Geopolitics meets the supply chain

Parties to construction projects are navigating increasingly uncertain waters caused by world events: from disruption in availability of essential materials caused by international conflicts, to a rapidly changing tariff landscape and energy price fluctuations.

How are businesses to transact in an environment where commitments are made months or years in advance, when the underlying commercials can change within days or even hours?

In this article, we discuss some of the ways in which businesses are mitigating these risks; around pricing, change in law and force majeure.

Pricing

The construction and engineering industry, particularly for projects with international supply chains, has seen an increasing move away from fixed-price, lump sum contracting in recent years. For buyers, that has led to an increasing pressure to sign a ‘blank cheque’ for its suppliers. The challenge is in finding a balance between open-ended reimbursement of costs while allowing scope for reasonable flexibility.

Indexation still tends to be very much a feature of longer-term contracts and will provide an amount of relief against increased inflation, including increased inflation arising from international conflicts. But this is of limited protection for contractors and suppliers whose exposure is around specific areas within their scope. For that reason, parties often deal with this in a more targeted way. For example, adjustment in respect of specified goods and materials by reference to changes in “market” pricing (with the onus being on the contractor to provide evidence for that change) or in respect of labour, by referring to an appropriate industry wage-fixing body such as the Construction Industry Joint Council.

In other cases, such as fuel-intensive or steel-intensive scopes, parties are often agreeing controls over this. For example, through agreement on what the procurement process for those materials or consumables will look like, again ensuring that there is a degree of transparency and competitive tension in the process.

Buyers are also increasingly committing funds early enough in the process to secure pricing at a particular level. While this reduces exposure to price fluctuation, it can also bring risks such as the supplier becoming insolvent after payment, but before delivery. These risks can be mitigated through performance security – usually in the form of an on-demand advance payment bond – as a condition to that early payment. There may be a cost associated with that, but it can be a useful hedge for buyers and developers against price uncertainty.

Change in law

Performance might not only be affected by the invisible hand of the market. Frequently (particularly in the context of geopolitical risk) they are affected by the highly visible hand of governments in the UK and abroad. For that reason, “change of law” drafting is increasingly under the microscope.

Most contracts are drafted on the basis that parties will comply with their obligations at law, whatever those are at the time parties perform them. In those cases, compliance with changes to requirements at law remains a supplier risk.

Suppliers might be willing to live with this in a short-term contract, but for longer durations parties are more likely to negotiate around sharing the time and cost implications of changes in law. This may include:

•  the imposition of tariffs – for either importers or exporters, depending on who carries the obligation to pay those tariffs;
• the application of sanctions leading to changes of subcontractor; and
•  changes to border controls affecting the movement of goods or people, as we frequently saw from Brexit.

As these changes quite often involve some prior visibility there will typically be a “foreseeability” threshold. For example, as legislation is passed, or where there is a time lag between legislation being passed and coming into force. This might include reference to what would have been foreseen by a “competent and qualified contractor”, or include specific references to laws or industry standards expected to come into force and therefore to have been priced and programmed by the contractor.

Frequently overlooked in this context is how the foreseeability test is often taken from a specified “Base Date”. If the contract price and programme was set at a tender date but parties do not proceed to contract until many months later, what is “foreseeable” by the date of execution might be very different. Parties need to be mindful in this context of agreeing not only what changes are unforeseeable, but when they are treated as having been foreseeable.

Force majeure

Very often, when world events intrude on contract performance, attention turns to the force majeure clause. However, there is no settled definition at common law of “force majeure”, with parties frequently instead agreeing what that covers. This is typically framed either by specifying qualifying criteria, such as events beyond a party’s control that could not reasonably have been foreseen, avoided or overcome, or by listing specific events (for example, war, blockades or epidemics), or a combination of the two.

Crucially, they are most frequently geared towards a party being prevented from meeting some or all of its obligations, not simply that its obligations have become more difficult, expensive or time-consuming to perform.

Particularly on international contracts, parties are increasingly focussing on the geographic coverage of force majeure drafting, which by default is often limited just to the country in which the project is located. That is increasingly out of step with international supply chains, where goods are manufactured in various locations and shipped through others still. In those cases, parties are likely to negotiate around force majeure applying to whatever geographies the contract is being performed in. Equally, however, developers and buyers are taking steps to understand and mitigate that exposure, for example by having more control over subcontractor selection, giving them the right to favour (and potentially pay the additional cost of) a supplier in a location less likely to be affected by force majeure events.

Key takeaways

Parties to construction and engineering projects, particularly with cross-border reach, recognise that the challenges created by work events are not zero-sum risks. Sophisticated developers and contractors are properly engaging on these terms in a way that allows them to proceed to contract in an inherently uncertain time, by:

• thinking about those areas where their contracts are vulnerable to world events and reviewing the drafting to make sure it will respond to those events;
• where possible for buyers, avoiding setting up payment terms as a blank cheque, considering instead whether some science can be applied to ensure there is proper rigour to the process;
• considering whether change in law protection is appropriate, and if so, whether there should be a foreseeability element (as well as the point of time that test is triggered); and
• on force majeure, considering the drafting in detail: whether it responds to the types of events we are seeing just now, and where those are happening. And for customers concerned about international supply chains, considering how to limit that exposure.

Our construction & projects team regularly advises on the drafting and negotiation of these issues for construction contracts across all sectors, and on the resolution of disputes arising from them. If you would like to discuss the issues arising from this article and the impact on your business, please get in touch with us.

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