risk strategy c&pguidedraft5ach4 packagecontractstrategy

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APM Revised Procurement Guide : Chapter 4 Contracting Strategy 1

Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG,Association for Project Management, 2009 forpublication in its forthcoming Guide. This draft is for consultation only & may be printed or distributed only for that purpose.

Please send comments to [email protected] post on the C&P Wiki at apmcandpsig.org

4.0 STAGE 3 DEVELOP PACKAGE CONTRACT STRATEGY.

This chapter covers the development of the contract strategy for each individualcontract package. It is important because research has shown that contract strategy hasas large an effect on a contracts success as any technical decision. In pr

At a higher level, contract strategy means deciding how the main risks associated witheach contract package will be allocated to the parties to that contract and through whatmechanisms. As contracts allocate risk, these high level decisions should be made priorto selection of any industry or sector standard conditions of contract and before anysubsequent drafting is done.

By risk, we mean both :

threat, which is a negative risk and if it occurs will have a detrimental effect onthe project and / or risk owner; and

opportunity, which is a positive risk and if it occurs will have a beneficial effect onthe project and / or risk owner.

In this incidence, by risk owner we mean the party that bears the consequences, asopposed to manages the risk. If a risk is contracted out to a party, then while they maybear the negative consequences if the threat occurs, they may well gain the positiveconsequences or benefit either if it does not occur and they have included acontingency in their project sum or if they manage in an opportunity.

In a bi-party contract, theoretically risk can be completely allocated to the Client,completely to the Contractor or it can be shared either at a contract level by a pain /gain share mechanism or for a specific risk type by specifying a threshold at which pointthe risk above this point is transferred. For instance, in construction projects, thecontractor takes the risk of adverse weather up to a defined threshold and should

therefore allow some contingency. Beyond that threshold, the Client takes the additionalrisk over and above that point.

Before continuing, it is worthwhile considering some principles of risk allocation andsharing as they affect virtually all aspects of this chapter. When allocating or sharing riskconsider in order,:

1. if the risk occurs, the effect on the organisations business : for a threat, if it iscompletely allocated to the contracting party, they will take all the pain. However,they will almost certainly add in a contingency to the Contract sum to partiallycover this. The smaller the contracting party is, the larger this contingency is

1.Concept

&Feasibility

2.DevelopProjectProcure-ment

Strategy

3.DevelopPackageContractStrategy

4.Draft

Contract& DetailRequire-ments

5.Select

Contractor& EnterContract

6.Delivery ofRequire-

ment& ManageContract

7.Operate :Deliver

Outcomes& ReceiveBenefits

8.Disposal

orUpgrade


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likely to be as it is a larger risk relative to their size. And if the contingency doesnot cover the cost of the threat then, if the risk occurs they may well devoteconsiderable energy to try and find other ways of re-gaining this money throughthe contract. This could detract from them focussing on what is important to theclient. In extreme cases, they may go bankrupt which means the consequencesof the threat will revert back up the contractual chain.

2. who can best influence it happening : On the basis that prevention is better thancure, this principle comes before the next one. Obviously, opportunity wants tobe managed in and threat out. By allocating a risk to the party best able tomanage it in or out, they become motivated to manage it in or out.

3. forthreat, who can best minimise the consequences : by allocating a risk to theparty best able to minimise the consequences they are motivated to do so, ratherthan make the most of the other parties misfortune.

4. clarity over above for minor risks, allocating more frequently occurring minor risksto the contracting party : For minor risks, the first principle does not apply. Allother things being equal, the parties are relatively indifferent over who takesminor risks. However, if a minor risk is likely to occur frequently and it is allocatedto the client party, there may well be frequent arguments over adjustments to thecontract sum. To avoid this, it is best if they are allocated to the contracting party.

As these are principles, in the real world there may well be contradictions. For instance,a small specialist software services company may be the best organisations to managein the opportunity for a critical part of an IT system due to their specialist knowledge, butunable to take the consequences e.g. the full damages if they fail to. Equally, if the

client is planning to exploit the system on the open market, they will not wish to allocatethe full benefit to the service company.

INPUTS

The Inputs to this Stage are the outputs of the previous stage, which are used as thestarting point for the development of the contract strategy for each contract package orgrouping of packages by type. That is the Project Procurement Strategy Documentwhich, as well as giving the overall procurement philosophy and approach for the wholeproject, includes for each package :

its scope

the interactions and interdependencies with other packages and proposedresponses to manage these and

the nature of the relationship sought with the supplier. This is primarily what isdeveloped in this stage.


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Copyright : Jon Broome on behalf of Contracts & Procurement (C&P) SIG,Association for Project Management, 2009 for publication inconsultation only & may be printed or distributed only for that purpose.

Please send comments to [email protected] post on the C&P Wiki at apmcandpsig.

ACTIVITIESINPUTS

ProjectProcurementStrategyDocument,giving overallapproach &summarisingfor each majorpackage orcategory ofpackages :

PackageScope

Inter-actions &

depend-encies +proposedresponses

The Natureof Relation-shipsought

1. InformationGathering

2. Prioritising &Getting Specific

3. Choosing best fitcontract strategy

4. Second order risk allocation : Additional risks & thresholds, Use of incentives

5. Means of Redress :warranties, bonds etc

6. Select form of(if prac


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1. Information Gathering.

This stage is predominantly about gathering more detailed information about thecontract package and the participants to it. This information is equally valuable for theStage 5 when selecting the supplier. It is suggested that three inter-related mainheadings are used to gather information under.

Partic ipants Drivers & Constraints : The client organisation needs to be clear abouttheir drivers for the contract as opposed to the project. For instance, the contract maybe time driven as it is on the critical path of the project, while the overall project is not orvice versa : the overall project is time driven, but the contract is off the critical path andso is not. In addition, what is the clients attitude to risk versus their desire for certainty.This is different from their ability to take the consequences of a risk. For instance, thepublic sector mentality is often very risk averse, yet very few organisations have a

greater ability to bear risk than the government.

Likewise, what are the probable drivers to be for the likely supplier participants ? It is alltoo easy to say that a supplier is only driven by money. While this is partly true, it isoften a simplification : suppliers ultimately want to make profit, but how important is it forthem to, for instance :

be cash flow positive maintain market share in order to preserve workforce and get return on capital

gain market share

be willing to sacrifice some short term profit from the contract in order to have along term profit stream from a client

have certainty of profit versus the opportunity to maximise profit if the contractgoes well, the opposite of which is making a loss if it does not. This is reflected intheir willingness to take contractual ownership of risk. In boom times, this maymean transferring risk to a supplier will carry a high price for a client. Inrecessionary times, the client may get better value.

In some cases, the opposite of a driver is a constraint : i.e. the need to be cash flowneutral, otherwise they cannot do business. However, constraints can take a number offorms. A good high level aide memoire is the acronym PESTLE which stands for :

Political : for instance, is there a political imperative to use a UK supplier

Economic : for instance, the need for an even spend in successive financial

years

Social : for instance, the need to ensure local sub-suppliers or labour isused.

Technological : for instance, on a large project, there may be a need forcommon IT management platforms amongst all suppliers.

Legal : for instance, in the construction industry, construction contractshave to comply with an act of Parliament with regards topayment and dispute resolution procedures.

Environmental : for instance, the need to comply with environmental constraintsin a planning application.


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Strengths & Weaknesses of the Likely Parties principally applies to the parties :

commercial ability to bear financial risk. For instance, a 250,000 risk might be arelatively minor risk to a 1 billion turnover company, yet bankrupt a 1 millionturnover company. The former might price the risk competitively and as astatistic (similar to an insurance company), while the latter might price it higherin absolute terms as relative to their size it is a large risk. This is despite thempotentially being much more entrepreneurial and willing to take on risk.

commercial and technical ability to manage different types of risk.

Contract specific threats and weaknesses : so far project level risks should havebeen identified. These may well be high level generic risks which can be developeddown to more tangible contract level risks. For instance, in a construction project,

unforeseen ground conditions may have been identified as a generic project level risk.In order to gain greater certainty, further investigation might have revealed more detailabout the location and type of ground risk and consequence should it occur.

Alternatively, they may be specific risks related to that contract and / or its interactionswith other parallel contracts. The PESTLE acronym can be used to generate sources ofrisk.

2. Prioritising & Getting Specific

From the mass of information generated from the above, it is important to pick out the

key drivers, pertinent strengths and weaknesses and main risks, prioritise in terms ofimportance and get specific about them.

For instance, of all the drivers mentioned by the various stakeholders, which are theimportant ones for this contract, how precisely are they going to be expressed for thiscontract i.e. as specific objectives and, if an opportunity, are you going to put extraemphasis on their achievement by incentivising them in a way which matches thecontracting parties drivers.

Where constraints are identified, they can be challenged and potentially made broaderby asking two simple questions :

who or what says this has to be constraint ? which identifies the cause; and what would happened if we did not have this constraint ? which identifies the

consequences.Generally, the fewer constraints or restrictions on how the contractor can deliver thecontract, the more leeway there is for innovation. As a result of this, the important andreal constraints are left in, while the less important ones are relaxed, re-expressed ordisappear.


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For all the risks identified, which are the main risks and how precisely will they beexpressed and, in accordance with the principles of risk allocation and sharing,allocated under the contract given the likely parties strengths and weaknesses.

It could be argued that precisely defining objectives, constraints and risks at this stageis unnecessarily detailed. However, without this precision, then (a) stakeholders and theproject team may think they agree, but in reality not and (b) lawyers and technicalpeople who will draft the contract and detail the requirements may define themincorrectly.

3. Choose best fit contracting strategy.

Choosing the best fit contract strategy is about selecting the most appropriate bigpicture risk allocation given the contract objectives, constraints, risks and the strengths

and weaknesses of the likely parties to the contract. Below is a diagram which reflectsthe most likely best fit contracting strategy for the contract.

What Sort ofContracting Strategy ?

Short Medium Long Permanent

Complexity

/ Degree ofUncertainty

Low

High

Partnering Style Contracts- Strategic Alliances : frameworks,outsourcing, partnerships- Project alliances- Target costs contract

J oint Ventures

TIMESCALE

Scheduleof Rates

Bill ofQuantities

Fixed price contracts- activity schedule- lump sums- milestone payments

Input Based Contracts :- Management contracting- cost reimbursable- fee based arrangements

Design BuildFinance

Arrangements

We will now briefly go through each of these contractual arrangements identifying thekey features of each, how terminology might vary from industry or sector to sector andwhen to use them.


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Schedule of Rates : A schedule of rates is where the client organisation puts togethera list of pre-identified services or goods, possibly with quantities against each item, andasks potential contractors to tender against these rates. Once selected, quantities arecalled off and the contractor is effectively paid quantity multiplied by rate.

A Schedule of Rates is typically used where the client can define what they want, butnot necessarily the quantity wanted. Often, this is for commodity type goods or serviceswhere there are multiple suppliers. Consequently, the client gets value for money byopen competition with the supplier being chosen on the lowest total price for thecombination of goods or services.

A Schedule of Rates can also be used for a longer term call-off contract, perhaps withmultiple suppliers : for any given order the client evaluates which supplier will give thebest deal and places the order accordingly.

Bill of Quantities : A Bill of Quantities is very similar to a Schedule of Rates with thekey difference being that the quantity of work is much harder to forecast, so the supplieror contractor gets paid for the quantity of work they have actually done as opposed tothat called off by the Client. For instance, in civil engineering, the Bill of Quantities uponwhich the contractor tenders is an estimate of, for instance, the volume of earth by typethat needs to be moved. This volume is re-measured once the work has been done,with the Contractor being paid tendered rate x quantity of work done.

The problem with this approach is that the costs to the contractor of doing the work arenot solely related to the quantity of work done : method and time taken as well as, in the

case of the earthworks example, the ground found and weather can have major effectson the contractors costs. Consequently, the rate charged is often subject to change.

Fixed Price Contracts.

Fixed Price Contracts are a generic category of contracts based on the establishment offirm legal commitments to complete the required work. A performing contractor is legallyobligated to finish the job, no matter how much it costs to complete. Consequently, theyshould be used only where the client can clearly describe what it is they want, theconstraints in which it is developed and the risks for the contractor are small. They arenormally used where the contract describes a sub-project in itself.

The description of what is wanted can be a fully developed or detailed design or afunctional or performance specification leaving the design to the contractor. However itis expressed, the important points are that it is a full and unambiguous description,which is unlikely to change. Likewise with the constraints. Virtually all literature statesthat if there is likely to be a high degree of change then this is unlikely to be a suitablecontracting strategy, as contractors use the lack of visibility in pricing to charge morethan the true cost for changes. On the other hand, contractors would argue thatbecause they are priced keenly and planned in detail any change causes delay anddisruption costs, which one extensive Canadian study of construction projects foundtypically amounted to twice as much as the direct costs of the change.


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Linked to this is the degree of risk retained by the Client : if too much is retained by theclient, then as and when it occurs, this will be paid as extra under the contract.However, if uncontrollable risk is transferred to a contractor, then the client may well paya high risk premium. Consequently, while this method can be used for very complexprojects, the important thing is that the Contractor is experienced in this type of work, sothe risks are small for him or her.

There are several variants on fixed price contracts in terms of how the contractor is paid:

Milestones payments where the contractor is paid when he or she has metmilestones specified by the client. This has the drawback that the contractoradjusts his programme to get early payment as opposed to minimise costs and,as the milestones are typically high level and do not fully correlate with the

programme, provide little transparency of cost for when change occurs. Lump sums are where the contractor breaks the works down into operations and

is paid at regular intervals according to percentage completion of each operation.This provides more transparency of cost than milestones as the lump sumoperations match the programme. However, each operation is described at quitea high level and arguments do result over the percent of work complete. EarnedValue Analysis can be used with this method.

Activity Schedulesare like lump sums except the contractor only gets paid forcompleted activities. Consequently, the contractor will break their activityschedule down into more detail than lump sums, which provides greatertransparency and better monitoring. It is, however, more work for the tenderingcontractors.

As fixed price contracts are often tendered against functional or performancespecifications, the contractor has to do some design or developmental work pre-contractto derive a price to tender. Clients often want to check this work to ensure it complieswith their requirements. This is then incorporated into the contract.

However, depending on the type of project, doing this design or developmental work toa level where a meaningful price can be tendered can be quite onerous on the tenderingcontractors. Consequently, some clients ask for outline designs and indicative prices.They then select the best combination and work with the preferred contractor to de-risk

the contract package and develop the design to give the client sufficient certainty ofwhat will physically be delivered. As a result, the contractor can price more accuratelyand the client gets a more sharply priced contract to enter into. This is called aPreferred Contractorroute.

Unfortunately, once a preferred contractor is chosen, even though the client has theoption of going to another contractor, as time progresses the client becomesincreasingly tied into using this contractor and this is can be exploited. Consequently,this approach is usually used by repeat order clients with a small group of favouredcontractors, where there is a longer term overarching commercial relationship.


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Turnkey contracts are usually let as fixed price contracts. A Turnkey contract is acomprehensive contract in which the contractor is responsible for the complete supplyof a facility, usually with responsibility for fitness for purpose, training operators, pre-commissioning and commissioning. It usually has a fixed completion date, a fixed priceand guaranteed performance levels.

Partnering Style Contracts.

Partnering is defined as an arrangement between two or more organisations to managea contract between them cooperatively, as distinct from a legally establishedpartnership. While partnering can be done under other previously mentioned contractingstrategies, certain strategies lend themselves to this approach due to way in which theyprovide cost transparency and align commercial objectives.

Under these arrangements the primary means of re-imbursing the contractor is throughdirect payment of their costs, plus a fee of some sort for head office overheads andnormal profit. To be re-imbursed the contractor has to be able show his costs, hence thecost transparency.

The commercial alignment comes from a meaningful target being established aroundwhich savings and over runs of cost plus fee are shared. This is often referred to as apain / gain share mechanism and creates the incentive for both parties to work togetherto minimise costs. Essentially this means that there needs to be sufficient scope withinthe requirements to take out cost either through managing out threat or managing in

opportunity through joint working. In other words, there is little point in using this typeof contracts for a fully defined and detailed requirement where the client is not going tocontribute.

There are a number of types of contracting arrangements which reflect the scope forcooperation and innovation.

Target Cost Contracts : are between two parties, where a contract target price isagreed, tendered, negotiated or built up on an open book basis. This target essentiallycomprises the contractors costs, an allowance for the risks included within the targetand their fee. The pain / gain share operates around this target.

During the contract, the target is adjusted for pre-defined reasons normally to do withthe client changing something, not doing something which they are contractuallyobligated to do (which would otherwise be a breach of contract) or a limited number ofthird party events over which the contractor has no control.

A specific type of target cost contract is the Guaranteed Maximum Price (GMP)Contract. The essential difference is that at some point, often the target, the clientsshare of any over-run is capped, so the contractor takes all the pain beyond this point.In addition, the reasons for adjusting the target are often reduced to the legal minimum.


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Project Alliances typically have the following characteristics compared with target costcontracts :

There are more than two parties tied into the alliance incentive mechanism. There is usually a courting phase where the parties work together at cost to

develop a sufficiently robust requirement and hence alliance target, whereby allare comfortable in entering into it. Note though that if the requirement is overdeveloped it defeats the point of entering into an alliance.

This alliance target is much more extensive in its coverage, including almost allrisks normally borne by the client as well as their project related costs e.g. ofmanagement and, in construction, land take etc.. Note : the costs of auditing theparties accounts are usually excluded from the alliance costs for obviousreasons.

As a result of the previous two points, the reasons for adjusting the alliancetarget are far fewer than under a target cost contract.

The Early Contractor Involvement (ECI) contracting strategy is a half way housebetween target cost contract approach and full project alliance. Here the Contractorworks at cost with the client to develop the requirement to a point where it can bepriced. At this point a target cost contract is entered into, but with the contractor takingresponsibility for the current design i.e. under a target cost contract, if there is an errorin the requirement, the client corrects it and the target is adjusted. Under ECI, the costof any error is included within the target creating greater commercial alignment.

Prime Contracting is similar to the ECI route with two developments : a greateremphasis on collaborative working down the supply chain, who are incentivised, and afitness for purpose liability. In this sense, while the contractor is paid on an open bookbasis with pain / gain share, their liabilities are closer to the Turnkey contract model.

Strategic Alliances take two main forms :

Project based frameworks whereby a client enters into a framework agreementor contract to use the contractor for projects of a certain type over a period oftime, although almost all agreements have a non-exclusivity clause whereby theclient does not have to use the contractor. Indeed most clients keep their optionsopen by having a number of contractors in any framework. This is both topromote some competition and avoid becoming dependent on one supplier.While the early projects may be defined enough to price, later ones will needdevelopment before a meaningful price can be agreed. As each project matures,a contract is let. Often this contract is let under one of the previous partneringstyle arrangements i.e. a target cost or project alliance.

This arrangement includes the following advantages : it avoids the need tocontinually go out to the market; the need for a contractor to continually do a fulltender on a speculative basis; allows the contractor to invest longer term as thereis greater likelihood of future work; if programmed correctly, allows for continuityof use of resources as opposed to de-mobilising, doing nothing and re-mobilising;and allows for continuous improvement as learnings from one project are taken


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from one project and utilised in subsequent ones. All of these can result inprogressive and sustained improvements in projects in terms of time, cost andfitness for purpose.

However, there is a danger of complacency creeping into a relationship where asingle contractor has all the work. Consequently, most clients have a number offramework contractors for a specific type of work, benchmark performanceagainst each other and reward the higher performing ones with a greater share ofthe work.

Term Service or Strategic Outsourcing arrangements, whereby a level ofservice is stated as a requirement. This could be for maintenance of an assete.g. a road or building or for an IT based service. This could be delivered under aSchedule of Rates or Fixed Price contract, with a reason for termination being

that performance falls below a certain level. What makes this a strategic allianceis :

o whatever the service is, it is normally stated as a performance and / orfunctional requirement in order to allow for continual improvement in how itis delivered with both parties being able to contribute to the improvements.

o the nature of the service operated tends to be strategic or business criticalto the client organisation

o the improvements can be in cost savings which are shared by a pain /gain formula and / or in measures around the quality of service againstwhich incentive payments are paid.

Input based Arrangements

Input based arrangements are where the Contractor is reimbursed their costs plus anallowance for his head office overheads and profit. They therefore rely on trust tooperate effectively. The main drawback of all these arrangements is the lack of a directcontractual incentive to reduce costs. It was mainly for this reason that the target costand project alliancing arrangements were developed.

There are three main arrangements :

Fee based arrangements whereby the contractor or service provider provides

details of their fee per unit of time at the start of the arrangement. Within agreedparameters, they are then paid the quantity of time used multiplied by the rates.This arrangement is often used at the start of a project where poor decisionsmade or work done up front can have a large effect later on. Consequently, it isnot worthwhile skimping on this stage. Having said this, many professionalappointments are also made on this basis for the management of projects e.g. inconstruction management a contractor is appointed as a professional tomanage the construction of the works with all the works contracts being directwith the client. This does, however, call for strong project leadership from theclient. In other sectors, this role is sometimes referred to as that of the ProjectIntegrator.


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Cost reimbursable contracts whereby the contractor does work at cost whichcould be both management and doing the project - and provided he or she canshow that these costs were incurred in providing the asset or service, he or sheis paid this cost plus a tendered fee. This can be a fixed fee or a percentage feeapplied to the costs incurred. This arrangement tends to be used where there isan existing commercial relationship and time or quality driven work emerges,often with significant risks. For instance, in emergency work, it avoids the needfor a requirement to be fully developed and then priced by the contractor,including for unknown or unquantifiable risk. Instead, they are appointed quicklyand start work quickly.

Management based contracts, whereby the main contractor only manages thework, much like a construction manager or Integrator. The difference is that allthe works contracts are let through the contractor as opposed to directly with theclient. This gives a harder contract as the management contractor has a fitnessfor purpose liability to deliver, as opposed to a reasonable skill and care liabilityand can have damages levied for late delivery. The downside is that therequirement has to be developed more for this fit for purpose liability anddelivery date to be established. As the contractor now has commercial liabilities,he or she potentially has a position to defend which undermines theirprofessional incentive to work in the best interests of the client. For instance, ifthe project is running late, there is an incentive to spend the clients money toavoid late delivery damages. Equally, if the client introduces a change, there isnow a potential motivation to exaggerate the amount of additional time needed to

cover up for other delays for which the contractor would pay damages.

A Joint Venture(JV) is a contractual arrangement in which resources are combined be they equipment, expertise or finance by two or more participants with a view tocarrying out a common purpose. This typically takes one of the following forms :

a consortium agreement.

a limited liability company

a partnership or

a limited partnership (whereby the partners liability is limited).

Another subtlety is whether they are :

a vertical joint venture. For instance, a local authority and term servicescontractor would normally be in a more traditional client / contractor arrangement.Instead, in one arrangement, they formed a joint venture to both carry out thiswork and seek out extra work within that county for other clients. The profits weresplit by their respective share ownership.

a horizontal joint venture whereby two or more parties to come together to jointlypursue and realise an opportunity which neither could pursue on their own.

More specific reasons for forming a joint venture could include a combination of :


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Limitation of risk, whereby neither party could bear or wishes to bear the entireconsequences of the downside risk on their own.

Pooling of resources, either because the opportunity is too big for only one party(almost the opposite of limiting risk) or because they have complimentaryexpertise : neither party could deliver the opportunity without the other.

Access to market, particularly for work in overseas jurisdictions, where a foreigncontractor may have to form a joint venture with a local contractor. However, itcould also be that one partner is already well established in that sector.

A more integrated approach through eliminating contractual interfaces

The main disadvantages of a joint venture approach is the cost and risk of setting upone, meaning that the size of the opportunity has to be worthwhile this cost. The costnot only includes the legal costs, but also being clear about the commercial reasons andscope of the arrangement, the strategic direction and management of it onceestablished, as well as the day to day integration of systems and cultures once it isplace. There is a significant risk the joint venture may fail.

Often J oint Ventures are formed to bid for the contractual approaches outlined below.

Build, Own, Operate, Transfer (BOOT) contracts are where the client has arequirement for something to be supplied to them and this requires a specialist facility tobe built. For instance, the client may require energy to be provided to a remoteproduction facility close to the base resource. They therefore want a specialist energycompany to take full responsibility for the building and operating of the asset, so theyinitially own it, but after a set period of time ownership is transferred. Typically, this ispaid for as a combination of a lump sum for setting up the facility and as a Schedule ofRates / Bill of Quantities for delivery of each unit of, in this instance, power.

Design, Build, Finance & Operate (DBFO) contracts are often, when the client is thepublic sector, known as Private Finance Initiative (PFI) contracts or more recentlyPublic Private Partnerships (although this can include a number of other arrangementsboth informal and formal e.g. joint ventures). The main difference is that, such is thesize of the project, that a financing organisation such as a bank, needs to be part of theJ oint Venture.

The project part of these contracts is design and implementation of a new or improvedasset, service or system which is funded by the contracting organisation. The build partcomes from their original use for construction projects. Once the asset is in operation,the client pays the contracting organisation for its operation, often with a large part ofthis payment based on performance. E.g. for a non-toll road, it may be percentage timethat all lanes can be used and average traffic speed. These payments both service andprogressively pay off the debt with an allowance for profit. If performance slips too muchfor a period of time, then the client can take over the asset. Often, built into the contractis a requirement to improve the asset towards the end of the operate part contractbefore ownership reverts to the client.


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The typical contractual structure of such as deal is shown below.

Principal /

Concessionaire

Promoter

Users

Operator

ConstructorInvestors

Lenders

Suppliers Supply

Contract

Loan

Agreement

Shareholder

Agreements

Operation

Contract

Construction

Contract

Off take

Contract

Concession

Agreement

PFI&PPPWhatdoesitlooklikecontractually?

The main advantage of this approach is the focus of the contract on performance or thecapability it gives the client or even the benefits it delivers for them and, within thisbroad frame, the allocation of risk to the party best able to manage it.

There are essentially 3 types of PFI deal : Pure PFI : which are normally commercially viable without financial support,

sometimes identified & promoted by concession company e.g. Channel TunnelRail Link.

Part PFI : which are not commercially viable on own, so sweeteners, such asexisting assets are included in deal. For instance, in the second Severn crossing,the bridge was handed over to the concessionaire for them to derive income fromboth during construction and afterwards. Likewise

Public Private Partnerships : where government holds a competition and selectsa Concession company to run a service on its behalf or for it and pays thecompany for doing it. Being cynical, one could say that they were an attempt tore-branded the PFI projects with a more politically acceptable name. However,often they function as outsourced services, where the quality of the outputs from


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the concession company are partially dependent on the inputs coming in fromgovernment client. i.e. there is greater interdependency between the two parties.

The main drawbacks of the approach include ; The cost of setting up such an arrangement I.e. for a whole life cost of less than

20million it is almost certainly is not worthwhile.

The performance required, capability required or benefits wanted must betangible enough to be specified as a contractual requirement which can bemeasured and paid against.

In addition, however these criteria are expressed, they must be sufficiently longlasting to be valid for the duration of the operate part. For instance, the purposeof a road may well stay the same for a 25 year concession, but for a hospital, thepurpose, range of functions and demand for them for that duration will varyenormously. Consequently, change will occur for which (a) the contractor willwant payment and (b) will mean the original criteria against which they are paidmay become both invalid and / or unobtainable due to these changes.


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4. Second Order Risk Allocation

Having selected the primary risk allocation by choosing the best fit contracting strategy,

the next step is to fine tune the contracting strategy by decide on : what risks are excluded from the contract sum and would cause an adjustment to it.

In some instances this means defining thresholds. For instance, in constructioncontracts, this could be the level of rainfall in a particular month.

the degree to which the Contractor will be incentivised to meet the contractual levelof performance and exceed it if desired.

4a. Additional Risk and Thresholds.

By deciding which risks will cause an adjustment to the contractual sum, you are, bydefault, deciding which risks will not. Having identified these risks and assessed them interms of likelihood and impact, they need to be defined precisely and allocated or

shared in accordance with the principles identified in the introduction to this chapter.

A common issue which arises is the deletion (from standard forms) or non-inclusion ofclauses that cause adjustments due to breaches of contract by the client or hisrepresentatives. This is pointless. Not having such a mechanism potentially leads to thecontractor suing or claiming for breach of contract on completion of the contract foradditional money and time. It could mean time for completion becomes at large. Aswell as the uncertainty, it is much more expensive and time consuming than managingand agreeing these changes through the conditions of contract as the contractprogresses.

Linked to this, is the importance of having clauses which allow for changedcircumstances whilst the contract is being delivered e.g. changes to the Requirementwhether in scope or upgrading its performance. Failure to have these will either result inthe contractor refusing to do the work and the asset potentially not being fit forpurpose or the contractor being able to hold the client to ransom by re-negotiating thecontract on his terms. During the contract, discipline needs to be exercised in onlyinstigating essential changes !

Lastly, 3rd party or uncontrollable risks for which the client will take some or all of the riskneed to be identified and defined. These fall into two camps :

Unlikely, but high impact risks : These are allocated on the basis of who can best

bear the consequences, which will typically be the financially stronger party. Forinstance, the risk of a third party striking which eventually has an impact on theworks.

Frequently occurring, but minor impact risks where the issue is the cumulativeimpact of them occurring. For instance, if a contractor is working on a live assetsuch as a railway, where he or she has to stop frequently for trains to pass, butexactly how often and when cannot be defined. Inflation is another example.

For the former, the risk transfer threshold may be set, for example, whereby thecontractor takes the risk of the first week of any delay caused by the strike. For thelatter, it may be decided that the contractor takes the risk of X stoppages of up to Y


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minutes per month which is set a little above the normal amount to be expected. Abovethis point, the client takes the risk.

4b. Use of Incentives.

Incentives can be either set negatively in the form of liquidated damages or pain orpositively in the form of bonus or gain share. More often, only damages are used. A pre-requisite for the use of incentives is that the level of performance, be it time, efficiencyimprovements, service level, cost savings etc. can be measured or describedunambiguously. Another pre-requisite is more common sense : achieving the desiredlevel of performance has to be within the control or at least significant influence of theparty upon which the incentive is set. This leads us back to the principles of riskallocation and sharing in introduction to this chapter.

The most common form of damages are for late delivery (delay damages), but can alsobe for performance below the level stated in the contract. (For performance damages toapply, the Requirement has to be stated as a performance specification.) If the quantumof damages per unit time or unit of performance are not stated in the contract, then theclient can claim for the true cost, both direct and consequential, of this lack ofattainment. This can be an expensive legal process and some contractors refuse totender on work unless damages are stated. For this reason, it is normal practice tostate the time related damages in the contract. For the majority of the world, with thenotable exception of the USA, the level of damages cannot exceed a genuine pre-estimate of likely loss at the time that the contract comes into existence, otherwise theycan be legally challenged as a penalty.

The upshot of stating the level of damages is to state the maximum liabilities which canfall on the contracting party, which reflects the parties ability to bear risk and thepremium the client is willing to pay for risk transfer. Typical limitations on liabilitiesinclude : maximum time related damages payable; maximum performance relateddamages payable; maximum liability for indirect or consequential loss; maximum liabilityfor damage to clients property; maximum liability for design defects (if the contractor isresponsible for design); and maximum total liability.

The last form of negative incentive only applies to those where there is a pain share /gain share mechanism for cost i.e. the contractor bears a share of the pain under

partnering style contracts. While some clients chose to cap their own liability for anyover run through use of Guaranteed Maximum Price (GMP) contracts, others choose togo the other way, where they cap or more often considerably reduce the contractorsshare of any large over run. This typically happens on big contracts with a financiallystrong client (both relative to the contractor), where the contractor cannot bear thefinancial consequences of a contract that has gone significantly wrong.

The other side of the coin to damages is bonuses, which are generally paid forperformance above that stated in the contract or occasionally for meeting it e.g. theopening date of a venue which cannot slip. Obviously, it is only worthwhile specifyingbonuses if the increase in performance is of benefit to the client. Equally obvious, the


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client does not give all the benefit to the contractor as then none is left for the client !However, it does have to be set at a level that makes it worthwhile for contractor topursue.

Bonus are not used as much damages in the UK. In the USA, they are used much morewidely and research has found that a well thought out incentive plan stimulates superiorcontractual performance, whereas use of damages alone has negligible or evendetrimental effect on project performance. Psychologically, this is because :

it is always in both parties interests to strive for bonus payments. Consequently,even when difficulties are encountered, people continue working together to tryand achieve them,

whereas, when it becomes evident that the contractually defined level ofperformance is unlikely to be met, the contractor tries to put blame on the clientin order to avoid paying the damages. The client tries to put this blame back onthe contractor.

Our view is that incentives should be used be more widely to stimulate superiorcontractual performance. With the expected rise in benefits contracting, we expect theiruse to rise in any case, as in complex situations with interdependent contractualobligations, it will be hard to show that the client no responsibility for the underperformance of the contract and therefore hard for them to enforce damages.Consequently, basic contractual performance levels with be set low, with performanceabove this contractual minimum rewarded with bonuses.

The last form of bonus is the sharing of gain under partnering style contracts. A note of

caution though : if these gains are made entirely through the efforts of the contractingparties without, for instance, the collaboration of the client under target costarrangement, then this may be viewed as lost profit by the contractor. Consequently, theinitial target cost will be set higher by the contractor to make up for this loss of profit.


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5. Means of Redress

This section covers retention, guaranties, warranties, and, applicable if you are in the

United Kingdom, The Contracts (rights of third parties) Act 1999. Essentially all aremeans of redress for under performance of the contract by the contractor or a sub-contractor or sub-supplier.

Retention is where apart of each payment is retained as the contract progresses inorder to ensure satisfactory performance or completion of contract terms. Typically thisis 3 to 5% of each payment. Once the contractor has completed the works, then half ofthis usually paid back and, following a period in which the contractor has to maintain theworks (typically 1 year), the remainder is paid back minus the cost to the client ofcorrecting any outstanding defects, which the contractor should have corrected.

Its purpose therefore is to ensure that the contractor completes the works; that it hasminimal defects in it; that if there are any, he or she will make a return visit to correctthem; and if they do not, the client has some money to correct the defects themselves.

The downside of applying retention is that it detracts from the cash flow of the contractorand he or she has to finance this cost. Consequently, they include this financing cost intheir contract price. As a result, where there is an overarching repeat order commercialarrangement, more enlightened clients have stopped this practice.

At the other end of the spectrum, some clients and contractors with theirsubcontractors - have abused the retention system so much, in terms of holding on to

cash, that some contractors price on the basis that they will not get retention back at all.

In addition, the sums retained after the works have been completed may not be enoughto cover major defects in the work, leading to legal proceedings which having retentionwas intended to avoid.

Guarantees are a legally enforceable assurance of performance of a contract by asupplier or contractor. Typically, a third party to the client and contractor provide aguarantee as to the performance of the contractor under the contract. Should thecontractor not perform or refuse to rectify their lack of performance, then this third partyguarantees to pay for the costs associated up to the point required under the contract.

An independent party is normally required to witness the signing of a guarantee for it belegally effective and, should the need arise, (another) independent party is normallyrequired to confirm non-compliance and that it is due to the contractor.

The two most common forms of bond or guarantee are :

Parent company guarantee : While the advantage of this is that payment from thecontractor to take out this guarantee is likely to be minimal or non-existentcompared with taking out a bond (see below), it is unlikely that this third party isindependent both in mindset and / or finances. Consequently, in a dispute overwho is liable for the lack of performance, the guarantor is likely to listen to andtake the side of the contractor and be hesitant to pay out. Financially, if the


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contractor defaults due to financial pressures from their parent company e.g. itgoes into administration, then the parent company is unlikely to be able fulfil theguarantee.

A Bond from a bank or other financial institution : The advantage of this over theparent company guarantee is that the financial institution is more independentand supposedly financially stronger (although at the time of writing in the creditcrunch of 2009, this is arguably not the case). Consequently, they are morewilling and able to pay if called upon to do so. The disadvantage is that thecontractor has to pay for this bond and that cost is added onto the contract pricewhich the client will pay.

A Warranty, in this context, is a promise given by a contractor to the client or ownerregarding the nature, usefulness or condition of the supplies or services delivered under

the contract, usually at a level set above that required under Statutory Law, with theremedy being damages payable. Two common forms are :

A warrant for fitness for purpose : as a designer providing a service, underStatute Law, the consultant designer has to excise reasonable skill and care ofthe average professional. Providing he can demonstrate this, he should not beliable for damages if what he designs does fulfil its purpose due to the design. Ifthe client insists on and the consultant signs a contract warranting fitness forpurpose, then the consultant will be liable.

Collateral warranties : Historically, the doctrine of privity of contract generallymeans that a contract cannot confer rights or impose obligations on any person

who is not party to that contract (except by tort of contract, whereby a duty ofcare has to be shown to exist and negligence then proved). Collateral warrantiescreate a relationship between parties who are not in contract with each other andnormally last for 12 years from date of completion of the contract. For instance, aclient has a new asset built, with various parts designed, supplied and installedby specialist subcontractors to the main contractor e.g. heating, cooling andventilation. Should they not work, with a collateral warranty, the client can dealdirectly with the original supplier, who if they do not remedy the situation is liablefor damages, as opposed to via the contractor who may not be that bothered oreven in existence any more.

The downside to warranties is that for a large project with many sub-contractors and

suppliers to the main contractor is, a myriad of additional contract terms are created allof which add complexity and cost (for lawyers to draft them).

For this last reason, in the UK, TheContracts (Rights of Third Parties) Act 1999 waspublished. This allows a party who is not one under the contract to enforce a term of thecontract if the contract expressly states that they may or a term confers a benefit onthem. For instance, as a property developer who has the intention to sell on acompleted building to an occupier, it allows that occupier to enforce the developerscontractual rights on the contractor.


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However, if as a contractor, you enter a contract with a government organisation wherethe beneficiaries are the general public, you could then find members of the publicdemanding their rights ! This would be costly and the client would pay as a result for thisrisk transfer. As a result of protests at the drafting stage of the act, it allows the partiesto a contract to opt out of it, either be expressly stating which terms are not subject tothe act or by stating a blanket opt out, with, if desired, expressly stating which terms aresubject to the act and who can enforce them. Given this, a well drafted schedule ofrights for third parties becomes much simpler and cheaper to put in place as analternative to a myriad of interconnecting collateral warranties.

6. Choose best fit standard conditions of contract if applicable.

In many engineering and construction sectors there are standard forms alreadypublished, often by an industry body 1, which cover many of the main contracting

strategies and other aspects discussed in this chapter. The advantages of using astandard form include :

They have already been written. Consequently, the client does not need to spendtime and money having them drafted from scratch.

They have, in theory, evolved and been fine tuned over time to take outambiguities and inconsistencies which cause dispute. Where this is not the case,case law may exist to confirm their legal interpretation.

Familiarity amongst practitioners with both their interpretation and the proceduresneeded to operate them. In some cases, this may mean a better the devil youknow state of mind that a good contract !

The contra preferentum or constructor against the grantor rule will not apply tothe standard terms. This rule means that when there is an ambiguity orinconsistency in the contract e.g. where there are two ways in which a term couldreasonably be interpreted, then the interpretation most favourable to the partywho did not draft it is taken. In standard conditions, neither party wrote them sothis does not apply.

Consequently, where practicable, it is advisable to use a standard form. However, whenthis is so, it is likely that some fine tuning will be required and this is where the draftingteam in the next stage need to be briefed and managed properly.

1 For instance in the chemical industry, there is the IChemE family of forms; in the heavy engineering

industry, the MF series; in building the JCT family and in civil engineering, the ICE contracts; with theNEC3 family being sufficiently flexible to apply to all the previously mentioned sectors.


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OUTPUTS

The output from this stage should be, for each package or grouping of packages bytype, a briefing document for the contract drafters and those who will detail therequirements.

For the drafting team, it should tell them :

the best fit contracting strategy together with any nuances or alterations notdetailed below. e.g. what and how exactly the contractor is to be paid, the testingregime etc.

which form of contract to use (if applicable);

the means of redress to be specified for what default and the quantum againsteach;

what (additional) risks are allocated to the client and which are retained by thecontractor and if already derived, the precise wording to be used;

the extent of any pain / gain share (if applicable);

the type and level of incentives, whether expressed as bonuses or damages, tobe used and what measures they are payable against.

For all of these factors, a note should be made of why the decisions were arrived at.

This document should also be written in plain enough English for the more technicalorientated people who will write the Requirements. They will also need to know :

Key terminology to be used e.g. in more tradition construction contracts the keyclients person was the Engineer or Architect. These were replaced with the

Project Manager and Supervisor in the New Engineering Contract (NEC).When this started to be used instead, many contract documents still referred tothe Engineer or Architect who do not exist in the NEC.

The Scope of the Requirement and how it is to be expressed e.g. as aperformance / functional specification or fully designed. This includes how it willfit in with what is already there e.g. what the Contractor can expect to find interms of existing facilities; how a processing plant links in with existingprocessing capabilities; what outputs from other IT processes are the inputs tothe new one etc..

constraints or boundaries on how the contractor can fulfil the Requirements e.g.in construction, hours of working, maximum noise levels, permissible access etc.

risk strategy c&pguidedraft5ach4 packagecontractstrategy

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