completed, then stabilising at a lower level following practical completion to reflect operational cost, and commercial return.  

At each point, the loss of a project participant has varying impact.  

If the owner becomes insolvent, for whatever reason, then termination rights will be triggered under the agreements with all other project participants.  They may walk away, or they may agree with the other participants to cooperate in finding an alternative owner to take over the project.

Similarly, the loss of the contractor does not need to be fatal to the project, if subcontractors and suppliers are prepared to enter into new arrangements with the owner or with a new contractor.  In each case, their interests will differ, but the approach is the same - consider the impact of project disruption, and put in place arrangements which minimise, so far as practicable, the consequences of such disruption.

What is required is more than just having termination rights under their contracts - those arrangements must recognise the interconnected nature of projects for all participants.  

Default and termination gets complicated and messy; less so if everyone is committed to maintaining a project, for the project's sake as a distinct concept.

Collateral Arrangements

Collateral agreements and securities serve two purposes - (1) to provide security for performance, and (2) to deal with disruption and default.

Most construction contracts recognise that securities for performance and direct undertakings from subcontractors to owners are a normal part of construction projects.  There are, however, considerably more collateral agreements which could be used.

Parent company guarantees

Increasingly, owners, consulting engineers, construction contractors, off-take purchasers and other participants have complex ownership structures designed to separate operational entities from holding companies, and in many cases to isolate project risks from their other activities and assets.  That may take the form of shelf companies, formed specifically for the project, or the separation of operational and asset holding companies.

The difficulty with these structures is that, while they make share the company name and therefore reputation of the ultimate holding company, their liability is limited to the assets of the contracting entity.  That is usually the point of such structures.  

Where a company's reputation and group accounts are offered during the tender process, then it is not unusual to seek a commitment from the company's ultimate holding company in the form of a parent company guarantee.  Such guarantees typically contain the following undertakings:

• to ensure that the subsidiary is sufficiently resourced and capitalised to comply with its contract obligations
• not to dispose of the subsidiary or to act in any way which may adversely impact on the subsidiary's ability to meet its obligations, and
• as primary obligor, to perform the subsidiary's obligations itself in the event of default by the subsidiary.

These obligations can be difficult to negotiate, and should therefore be highlighted as a requirement for tendering for any project.

Bonds

Bonds are effectively promises to pay.  They generally fall into two categories - conditional or default bonds (eg, the form of bond in Schedule 3 to NZS3910:2003) and on-demand bonds, or letters of credit (eg, Schedule 3 to NZS3910:2023).  The former covers default, and should therefore reflect the likely losses sustained in the event of default and the delay involved in going through the disputes process and exhausting any rights of appeal.

On-demand bonds are simply a promise to pay up front, on demand without proof of loss.  Typically, they cover significantly lower amounts than default bonds, for example the likely cost of replacing the defaulting party.  Any amount demanded under such a bond will need to be included in any final costs award.

Bonds are frequently provided for the following:

• performance bond - to secure overall performance, typically for between 5% - 10% of the contract price, released on practical completion.
• advance payment bond -  to secure repayment of upfront advances for equipment purchase and site establishment; the advance is repaid by agreed deduction (eg, 10%) from progress payments.
• offshore manufacturing bond - where progress payments are made for the fabrication of plant outside of jurisdiction, the total cost of such equipment is secured by an on demand bond, released once the items are on-site and inspected for damage or defects.
• retention bond - provided on practical completion, in lieu of retention deductions being made from progress payments.  This eases the contractor's cashflow, and avoids the necessity for complying the with trust obligations in the Construction Contracts Act 2002.

Care needs to be taken that such bonds are in a form which enables the party calling the bond to receive the funds without delay, at the time the funds are needed.

Warranties

Most contracts include warranties of some description, whether expressed or implied.  

Engineering and design consultants warrant that they will use the skill and care reasonably expected in the industry for similar projects; and contractors will warrant that the works will be carried out in a good and workmanlike manner, in accordance with the contract.

As a matter of law, those warranties are generally limited to the contracting parties.  So, while others may have a reasonable expectation that such standards have been met, they do not enjoy the benefits of those warranties.  

The following may be considered:

• design warranty - historically, "fitness for purpose" warranties have been requested.  As these are largely uncertain, without the purpose being specified, and un-insurable, they have largely fallen out of use, in favour of a warranty that the design meets the requirements of the contract.  
  
  Many consulting firms argue that their liability should be limited to the cover of their professional indemnity policies, but then decline to disclose their levels of cover.  
  
  Most standard form consultancy agreements include by default inadequate levels of cover.  Care should be taken to ensure that any such caps properly cover the risk associated with breach of professional duty.
  
  The benefits of such warranties should extend beyond the contracting party to those who will suffer loss in the event of such default, for example building occupiers.
• subcontractor warranty - subcontractors and key suppliers are increasingly vital to successful project completion, yet they have no direct connection to those further up the contract chain.
  
  Subcontractor warranties generally provide for three direct obligations to owners:
  
  (1)  they have read the relevant parts of the head contract, and they undertake to comply with the head contract to the extent relevant to the subcontract works,
  
  (2)  in the event the head contract is terminated, they agree to the novation of the subcontract to the owner, or such other contractor nominated by the owner, and
  
  (3)  they will not terminate their subcontract without first giving notice to the owner, enabling the owner to rectify the breach or to take a novation of the subcontract, as provided in (2) above.

Both warranties have their challenges, not least persuading consultants that they have obligations to end users and satisfying subcontractors that they will be paid in the event of the novation of their subcontracts.

Tripartite agreements

The final piece in the puzzle is to establish direct relationships between all project participants, recognising that they should exercise their contractual rights in recognition of the rights and interests of others involved in the project, but with whom there is no contractual nexus.  Obvious examples include retaining off-take purchasers (eg, power purchasers or lessees), funders or subcontractors in the event of the insolvency of either the owner or the head contractor.

At its most basic, such tripartite or umbrella agreements require owners, funders, contractors and end-users not to terminate their respective contracts without first giving notice to the other parties, and providing them with the opportunity to rectify the relevant default or to engage with an alternative party to replace the party in default.

Most contracts also provide for arbitration in the event of dispute.  The parties to such arbitral proceedings are typically limited to the parties to the agreement to arbitrate (there is a limited ability to consolidate concurrent arbitral proceedings under clause 2 of Schedule 2 to the Arbitration Act 1996).  This can cause difficulties where there is disagreement over whether a project failure arises from design, workmanship or equipment defect, each arbitrated before different tribunals with conflicting findings of fact and/or law.

The solution to this issue is to provide for consolidation in the underlying contract and/or to include a collateral agreement primarily between the owner, designer, contractor and relevant subcontractors to referring any dispute involving one or more of the parties to a single arbitral proceeding.

Conclusion

When projects come unstuck, it is natural to sit down with all project participants at some stage to explore how to keep the project on track.  Having collateral agreements in place to deal with default, and to provide some level of protection to the remaining participants while those options are negotiated, can make such negotiations considerably easier.