August 18, 2016

Contracting strategies and the impact of Brexit - paper 2

With a process now developing for resolving some of the political and constitutional issues raised by the outcome of the referendum, the general decision in the industry to avoid panic seems to have been the correct one.

We still have lots of uncertainty – that hasn't changed – but most projects will have to continue over the coming months with the parties fully bound in to the terms they agreed at the outset.  As promised in our introductory paper, assuming that a project has not been suspended or cancelled (which we covered in our paper of June 30), we now turn to the short/medium impact of the referendum and strategies relating to projects which are still being delivered.

Labour/Inflation

The first issue is the impact upon the cost of delivering a construction contract.  Unless there is a very significant and immediate  reduction in the activity levels in the industry (perhaps through suspensions, cancellations and mothballing new projects – see the previous paper) it seems likely that there will be no immediate general downwards pressure on the cost of delivery.

Issues of skilled labour from the EU touch upon various aspects of the industry. It now seems fairly certain that no-one is being 'sent home' in the near future; any contraction in the supply of skilled labour in the short term (and perhaps over the next 2 years, which should see many projects to a conclusion) is likely to be caused by a drop in the influx of new workers and individuals presently in the UK changing their plans and finding work elsewhere in the EU.  The driving forces of these effects will probably be uncertainty (why make your home in the UK when you could make it elsewhere in the 'rich' parts of the EU, and have better security of tenure?) and the comparative lack of buying power of Sterling when compared to the Euro when remitted to their home countries.  This is of course the very essence of the free movement of labour.

A reduction in the supply of skilled labour (without any corresponding decrease in activity levels) will likely have two key effects.  First, the price of skilled labour may rise as the same number of projects chase fewer people.  Second, as we saw over the last couple of years, there may be a real impact on the deliverability of projects where a steady stream of key trades might not be available.  This may lead to the familiar disputes regarding the real reasons for projects going over schedule and over budget, i.e. claims for liquidated damages from employers and claims for loss and expense by contractors.

A more immediate effect on the cost of performing contracts will be inflation in the cost of plant and materials to be imported from overseas.  At the time of writing, and comparing the 1 June 2016 to the 1 July 2016, the pound has lost 10% of its value against the US dollar and the Euro.  It seems unlikely that the pound will bounce back any time soon.  Those contractors who are fortunate enough to have agreed fixed prices in sterling with their overseas suppliers might be sufficiently insulated from the fall in value.  Equally those who negotiated payment in a currency other than sterling, or who agree helpful fluctuation options (see for instance Schedule 7 of JCT DB 2011) may find themselves protected.  The remainder under lump sum contracts, or those with agreed rates, will find themselves stuck in the middle and bearing the consequences of the devaluation of sterling unless they can rely upon any contractual methods of relief.

What Can a Contractor Do?

Probably not a great deal.  However, here are a few things to think about.

Laissez Faire contracting

The starting point is that a contractor who has agreed to perform a contract for a lump sum, or on agreed rates, is going to carry the risk of a shortage of labour in the market or an increase in expense.  English law is known for being very 'laissez faire'.  Although this sounds elegant, in reality it means that the courts will not generally interfere with, or rewrite, a bargain that was bad or that became bad as a consequence of changing circumstances.  Commercial, political or economic issues are unlikely to lead to the termination of the contract for frustration i.e. the doctrine which may release the parties from their obligations under a contract if subsequent events mean that the contract is no longer capable of performance.  The attitude of the Courts is that the contractor took the risk of delivering a project for an agreed sum/at agreed rates, and so the Court will not release him from that obligation.  The corollary is that if exchange rates moved in the contractor's favour, the employer would not be able to appropriate any of this benefit either.

Force Majeure

Equally, although all standard form contracts contain 'force majeure' clauses, which effectively forgive non-performance for a time caused by extreme events, it is unlikely that a contractor will be able to rely upon those provisions just because of a general shortage of labour in the market or an increase in expense.  JCT DB 2011 provides that "force majeure" (uncapitalised and undefined) is a Relevant Event (allowing relief in time, but not money) does not attempt to give any definition to this phrase.  It is notable that other events that might often be thought of as "force majeure" events are expressly referred to as separate relevant events (for instance war, strikes, exceptionally adverse weather) and so "force majeure" must naturally mean something additional to those matters.  Although English Courts have always been reluctant to provide relief to contracting parties when the circumstances of performance change, it is not beyond contemplation that in extreme circumstances a rapid contraction in labour (perhaps caused by a policy of repatriation of EU workers) may fall within this category, particularly if this was not foreseeable at the time of contracting.

In a similar vein, Clause 2.26.13 of the JCT says that "the exercise after the Base Date by the United Kingdom Government of any statutory power which directly affects the execution of the Works" is also a Relevant Event.  Could the implementation of a government decision to leave the EU, thereby closing down access to free movement of labour overnight, be said to "directly affect the execution of the Works"?  Quite possibly.  If so could lesser exercises of statutory power relating to the referendum raise similar issues? 

That Sounds Defeatist - What Might Contractors Do?

The reality is that sub-contractors will often seek to claim their increased costs caused by this effect against main contractors.  In turn, main contractors may seek to pass up the increases in costs to the employer.  We have spent the last two years dealing with disputes which were often driven by the strengthening of bargaining position of sub-contractors, suppliers and trades over time; jobs bid for in 2012/2013 based on the (then) current availability of resources/market prices have often proved to be undeliverable by main contractors on time and on budget when the sub-contracting market had changed by 2014/2015.  This effect caught many main contractors short, eradicating their profit margin and often meaning that the project would be delivered at a loss. 

A Shortcut

Over 2014 and into 2015, a development in the law opened opportunities for contractors to use the payment mechanism to substantially improve their position.

In essence, contractors would identify loss and expense as lump sums in their interim accounts.  These were often expressed as line items with little or no support.  In the normal course such claims would be simply rejected by the employer/contract administrator as being unsupported, and the loss and expense items would generally be held over until the end of the project/the final account where it might be supported, argued over, adjudicated upon or agreed, along with any corresponding claims for liquidated damages for delay.

The case of ISG v Seevic (2014) changed all of this.  In that case it was found that under both the JCT form and under the provisions of the HGCRA (as amended), should an employer/contract administrator fail to issue a Payment Notice within the very strict timelines set out by the HGCRA, the face value of the contractor's application is established as the value of that interim payment.  In the absence of an effective Pay Less Notice (which also must be served within a strict timeframe), this sum became due as a debt.  There was no power for the Court or Adjudicator to look at the true value of the interim application – the contractor would be entitled to be paid his claim for loss and expense in full, along with the rest of his application.

So why not simply claw back the overpayment in the next interim payment cycle?  This is not as easy as it seems.  While the NEC3 form does allow for an overpayment in one month to be corrected by a repayment from the contractor the next, it is arguable that the unamended JCT form does not.  Under the JCT form, the employer arguably must wait until the final adjustment/final certificate process is complete – this only occurs after the end of the defects liability period, leaving an employer without his money for perhaps a year or more.  This commercial disadvantage has often led to settlements on terms beneficial to contractors, who often will never be put to the trouble of having to prove or support their claim for loss and expense.

Trends

  • Over the last 2 years following ISG v Seevic we have seen the following trends:
  • Contractors and subcontractors are becoming increasing ambitious in the sums claimed in their interim accounts.  Whilst the first few cases contain loss and expense line items in the sums of hundreds of thousands pounds or just breaching one million, we now regularly see loss and expense claims which add 50 to 100% to the original value of the works.
  • Employers/contract administrators are becoming increasingly aware of this issue and the need to meet the very strict terms of the payment mechanism.
  • In turn, often denied the easy win caused by the employer simply forgetting to respond in time, contractors are deploying increasingly sophisticated arguments to pursue their application.  We now regularly see projects where gaps/mismatches between the provisions of the contract and the strict requirements of the HGCRA (as amended) allow the contractor to pursue arguments that the monies applied for are payable on their face, even where the employer has met the requirements of the payment mechanism set out in the contract in every respect.  This 'gap' has often been caused by well-meaning attempts to lengthen the period of time for payment, or to introduce new elements to the process (for instance the requirement for the contractor to issue an invoice).  Other fertile grounds for these arguments include drafting issues with Payment and Pay Less Notices.
  • The Courts have continued to apply the principle in ISG v Seevic in respect of interim applications, although a new principle has emerged to mitigate the strict effect of this rule in the harshest of circumstances.  For instance, where the contractor succeeded generally on its argument in Galliford Try v Estura (2015) the Court believed in all the circumstances that to order payment of the amount in full would be unacceptably harsh – it would amount to a 'manifest injustice'.  In those special circumstances the employer was only forced to pay part of the awarded monies initially, pending the determination of the final account. 
  • It may be the case that this principle of 'manifest injustice' is ripe for extension, particularly in circumstances where the value of contractors' interim applications become ever more ambitious, possibly to the point where they over-reach themselves.
  • The Court of Appeal in Harding v Paice (2015) has also caused some pause for thought.  In that case the court of Appeal declined to apply the strict rule in ISG v Seevic (which related to interim applications, ultimately governed by the HGCRA) in circumstances where there was a contractual final accounting exercise following the termination of the project (i.e. a payment process not governed by the HGCRA).  It is notable in that case that the Court of Appeal declined to either endorse or criticise the decision in ISG v Seevic and it may be that this principle is also due to be tested in the Court of Appeal at some point.

We had already anticipated seeing many more of these disputes before the referendum but it must be the case that any losses caused by inflation or delay/disruption following the outcome of the referendum may well find themselves into sub-contractor and main contractor's accounts.  The current law lends itself to extremely strategic behaviour and very technical arguments.  However, from a paying party's perspective (whether employer or contractor) there are always arguments and/or strategies that might be deployed to respond to these types of claims, along with opportunities for settlement.  However, the key to avoiding these claims is to make sure that the payment mechanism is followed to the letter (assuming that it complies with the HGCRA) and to be alert to signs that such a claim is coming act before it is too late - for instance a significant jump in the claim for loss and expense around or after practical completion is a real red flag.