Construction projects involve a purchaser of construction services and suppliers of construction services. A developer contracts with the supply chain to perform services and carry out construction works on its behalf to a defined timetable (time) for a pre-agreed price (cost) and to certain specifications and standards (quality). The main participants in a construction project are as follows:
• Developer: the person for whom the project is to be delivered. The developer appoints the supply chain and pays for the project (frequently with debt finance).
• Professional consultants: the developer will appoint professionals to design and manage the project. On the design side, consultants frequently include an architect, a structural engineer and a mechanical and electrical services engineer. In terms of managing the project, consultants hired may include a project manager to manage the day-to-day aspects and a cost consultant to advise on project costs and to value interim payments.
• Contractor: the developer will engage a contractor, or possibly more than one, to construct the project. The contractor may be responsible for all or some of the design depending on the procurement strategy.
• Subcontractors: the contractor typically employs specialist subcontractors to carry out the majority of the physical site works in distinct packages.
Contracts
The most commonly used forms for construction projects in the domestic real estate sector are published by the Joint Contracts Tribunal. Developers often require the contractor to accept changes to the allocation of risk in standard form building contracts and great care needs to be taken with their drafting as changing one provision may have a knock-on effect on another. Consultants are normally employed under a professional appointment. There are forms published by professional and trade bodies and consultants often have their own standard terms. However, most sophisticated developers will insist on using bespoke forms of professional appointments prepared by their solicitors.
Caps on liability are a hot topic in the construction industry but where these caps are agreed with contractors, they tend to be limited to liability for consequential losses arising out of design defects. Liability caps are also becoming more common in professional appointments. In this case, care needs to be taken in negotiating them to avoid exposing the developer to unacceptable levels of retained risk in his dealings with purchasers and tenants. Additionally, a developer will want adequate protection in design and build projects when a contractor assumes responsibility for design consultants’ work as consultants tend to ask for caps on liability which are not limited to liability for consequential losses. Contractors, like developers, do not like retained risk.
Other documents in a construction project may include performance security such as performance bonds and parent company guarantees. A performance bond is security from an entity unconnected with the contractor, which is usually capped at 10% of the contract sum, lasts until practical completion and requires default to be established. A parent company guarantee usually comes from the contractor’s ultimate parent, whose liability is co-extensive with the contractor’s liability and lasts for the duration of the limitation period under the building contract. Collateral warranties and third party rights may also be required in favour of persons who will acquire an interest in the development such as funders, purchasers and tenants and provision needs to be made for them in the contract.
Procurement routes
There are several procurement routes which the developer can choose and only the two most frequently used in the UK real estate sector are touched on here.
Under a “traditional” procurement route, responsibility for designing a project is split from the responsibility for its construction. The professional design consultants prepare the design and the contractor builds the project in accordance with the design. The contractor may be responsible for a discrete element of the design, often called the contractor’s designed portion. This is not to be confused with a design and build contract however, just because the contractor has some responsibility for design.
Many developers adopt a “design and build” procurement route whereby the contractor is responsible for the design and construction of the project. This can be useful where the developer wishes to have a single point of responsibility for design, workmanship and selection of materials. Employing a contractor under a design and build contract (such as an unamended JCT Design and Build contract) does not necessarily mean that the contractor is responsible for the design in its entirety and the contractor’s obligation may be confined to completing the design prepared by the professional team retained by the developer, in which case there is no single point of responsibility for design.
Other stakeholders
The developer may procure a project for its own use but most projects will be intended for a commercial tenant and institutional purchaser. There may also be debt finance from a bank to consider.
These stakeholders will generally want to ensure that they have a comprehensive and enforceable set of rights against the supply chain in respect of the design and construction of the project, often referred to as the construction package. A commercial developer will be incentivised to offer a strong construction package so there is a remedy in the event of latent defects which manifest themselves, usually for up to 12 years after its completion and to limit his own exposure for such risks.
Collateral warranties and third party rights
Where rights against the supply chain are to be provided to a stakeholder, this is usually achieved by getting collateral warranties or vesting third party rights in the stakeholder. These rights provide direct recourse against the supply chain by the stakeholder for its losses. They routinely contain provisions which ensure that the supply chain member’s liability is co-extensive with his liability to the developer. This means that when acting for a purchaser or tenant, there needs to be not only control rights over the approval of the terms of a construction contract but also restrictions on how those construction contracts are dealt with during the project.
The more robust the collateral warranties/third party rights, the more likely the developer is going to get a clean exit on sale/release as part of an agreement for lease. A purchaser or tenant will also wish to know that the developer’s failure to pay the supply chain cannot be set-off against any claims they may wish to bring so it is prudent to check this is carved out.
Insurance
Insurance is key in the management of risk and the degree of transfer of risk to an insurance policy will depend on the drafting of the construction contract.
Professionals and contractors with design responsibility will usually be required to maintain professional indemnity insurance. This covers the insured (the professional not the developer) against claims in respect of errors or omissions and provides some comfort to the developer that a successful financial claim for professional negligence will be met out of the proceeds of insurance. As it operates on a “claims made basis” it is the policy in force at the time the claim is made which will respond. The obligation to maintain professional indemnity insurance should last for the limitation period, usually six or 12 years.
Works and materials on site should be insured against physical damage under an “all risks” policy which insures the contractor and the developer and effectively transfers the financial risk of certain events such as fire or flood to the insurance policy so as to avoid the need of costly litigation. This may however mean that the entities which are insured under a policy like this cannot sue each other in respect of the consequences of such risks.
Developers should ensure that the contractor has adequate public liability insurance to meet claims for personal injury, death and damage to third party property brought by third parties in respect of the contractor’s legal liability and it is common for the benefit of these policies to extend to the developer. Developers should also consider whether to take out a separate business interruption insurance policy in respect of the losses they may incur should the project be delayed.
Latent defects are common on large developments but insurance comes at a cost, does not cover all defects and is subject to deductibles and exclusions. For developments involving new residential accommodation, a latent defects policy is a must have if the accommodation is likely to be sold to members of the public requiring mortgages. The technical requirements of the insurer need to be accommodated at the design stage.
Risk allocation
Construction law is all about risk management and construction contracts allocate risk between the parties. It involves an understanding of the market position in the industry, the key risks peculiar to the project, how insurance works and what risks can and should be transferred to insurance. As a result construction contracts can be complex. Getting the risk allocation or drafting wrong can result in the developer assuming more risk than he needs to and can have an adverse effect on the profitability of the development. If in doubt, a specialist should be consulted.
Why this matters
The UK domestic real estate market is generally regarded to be a safe investment, attracting private equity houses, pension funds, investment funds, sovereign wealth funds and high-net-worth individuals.
Its success has been driven by a strong and high-quality construction industry which in recent years has contributed circa 6.5% of the UK’s total economic output.
It is, however, an industry where profit margins are small, risks are perceived to be high and insolvency is a constant threat, so it is important to understand the industry’s approach to an acceptable level of risk allocation.
Allocating too much risk to the supply chain is likely to result in unacceptable levels of risk being priced into the project.
Construction contracts deal with the allocation of three principal types of risk: time, cost, and quality. It is important to understand that while detailed, construction contracts are not exhaustive and deal with the risks most commonly encountered on a typical construction project.
Getting the allocation of risk wrong may have considerable consequences for a developer and its exit strategy and may result in retained risk for the developer in his dealings with purchasers and tenants.
This can be problematic where debt finance is required as lenders prefer to see that a developer has managed the risk profile of the project and perceived risk has either been transferred to the supply chain, transferred to insurance or where retained is quantifiable, limited and manageable.
The preparation of construction contracts involves an understanding of how projects are procured and where risk should be allocated (including through the use of insurance policies) not only by reference to the particular project and the complexities of the site but also by reference to market practice and what is acceptable in the industry.
Further reading: Construction Law, Professor John Uff, Sweet & Maxwell
Gordon Anderson is a partner and head of London construction at Irwin Mitchell LLP