Construction contracts and risk management for today’s market realities

April 3, 2022 BDO CANADA

The echo effects of the COVID-19 pandemic combined with a volatile commodities market are creating havoc across the construction industry.

Labour shortages, unpredictable timelines, and shifting prices are the new normal. It used to be that committing to a firm deadline and accepting minor penalties for lateness was a reasonable expectation for a construction company. Today, it’s nearly impossible for construction company owners to accept these conditions. As a result, they have no control over what could disrupt the supply chain this week.

Complicating matters further, current inflation trends make it difficult to forecast future cash flow and stick to the contract price. But the way contracts are set up between construction firms and project owners hasn’t fully caught up yet.

Risk isn’t what it used to be

Pre-pandemic, each side of a construction project was generally aware of the risks associated with their project based on their experience and the construction industry in general. Project agreements generally addressed these risks.

However, since March 2020, risk has become far more complex:

For these reasons, it’s unrealistic to expect any one party involved in a construction project to assume full financial responsibility for events unforeseen and out of their control, such as a pandemic or a war.

But more than that, it is prudent business practice for the parties involved in a construction contract to shirk risk responsibility due to these kinds of events.

Perhaps, a more productive approach would be to share the risk of such events and work together. As project partners, parties can join forces to mitigate the risks of unpredictability, avoid delays, and create plans that keep a project on track and on budget as best as possible.

Trends in construction contracts are addressing modern risk

BDO’s construction team is seeing a definite shift with contracts throughout the industry.

“We are seeing a shift to finding more collaborative solutions in dealing with the 2022 realities among our client base and this is consistent with the discussions we hear among general industry players in this space,” says Chetan Sehgal, a partner with the firm’s Forensic Disputes and Investigations practice and leader for the Construction Disputes & Advisory practice. “And the first question I’ll ask them is ‘what part of the risks are you prepared to share, and which ones are you prepared to live with, and do you know the related potential financial exposure of each?’”

“While contractually managing risks is a challenge undertaken by legal advisors, among other things, BDO’s advisory team assists clients by modelling out the potential financial exposure related to different risks to allow our clients to make more informed decisions.”

Our approach is intentionally collaborative, because “bid/no-bid and tender/no-tender decisions are being made specifically on how flexible and collaborative the other party is willing to be.”

Integrated project delivery

One way to demonstrate flexibility is in the approach to delivery. It hasn’t changed much in the modern history of construction, but integrated project delivery (IPD) is a new approach that makes sense for today’s risk climate.

Three key differences distinguish IPD:

  • Traditionally, both sides of a construction contract brought their own success metrics for inclusion in the contract. With an IPD approach, the parties create common definitions of success.
  • Costs and profits traditionally negotiated by each independent entity would be, in the IPD approach, pooled together. This incentivizes project success over individual self-promotion.
  • Rather than setting up the project schedule as sequential tasks being performed independently, the IPD approach unifies the project team as much as possible and creates the delivery schedule together.

These demonstrations of good faith on both sides help now and into the future. By aligning the interests of the two parties, the two sides prioritize the success of the project.

How collaboration is changing construction contracts

Good faith and a shared commitment to success are becoming important factors at the contracting stage.

Somewhere along the way, adversarial relationships between project owners and construction companies became more common or the expected norm. The current circumstances are steering the industry towards a huge win for collaboration and as a result successful project delivery.

Among other ways, contractual sharing of risks appears to be happening on two fronts: pricing and scheduling.

Pricing

More and more construction companies are requiring contracts that provide more pricing flexibility to succeed in today’s inflationary environment. This includes cost-plus contracts to ensure the project can absorb unanticipated cost increases, for example from supply chain issues and/or labour shortage issues.

“Committing to a fixed price when only 15% of the project has even been designed is extremely challenging in today’s business climate,” says Chantal Cousineau, a Quebec-based BDO partner and Practice Leader, Real Estate & Construction.

“In retrospect, if it wasn’t equally unreasonable before the pandemic, it was definitely unfair to construction companies, and stress-inducing for project owners who were compelled to tell their investors why they needed more capital.”

Accountability has never been more important than it is right now, and it’s important for both sides of a contract to share it.

Scheduling

The practice of project owners and construction firms jointly defining and codifying the critical path of a project is something relatively new, and Ms. Cousineau is encouraged by it.

“We’re seeing both sides of the contract make arguments for and against tasks that need to be part of the critical path—which is to say they’re deciding as a group what could and won’t endanger the target completion date. This is leading to more adaptability for delays caused by supply chains, weather events, and staff shortages.”

In today’s construction dynamic, there are many unforeseen events that cannot be controlled, and it’s important to have clarity between all stakeholders when managing construction delays. When both parties understand the critical path, unexpected delays can be mitigated, and timelines recovered.

Industry players adapting their approach to contracts

One interesting change that Sehgal has seen is the concerned parties collectively retaining a third party as a contract monitor.

“We are seeing more and more requests to explore options to be a neutral watchdog, making sure that each party is taking care of its end while honouring the relationship with the other party and doing the right things for the project. This not only keeps everyone accountable, but also ensures the speed bumps that may impact the critical path can be dealt with proactively and keep the project on track.”

“We’re in one of those unique moments in history where we all have a common enemy,” says Sehgal, referring to the effects of a volatile market. “As human beings, we instinctively know we have a better chance of survival, or success in this case, if we work together.”

“The willingness I’m seeing across the board to meet in the middle, from all corners of the construction industry, is proof positive. And when that happens, everybody wins in the end.”

Connect with our team for help assessing your project, identifying the hidden contract risks, creating a going-forward negotiation plan, or navigating a lawsuit.

Chetan Sehgal, Partner, Forensics Disputes & Investigations, Real Estate & Construction

Chantal Cousineau, Partner, Practice Leader, Real Estate & Construction

Jameson Bouffard, National Real Estate & Construction Leader

Matt Peron, National Construction & Development Leader

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