Like any other business, the construction industry is prone to a number of risks that may affect the viability of a Project. However, the construction industry is a capital-intensive industry wherein materialization of even a small risk can cause substantial delay and financial losses with respect to the completion of a Project. Therefore, risk management assumes immense importance in the construction sector.
Practically, risk management can be done in two ways. In the first instance, it can be done by suitably tailoring the contract to provide for all future contingencies. However, it has been seen that the parties to a contract cannot possibly foresee all future risks and hence, there may be some gaps in the contract. Therefore, in absence of such gaps, the legal principles of contract law and the contemporary jurisprudence of the applicable legal system come into the picture.
In light of the aforementioned background, it is surprising to see that though risk management is a significant part of the construction industry, little attention has been paid to analyze the contemporary legal position in India regarding the same. Therefore, in light of this research gap, this article aims to analyze various risks that are usually prevalent in a construction contract. Next, this paper analyzes contemporary case law and comments on the risk management jurisprudence prevalent in Indian law. Finally, this paper comments on the suitability of the current risk management strategies and the possible solutions to overcome the same.
Understanding Risk and Risk Allocation in Construction Contract
The term “risk” is seldom defined in a contract. This usually implies that risk is to be understood in the ordinary sense. Therefore, in the construction industry, risk can mean any contingent event that can have an adverse impact on the viability and duration of a Project. Therefore, risk can range anywhere from lack of adequate machinery, delay in payment, etc. to force majeure situations leading to premature termination of the Project.
To attribute the loss arising consequent to materialization of risk, the risk is tied up to the concept of obligation or responsibility. In other words, the management of risk is left to be borne by the Party who is under the obligation of completing the most closely associated task with that risk. This leads to two broad categories of risk allocation namely, Contractor borne risks and Employer borne risks. These are discussed below:
a. Contractor borne risks: In a simple construction contract, a contractor is required to build a specific road, building, etc. on the instructions of the Employer. Naturally, the Contractor requires labour and machinery to complete its task. Therefore, all risks associated with the shortage of manpower and machinery are allocated to the Contractor. This implies that in the event there is a shortage of manpower, even if it is without the fault of the Contractor, the Contractor would be liable for all damages arising out of such manpower simply because it was the Contractor’s responsibility to manage such risk and provide for the adequate workforce. The Supreme Court in the case ofEnergy Watchdog v. CERC has recognized the concept of risk allocation as prevalent in England and held that the Contractor cannot raise the plea of frustration when there is an increase in the rate of inputs.
b. Employer borne risks: Usual obligations of the Employer include timely payments to the Contractor, provision of encumbrance-free site, etc. Therefore, at times it may happen that the site may be caught up in some unmeritorious litigation, etc. However, in such a case, the employer is held liable for damage arising out of delay in handover of the site as the responsibility to provide an encumbrance-free site was attributable to the Employer.
Apart from the aforementioned categories of risk, another popular categorization of risks is force majeure risks. These risks pertain to extraordinary events that are undoubtedly beyond the control of the Parties. These events are so uncertain in nature that no party is presumed to have accepted the risk of such events. These include natural disasters, war-like situations, and most recently COVID-19. Force majeure clauses usually provide for a temporary suspension of contract or premature termination of contract depending upon the severity of the Force Majeure event. Moreover, these clauses usually provide that the Parties bear the losses arising out of non-fulfilment of reciprocal responsibilities and neither Party can claim any consequential or special losses from each other. In this respect, it is noteworthy to mention here that the Hon’ble Supreme Court in the case ofSouth East Asia Marine Engineering and Constructions Limited v. Oil India Limited has interpreted the concept of risk allocation arising from a force majeure clause. In this case, the court held that though the parties do not have any control over the occurrence of the force majeure event, it is perfectly valid that the parties agree upon the consequences flowing from a force majeure event under Sec. 32 of the Indian Contract Act, 1872. In light of this ruling, the Court upheld the validity of payment of a force majeure rate to the Contractor that was less than the agreed contract rate.
Finally, the last but the most controversial category of risks are called residual risks or third-party risks. By their very definition, any risk that does not fit into the aforementioned categories falls into this category. Therefore, these risks can neither be attributed to the Parties nor can they be raised to the extraordinary risk status of a Force Majeure event. These risks include abnormally high rainfall, encroachment by local villagers etc. It is noteworthy to mention here that these risks normally represent the ambiguities of risk management in the contract. Therefore, the next section of this paper would analyze the current jurisprudence and techniques for managing these risks.
Attribution of Residual Risks
There are a number of contractual and legal tools to attribute and manage the losses arising consequent to the materialization of residual risks. These are discussed below:
a. Liquidated Damages and Risk Purchase Costs: Liquidated damages are referred to the predetermined measure of damages, which are to be paid upon the breach of the contract by the parties. These damages are covered under the ambit of Section 74 of the Indian Contract Act, 1872. These clauses are effective in the nature of risk purchase costs. To illustrate the concept of risk purchase costs, assume that in a concession agreement for toll collection on a highway, there is low traffic which is a business risk that the Contractor bears. Owing to this shortfall in traffic, the Contractor is unable to pay the concession fee to the Employer. Moreover, let’s assume that this results in a loss of Rs. 1,000 crores. Now, assume that there is a clause for liquidated damages for a maximum of 500 crores. Now, once this amount of 500 crores is paid to the Employer, the Contractor is out of the picture and the Employer has effectively ‘purchased’ Contractor’s risks of (-) Rs. 1000 crore by receiving a sum of (+) Rs. 500 crores. Thus, there is a loss of Rs. 500 crores to the Employer. Another way to see this is that the actual Rs. 1,000 crore losses got apportioned between the Contractor and the Employer equally.
In this regard, the courts have literally interpreted liquidated damages clauses to carve out agreed-upon events for which risk purchase in the form of liquidated damages was stipulated. For instance, the Supreme Court in the case ofSteel Authority v. Gupta Brothers, has recognized situations where a contract does not expressly stipulate for all forms of risks. In the present case, the Court held the liquidated damages clause only applied in case of “reasons beyond the control” of the Contractor and not in cases of wilful refusal to give delivery of goods. In such circumstances, the Contractor would have to bear the losses out of a risk for which there is no liquidated damages clause. Therefore, liquidated damages are important components of risk allocation in the form of risk purchase in a construction contract.
b. Use of risk clauses: Some contracts may contain risk clauses that specify that all residual risks which are not expressly dealt with within the Contract are attributable to one party (usually the Contractor).
c. Rule of Contra Proferentem: Most construction contracts in the Indian construction industry are in the form of pre-drafted tenders that are drafted by the Employer and hence, they are usually standard forms of contracts. In this respect, the rule of contra proferentem says that every ambiguity in the contract has to be interpreted against the maker of thecontract. Therefore, it is possible that the Contractor may invoke the rule of contra proferentem to argue that all residual risks are to be borne by the Employer in the absence of a risk clause.
d. Limitation of Liability Clauses: As a corollary to the rule of contra Proferentem, the contract may contain a limitation of liability clause. These clauses effectively create a ceiling on the liability of the Employer arising out of residual risks. Thus, an Employer may choose to limit his liability to 10 crores or a certain percentage of contract value like 10%. This effectively transfers the majority of Employer risks to the Contractor.
Limitation of liability clauses is deemed to be valid in Indian law provided that they conform with the requirements of the relevant legislation. This has been highlighted by the Delhi High Court in the case ofSurya Pharmaceuticals Ltd v. Air India Limited. Therefore, if the limitation of liability clause does not comply with any provisions of the relevant statute, it can be deemed to be void and unenforceable, and the provisions of the statute shall prevail no matter what.
When it specifically comes to construction contracts, the Supreme Court in the case ofBharathi Knitting Company v. DHL Worldwide Express Courier Division of Airfreight has highlighted that the limitation of liability is completely dependent on the facts of the case, along with the terms of the contract, as agreed between the parties. Therefore, if the terms of the contract exclude the liability for any consequential or special damage, or any indirect loss or damage, then the same shall be applicable upon the parties, considering that they have contractually agreed to such terms.
Currently, the jurisprudence related to the limitation of liability in construction contracts can be understood through the case ofSimplex Infrastructure v. Siemens Limited decided by the Bombay High Court. In this case, the petitioner and the respondent had entered into a works contract with an initial contract price of almost Rs. 146 crores. The petitioner had to complete the works in accordance with the schedule of the Specific Milestone for Main Civil Works (MCW). However, considering the extreme delays and repeated amendments in the project scope, the respondent asked the petitioner to engage additional resources in the project and promised additional payments in relation to them. The parties made three amendments to the contract and the work was eventually completed, with an increased contract price of Rs. 216 crores. However, once the work was completed, the respondent, through the encashment of the Bank Guarantees, took back the additional compensations that had been promised and paid in terms of the amendment agreement. The petitioner, therefore, sought to injunct the respondent from the encashment of the bank guarantees. Now, the contract between the petitioner and the respondent also contained a limitation of liability clause, which excluded the petitioner’s liability for specific losses, inclusive of the loss of production, loss of profit, and any indirect or consequential damage, along with capping the petitioner’s liability for all losses, damages, or claims arising out of the contract. The clause further contained an exception stating that it would not be applicable to any damage or loss or claims which are caused with intentional or wilful misconduct of the petitioner. In this respect, though the Court held that the instant case fell within the ambit of the exception, the court also commented upon the applicability of limitation of liability clauses. what happens in a situation where no such exception exists in the limitation of liability clause. The court observed that:
“… no unascertained amount of damages can be claimed beyond the scope of the contract when the contract restricted the claim for damages to the liquidated damages stipulated therein.”
Therefore, this case provides an example of how it is important to consider the scope of the clause, along with the exceptions highlighted. The applicability and enforceability of the limitation of liability clause are completely dependent on the terms of the contract along with the facts of the case.
e. Ex-ante agreement as a formula for calculation of delay damages: Various formulas exist for the calculation of damages arising out of delay such as Hudson’s formula, Emden formula, etc. The Supreme Court inMcDermott International Inc. v. Burn Standard Co. Ltd. has held that the suitability of a particular formula needs to be analyzed on a case-to-case basis. In this respect, it has been suggested that the Parties may agree upon the appropriate formula at the stage of drafting of the contract itself. However, in the authors’ practical experience, such a solution is rarely implemented in the Indian construction industry.
f. Deemed Knowledge Rule: This rule is usually invoked with respect to defects in the Project site. As per this rule, when a tender is issued, the potential bidder is obligated to visit the Project site and have knowledge of all problems at the Site. Consequently, the contract imposes a presumption that the Contractor has agreed to accept the site on “as is where is basis”. This rule is based upon the exception to19 of the Contract Act. The problem that arises with this rule is that sometimes certain defects are discovered only after the Site is excavated and hence, no party could have discovered the defects with ordinary prudence. Therefore, the question arises as to who would bear the loss arising out of such a risk. In this respect, two approaches are possible. On one hand, there may be some obstacles which are existent at the site and the Employer is not aware of the same. In such a case, the deemed knowledge rule may be interpreted in favour of the Employer and against the Contractor. However, Indian courts have strictly interpreted these clauses and usually awarded damages in favour of the Contractor. This is because the Indian courts have read in the concept of misrepresentation in such cases. In other words, the Employer cannot disclaim liability arising out of a risk by giving incomplete and inadequate information to the Contractor and expect him to re-inspect the site.
g. Prescriptive safety standards, bank guarantees, etc: This is a device employed by the Employer to transfer most of the immediate liability on the Contractor in case residual risks materialize. For instance, it is a common sight to see that once the dispute becomes imminent, the Employer at the first instance encashes bank guarantee to deal with any possible liability arising out of materialization of a risk. For instance, today COVID-19 has become an obvious and frequently invoked force majeure event. However, the question arises as to who would bear losses pertaining to circumstances that led to a COVID-19 lockdown. In other words, even prior to the lockdown there was an economic slowdown, etc. Obviously, in such circumstances, the Force Majeure clause would not apply but the attribution of losses may not be clear until properly adjudicated. On the other hand, various immediate demands start coming once such a situation crops up. Therefore, by encashing bank guarantees, the Employer de facto transfers the risk to the Contractor even though it may be ultimately held that both the Parties were to share the risks equally.
h. Apportionment of liability: It has been opined that in situations like Change of law, the resulting liability is apportioned between the Employer and theContractor. This means that the liability is sub-divided between the Employer and the Contractor depending on the circumstances experienced.
i. Termination for Convenience: Termination for Convenience Clauses are inserted with an aim to allow either of the contracting parties to evade or discontinue their contractual obligations, based on the conditionalities stipulated within the contract. Understandably, the operation of such clauses is capable of having serious ramifications for the party against whom such a clause is invoked.
In respect of construction contracts, Indian courts have upheld termination for convenience clauses provided that all prerequisites like prior notice, etc. are duly fulfilled by the party invoking such clauses. One aspect that needs to be noted here is that such clauses do not exonerate the invoking party’s liability to pay damages resulting from its default/materialization of risk. The intent behind these clauses is to provide an easy exit route from a non-viable contract when an ‘inconvenience’ creeps in. For instance, in Indian law financial non-viability is not a valid ground to terminate the contract but the parties may provide for termination for convenience clause to exit an unviable contract with minimal losses.
The above section has shown that contractually the Employer has a lot of leeways to transfer most of the residual risks to the Contractors. On the other hand, Indian courts have come in aid of the Contractor by strictly interpreting residual risk clauses. Nevertheless, in any event, huge losses are incurred by both Employer and the Contractor due to improper and inadequate risk allocation. The next section of this paper would comment on some techniques and principles that may be used for proper risk allocation.
Conclusion and Recommendations
It has been opined that risk is not being managed by the Party who is best suitable tomanage it and there is a tendency to pass on most risks to the Contractor. Considering this observation, critics have proposed the enactment of specific infrastructure laws that may regulate infrastructure contracts. However, as per the authors’ opinion, this is not a reasonable solution. In this respect, the Supreme Court in the case ofCentral Inland Water Transport Corporation v. Brojo Nath Ganguly has held that an imbalance of bargaining power between the parties is an essential part of any commercial transaction. Therefore, regulating contracts through special statutes would go against the very nature of a commercial transaction.
On the other hand, it is undeniable that the above analysis has shown that there is no clarity by the Indian courts while interpreting risk allocation and related concepts in absence of a well-drafted construction contract (which is usually the case). Due to this lack of clarity, the current jurisprudence on risk allocation has been confusing and hence requires adequate measures right at the stage of contract drafting to inculcate more clarity in their interpretations. Therefore, to ensure better risk allocation, the authors’ propose the following suggestions:
1. Fair and Equitable allocation of risk:Shapiro has opined that ‘proper risk identification and equitable distribution of risk is the essential ingredient to increasing the effective, timely and efficient design and construction of projects.’ This is because the improper allocation of risks results in delay and disputes that lead to a huge waste of time and money. Furthermore, these losses increase manifold in complex projects where third-party entities like lenders, sub-contractors are also involved. Therefore, it would be in the interest of the Employer to draft a balanced contract that takes into account past learnings to reduce time and overall project cost.
2. Definition of risk: It has been seen that the term risk is usually not defined in contracts in India. Therefore, it would be prudent to properly describe risk and risk allocation right at the stage of the tender document to give an ex-ante clarity regardingrisk allocation.
3. An appropriate mix of special clauses: In the previous section, this paper has highlighted clauses like liquidated damages, limitation of liability, termination for convenience clause, etc. It is recommended for the Contractor and the Employer to tailor their contract and includes clauses to properly manage their risks. Some of the ways the parties can do so are by adding a supplement to the termination clause within the contract to claim liquidated damages, a clause to provide adequate refunds in case of delay or termination,etc. Similarly, limitation of liability may be drafted in light of maximum liquidated damages that can be imposed. Another way could be to divide the residual risks into force majeure events and termination of convenience clauses for proper risk allocation etc.
4. A fair interpretation of the contract: In this paper, it has been argued that risk allocation should be done in the contract itself. Subsequently, all adjudication authorities should strictly abide by the contractual stipulations and implement the agreed-upon risk allocation. InCoastal Gujarat Power Ltd. v. Gujarat Urja Vikas Nigam Ltd., it has beenopined that unnecessarily transferring producer or contractor risks to the Employer does not leave any incentive for the Contractor to reduce costs or mitigate the risk. Hence, authorities should not resort to “save the little guy” approach and interpret the contract keeping in mind the commercial nature of the industry.
5. Adoption of Appropriate Contract Management Practices: It has beenseen that many contractors in India do not know about the modern-day tools of risk management. In this respect, it is important to mention here that although large contractors and business houses have sophisticated risk management teams, small contractors need to understand these risks and adopt appropriate risk management practices to reduce the losses arising out materialization of such risks.
In conclusion, it can be stated that there is no major problem with the legal interpretation of Indian courts and arbitrators. Nevertheless, this is not a cause for celebration as Indian courts fail to appreciate the commercial intent of the parties in a commercial contract. On the other hand, Indian construction contracts need to be revisited in terms of better and smarter drafting to provide for better risk allocation which would lead to time and cost saving for all concerned parties.
About the Authors
Mr. Meenal Garg is an Associate at K.N. Legal, New Delhi.
Muskaan Aggarwal is a 3rd Year Law Student at Jindal Global University, NCR.
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Preferred Method of Citation
Meenal Garg and Muskaan Aggarwal “Critical Analysis of Allocation of Risk in Indian Construction Contracts” (28 October, 2021)
Very informative & well written Article.