Undertaking construction works? Make sure your ... - Farrer & Co

Page 1Undertaking construction works?Make sure your contractor is not committing suicideClive Lovatt | 19 September 2011Clive Lovatt, partner in our Construction team, provides some salutary advice to those who might be about to embarkon construction works, including a word of warning around low quotes and bids.Undertaking construction worksAn expanding business often needs new or additional space – be it a factory, warehouse facilities or office space.Moving a business to new premises may involve any number of property and construction issues, in terms of thepurchase of a freehold or the entering into of a lease and comfort that “new build” premises have been constructedproperly. In those circumstances, most businesses will deal with a property developer or similar and will have little orno involvement with the “sharp end” of the construction industry.However, where a project involves the development of additional facilities on an existing site already owned by abusiness, it is likely that the business will need to engage with construction industry professionals (architects,structural engineers, project managers and the like) and with a main contractor. This will normally involve thebusiness entering into a series of detailed contracts which manage the “risk” of the design and construction process.The construction industry is complex and construction businesses are highly competitive. Even in the most benigneconomic climate, entering into contracts which address risk properly is far from easy. When the economy isstruggling, the risks become more acute and the process still more difficult. A feature of previous periods of down turnin the construction sector has been the “suicide” bid by main contractors chasing work. Today’s difficult times are nodifferent.Profit margins in the U.K. construction industry, particularly for main contractors, are very small at the best of times.By way of example, in 2004 (a relatively good year for the industry) a leading U.K. contractor, with a reputation forbeing well managed and financially stable, undertook business worth £4,171 million. Its gross profit on this was £257million, roughly 6% of turnover. That profit margin is not unusual; in fact, across the industry, it is quite good. Poorprofitability is normally off set by good cash flow. On most projects contractors will receive periodic payments, usuallymonthly, and the regular flow of money though a contractor’s accounts can be expected to keep its bankers happy.In times of recession, therefore, it becomes important to maintain cash flow. What contractors have done in the past,and continue to do today, is “buy” work. They reduce their profit margin, so that often it becomes a “negative margin”(the contractor’s tender price is lower than the cost to him of undertaking the work) and (on paper at least) he is boundto make a loss. The rationale of this apparently odd commercial position is that by buying the work, the contractor isachieving the short term aim of protecting his cash flow, albeit at the cost of his medium term profit. This is a suicidebid.At first blush, this might appear to be a good thing for an employer, who may have his project carried out for the bestpossible price. Indeed, many employers do take advantage of tenders based upon “negative” profit margins.However, this course of action is fraught with risk and real gains for the employer may be illusory.First, the employer faces the risk that the contractor becomes insolvent. Whilst the contractor would undoubtedlyhope that any projects he is undertaking at a loss would give him time to find profitable work, this is not necessarily thecase. In difficult economic times, contractor insolvencies are common.Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk

Page 2The insolvency of a contractor part way through a project is problematic for an employer. Not least, he must findanother contractor to complete the works. This will usually be more expensive than if the original contractor hadfinished the project. Moreover, the replacement contractor will not normally warrant the works undertaken by theoriginal contractor, which might cause difficulties of causation if defects are found some time after completion. Theremay be many other problems to ensnare the employer. For example, ownership of materials delivered to the site butnot incorporated into the works. The employer may be faced with claims by suppliers for the return of materials forwhich the employer has paid the contractor, but the contractor has not paid the suppliers. Getting a project back ontrack may be costly and time consuming.Secondly, unscrupulous contractors may seek to turn a loss making contract into a profitable one. The price for theworks may be fixed, but almost all contracts for building works will contain mechanisms by which the price maychange. Such mechanisms are essential. For example, in a complex project an employer may need to vary theworks. Most building contracts will allow this and the value of the variation is established and paid to the contractor.In addition, the contractor will normally recover “loss and expense” in relation to the disruption suffered inimplementing the variation. A contractor on a loss making project may seek to inflate both the value of the variationand the amount of any loss and expense suffered by him. Of course, a claim can be resisted by the employer, but thiswould involve time and money. In addition, the methods of resolving disputes under building contracts do generallyfavour the claimant contractor in cases of this type.Thirdly, whatever the good intentions of the contractor, works may be less well constructed in a project where thecontractor is struggling to break even. Short cuts and deficiencies in terms of working methods, materials used andthe quality of finishes are all real risks.What should an employer do? The answer is simple. Very low bids should be treated with suspicion and the tenderexamined carefully. It should almost always be possible for an employer’s quantity surveyor or project manager toestablish whether a contractor can really carry out the works for the proposed price. If the works are under priced, theemployer should look at other tenders.In short, an employer is more likely to get what he wants (a building that is built in accordance with the specificationand that he can use effectively for his business) if he ensures the contractor is paid a proper price for the works.In the world of construction, it is always best to look a gift horse in the mouth.If you would like to discuss this further, please contact Clive Lovatt (partner in our Construction team), or your usualcontact at the firm on +44 (0)20 3375 7000.This publication is a general summary of the law. It should not replace legal advice tailored to your specificcircumstances.© Farrer & Co LLP, September 2011Telephone: +44 (0)20 3375 7000 Email: enquiries@farrer.co.uk Web: www.farrer.co.uk