Why Construction Arbitration is Complex? (IV)

Did you know that in the Code of Hammurabi, contractors could face the death penalty if a construction collapsed and caused the owner’s death?

Because of the importance that construction contracts have always had, all ancient civilizations already had ways of documenting contracts in general, and construction contracts in particular.

In ancient Egypt, Mesopotamia, classical Greece and the Roman Empire, contracts were documented on clay tablets, papyri, stones, bronze or wax tablets.

In addition, there were laws regulating such contracts, as found in the Code of Hammurabi or in the rules regulating the contract of locatio conductio operis in Rome.

Later, in the Middle Ages, they were documented in parchments.

And what was common to all of them was that they identified the parties to the contract, its object, the materials to be used, the terms, payment and penalties.

There was a concern about recording these agreements due to the economic importance of these contracts and witnesses were often used to record the will of the parties.

This is probably how the pyramids in Egypt, the roads and aqueducts in Rome or the cathedrals in the Middle Ages were built.

In our times, the complexity of construction works, and construction processes has led to the development of different models of standard contracts to regulate the rights and obligations of the parties in an orderly, recognizable and practically tested manner. This helps the parties when deciding which type of contract to use.

The variety of types of projects, the diverse experience of the owners and, sometimes, the client's need to obtain financing make the variety of contracts used in this sector very wide.

Each client may have its own sample contract that it has tested and improved over time.

This may be the case for a developer who traditionally uses a sample contract that has worked well for him and has been modified and adapted considering experiences with various contractors in the past.

In general, it is the clients who usually decide on the type of contract to be used depending on their needs, the control they want to exercise over its execution, the risks they are willing to assume and their financial capacity.

After choosing the type of contract with the above considerations, the client usually establishes a competitive process for selecting the contractor.

The type of bid submission and the contractor selection process itself also depend on the type of contract chosen.

The contract is the fundamental tool that regulates the relationship between the client and the contractor and other possible intervening parties.

In addition to establishing the purpose and scope of the works to be executed, their price, form of payment and time for completion, the contract is, overall, a tool for defining, regulating and distributing risks.

It has been said that the distribution of risks must be done considering which party can foresee and control them better, who is in a better position to assume them and who benefits or is harmed when the risks materialize. The size and complexity of the project must also be considered.

Numerous professional associations have published sample contracts adapted to various circumstances and needs at the international level.

All of them are characterized by a risk-sharing proposal following different principles and aiming to reflect the best practices in industry.

As an example, some of these model contracts are the following:

• The FIDIC contracts published by the International Federation of Consulting Engineers have a great reputation today. The most recent version of their contracts is from 2017. These model contracts are the most widely used in international construction and are used by, among others, the World Bank, the Inter-American Development Bank and the European Development Bank.

• NEC contracts (New Engineering Contract), of English origin whose first version was published in 1993, and the latest version is the 2017 one called NEC 4.

• The Institute of Chemical Engineers of the United Kingdom also publishes, since 2003, eight model contracts for the construction of industrial plants. There are several current versions between 2013 and 2023.

• Since 1931 the Joint Contracts Tribunal has also produced model contracts in the United Kingdom known by the acronym JCT. The current versions are those of 2024.

• The American Institute of Architects also publishes numerous model contracts.

Although this is not the place to study in detail the various types of contracts, I will make a brief reference to FIDIC and NEC contracts because they have a very wide diffusion and application in international construction contracting.

These contracts contain a balanced drafting of the rights and duties of each party and establish a reasonable allocation of risks.

It can be said that they are drafted in an equitable manner which makes the parties clearly aware of their rights and obligations.

They also contain an agile mechanism for resolving disputes that may arise and for resolving disputes over delays and over modifications or variations.

These contracts have been tested over time, reflect the best practices in the industry and, if properly used, improve the relationship between the parties and the development of the project in many aspects They also avoid harmful effects on the contractual relationship.

The FIDIC Contracts

FIDIC has developed several types of contracts that are known by the color of their cover. The first three are the most common ones and the most tried and tested.

• The Red Book (Construction Contract) is the standard construction contract for building and engineering works designed by the client.

The price is paid according to the work really performed and the initial budget for the work is fixed by an estimate of the final price.

• The Yellow Book (Plant & Design-Build Contract) is the contract for electrical and mechanical plants and for building and engineering works designed by the contractor.

The price is fixed on a lump sum basis as the contractor is responsible for the project and assumes any deficiencies and inaccuracies in the project.

• The Silver Book (EPC/Turnkey Contract). In this contract the contractor is responsible for the entire process of drafting the project, procurement and construction, finally delivering to the client a final product ready to be put into operation.

The contractor bears almost all the risks and must deliver a product that meets the operating characteristics required by the client.

This is the typical contract for the construction of industrial plants when the contractor must design and build a plant that must meet specific requirements in terms of operation, performance, capacity, etc., and must deliver it in operation. The price is usually fixed on a lump sum basis.

• Finally, I will highlight the Emerald Book which is the contract for underground works and is the most recent one of the FIDIC contract saga. Underground works generate the greatest difficulties, not only in their execution, but also in the allocation of risks, especially unforeseen risks where, in this type of work, it is not always possible to know the characteristics of the subsoil.

Most types of FIDIC contracts provide a multi-level dispute resolution mechanism:

• In first instance the Engineer decides.

• This decision may be reviewed by the Dispute Board, which is an independent panel of one or three experts who issue their decision. This decision is immediately enforceable so that the work is not suspended.

• The Dispute Board’s decision can be challenged by the party in disagreement in a subsequent Arbitration before the International Chamber of Commerce, which is the institution recommended by FIDIC.

All these contracts are based on the so-called Golden Principles which ensure that the contracts are drafted in a professional manner, with a balance in the performance of the parties and that they are adapted to the legal peculiarities of various countries.

The importance and widespread use of these contracts has meant that in some countries, such as Peru, the government has authorized the use of international standard engineering contracts such as FIDIC or NEC in some public investment projects.

The NEC Contracts

They promote a collaborative environment between the parties involved to obtain better contract management through an early resolution of the disputes that may arise.

There are several types of NEC contracts, but the one we are most interested in is the Engineering and Construction Contract, which has five options depending on the payment option:

• Option A.- Priced contract with activity schedule. The contractor prices each activity contained in the activity schedule. The client makes payments for every completed activity.

The price is fixed in advance, and the contractor assumes the financial risk.

• Option B.- Priced Contract with Bill of Quantities. The Bill of Quantities contains a list of work items and the contractor prices their quantities.

• Option C.- Target Contract with activity schedule. In this contract the contractor prices the activities in the schedule by adding a fee to the actual costs.

The client makes interim payments. The difference with the target price is shared by both parties as agreed by them.

• Option D.- Target Contract with Bill of Quantities. The Bill of Quantities contains a list of work items and the contractor prices their quantities by adding a fee to their actual costs.

The client makes interim payments and savings and overruns on the target cost are shared between the parties as agreed.

• Option E.- Cost Reimbursable Contract. The contractor receives payment of the costs of the works plus a fee. In this case the client bears the financial risk.

As we have seen, to understand construction disputes well and then being able to represent any party or decide on the disputes, it is necessary to have a good knowledge of these types of contracts and how they work, i.e., what are their regime of rights, obligations, risks and the dispute resolution mechanisms.

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