Risks in Construction Contracts

Risks in Construction Contracts take a variety of forms, including risks of changes in the legal framework, risks of changes in rates, risks of changes in costs, and classification of investment project management.

This “Risks in Construction Contracts” article shall focus on the analysis and clarification of relevant aspects and the recommended remedies.

Risks of changes in rates

Changes in rates are one of the most explicit risks to construction contracts, especially in contracts that have two or more payment currencies, or the payment currency is converted from a foreign currency.

During the ten-year period from 2007 to 2017, VND tends to decrease in value in comparison to strong currencies, like the USD (see the table below)

In this period, VND lost an estimated 40% of its value in comparison to the USD, from 16.061 VND/1 USD in 2007 to 22.450 VND/1 USD. Therefore, the underestimation or lack of attention to the effect of the changes in rates on construction contracts potentially has dire consequences.

Although changes in rates might not affect contracts of low value or short time of completion, much. However, it is entirely different for contracts of high value, with a high ratio of foreign investment, or have multiple payment currencies, or an extended duration of completion. All of these elements either directly or indirectly result in significant increases in capital for the projects and one or all parties must implement risk allocation mechanisms due to the changes in rate.

Changes in Rates

In practice, the situations where the effects of changes in rates affect the construction contracts that should be paid attention to more, are the following:

A fixed exchange rate between VND and another currency used for payment during the implementation process despite there being a significant change in the exchange rate of VND and that currency. Upon the occurrence of any damage, the contractor might request the employer to compensate or mitigate the damage due to the change in rates.
The buying rate, the selling rate, or the average exchange rate (of buying and selling) used for the conversion required for payment are not specified
Situations in which there is no direct exchange rate between the currency used in the tendering process and the currency used in the payment process. For the conversion to be possible in this case, a medium of exchange, which is the VND or other intermediate currency, is required.

Rates Adjustment Mechanism

In some cases, to deal with fluctuations in the exchange rates or global events that could have significant impacts on the economy, the authorities, especially the State Bank, would often make decisions to expand the exchange rate adjustment margin as has been done in the past.

When such situations take place, one of the parties might refer to the agreement of the contract to request price adjustment due to changes in laws.

Currently, the issue of whether or not a party could refer the decisions of the authorities to request the other party to adjust the contract price due to changes in law has yet to provide a unified answer.

Recommendations

To summarize, it is clear that the risks associated with changes in rates in construction contracts are always present and could be affected by many elements

Therefore, extra caution must be exercised when entering into any particular construction contract and a multidimensional perspective is encouraged to be adopted so that all important matters are covered, and avoids situations in which changes in rates would affect the implementation process of the construction contract or disputes would emerge, which in turn increases the cost of the project.

Aside from the above changes in rate, the risks of changes in costs (changes in price) are also of great importance.

With the exception of lumpsum contracts in which adjustments to the price are not allowed, or are fixed unit price contracts, all other contracts would allow for adjustments to the contract price if the cost of construction exceeds the original expectations.

The Formula of Contract Price Adjustment

From a legal perspective, the Vietnamese’s approach to the application of stipulations on changes in costs in construction contracts has been similar to that of FIDIC since the 2007.

At the present time, the Ministry of Construction has already issued guidelines for the calculation of price adjustment similar to that of FIDIC Red Book 1999, and FIDIC Yellow Book 1999[1]

Price Adjustment due to changes in laws vs. changes in costs

However, the adjustment of contract price due to changes in costs, by nature, is a form of negotiation between the parties, in which the contract price is adjusted upon the occurrence of the event, situation, or at a predetermined time.

The adjustment of contract price due to changes in costs is completely different from the adjustment of contract price due to changes in laws, an example of this is the adjustment of the price of construction contracts which is made possible due to the promulgation of Circular 09/2008/TT-BXD.

This is the type of contract and contract price regulated by the changes in laws (requested by law) to reflect the actual situations so that compliance by parties is obligatory. In this situation, Non-compliance with such laws might be considered as a breach of contract.

In contrast, since this is an adjustment of contract price due to changes in laws, the method of adjustment, scope of application, etc. must adhere to the given regulations.

These two elements are what distinguish adjustment of contract price due to changes in costs from adjustment of contract price due to changes in laws.

Challenges of adjusting prices due to changes in cost

Finally, as mentioned in Section I.2 above, due to the prolongation of time for contract implementation, the evaluation of the effects of price on the contract implementation potentially encounters hardships.

The intertwining of multiple elements such as the quantity of works, moments of fluctuation, etc., requires particular attention whenever the matter of price adjustment is concerned, and definitive answers must be given to the following questions.

Is it possible to adjust prices due to changes in costs?
If possible, is it applied to all parts – as a whole – that constitute the contract price, including plants, workers, equipment, petroleum, etc. or is it only applied to one or some certain materials?
When is the moment of fluctuation?
Has the Base Date been established?
What are the sources of data (Most Significant bit) or the coefficients for adjustment? (General Statistics Office of Vietnam, Department of Construction, or other agencies)
Is the contractor entitled to claim price adjustment in cases where the time of contract implementation is extended due to the contractor’s fault?

Risks of Contractor’s Capabilities

The expertise or contractors is one of the matters that Employers are especially concerned about due to the complexity and uniqueness of the construction field.

The Contractor’s Capabilities include:

Prior successful experience with projects similar to that of the Employer’s desired project.
Financial credentials.
Comprehensive knowledge of the provisions of law, environment, culture, weather, climate, and hydrology of Vietnam.
Management and operational ability

Risks of Contract Termination

When the Contractors are unable to ensure their capabilities during the implementation of projects (under any conditions), the risk of the project/package not being completed on time and/or the significant increase in costs for project/package implementation are extremely high.

Termination of the construction contract due to a contractor’s violation and request that the contractor bear responsibility for the damages incurred, is only a temporary solution, because in many cases, the costs, damages, losses, and responsibilities result from out of the construction are much higher than the value of the contract previously undertaken by the contractor.

Contract Termination Costs

Costs incurred by the contractor because of contract termination are likely to include:

Contract termination costs due to contractor violations
Cost of finding a substitute for the previous contractor
Implementation costs for unfinished works by other contractors, including fluctuation costs until a new contractor is secured
Project Management Costs
Loan interest
Insurance Costs
Responsibilities borne by the Employer towards third parties, etc.
Expected profit lost due to delays in putting the project/package into use

Employer Safeguard Mechanism

Due to the aforementioned reasons and explanations, construction contracts ought to give the Employer the ability to immediately replace or request the contractors who are unable to ensure their capabilities to rectify the situation, including but not limited to:

Requesting the bank, financial organization, or parent company of the contractor to perform the undertaken guarantee obligations.

Terminating the contract with the existing contractor and assign the remaining works to other contractors.

Directing payments to other members of the joint venture or subcontractors who perform major parts of the works.

Requesting that the contractor to perform remedial activities such as replacing unqualified workers, making financial arrangements for projects, opening bank accounts exclusively for the implementation of the project, etc.

The most unfavorable situation

However, in practice, the risks of not being able to monitor of the Contractor’s capabilities continue to exist, especially for projects in which termination would require the approval of the investment decision authorities; funding authorities, etc.

In these cases, the objective of the project might be completely extirpated.

Recommendation for Contract Drafting

Succinctly, when entering contracts that are high in value or complexity, or the contract is implemented for the first time, or the contractor and the sponsor (funding authorities) share the same nationality, etc., extra caution must be taken to ensure that there are backup provisions being considered, consulted upon, and drafted. Such backup provisions should be about the entail the:

Entirety of the contract price, which includes the contractor’s obligations in accordance with the contract’s provisions.
Employer’s warranty and representation on matters pertaining to (i) legal circumstances of the joint venture and the changes in the status of the members, if any; (ii) the comprehension of the contract’s requests including aspects on drawings, technical specifications, or other specifications from the Employer
Employer’s entitlement to terminate the contract, or keep the guarantee, and/or any other safeguarding measures for the Employer’s interests
Employer’s entitlement to refuse payment if one or some of the contract’s basic obligations are not fulfilled.

EPC/Turnkey Contracts’ Scope of Application

Silver Book 1999 (EPC/Turnkey) is only recommended for:[2]

Mechanical and Electrical – Engineering works of civil construction
Energy Projects such as thermal power, hydropower, nuclear power
Chemical plants, petrochemical refineries
Projects in which the unification of production lines and technological equipment is required

The Diminishing Role of the Engineer

An outstanding feature of EPC/Turnkey contracts is that almost all risk would be assumed by Contractors, and the contractors hold the rights over the implementation of the entire project without any intervention from the Employer or the Employer’s representative.

In the Silver Book 1999 – EPC/Turnkey Conditions of Contract, introduced by FIDIC, the role assumed by the Engineer in Red Book 1999 and Yellow Book 1999 is instead handled by the Employer[3].

This characteristic, which is usually neglected by many, is the origin of many probable risks that Employers or Contractors may encounter:

The results of testing, inspection, and trial runs not meeting the specifications of the Employer, including failure to meet the conditions under which products are brought into the market.
Inability to completely anticipate all matters requested in the Employer’s Specifications; or
Schedule/method of payment is incompatible with the requests of EPC/Turnkey Contracts
Employers and Contractors improper application of rights and obligations during the implementation of the contracts
Increase in costs incurred by the Employer due to usage outside of the recommended use for Silver Book 1999 – EPC/Turnkey
Increase in liability assumed by the Contractor when the project is not one of the situations for which Silver Book 1999 – EPC/Turnkey is recommended

Risks of classification of construction investment management

In Vietnam, the classification of construction investment project management for state-funded projects, or projects in which state administrative agencies are involved, is rather complicated

Dangerous Consequences

In most situations, the classification of construction investment management may cause grave consequences to the bidding process, management of the project, and the construction contract, in particular:

Conflict of Purposes

Firstly, the imbalance between the needs for administrative management, conservation of the state budget, and the demands for versatility and profit optimization by the contractor.

Usually, for a construction investment project to commence, a Project Management Unit is established to enter into the contract as an/the Employer.

Per the law, the established Project Management Unit are legal professionals who possess their own stamps, accounts, and personnel with adequate qualifications, capabilities, and experience in the construction field to proceed with the implementation of the project[4]

Consequently, the Project Management Unit is supposed to have the ability to make independent decisions and be responsible for any decision made pertaining to the signed contract.

However, the Project Management Unit’s operation mechanism is influenced by many state administrative management factors, and the Project Management Unit, by nature, is not an entity with actual authority, instead, said authority belongs to other entities, especially the investment decision entities.

Relevant Authorities for the Development of a metro project

Legal Consequences

In many circumstances, such classifications of construction investment project management would inadvertently lead to scenarios in which (i) an unqualified organization (or at least one that does not hold authority over project development) which is heavy on procedures and administration – the employer of projects -, is assigned the position of Employer and manages (ii) an organization specializing in providing construction services, namely, the contractor – an entity whose ultimate objective is to maximize profits.

This is the main reason why almost all Employers of infrastructure projects in Vietnam have been, are being, or will be claimed by the contractor, or in some cases, the dispute is even brought to arbitration or the courts, thereby resulting in more costs for the implementation of projects

Difficulties in determining applicable law.

The difficulties in determining applicable law are due to the flickery definition of the term “state budget”

Currently, there are myriad of law provisions mentioning the term “state budget” or “usage of state budget” in Vietnam[5], especially the Law on Bidding 2013, Article 4.44 defines a similar term “state capital, accordingly, the said term includes state budget and other types of capital that could be considered state capital.

However, there is no provision clarifying the content and scope of the term “state budget”, specifying which types of capital could be constituted as the state budget and the sources of the foregoing.

The correct identification of the state budget would, in turn, help the appropriate applicable law to be determined for the contractual relationship entered into by the parties

Potential Legal Disputes

If there are any doubts or insecurity about either the usage of the state budget in the project or the application of Decree No. 37/2015/ND-CP (or other documents) to the entities of the contract, there is the potential for disputes under the following situations:

A party that should have been subjected to the regulations of Decree No. 37/2015/ND-CP but does not follow through, results in the violation of the contract, relevant laws, or in certain circumstances, is considered as a crime due to intentional misconduct.
A party despite not being subjected to the regulations of construction laws, particularly Decree No. 37/2015/ND-CP (or other documents), consistently insisting on the application of the laws or demanding the other party to apply the foregoing;

In practice, there are many conflicts between the parties, and one of the issues that the parties always focus on is whether or not the Laws of Vietnam on bidding, with respect to construction contracts with foreigners are applied.

There are multiple issues that the parties must clarify, specifically:

Is the purpose of the state budget to determine the ratio of state capital within the organization of the Employer and Contractor, or to determine the ratio of state capital within the total investment amount of the project?

Is the determination of state capital for the whole project or for a certain package?

What type of capital could be considered the state budget? Could loans from development banks and guaranteed capital by the state, etc., and utilized by the Employer considered a state budget?

Conclusion

Therefore, upon participation in construction contracts, extra caution should be exercised, especially for the following issues:

Does the project/package fall within Decree No. 37/2015/ND-CP’s scope of application?
Is Decree No. 37/2015/ND-CP chosen as the applicable law?
If Decree No. 37/2015/ND-CP is applied, do such applications require strict adherence (based on laws), or is it simply honoring the strength of the law?
What is the basis or evidence proving that such application is consistent with the provisions of the law?
What is the state budget utilized by the Employer or Contractor? How many types there are? does it constitute a part of, or the entirety of the project/package being implemented by the parties involved?

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[1] Appendix 5 attached to Circular No. 06/2007/TT-BXD; Article 13.7 Red Book 1999, Article 13.8 Yellow Book 1999.

[2] See more at www.fidic.org/

[3] Clause 3, FIDIC Silver Book 1999

[4] See Article 45, Law on Construction 2003; Article 33, Article 34, Decree No. 12/2009/ND-CP; Article 63, Article 64, Law on Construction 2014

[5] See Law on Construction 2014, Law on Bidding 2013, and Law on Public Investment 2014.