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A brief understanding of “Contracts” for Construction

This post is an attempt to the introduction to what the essence of a contract is for the construction industry. It need not be a sacrosanct post, however it will provide you with the essentials that could help you understand the concept.

What is a contract?

  • A voluntary, deliberate, and legally binding agreement between two or more competent parties is a CONTRACT. 
    • The highlighted terms in the above sentence are very essential in terms of the legality of the contract and the most important term by far is the word "competent", this is because if a party in the contract can prove that he is say an illiterate and was not in a position of understanding the terms and conditions for what he signed off then the Contract Document will be considered as void, thereby making the contract not legally binding. 
  • It is also essential to have 1) an offer and 2) an acceptance, for the legal acceptance of the contract, hence if an offer and an acceptance are established as implied or spoken form is also a legally valid form.
      • An offer is a document that lists the specific details of the services being offered.
      • An acceptance is a document that explicitly cites the approval or agreement of such an offer.
  • A contract can be in written or implied or spoken forms.
    • A question that could most likely arise here is how can a spoken or a implied contract be valid legally. The answer to this is, if one can establish that a proven offer and an acceptance is in place than an implied or spoken contract will be valid, however it is also essential that the such claim is associated with physical works present and completed at site.
  • For a Contract to be legally valid a signed agreement is required to establish the authenticity of the terms and conditions agreed between the parties. In India (for the current year i.e 2019) the agreement has to be in a stamp paper of minimum value of INR 500/-.
  • A contract will always define obligations in terms of TIME and COSTS, which are the two most essential aspect of construction.
What is the importance of a contract in a project?

  • In general we need to have an alignment for any project to the JUDICIAL system, this alignment of sorts is what we can very simply call as a CONTRACT.
  • A contract is not only important for construction and its numerous arms but a contract is essential for most aspects of business, this could include you opening a bank account to you buying a home as an individual.
  • Even a marriage requires a contract!
  • Essentially there have to be TWO parties to enter a contract but there are forms of contracts that can be multi-party.
  • For a construction project the contract  will provide a better control on the roles and responsibilities of the party/parties involved. Since a contract should ideally define the matrix of responsibility it is essential to list out the specifics, it will have to define every aspect of agreement as well as we need to take into account possible areas of dispute that may arise. If the contract is not clear on an aspect, this could lead to arbitration (Arbitration in itself is a vast subject and hence I will not get into it here). 
To take this forward we will have to learn about the FOUR types of contracts that are most widely used (I am not stating that these are the only for type of contracts but these are the most commonly used variation in terms of the type of contract):

1. LUMP SUM OR FIXED PRICE CONTRACT:
  • In this type of contract the overall cost for the project as a whole will be agreed upon.
  • This cost will include all construction related and dependent activities.
  • This type of contract need not include a BoQ, however will have to include specifications and detailed drawings.
  • May include incentives or benefits for early completion and/or may also have penalties or liquidated damages, for delays.
  • This type of contract is preferred when a clear scope is defined and a scheduled timeline is in place.
  • This type of contract will transfer a large part of the risk to the Contractor, therefore giving the contractor the liberty to charge necessary mitigation costs to imbibe such risks.
  • The only liability/risk that the Employer could face with such type of a contract is if the Contractor abandons work midway it will be difficult to ascertain the exact values payable/liable to the each other.
2. COST PLUS CONTRACT:
  • In this type of contract the actual costs in terms of the services, purchases and/or other expenses directly generated in the project for the construction activity are reimbursable with the requisite off-top as agreed upon.
  • This contract must efficiently define the specifics about a certain pre-negotiated amount/ percentage covering the contractor’s overhead and profit.
  • It would be ideal to classify the costs involved as direct and indirect costs, where direct costs will refer the costs which are directly incurred i.e material, labour etc., and indirect costs will refer to the running costs of the project which will include costs such as supervision and general plant and machinery.
  • The variations in this type of contact will only be in terms of how the handling of the overheads and profits are defined, for example we can have:
      • Cost Plus Contract with a Fixed Percentage as mark up
      • Cost Plus Contract with a Fixed Fee as mark up
      • Cost Plus Contract with Guaranteed Maximum Price where the negotiation amount is part of the contractors mark up 
      • Cost Plus Contract with Guaranteed Maximum Price and Incentive/Bonus which is similar to the one above except that a bonus maybe given which can also be linked to the time of completion and handing over.
  • This type of contract is used when the scope is not clearly defined.
  • This type of contract will have more risks towards the Employer and the supervision costs for the Employer will be high not only in terms of bills and claims but also in terms of the quantum of supervision involved.
3. ITEM RATE OR UNIT PRICE CONTRACT:
  • This is the most commonly used Contract type in India.
  • This is the most efficient type of contract to manage during the Tender Stage since it enables analysis of individual items and the respective rates.
  • Since there is BoQ that will be involved in this type of contract, each item will be priced. This  price maybe further be divided into direct and indirect costs depending on the requirements of the project.
  • This type of contract places equal risk to both the Employer and the Contractor.
  • There will generally be a cap on the additional scope and/or de-scoping values, this cap is to be able to establish the indirect costs involved.
  • The rates in this Contract maybe time bound and the Employer will be liable to pay escalations as per the dictations and language of the signed Contract.
4. MATERIAL AND TIME CONTRACT:
  • This type of contract is very rarely used for large scale projects.
  • It is usually preferred when the project scope is unclear and/or has not been defined.
  • Hourly or daily rate or some times rate per area is agreed upon which shall include all additional expenses that may arise during the construction process.
  • There need not be a distinction of costs however a clear definition of what the costs include needs to be defined as part of the contract.
  • Necessary provisions to cap the timeline or the amounts to be spent maybe put in place to help monitor the project.
  • Useful for small scopes or when you can make a realistic guesstimate on the duration of the complete scope.
What are the document which would form a Contract?
A typical contract document will have the following documents:
    • An Agreement
    • The General Conditions (FIDIC, JCT, NEC3 ECC, Bespoke etc.) 
    • The Special Conditions (Modifications to specific clauses of the General Conditions)
    • Drawings
    • Specifications
    • BoQ
    • Tender documents (Minutes of meeting, Response to Request to information, amendments, addenda etc.)
    • Letter of Intent
    • Letter of Acceptance
    • Contractual Bid
(I am hoping these are clear, if you do require any specific clarifications please get in touch with me so that I can elaborate the same)

What would be the Process of Contract formation for Construction?
Appended below is the IDEAL process for formulation or finalization of a contract, please note that this would vary from organization to organization and also basis the volume of the package being finalized, there is no hard and fast rule to this process:


Key:
TES - Tender Event Schedule
BoQ - Bill of Quantities
EoI - Expression of Interest
PTE - Pre Tender Estimate
RFI - Request for Information

A few point to help you understand the flow chart better:
  • The Design consultant/team will be responsible for the stability and validity of the design.
  • Once the above has been affirmed, the drawings and specifications are sent out to the "Pre-Contract" or "Tender" Team.
  • The pre-contract team will then formulate the BoQ & align the same with the specifications and the drawings. This is place to note that the "Description" in a BoQ is different from the "Specification". The description need not capture all possible aspects of construction, it need only essentially state the head of work, whereas the specification needs to be detailed and needs to capture every aspect of the process involved to obtain the final product.
  • While the BoQ is being formulated, a parallel process to obtain EoI from the Contractors and pre-qualification of the Contractors needs to progress.
  • The pre-qualification should involve "measurable credentials" of the contractor in terms of the commercial, technical and financial strengths of the Contractor. These credentials are then ranked and categorized basis the requirement of the project.
  • Post the pre-qualification process, the TENDER is floated. This tender can be an open tender, where the values are known to competitors, a closed tender where the values are unknown to the competitors or E-tender where the entire process is based online.
  • You may want to note here that there could be cases where a "tender fee" is charged. This fee is essentially to ensure that the contractor does withdraw or withhold the quote post collection of the tender. The tender fee in some cases maybe refundable, but it is not a mandate to refund the same.
  • While the PTE can be prepared before the floating of the tender it can also be a parallel process to the tender. The PTE is nothing but an estimate of costs as envisaged by the Employer against the particular items of the BoQ. This PTE will have to be aligned with the approved budgets of the Employer/Client as the case maybe.
  • The cycle of RFI & RFI response is to ensure that the bidders/tenderer are on the same platform to quote, since my understanding of a given detail need not be your understanding of the same given details, hence RFI's form an essential part of any tender.
  • You will notice a repetition of the works COMMERCIAL, TECHNICAL and CONTRACTUAL in the flow chart, this is because these words cover the  most important aspects of the project COST,STABILITY, TIME & TERMS.
So that must have been a long read to get through, do let me know if you need any specific details I can share with you.


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