Employers avoid paying more under existing contracts, but forcing unprofitable work risks contractor insolvency. Contractors now seek protection from price fluctuations, preferring short projects or cost-plus letters of intent. Cost adjustment mechanisms, like FIDIC 1999 Sub-Clause 13.8, may help.

Construction costs are escalating

Under existing contracts, an employer will not want to pay more for the works. But forcing a contractor to perform works that are unprofitable or causing a massive loss is unlikely to be in the best interests of the project. It may result in the insolvency of the contractor forcing the employer to abandon the contract or re-let it, probably at a premium.

In new contracts, contractors are demanding protection from unpredictable price fluctuations. If a contractor feels exposed, it might only bid on projects with short construction programmes which give costs less time to increase. Or the contractor might seek to start work under a letter of intent on a cost-plus basis which then never crystalises into a full contract.

Is a mechanism for cost adjustment, such as FIDIC 1999 Sub-Clause 13.8[1] [Adjustments for Changes in Costs], an answer?

Type of contract

The type of contract usually informs as to which party takes the risk of price fluctuations.

• In reimbursable or cost-plus contracts, the employer takes the risk. The contractor is reimbursed the actual cost, plus allowances for overheads and profit. If the contractor’s actual costs increase, the contract price will increase also.
• In remeasurement contracts and fixed price/lump sum contracts the contractor usually takes the risk unless there is a mechanism for cost adjustment.
  • In remeasurement contracts (such as the FIDIC Red Book – For Building and Engineering Works Designed by the Employer) the contract price is based on approximate quantities and a schedule of rates and prices. But, if the rates and prices can be adjusted where price fluctuations occur, the contract price is recalculated using the new rates and prices and the final agreed quantities. The actual work done is remeasured when the works are completed.
  • In fixed price/lump sum contracts (such as the FIDIC Yellow Book – Plant and Design Build) the contractor provides an overall figure, ‘a lump sum’, for all the works that are agreed to be carried out under the contract. But, if the amounts due to the contractor can be adjusted where price fluctuations occur, the contract price is recalculated.

Legal principles

It is a basic principle of law that agreements must be kept. The Latin term for this is pacta sunt servanda. Therefore, unless there is a mechanism for cost adjustment, the contractor in a remeasurement contract or fixed price/lump sum contract may have a problem. In such circumstances, there are some legal arguments which might be deployed depending upon the governing law of the contract and local legal advice.

Fundamental change of circumstance

Some legal jurisdictions will allow a contract to be modified where it becomes inapplicable because of a fundamental or extraordinary change of circumstances. For example, under:

• the legal doctrine of rebus sic stantibus (meaning ‘things thus standing’[2]) which is sometimes described as an ‘escape clause’ to the principle of pacta sunt servanda; or
• the French doctrine of imprévision (meaning ‘lack of foresight’)[3].

Impossibility

A contractor might seek to argue that a contract has become impossible to perform; it is so different to the original bargain that it is frustrated so as to discharge the parties’ obligations.

Under the FIDIC 1999 editions, Sub-Clause 19.7 provides a remedy when any ‘event or circumstance outside the control of the Parties (including, but not limited to, Force Majeure) arises which makes it impossible or unlawful for either or both Parties to fulfil its or their contractual obligations…’.

There is similar wording at Sub-Clause 18.6 of the FIDIC 2017 editions.

However, economic unprofitability is unlikely to make it impossible or unlawful for the contractor to fulfil its contractual obligations. Just because something costs more to build does not make it impossible to build.

Force majeure

A contractor might seek to rely on force majeure, either under the governing law or in accordance with the contract conditions.

For an event to qualify as ‘Force Majeure’ under the FIDIC 1999 editions, five requirements must be met:

• it must be an exceptional event or circumstance;
• which must be beyond the parties’ control;
• which such a party could not have reasonably provided against before entering into the contract;
• which having arisen such party could not have reasonably avoided or overcome; and
• which was not attributable to the other party.

There is similar wording at Sub-Clause 18.1 of the FIDIC 2017 editions. However, the term Force Majeure is not used. The term Exceptional Events is used instead, although the definition does not actually require the event or circumstance to be exceptional.

Both Covid and the Russia-Ukraine war might fall within the FIDIC definition of Force Majeure. But to be entitled to an extension of time (or, in the case of the Russia-Ukraine war, Cost[4]), the contractor must be ‘prevented’ from performing any of its obligations under the contract by Force Majeure (and is subject to giving the prescribed notice). This means a physical or legal prevention. Economic unprofitability will not normally suffice. The mere fact that the cost of performance has increased is insufficient for prevention. So, whilst the Force Majeure clause may give the contractor extra time to procure materials that were prevented from being procured on time because of Covid or the Russia-Ukraine war, it is unlikely to assist a contractor who is merely obliged to pay higher prices than originally estimated.[5]

Good faith

A contractor might seek to rely on the principle of good faith which, under some legal jurisdictions, may be implied into the contract. Good faith arguments are usually raised as a matter of last resort.

Escalation clauses

A mechanism for cost adjustment is, potentially, a more reliable way to limit the contractor’s risk.

In the FIDIC 1999 editions the escalation clause is at Sub-Clause 13.8, and in the FIDIC 2017 editions it is at Sub-Clause 13.7. Sometimes the escalation clause is deleted or modified.

Sub-Clause 13.8 of the FIDIC 1999 editions (or Sub-Clause 13.7 in the FIDIC 2017 editions) is an ‘opt-in’ clause. It applies only if:

• Under the FIDIC Red and Yellow Books 1999 – a table of adjustment data is included in the Appendix to Tender.
• Under the FIDIC Silver Book 1999 – provided for in the Particular Conditions.
• Under the FIDIC 2017 forms – a Schedule(s) of cost indexation is included in the contract.

The table of adjustment data or Schedule(s) is a complete statement of the adjustments to be made to the cost of labour, Goods and other inputs to the Works (for example, fuel). Any other rises or falls in the Costs are deemed to be included within the Accepted Contract Amount. No adjustment is applied to work valued on the basis of Cost or current prices.

Where it applies:

• Under the FIDIC 1999 editions – the amounts payable to the contractor are adjusted for both rises and falls ‘in the cost of labour, Goods and other inputs to the Works’ by adding or deducting amounts calculated in accordance with a prescribed formula (in the FIDIC Red and Yellow Books) or as set out in the Particular Conditions (in the FIDIC Silver Book).
• Under the FIDIC 2017 editions – the amounts payable to the contractor are adjusted for both rises and falls ‘in the cost of labour, Goods and other inputs to the Works’ by adding or deducting amounts calculated in accordance with the Schedule(s).

In the FIDIC Red and Yellow Books 1999 a formula is set out, but this may be amended as the parties choose. The wording states: ‘The formulae shall be of the following general type’. The formula is as follows:

The FIDIC Yellow Book Guidance suggests that in a plant contract formulae which are more directly related to the timing of costs incurred by the manufacturers be adopted.

The FIDIC Silver Book 1999 and the FIDIC Gold Book 2008 do not set out a formula. The FIDIC Silver Book Guidance suggests that the wording for provisions based on the cost indices in the FIDIC Yellow Book be considered.

The FIDIC 2017 editions do not set out a formula either. The Guidance states: ‘It is recommended that the Employer be advised by a professional with experience in construction costs and the inflationary effect on construction costs when preparing the contents of the Schedule(s) of cost indexation’.

It is recognised that the formula set out above to calculate the adjustment multiplier (Pn), which is to be applied to the estimated contract value, is crude, but it is a fast and reasonably credible way of calculating and reimbursing fluctuations in costs.

The formula relies on:

• A fixed element (a), representing the non-adjustable portion in contractual payments, which is fixed at the time of Contract. FIDIC suggests 10% in the Appendix to Tender or Guidance.
• The weighting of the resources (b) (c) (d), which is determined at the time of contract. For example, a road project might be 20/40/40 for labour, equipment and materials.
• Cost indices for the current ‘now’ value (n) and the original value (o) for each of, for example, labour (L), equipment (E) and materials (M), which need to be updated frequently (preferably monthly rather than quarterly or annually, but that will depend upon the cost indices chosen).

Fixed element (10%)

Where there is contractor compensable delay which pushes the project into a period of inflation, it seems unfair that this portion is non-adjustable. Perhaps, it might be claimed as a prolongation cost as it falls squarely within the definition of ‘Cost’. The author is not aware of any precedent on this.

Weightings

In the FIDIC Red and Yellow Books 1999 (but not the FIDIC Silver Book 1999 or the FIDIC 2017 editions), the weightings may be adjusted if they have been rendered unreasonable by way of a Variation to the Works.

The last paragraph of Sub-Clause 13.8 of the FIDIC Red and Yellow Books 1999 states: ‘the weightings for each of the cost factors stated in the table(s) of adjustment data will only be adjusted if they have been rendered unreasonable, unbalanced or inapplicable, as a result of Variations’.

Therefore, the claiming party would need to demonstrate that the original contract weightings were correct at the time of contract and that a Variation had rendered them unreasonable, unbalanced or inapplicable. Inflation alone would be insufficient.

This provision does not apply simply where the original contract weightings fail to reflect the actual contract weightings. Sub-Clause 4.11 of the FIDIC 1999 editions states: ‘The Contractor shall be deemed to have satisfied himself as to the correctness and sufficiency of the Contract Price. … Unless otherwise stated in the Contract, the Contract Price covers all the Contractor’s obligations under the Contract (including those under Provisional Sums, if any) and all things necessary for the proper design, execution and completion of the Works and the remedying of any defects.’. The FIDIC 2017 editions have similar wording.

Cost indices

Cost indices provide a simple way to relate the original value to a corresponding cost now. Unfortunately, cost indices are not an accurate reflection of the actual costs, but they are easy and reasonably credible.

The choice of cost indices is important, and when choosing them it is necessary to understand, for example:

• Exactly what they measure. Many indices are intended to reflect only general building construction.
• In which location. The indices ought to align with the source of materials. Changes might be needed to the indices if there is a change in supplier or country of origin for the supply of materials, for example because of sanctions.
• In which currency. The currency of the cost indices and the currency for payment ought to align, otherwise there may be scope for further adjustment when the currency of the cost indices is converted into the currency of payment.

The categories of the cost indices are usually broad and not necessarily linked to specific items in the bill of quantities. Therefore, they do not work well with bespoke construction elements.

After the Time for Completion

Under the FIDIC Red and Yellow Books 1999 and the FIDIC 2017 editions, if the contractor fails to complete within the Time for Completion (meaning the time for completing the Works including any extension of time due to the contractor), further price rise risk is allocated to the contractor, and the benefit of any falling prices is allocated to the employer.

Adjustments to prices after the Time for Completion are made using the most favourable to the employer of:

• the index or price applicable from the date 49 days (i.e. 7 weeks) before the expiry of the Time for Completion; or
• the current index or price.

Procedure

Under both the FIDIC 1999 and 2017 editions, an application for an Interim Payment Certificate under Sub-Clause 14.3 must include any amounts to be added or deducted for changes in cost under Sub-Clause 13.8. The contractor is not obliged to give notice under Sub-Clause 20.1 of the FIDIC 1999 editions.

Other options

There are also practical things which the parties might consider in order to manage the risk of escalating construction costs in a smarter way.

During the tender process:

• The employer might give the contractor more flexibility when procuring materials by being less prescriptive in the specifications, for example in respect of the identity of the supplier and/or the type of material.
• The employer might encourage value engineering and permit alternative products where previously specified materials have dramatically increased in price.
• Provisional sums might be used for specific defined materials, to allow for greater price flexibility.
• The contractor might date limit its pricing for specific materials, therefore limiting its period of risk.
• The contractor might procure goods locally, where possible, in order to reduce transportation costs.
• The contractor might build closer and more collaborative relationships with suppliers.

During the works:

• The employer might agree to vary the contract to take into account some of the suggestions above.
• The contractor (or the employer) might identify capacity in the supply chains, buy price volatile goods, equipment and materials in advance and negotiate a delayed delivery or stockpile them[6]. The contractor might need to do this in any event because of excessive lead in times.
• The employer might agree to pay more in a supplemental agreement[7].

Conclusion

Contractors are demanding protection against escalating construction costs.

Although not without criticism, a mechanism for cost adjustment such as FIDIC 1999 Sub-Clause 13.8 is a reasonably credible way to limit the contractor’s risk if professional advice is sought on the correct cost indices to apply when preparing the contract documents.

I’d be interested to hear about your experiences and how you are addressing escalating construction costs in current and future projects.

Please call me, Victoria Tyson on +44 (0)20 3755 5733 or email Victoria.Tyson@howardkennedy.com to discuss your specific situation.

[1]   FIDIC 2017 Sub-Clause 13.7.

[2]   For example, under Polish law.

[3]   Article 1195 of Ordonnance No 2016-131 of 10 February 2016, enforceable in contracts concluded after 1 January 2016, states: “Where a change of circumstances that was unforeseeable at the time of the contract’s conclusion renders performance exceedingly onerous for a party that has not accepted to assume such risk, the party may ask the other party to renegotiate the contract”

[4]  War is payable under Sub-Clause 19.4(b) but Covid Is not. Natural catastrophes are excluded. For Cost, the event or circumstance must be of the kind listed in sub-paragraphs (i) to (iv) of Sub-Clause 19.1, and in the case of sub-paragraphs (ii) to (iv) occur In the Country.

[5]   Further, there is no entitlement to Cost in respect of natural catastrophes, and to be entitled to Cost in respect of the other specified categories, the force majeure must have occurred within the Country unless the force majeure arises out of “wars, hostilities (whether war be declared or not), invasion, act of foreign enemies”.

[6]   This will require up-front payment and security in relation to such payments.

[7]   For example, in the English case of Williams v Roffey Bros [1990] 2 WLR 1153 a contractor realised it had priced the works too low and would be unable to complete at the originally agreed price. It approached the employer who had recognised that the price was particularly low and was concerned about completing the contract on time. The employer agreed to pay the contractor more.

The English Commercial Court has now confirmed in two separate decisions that an arbitral tribunal may award a winning claimant its third party funding costs. How significant are these decisions and it is time to rethink the potential reward and risk of international arbitration?

Introduction

The English Commercial Court has now confirmed in two separate decisions that an arbitral tribunal may award a winning claimant its third party funding costs. How significant are these decisions and it is time to rethink the potential reward and risk of international arbitration?

The First Decision – Essar v. Norscot (2016)[1]

This case concerned an ICC arbitration with a seat in England. The tribunal awarded Norscot its funding costs, i.e., the sum that Norscot owed to a third party funder for advancing sums for the purposes of the arbitration.

The tribunal found that provisions in the English Arbitration Act 1996 (including section 59(1)(c) which defines the ‘costs of the arbitration’ to include ‘the legal or other costs of the parties’) and the ICC rules of arbitration (article 31(1) of the applicable rules which defined the ‘costs of the arbitration’ to include the ‘reasonable legal and other costs incurred by the parties for the arbitration’) gave it a wide discretion as to what costs it could award to the winning party. In light of Essar’s conduct, of which the tribunal was critical, these included Norscot’s funding costs as reasonable ‘other costs’.

Essar applied to the English court to set aside the award under section 68 of the English Arbitration Act 1996 on the grounds that the arbitral tribunal exceeded its powers by awarding the funding costs and this constituted a serious irregularity. The English Commercial Court dismissed the application. It found that the tribunal had the power to award funding costs because as a matter of language, context and logic they fell within the definition of ‘other costs’ and the decision whether or not to award such costs then fell within the tribunal’s general costs discretion.

The decision in Essar raised a number of questions regarding the recovery of funding costs in arbitration including: how significant is a party’s conduct to this recovery (for example, does the conduct have to lead to the other party’s impecuniosity?), whether a tribunal may exercise its discretion if the funding was not strictly necessary to bring the claim (for example, where the claimant has sufficient funds to pay its arbitration costs but chooses to obtain third party funding for commercial reasons, such as to ease cash flow or hedge risk) and at what stage the funding should be disclosed.

The ICCA-Queen Mary Report on Third Party Funding in International Arbitration (2018)[2]

This Report was published after Essar v. Norscot and considers many questions relating to third party funding in international arbitration in light of its rapid evolution. The Report notes that there were (in 2018) very few reported cases dealing with the award of funding costs[3] and that, under the majority of arbitration rules, a party may recover costs which it has ‘reasonably’ incurred in the arbitration, with three caveats.[4] First, the tribunal may not in fact have the power under the applicable laws (or rules) to award funding costs. Second, the amount of funding costs must generally be reasonable and this will depend on the circumstances. Third, if a tribunal decides to award funding costs, this should ordinarily be possible only if details of the funding costs are disclosed from the outset of the arbitration or at an early stage because ‘ordering an unsuccessful respondent to pay funding costs constitutes a significant shift in the risk associated with the outcome of the arbitration’.[5]

Disclosure of Funding Arrangements: Revisions to Arbitral Rules

Various arbitral institutions have amended their rules to require parties to disclose the existence of a third party funding arrangement. For example, Article 11(7) of the 2021 ICC Rules requires parties, in the context of assisting arbitrators with their duties regarding conflicts of interests, to ‘promptly inform the Secretariat, the arbitral tribunal and the other parties, of the existence and identity of any non-party which has entered into an arrangement for the funding of claims or defences and under which it has an economic interest in the outcome of the arbitration’.[6]

The Second Decision – Tenke v. Katanga (2021)[7]

In this case, Katanga commenced an arbitration against Tenke in respect of claims arising from contracts[8] for services at a mine in the Democratic Republic of the Congo. The contracts and the arbitration clauses were subject to English law and the arbitration proceeded under ICC arbitration rules with a seat in London. Katanga obtained funding for the arbitration from a related company (Logos Agvet Limited which was controlled by a shareholder of Katanga) on terms which included payment of a success fee. Katanga disclosed the existence of this funding only in the cost submissions stage of the arbitration and sought to recover the success fee as part of its costs in the arbitration.

The tribunal accepted that the funding costs were ‘other costs’ by virtue of section 59(1) of the English Arbitration Act. The tribunal considered whether the funding costs were reasonable because of the inter-company nature of the funding and also as to the amount.[9] It considered that the funding choice was not inherently unreasonable in the circumstances and awarded Katanga its funding costs.

Tenke challenged the award under section 68 of the Arbitration Act 1996 on the grounds of serious irregularity.[10] This included a challenge to the award of funding costs as being an excess of power (section 68(2)(a)).

Tenke made a number of arguments in respect of its challenge to the award of funding costs.[11] These included that, when the Arbitration Act 1996 was passed, it could never have been intended that ‘costs of the arbitration’ or the ‘legal or other costs of the parties’ (as these phrases appear in the Act) would encompass a fee paid to a funder or costs relating to a loan taken out to pay for legal fees; a fee payable to a funder is not recoverable in English court litigation and there is no reason to think that Parliament intended a different rule to apply to arbitration; the decision in Essar was wrong and met with surprise and concern in the field of international arbitration; but the present case was much worse because the funding was not even provided by a regulated third party funder but by a company related to Katanga; there was no finding that Katanga needed the funding to pursue the arbitration; and, if the award was permitted to stand, it would encourage claimants to take out shareholder loans so that shareholders could recover ‘fees’ safe in the knowledge that (unlike third party funders in court litigation) they were beyond the reach of the arbitral tribunal and courts if the claimant did not win the arbitration.

The English Commercial Court was not persuaded. It followed the reasoning in Essar and rejected Tenke’s challenge.[12]

A Rethink of Reward and Risk?

Increasingly claimants are seeking third party funding either so that they have the money to bring the claim in the first place or for other commercial reasons such as hedging risk. Where a specialised funder is concerned, the basic arrangement usually involves the funder providing funding to the claimant for a return, which may be a fixed percentage share of around 30-50% of monies recovered, or a multiple of around two to four of the funding to be provided, or a combination of both. The cost of the third party funding to the claimant can therefore be significant.

In the Tenke and Essar decisions summarised above, the English Commercial Court upheld the award of funding costs by two arbitral tribunals with very different facts. Accordingly, it seems there is an argument, at least in English law and provided the applicable arbitration rules permit it, that a winning claimant may recover from a losing respondent its funding costs as an ‘other cost’ if it can persuade the tribunal that (1) it was reasonable for that party to have recourse to the particular type of funding in the circumstances of the case, and (2) the amount of the funding costs was reasonable.

For the losing respondent, this may constitute a significant and highly unwelcome shift in the risk associated with the outcome of the arbitration in particular if the funding arrangement is disclosed by the claimant only towards the end of the arbitration.

Conclusion

Third party funding is increasingly a feature of international arbitration. As the cases above show, a winning claimant may be awarded its funding costs and a losing respondent may be liable for those funding costs, even if the funding arrangement is not disclosed until late in the arbitration, subject only to a test of reasonableness. The funding costs may be significant. Parties should therefore consider and monitor the possibility of third party funding during the course of any international arbitration.

[1] Essar Oilfields Services Limited v. Norscot Rig Management PVT Limited [2016] EWHC 2361 (Comm). See also the article ‘A Surprise Award of Third Party Funding Costs’ published in our newsletter of February 2017.

[2] International Council for Commercial Arbitration and Queen Mary University of London, ‘Report of the ICCA-Queen Mary Task Force on Third-Party Funding in International Arbitration’, April 2018. This 272-page Report contains a wealth of discussion and information on the subject of third party funding.

[3] Report, p151. In addition to Essar v. Norscot, the Report mentions ICC Case No. 7006, ICSID Case No. ARB/08/2, ICSID Case No. ARB/05/15, and SCC Arbitration No. 24/2007.

[4] Report, p158.

[5] Report, p158 to p159.

[6] See also for example the SIAC Investment Arbitration Rules (2017) which at article 24(l) give the tribunal the power in certain circumstances to ‘order the disclosure of the existence of a Party’s third-party funding arrangement and/or the identity of the third-party funder and, where appropriate, details of the third-party funder’s interest in the outcome of the proceedings, and/or whether or not the third-party funder has committed to undertake adverse costs liability.’ See also the HKIAC Administered Arbitration Rules (2018) which require the Notice of Arbitration and Answer and any Request for Joinder and Answer to include ‘the existence of any funding agreement and the identity of any third party funder …’ (articles 4.3, 5.1, 27.6 and 27.7) and sets out further provisions regarding the notice that is required if a funding agreement is made (article 44).

[7] Tenke Fungurume Mining SA v. Katanga Contracting Services S.A.S. [2021] EWHC 3301 (Comm).

[8] Katanga commenced two arbitrations but these were later consolidated.

[9] [2021] EWHC 3301 at para 68.

[10] Tenke advanced four grounds for its challenge; failure to adjourn the arbitration to allow a visit to the construction site; failure to adjourn the arbitration notwithstanding the illness of its leading counsel, the costs award; and the award of compound interest.

[11] [2021] EWHC 3301 at para 76.

[12] [2021] EWHC 3301 at para 92. The court noted that in light of Willers v Joyce, the court should ‘generally follow a decision of a court of co-ordinate jurisdiction unless there is a powerful reason for not doing so’.  It agreed with the court in Essar that, at its highest, the award of funding costs would be an erroneous exercise of an available power and so not susceptible to challenge under section 68. If there had been an error of law, there was a remedy under section 69, but in the present case that remedy had been excluded by agreement. [2021] EWHC 3301 at para 95.