Standard form contracts and risk allocation

Every construction project carries risks: the ground may be worse than expected, steel prices may rise, a design may contain an error, a permit may be late, the owner may change its mind. A contract cannot make these risks go away. What it does is decide who carries each one if it happens. Good risk allocation puts each risk on the party best able to control it, or, if no one can control it, the party best able to absorb or insure it, and it prices the risk honestly. Bad allocation pushes risks onto parties who cannot manage them, which produces inflated bids, disputes and sometimes insolvency.

Most of this allocation happens through standard form contracts, documents drafted by industry bodies representing owners, contractors, consultants and lawyers so that the same risk-sharing rules apply across many projects. In Canada the main families are the Canadian Construction Documents Committee (CCDC) forms for construction and the ACEC-Canada and RAIC forms for engineering and architectural services. This lesson looks at those forms, the delivery methods they support, and the clauses that do most of the allocating.

Why standard forms matter

Standard forms have three advantages. They are familiar, so contractors and insurers can price them quickly and courts have interpreted many of their clauses. They are balanced, at least in their unamended form, because they are negotiated by committees representing different interests. And they are coordinated: the owner-contractor form, the owner-engineer form and the subcontract forms use the same definitions and procedures, so obligations line up across the project.

The advantage is often eroded by supplementary conditions, owner-written amendments that change the standard terms. Some amendments are reasonable adjustments to local conditions; others shift large risks to the contractor or consultant. CCDC's standard forms carry the CCDC seal only when used without changes to the standard text, with amendments placed in supplementary conditions so that they are visible. Engineers who prepare contract documents for owners must understand what every supplementary condition does, and advise the owner when an amendment is likely to raise prices or invite disputes.

Delivery methods

The delivery method is the overall arrangement of who designs, who builds and how they are related. It is the biggest single risk allocation decision on a project.

• Design-bid-build is the traditional method. The owner hires an engineer to produce complete design documents, then procures a contractor to build to those documents, usually for a stipulated price. Design risk stays with the owner, which warrants (in effect) to the contractor that the design is buildable; the engineer is responsible to the owner for its own negligence. The method gives the owner control over the design and a firm price for a defined scope, but it is sequential and slow, and every design gap becomes a change.
• Design-build combines design and construction in one contract with a single entity, usually a contractor with engineers as subconsultants. The design-builder takes design risk, often under a fitness-for-purpose obligation, and can overlap design with construction to save time. The owner gives up detailed control of the design and must write a good performance specification. The engineer of record works for the design-builder, which can create tension between cost and quality.
• Construction management splits the contractor role. Under construction management for services (or agency), the manager advises the owner, which contracts directly with trade contractors. Under construction management at risk, the manager holds the trade contracts and guarantees a maximum price, usually agreed when the design is well advanced.
• Public-private partnerships (P3s) bundle design, construction, financing and often operation and maintenance into a single long-term contract with a private consortium, which is paid through availability payments or user fees. Collaborative models such as integrated project delivery and alliancing share risk and reward among the owner, designer and builder under a single multi-party agreement.

No method is best for every project. A small pedestrian bridge with a standard design and a competitive local contractor market suits design-bid-build. A large, schedule-driven project with innovation potential may suit design-build. A complex project whose design will evolve may suit construction management or a collaborative model. The program below gives a crude illustration of how the delivery method shifts expected risk between the owner and the contractor for the bridge.

# Who carries each risk under two delivery methods? Values in $ thousands.
risks = [
    # name, probability, cost if it happens, owner share DBB, owner share DB
    ("Design error",            0.15, 400, 1.0, 0.0),
    ("Differing site conditions", 0.25, 600, 1.0, 0.5),
    ("Steel price escalation",  0.30, 250, 0.0, 0.0),
    ("Owner scope change",      0.40, 300, 1.0, 1.0),
    ("Permit delay",            0.20, 200, 1.0, 0.5),
]

def exposure(method_index):
    owner = contractor = 0.0
    for name, p, cost, dbb, db in risks:
        share = (dbb, db)[method_index]
        owner += p * cost * share
        contractor += p * cost * (1 - share)
    return owner, contractor

for i, method in enumerate(["Design-bid-build", "Design-build"]):
    o, c = exposure(i)
    print(f"{method:17} expected owner risk {o:6.1f}k  contractor risk {c:6.1f}k")
print("Contractors price retained risk, so a lower owner risk usually means a higher bid.")

Design-bid-build  expected owner risk  370.0k  contractor risk   75.0k
Design-build      expected owner risk  215.0k  contractor risk  230.0k
Contractors price retained risk, so a lower owner risk usually means a higher bid.

The numbers are illustrative only, but the lesson holds: shifting risk to the contractor does not make it disappear. The contractor prices it into its bid, adds a margin for uncertainty, and fights hard over it if it materializes. Owners that transfer risks the contractor cannot control often pay more than if they had kept them.

Differing site conditions

The ground is the classic uncontrollable risk. If the subsurface conditions differ from what the contract documents indicate or from what a reasonable contractor would expect, the cost of dealing with them can be large. Most standard forms allocate this risk to the owner, through a differing site conditions clause: the contractor must give prompt notice before disturbing the conditions, the owner's consultant investigates, and if the conditions differ materially, the contract price and time are adjusted. The logic is that the owner controls the site investigation, and making contractors price unknown ground conditions would inflate every bid.

In CCDC 2, this is GC 6.4, Concealed or Unknown Conditions, which covers conditions that differ materially from those indicated in the contract documents and physical conditions of a nature that differ materially from those ordinarily found in the work. Owners sometimes amend the clause to make the contractor responsible for all subsurface conditions, or add disclaimers to geotechnical reports. Courts may give effect to clear wording, but disclaimers do not always protect an owner or engineer from a negligent misrepresentation claim, as the next section shows.

Responsibility for design information

When an owner gives bidders design information, such as drawings, quantities or a geotechnical report, and they rely on it to price their tenders, errors can lead to claims. In Edgeworth Construction Ltd. v. N.D. Lea & Associates Ltd. (1993), the Supreme Court of Canada held that the engineering firm that prepared tender documents for a highway project could owe a duty of care in tort to the contractor that relied on them, even though the engineer had no contract with the contractor, and that a disclaimer in the owner's contract with the contractor did not protect the engineer. The individual engineers who sealed the drawings were not personally liable in that case, because the contractor relied on the firm. Edgeworth means that engineers who prepare tender documents should expect bidders to rely on them, and should take care that the information is accurate and its limits clearly stated.

In both countries, then, the owner who gives a contractor a design generally bears the risk that the design is wrong, and the owner's remedy is against its own engineer, if the engineer was negligent. This makes the engineer's own services agreement, and the way it limits liability, extremely important.

Indemnities, limitations and waivers

Three kinds of clauses do most of the explicit risk allocation between the parties.

• An indemnity is a promise to compensate another party for specified losses, usually losses from claims by third parties. A typical clause has the contractor indemnify the owner and engineer against claims arising from the contractor's work. Broad-form indemnities that require a party to cover losses caused by the other party's own negligence are dangerous and, in many jurisdictions, unenforceable. A duty to defend, in which the indemnifying party must pay for the indemnified party's defence costs as claims arise, is particularly risky for engineers, because professional liability insurance often does not cover it.
• A limitation of liability clause caps the amount a party can be liable for, for example at the fee, at a fixed sum or at available insurance. Engineers commonly seek a cap, because their fee is small compared with the potential losses from a design error on a large project. Clauses also often exclude consequential losses, as discussed in lesson 4.
• A waiver of subrogation prevents a party's insurer, after paying a claim, from suing another project participant to recover. Combined with project-wide property insurance, such as builder's risk insurance, it avoids circular litigation among parties who are all insured.

Courts generally enforce these clauses between sophisticated parties, subject to the Tercon analysis. Engineers should check that any indemnity they give is limited to losses caused by their own negligence, that it does not include a duty to defend, that it is subject to the liability cap, and that it matches their insurance. ACEC Document 31 includes limitation of liability provisions designed to match professional liability insurance; owner-drafted agreements often do not.

Insurance

Contracts allocate risk, and insurance funds it. The usual insurance on a construction project includes commercial general liability insurance (for bodily injury and property damage to third parties), builder's risk or course of construction insurance (for damage to the work itself), automobile and equipment insurance, and for design professionals, professional liability insurance (errors and omissions insurance), which covers claims arising from negligent professional services. Professional liability policies are usually written on a claims-made basis, so coverage depends on having a policy in force when the claim is made, not when the work was done; firms must keep coverage in place, or buy extended reporting coverage, long after a project ends.

Contract requirements and insurance must match. A contract that requires an engineer to warrant a result, indemnify for others' negligence or accept unlimited liability can leave the firm uninsured for exactly the claims most likely to bankrupt it. Before signing, engineers should send unusual clauses to their insurer or broker for review.

The engineer as contract administrator

Under CCDC 2 and similar forms, the consultant administers the construction contract for the owner. It interprets the contract documents, reviews shop drawings, makes field reviews, evaluates claims and changes, certifies payments and certifies substantial performance. When it decides questions between owner and contractor, it must act impartially and in good faith, even though the owner pays it. A consultant that favours its client in deciding a contractor's claim, or that refuses to certify payment to put pressure on the contractor, may expose itself and the owner to liability. Its decisions are usually subject to the contract's dispute resolution procedure.

Submittal review is a particular source of risk. Engineers review shop drawings for general conformance with the design intent, not to check every dimension or to take responsibility for the contractor's means and methods. The review stamp should say so, and the engineer's conduct should match it: an engineer who redesigns the contractor's temporary works in the course of review may take on responsibility for them.