Managing Risk in the Construction Industry- A case study of the FIDIC Forms of Contract

Introduction

In the context of project delivery, risk can be described as an uncertain occurrence or set of circumstances that, if it materializes, will impact the attainment of one or more project goals (Brekoulakis & Thomas, 2018).

The construction sector possesses distinctive attributes. These include projects that typically span multiple years from inception to completion, involve collaboration among various stakeholders often from diverse geographical and cultural backgrounds with differing viewpoints on implementation processes, are highly complex with extensive documentation requirements, frequently occur in isolated areas, and are susceptible to environmental risks (Brekoulakis & Thomas, 2018).

These unique characteristics make it a hot bed of a large spectrum of risks which makes risk identification, risk allocation and risk management an ever-important aspect of managing construction projects. This article will highlight how the 1999 FIDIC forms handle this issue.

Risks in the Construction Industry

Risk identification is the first step to managing risks in the construction industry. Given the interplay between various parties, risks in the construction industry can arise from several areas. The different sources of risk can then be categorized as follows:

1)???? Design Risk

2)???? Construction and technical risks

3)???? Environmental and natural risks

4)???? Financial risks

5)???? Human resources and labour risks

6)???? Supply chain and Procurement risks

7)???? Political and economic risks

Design Risk

Design forms the backbone of most construction projects. Design is often handled in projects by the Employer or Contractor depending on the procurement route used on the project. Using the traditional route, the Employer is in charge of the design and the Contractor serves the role of implementing the design. Using the design and build route, the Contractor is in charge of both the design and implementation of that design in a way that creates a single point of responsibility.

There is always a risk with incomplete and inadequate design which can cause scope creep, increased costs of executing the project and a probable need for more time to execute the project.

Construction and Technical Risks

Construction and Technical Risks can arise from different aspects which include site conditions, quality control issues and protection of the works and equipment.

The risk of unforeseen ground conditions is well known to the construction industry. Certain types of work have a greater propensity for being affected by ground conditions, but most structures have subsoil foundations of some kind, so the phenomenon of unforeseen ground conditions is widely applicable. Accordingly, the potential time and cost consequences should be provided for and taken into account in the parties’ forward planning, which includes tender pricing.

Quality control issues largely rotate around quality management aspects of design, workmanship and materials delivered on site. This is tied into the works themselves and which party is in charge of them during different parts of the Contract Period.

Environmental and Natural Risks

As earlier mentioned, construction projects often occur in remote locations and there can be environmental risks associated with construction projects. This can be on the one hand from the materials used during the implementation of the projects such as oil spills and on the other hand it can be through the methods and process of project implementation for example dust and noise pollution from quarry activities on road projects.

Additionally, construction projects are exposed to natural disasters like earthquakes, volcanic eruptions and epidemics which can affect the progress of the projects.

Financial Risks

Given that construction projects are huge financial undertakings from all involved parties, financial risk is an existential risk for the projects. Therefore, the relationship between the funders and the parties to the construction contract is always important to the realization of project objectives. This is particularly important because cash flow is the lifeblood of the construction project without which ramifications that stretch up to insolvency of parties in the project can ensue.

Another arm of financial risk can be budget overruns due to a challenge to one or more of the triple constraints of cost, time and quality.

Human Resources Risks

Risk dealing with human resources on construction projects can exist under two arms, namely the availability of the human resources plus the health and safety of the personnel during the execution of the Works.

The construction industry is highly technical and as such is always in the need of experts in particular areas. Events such as Brexit and COVID-19 have caused shortage of expert labour in some jurisdictions which have put many projects in jeopardy. There is the additional risk that can come from strikes by the personnel which can lead to increased project times as the parties involved settle.

In most countries, the labour laws suggest that employers should ensure that employees are able to work in safe environments. Given that construction projects are highly risky environments, there is a heightened risk in dealing with the health and safety of not only the Contractor’s personnel but also the Employer’s personnel and visitors to the site.

Supply chain and procurement risks

The construction industry is very dependent on the global supply chains. This is because of the need to procure specialist materials and equipment essential to achievement of project objectives across different regions. As such, any disruptions to global supply chains for example through a pandemic like COVID-19 can cripple project delivery due to the longer times that are required to deliver these materials and equipment. Additionally, this creates an additional challenge of supplier reliability for these specialist materials and equipment. Furthermore, these disruptions cause price fluctuations which can increase the cost of performance. This can have a heavy bearing on the parties to the project.

Political and Economic Risks

Given that the construction projects happen under the ambit of an external environment that consists of the politics and economics of the jurisdiction in which it occurs and those where equipment and personnel are sourced, political instability and economic downturns can be massive risks to construction projects.

The effect of economic risks like rises in inflation, currency devaluations, economic downturns need to be accounted for in construction projects-more so for international construction projects. These different risks need to be allocated to the different parties and thereafter managed or mitigated for the effective delivery of projects.

Risk allocation in the Construction Industry

It should be noted that proper risk identification and equitable distribution of risk is the essential ingredient to increasing the effective, timely and efficient design and construction of projects (Bunni & Bunni, 2021).

Typically, in preparing the contract document bid package, the Employer (or main Contractor for the case of subcontracts) will be in a position to decide on its intended risk allocation. While there may be a temptation to allocate all or most of the major risks to the contractor (or subcontractor for the case of subcontracts), this may be tempered by an understanding of the potentially adverse consequences of allocating risk which include an increase in cost such that the project is no longer financially viable, prolongation of completion times, wastage of resources and the increased likelihood of disputes.

Therefore, it is important to create a “fair and balanced” allocation of risk which has largely been espoused in the formation of standard form contracts like FIDIC, NEC and JCT among others. Through the terms of the standard form contracts, the risk can be allocated along the following four principles that were proposed by Bunni:

·?????? Which party can best control the risk and/or its associated consequences?

·?????? Which party can best foresee the risk?

·?????? Which party can best bear that risk?

·?????? Which party ultimately most benefits or suffers when the risk eventuates?

This allows for the conferring of rights, duties and liabilities in a fair and equitable way to the different parties to the construction contract.

Risk allocation and management in the FIDIC forms of Contract

The FIDIC Forms handle allocation of risk in Subclause 17 (Risk and Responsibility). This Subclause concerns the allocation of responsibility for the following matters:

·?????? Loss or damage to the Works, Goods and Contractor’s Documents

·?????? Personal injury to any person

·?????? Property damage other than to the Works arising out of, in the course of or by reason of the Contractor’s design (if any), execution and completion of the Works and the remedying of any defects

·?????? Claims, loss or damage relating to matters or events, the risk of which are expressly allocated to the Employer

·?????? Loss or damage of facilities provided to the Contractor by the Employer (if any)

It should be noted that Subclause 17(Risk and Responsibility) is closely related to Subclause 18 (Insurance) and Subclause 19 (Force Majeure).

Subclause 17.1(Indemnities) handles indemnities where the different parties are indemnified mainly for risks from third party claims. The risks allocated to the Employer are spelled out in Subclause 17.3 (Employer’s Risks) which are largely risks out of the Contractor’s control and most of them are reiterated in Subclause 19.1 (Definition of Force Majeure). It should be noted that these risks are commonly uninsurable by general insurance cover and that the matters set out in items (b), (c) and (d) only relate to events within the Country (Baker, 2013).

The Contractor is largely responsible for the Works from the Commencement Date until the Taking Over Certificate is issued after which the responsibility for the care of the Works passes to the Employer in Subclause 17.2 (Contractor’s Care of the Works). This risk can be insured as seen below:

1)???? Contractor’s equipment as defined in Subclause 1.1.5.1 as in Subclause 18.2 (Insurance for Works and Contractor's Equipment).

2)???? Injury to people (Mostly third parties) as in Subclause 18.3 (Insurance against Injury to Persons and Damage to Property)

3)???? Injury to Contractor’s Personnel as in Subclause 18.4 (Insurance for Contractor's Personnel)

Whereas it is often mentioned that the only way risks are managed in the FIDIC forms of contract is through the Insurance Provisions in Subclause 18, the FIDIC forms of contract provide other ways of allocation and management of the different categories of risk enumerated above in different Subclauses.

Quality Management

Quality management can be looked at through the prism of design, workmanship and materials (Hughes et al., 2015). Under design, it should be noted that the law distinguishes between those who contract to supply a product and those who provide a service (Adriaanse, 2017). In the case of the former, there is a duty to provide a product that is reasonably fit for its intended purpose as it was held in the case of Hancock v BW Brazier (Anerley) Ltd[1] while in the case of the latter, the duty is only to take reasonable care in providing the service as it was held in Henderson v. Merrett Syndicates Ltd[2]. It should be noted that in Uganda, a warranty or condition as to quality or fitness for a particular purpose may be implied in a contract by the usage of trade or custom in Section 15(7) of the Sale of Goods and Supply of Services Act 2018 (herein referred to as “the Act”). The FIDIC books provide for the traditional route of procurement in the Red Book and provide for the design and build route in the Yellow Book.

In the Yellow and Gold Books, the Contractor’s design obligations are essentially identical and are primarily set out in Sub-Clause 4.1(Contractor’s General Obligations) and repeated in Sub-Clause 5.1(General Design Obligations). Under these Sub-Clauses, the Contractor is expressly required to carry out and be responsible for the design of the Works in accordance with the Contract and therefore carries the risk associated with the standard of care established (fitness for purpose) as was held in the case of Francis v Cockrell [3] and this is encapsulated in Subclause 5.8 (Design Error). It should be noted that even the Red Book provides for Contractor’s design in Subclause 4.1(Contractor’s General Obligations) albeit to a lesser level than the Yellow Book. In these circumstances, the Contractor will still be held to a standard of care of fitness for purpose (Baker, 2013).

In instances where the Employer hires a design team for the case of the Red Book, the duty of care established under the case of Caparo Industries Plc v. Dickman [4] is such that the designers will execute this task with reasonable care (Adriaanse, 2017). Therefore, the designer remains under a continuing obligation to see that the design will work as was held in the case of Brickfield Properties Ltd v Newton [5] and as such, designers will often hedge against this risk with Professional Indemnity Insurance.

The risk for workmanship and materials is squarely placed on the Contractor in Subclause 4.9 (Quality Assurance) and Subclause 7.1(Manner of Execution). These are supplemented or qualified by statute law for example section 15(3) of the Act that will imply terms into the contract such as the principle that all materials shall be of ‘satisfactory quality’. Section 15(6) of the Act implies conditions as per the quality of goods(materials) that should be supplied on site. To this extent, the Contractor is allocated the risk in case of rejection of Works under Subclause 7.5 (Rejection) and then carrying out Remedial Works under Subclause 7.6 (Remedial Work). The risk associated with Testing of the Works is placed under the Employer in Subclause 7.4 (Testing).

In terms of dealing with the risk of non-performance by the Contractor, the FIDIC Forms provide for Performance Security in Subclause 4.2(Performance Security) and provision of parent company guarantees in some cases when subsidiaries of parent companies are involved. Additionally, during the course of the execution of the Works prior to completion, the Employer is entitled under Subclause 14.3(c) to retain a percentage of the contract value of the Works executed during the period covered by an Interim Payment Certificate. This provides security, in the form of funds, against the Contractor’s failure to complete any work outstanding when the works are taken over and to remedy any defects or damage and in respect of any other liability of the Contractor to the Employer.

The issue of risks associated with site conditions will also be handled under this section. Whereas common law usually places this risk with the contractor (Hughes et al., 2015) as was held in the case of Bottoms v York Corporation [6] and is not altered even when the employer provides plans and specifications at the time of tender as was the case in Sharpe v San Paulo Brazilian Railway Co [7]. The FIDIC forms of Contract allocate this risk to different parties in the different books. Under Subclause 4.12 (Unforeseeable Physical Conditions), the Red and Yellow Books place the risk under the Employer while the Silver Book places this risk under the Contractor.

Environmental and Natural Risks

The FIDIC forms of contract separately handle weather associated risks and risks associated with natural disasters. In the most part, these are regarded as neutral events which are out of the control of any of the parties and therefore warrant an Extension of Time but not additional payment from the Employer. Exceptionally adverse climatic conditions such as inclement rainfall can be looked at under Subclause 8.4 (Extension of Time for Completion) and natural disasters are handled in Subclause 19 (Force Majeure).

Given that construction projects can lead to massive disturbance to the environment as earlier on discussed, Subclause 4.18 (Protection of the Environment) allocates the risk of protecting the environment on the Contractor to the extent that the Contractor shall ensure that emissions, surface discharges and effluent from the Contractor’s activities shall not exceed the values indicated in the Employer’s Requirements.

Financial Risks

Given that cash flow is the bedrock of the construction industry without which productivity is hampered and can lead to adverse effects such as insolvency of the Contractor, it is important for the financial risk to be allocated to a particular party in order to have financial stability. The FIDIC forms ensure that under Subclause 2.4(Employer’s Financial Arrangements), the Employer maintains that they will be able to pay the Contract price to the Contractor.

Furthermore, in cases when an advance payment has been made by the Employer to the Contractor, in order to avoid the risk of misuse of the advance payment and non-performance, Subclause 14.2 (Advance Payment) and Subclause 14.5 (Plant and Materials intended for the Works) provide for the provision of an Advance Payment Guarantee by the Contractor to the Employer. This guarantee shall be in the amounts and currencies equal to the advance payment.

Human Resources Risks

Given that human resource is a vital cog in the construction industry, handling risks that arise from dealing with people in different teams is very key. The FIDIC forms in Subclause 6.4 (Labour Laws) allocate the risk of complying with the relevant labour laws applicable to the Contractor’s personnel including aspects of their employment, health and safety and welfare to the Contractor. This is further reiterated in Subclauses 6.7 (Health and Safety) and Subclause 4.8 (Safety Procedure) and buttressed by Subclause 18.4(Insurance for Contractor’s Personnel).

Economic and Political risks

Economic risks that lead to variations of prices are handled in a number of ways by the FIDIC forms of contract. Variations of prices are handled by the operation of price indices in Subclause 13.8 (Adjustments for Changes in Cost) which allows for reimbursing contractors for changes in input prices over which they have no control at all. Even if the Contractor has caused the project to take longer than planned, the changes in market prices will be caught by this fluctuations clause as was held in Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd [8]. In that way, the Contractor is hedged against this risk.

Additionally, risks of price fluctuations due to currency devaluation can be handled by establishment of a fixed exchange rate at the formation of the contract and payment in different currencies more so for inputs which are sourced outside the country in which the Works are being executed.

Because the FIDIC forms mandate the Contractor to comply with the laws in Subclause 1.13 (Compliance with Laws), there is a provision under Subclause 13.7 (Adjustments for Changes in Legislation) to adjust the Contract price to take account of any increase or decrease in cost resulting from a change in the laws made after the Base Date which affect the Contractor in the performance of obligations under the Contract. This hedges the Contractor against political risk due to changes in laws. It should be noted that Laws are defined in Subclause 1.1.6.5 to include all national legislation, statutes, ordinances and other laws, and regulations and by-laws of any legally constituted public authority.

Conclusion

In conclusion, managing risk is very key to achieving project objectives. Standard form contracts like FIDIC allow for the allocation and management of risk through different contract provisions.

List of Cases

Brickfield Properties Ltd v Newton [1971] 3 All ER 328.

Bottoms v York Corporation (1892) HBC 4th ed, ii, 208.

Caparo Industries Plc v. Dickman [1990] AC 605.

Francis v Cockrell (1870) LR 5 QB 501.

Hancock v BW Brazier (Anerley) Ltd [1966] 1 WLR 1317 QBD.

Henderson v. Merrett Syndicates Ltd [1995] 2 AC 145.

Peak Construction (Liverpool) Ltd v McKinney Foundations Ltd (1970) 1 BLR 111

Sharpe v San Paulo Brazilian Railway Co (1873) LR 8 Ch App 597.

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List of Statutes

Sale of Goods and Supply of Services Act 2018

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Bibliography

Adriaanse, J. (2017) Construction contract law. London: Palgrave.

Baker, E. (2013) Fidic Contracts: Law and practice. Taylor & Francis.

Brekoulakis, S.L. and Thomas, D.B. (2018) The Guide to Construction Arbitration. London: Law Business Research.

Bunni, N.G. and Bunni, L.B. (2021) ‘Risks as allocated and classified in standard forms of construction contracts’, Risk and Insurance in Construction, pp. 140–153. doi:10.1201/9781003222514-4.

Hughes, W., Murdoch, J.R. and Champion, R. (2015) Construction contracts: Law and management. Abingdon, Oxon: Routledge.

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[1] [1966] 1 WLR 1317 QBD.

[2] [1995] 2 AC 145.

[3] (1870) LR 5 QB 501.

[4] [1990] AC 605.

[5] [1971] 3 All ER 328.

[6] (1892) HBC 4th ed, ii, 208.

[7] (1873) LR 8 Ch App 597.

[8] (1970) 1 BLR 111.