Construction Contracts

0-976511355

Preface

This book is written for major civil and engineering contractors, consulting engineers, and their clients in the energy industry. It is intended as a desktop companion and reference for project managers, project engineers, contract administrators, cost scheduling engineers, and others engaged in the field of oil, gas, and petrochemical plant construction. It is also valuable as a textbook to be used in the training and education of the above.

The book covers, inter alia, efficient preparation of bid packages, pitfalls encountered in the invitation to bid, advice on suitable contract formats, evaluation of bids, processing of variation orders, work procedures, avoidance of construction claims, quantification of delay and disruption costs, negotiation strategies in disputes, work breakdown structures and invoicing, and contract closeout procedures.

Edward Whitticks has had many years of experience as a field contracts manager on projects in North and South America, the Middle East, and the North Sea. He has written and/or administered more than 1,000 contracts for oil and gas construction worldwide.

Mr. Whitticks presently conducts courses and seminars throughout Europe, the Middle East, and India on contracts management and construction claims avoidance. He lives in Surrey, England.

CHAPTER ONE

Client Policy and Practice

1.1 Introduction

The oil, gas, petrochemical, and the energy industry in general instructs and imposes a duty upon its employees to observe certain policies regarding the contracting process and to maintain a high standard of ethics and fairness. All contracts are issued in writing and are intended to be executed prior to committing work to a contractor or a contractor starting work. Adequate safeguards and controls in terms of procedures, documentation, files, reviews, and approvals are expected to be established and maintained for all contracting activities.

Certain contracts, which are governed by institutional terms and conditions, may introduce a third party into the executed agreement, namely, the engineer. This title usually refers to a consulting company who acts, among other functions, as an intermediary between the client and the contractor. In these contracts, the client may be described as the owner or employer or company but in this work we will usually refer to one party as the client and the other party as the contractor. When the latter is obliged to engage another to carry out work, the contract will be made between the contractor and a subcontractor.

1.2 The Fundamental Contract Document

The construction contract is an agreement between the parties for the performance of work through the supply of labor and materials.

First, a valid contract must be sufficiently certain to have a practical meaning and before execution the parties must have agreed on all terms and conditions. Second, there must also be an agreement on the consideration and on the payment terms. Third, the contract must be in writing. A contract is not easily enforceable if it remains entirely as an oral agreement and without written evidence.

It is worth bearing in mind that the contract of magnitude in size and value—succinct, crystal clear with guaranteed protection against future construction disputes, and capable of being understood by all parties to the agreement—has probably yet to be written!

1.2.1 Letters of Intent

Letters of intent should only be used in special circumstances and should only be issued after all contractual matters are settled or specifically delineated in the letter of intent as being unresolved.

The letter of intent will be valid only if it contains, at the very least:

(a) Confirmation of the client’s intent to award a contract to a named contractor.

(b) Reference to the scope of work in the invitation to bid.

(c) The consideration (i.e., pricing for the work) or an invitation to submit monthly invoices based on percentages of work completed against the price quoted in the contractor’s bid proposal.

(d) The effective date of the contract (being the date when the client receives the contractor’s confirmation by letter).

(e) Reference to the receipt of the contractor’s agreement to the preceding (see d).

A letter of intent is defined as a contract designed for interim use only that sets forth certain agreed terms and conditions remaining to be negotiated (see the following example).

CRUDE OIL COMPANY INCORPORATED

Subject: Letter of Intent

Contract No. _______

Contract Title ____________________________

Effective Date: On receipt of your confirmation and agreement

(Contractor’s Name)

(Contractor’s Address)

Gentlemen,

This is to express our intent to enter into a contract with you for (description of Work) in accordance with your proposal dated (date), your subsequent letters dated (dates), and your meetings with our representatives held on (dates).

[Note to Contract Engineer/Administrator: Add here a clause specifying what was agreed and what was not.]

It is understood and agreed that this expression of intent is subject to the execution of a final contract in writing between us and that of this date and until a final agreement is reached, neither of us is bound to the other or to any third party by any legal or equitable commitment whatsoever except as set forth in the following text.

You may submit monthly invoices for payment based upon percentages of work completed against the price(s) set forth in your bid proposal dated (date). However, in the event we decide not to enter into a final contract with you for this work, we will reimburse you only for all costs and expenses incurred by you up to the date of our notification to you that we will not enter into a contract with you, plus _______ percent of such costs and expenses to cover profit. In such event, all your said costs and expenses shall be subject to audit.

Very truly yours,

W. H. Smith

Vice President, Procurement

CRUDE OIL COMPANY INCORPORATED

1.3 Invitations to Bid

Open bidding, that is, an open invitation to contractors to tender for work, is not a usual feature of oil company practice. Advertising in technical magazines and other media is more properly confined to the building construction industry and to work for government departments. However, in certain areas, there are regulations in force that oblige organizations proposing to embark on construction ventures to publicly announce their intentions. Work in refineries, gas plants, and on pipelines is, for the most part, highly specialized and only a limited number of contractors have the resources and the workforces to undertake such ventures. In an open tender situation, however, this consideration would not discourage a large number of contractors from having a shot at it. Invitations, therefore, are normally restricted to those organizations regarded by the client as capable of handling the work.

1.4 Lump Sum Contracting Preferred

Lump sum contracting is normally the preferred contract format when it can be properly used. Competitive bidding is used to select a technically and financially qualified contractor whose bid represents the least overall cost to the client. Negotiated contracting is only used in exceptional circumstances involving exceptional skills or equipment that would otherwise be unobtainable.

Lump sum, unit prices, day rates, and reimbursable cost fixed fees that are quoted under competitive conditions for defined work are not normally negotiated. There may be exceptions to this policy where:

(a) The contractor selected is the only one capable of performing the work within the project schedule.

(b) The selection of any other contractor would result in substantial additional costs to the client.

(c) The contractor selected possesses special expertise or other experience that would cause its work performance to be superior to that of other potential bidders.

The essence of a lump sum contract is that, in return for a lump sum payment, the contractor supplies such goods and services as it finds necessary to ensure that the end product is in accordance with its specification and meets the delivery and performance guarantees. Once the contract is in force, the lump sum price is fixed regardless of costs incurred by the contractor who must therefore include in its price contingencies for estimating design errors and for other unknown costs that may be incurred although their magnitude is uncertain.

The lump sum or hard money contract policy may be applied when:

(a) Detailed design engineering, drawings, specifications, and a defined project scope of work are complete or nearly complete. It is folly to begin a lump sum arrangement when only a limited amount of engineering is available at start-up although some clients need persuading in this respect. Situations vary as to the right time to consider lump sum, but circa 75 percent engineering could be a safe margin. Less than 10 percent may be considered unsafe. Some authorities hold that there can be no such thing as a fixed price lump sum contract without an adequate specification.

(b) It is possible to find contractors willing to compete for work involving a proprietary process (i.e., in a petrochemical plant) or special equipment (e.g., definable marine work).

1.4.1 Lump Sum Advantages

(a) The client is able to define the work and prepare drawings and specifications before going out to bid.

(b) In view of (a), the client may also prepare an in-house fair price estimate for bid comparison and know in advance its budget commitment.

(c) Close competition between bidders may be realized.

(d) The contractor has an incentive to adhere to schedule and budget.

(e) Responsibility for the project is with the contractor.

(f) Bid evaluation is easier.

1.4.2 Lump Sum Disadvantages

(a) There may be a long period between the decision to issue the requests for quotation from bidders and the contract award.

(b) A low-bid contractor may try to recover losses through excessive variation proposal orders and claims.

(c) Maximum design engineering may be necessary.

(d) Lack of flexibility—changes expensive.

(e) Open to claims attempts.

(f) Contingencies for risk and escalation.

(g) Importance of low bid price may result in unsatisfactory work.

1.5 Lump Sum Plus Unit Rates

For lump sum plus unit rates, the advantages and disadvantages are the same as lump sum, but it behooves the client to put as many unit rate offers in the request for quotation (RFQ) as possible. Whereas, if these are not requested, it suits the contractor to negotiate separately and possibly more advantageously during the course of the contract.

1.6 Unit Rate Only

A unit rate contract is one in which payment for the work is made upon the basis of completed quantities of specifically stated items of work and materials furnished and used by the contractor, each quantity being multiplied by the contractor’s bid price for that unit.

One advantage of entering into a unit rate–type contract is that work may commence earlier because the bidding cycle is shorter and engineering does not have to be firm at the time of placing the contract, thereby permitting construction to start sooner. The downside is that placing contracts on unit rate may involve both the client and contractor, and considerable time updating, pricing, and often remeasuring the work and agreeing on quantities.

1.7 Reimbursable Cost Contracts Where Necessary

Reimbursable cost contracts with fixed or percentage fees for hands-on work are usually the last choice for clients and will be used only where there is little or no engineering accomplished in the time available or in any other situation that makes a cost plus agreement unavoidable. Client contract managers will explore every possibility before entering into such an arrangement. In the late 1970s, when the oil industry was still enjoying a major boom, this policy was partially relaxed because many contractors were reluctant to accept any other type of contract unless the risk was minimal. In times of recession, the contractor may have to accept lump sum as the order of the day.

Guiding principles regarding reimbursable costs arrangements are as follows:

(a) The term reimbursable costs means those costs for performing the work under the contract for which the contractor receives direct reimbursement from the client as opposed to indirect reimbursement using fixed rates.

(b) Reimbursable costs include only those allowed under the contract.

(c) Reimbursable costs must have been incurred after contract award and be net costs actually incurred and paid.

(d) Reimbursable costs exclude the cost of materials, services, and other items that are provided for in fixed rates.

(e) Reimbursable costs exclude the contractor’s general costs of doing business and profit that are provided for in the fee.

(f) Costs not clearly identified in the contract as reimbursable costs require the client’s approval prior to committing the expenditures to qualify as reimbursable costs.

Guiding principles regarding fixed rates are as follows:

(a) Fixed rates are practical arrangements to pay the contractor for certain costs that it will incur in connection with work under the contract. Fixed rates are normally used for certain items of the contractor’s office costs, such as payroll burden for reimbursable personnel, departmental overhead, computer, and printing, and may be used for certain other costs such as construction equipment and expatriation of employees.

(b) Fixed rates should represent the contractor’s best estimates of fixed unit prices that will permit the recovery of costs incurred and paid in connection with work under the contract. They should be based on the contractor’s recent, but reasonable, actual net cost experience projected over the term of the contract. Reasonable estimating contingencies and escalation allowances may be used. However, fixed rates should not be designed as profit generators. The contractor’s total planned profit should be included in the fee. An exception to this is that fixed rates for construction equipment may include a reasonable return to the contractor on its investment in the equipment, if the cost of capital is not recovered in the fee or otherwise.

(c) The contract normally gives the client the option, where practical, of selectively supplying any or all services covered by fixed rates, such as construction equipment, or of requiring the contractor to purchase such services from others.

(d) Fixed rates, as agreed at award and documented in the contract, are fixed unit prices. After award, fixed rates are not subject to revision, either up or down, based on the contractor’s actual cost experience. However, if there is a change after award in the scope of materials or services required by the client or provided by the contractor under the fixed rates, then it may be necessary for the client and the contractor to agree on revised fixed rates to cover the new situation.

(e) Payroll burden for reimbursable home or branch office personnel may be reimbursed directly on an actual incurred and paid basis or indirectly through the use of fixed rates. If fixed rates are used, such rates are normally expressed as a percentage of reimbursable salaries. Separate rates are established for basic workweek hours and for overtime hours. The rate for overtime hours should cover only the contractor’s incremental costs related to overtime and the rate should be applied only to straight time salaries excluding any overtime premiums.

(f) Departmental overhead rates are normally expressed as an amount per reimbursable man-hours. Separate rates are established for basic workweek hours and for overtime hours of both contractor’s personnel and any agency or freelance personnel. The rates for overtime hours and for agency and freelance personnel should cover only the contractor’s incremental costs related to those situations. Rates for overtime hours should be applied only to hours actually worked.

(g) Fixed rates for departmental overhead should exclude the contractor’s bidding and research and development (R&D) costs that should be included in its quoted fee.

(h) Most clients will not permit the contractor to allow for the following expenses:

• The costs of salaries and traveling expenses of executive officers who are not directly assigned to perform work for the contract.

• Interest on capital employed or on borrowed money.

• General, administrative, and overhead costs relating to general company and all office operations.

• Consultancy services, unless specifically requested and related to the contract.

• Income tax.

• Costs for employee bonuses and profit-sharing plans.

• Employee severance costs.

• Employee relocation and recruiting expenses.

Guiding principles regarding the fee are as follows:

(a) The fee provides for the contractor’s recovery of its general costs of doing business, including:

• General and corporate overhead costs.

• Income, profit, franchise, occupational license, and personal property taxes.

• Income on capital.

• R&D and bidding costs.

• Profit-sharing and business risks.

The fee also provides for the contractor’s total planned profit related to performing the work under the contract.

(b) A fixed lump sum fee is normally used when the contractor’s work may be adequately described at the time of bidding. Otherwise, fixed rate fees applied to reimbursable engineering man-hours and construction management and staff man-hours are used. Fixed rate fees should be applied only to hours actually worked.

(c) The contract includes provisions for increasing or decreasing the fixed lump sum fee if client-authorized changes demonstrably affect the amount of the contractor’s services required to accomplish the work. The fee is adjusted according to the effects of changes on the costs of the contractor’s home and branch office and construction management services. The fee rate for changes should bear the same relationship to the cost of services as does the fixed lump sum fee.

Reimbursable cost contracts mean considerable audit surveillance on the part of the client, far more than would be necessary with a hard money contract. Every invoice for goods and services, for example, would have to be checked by the client. Whereas on a lump sum contract, the client is not particularly interested in how much the contractor pays for material provided it is within specification. The same applies to subcontracting.

1.7.1 Advantages of Reimbursable Cost Contracts

• Requires minimum inquiry definition.

• Shortest possible bid time.

• Complete flexibility.

• Client/contractor conflict of interest minimized.

• The client has control over costs incurred.

• The client can assess the contractor’s rates.

• The client may use the contractor to evaluate alternative schemes.

• The client may terminate at will without incurring substantial costs.

1.7.2 Disadvantages of Reimbursable Cost Contracts

• The contractor has no monetary incentive to minimize cost to the client.

• The client has no assurance of final costs.

• The client has to check and verify the contractor’s man-hours and expense records.

• Bid evaluation may be difficult.

• The contractor competition is only a very small part of the total cost.

• The contractor has no monetary incentive to achieve early completion unless covered by special conditions (see section on Incentives in the following text).

• Poor workmanship is still paid for.

1.8 Cost Plus a Percentage Fee

Using cost plus a percentage fee has advantages and disadvantages that are much the same as those mentioned in the preceding text with the fee based on the cost of construction.

1.9 Start Cost Reimbursable with Later Conversion to Lump Sum

One of the main reasons for using a cost reimbursable format is the absence of design engineering at the time of bid. However, if this is obtainable during the progress of the project, the contract may be converted to lump sum if agreed by both parties (or guaranteed maximum or target price and the like). Conditions will have been drawn up previously with the possibility of conversion in mind.

Conversion of a contract requires that the contractor shall quote alternative terms for undertaking the work so that the client has the option of accepting these terms or continuing on the reimbursable basis. Conversion of a contract may, of course, be negotiated at any time provided the project is sufficiently defined by then. If the possibility of conversion is foreseen at the original inquiry stage, it is desirable to provide for it in some special conditions spelling out, inter alia, the nature of the alternative tender(s) required and the performance delivery and cost responsibilities that would apply.

1.10 Provisional Contract Price Agreement

Given circumstances where a lump sum contract would be unsuitable and a cost-reimbursable arrangement would be unacceptable, there is a device that would suit most requirements and would result in a fair deal to client and contractor. This is the provisional contract price agreement and it works as follows:

(a) Bidders will indicate their fixed costs at a cost as described in the following text. Because of the possibility of front-end loading with finance charges (in situations where the successful contractor would be obliged to lay out a considerable sum of money before its first progress invoice is submitted), a proportion of the fixed costs is paid at the beginning of the contract and in monthly increments thereafter.

(b) Quantities relating to each unit price line item are estimated (by the client) and bidders will quote on these including profit. The total, when added to the fixed costs, is known as the provisional contract price.

(c) Substantial additions or deletions to the work over the life of the contract would actuate a sliding scale that allows for a reduction in the total unit price and an increase in the fixed costs or vice versa.

(d) The logic behind this arrangement is simple and fair to both the client and contractor. It is based on the premise that the award to the contractor of extra work of the same nature and using only limited extra labor and equipment should result in lower unit price cost, but possibly increased fixed costs. For example, in a contract involving the installation of one mile of pipe in a trench, the client instructs the contractor to lay an extra 500 yards of pipe and excavate accordingly. The contractor will use approximately the same amount of men and equipment and it would be reasonable to expect that the contract unit rate should be reduced. It would also be reasonable to allow the contractor more money for its fixed costs in view of the extra time involved in keeping its organization mobilized, and so forth.

(e) In the provisional contract price arrangement, the bidders are asked to quote on a sliding scale the relevant increases or decreases in prices for more or less work awarded during the progress of the contract. At the end of the contract the final amount to be paid or deducted is calculated by application of the sliding scale (see the following example).