Construction Briefing: Risk Allocation

ALLOCATING EACH RISK TO THE PARTY BEST ABLE TO HANDLE THE RISK

CPR Introduction


This Briefing presents Risk Allocation concepts to companies and their advisers who draft risk allocation provisions for construction contracts. Companies outside the construction arena, involved in long-term contractual arrangements prone to conflict, may also find this Briefing useful. They may be able to adapt these concepts to their own needs as they refine their conflict management processes.

CPR has continually fostered use of cost-effective resolution devices such as mediation. It has also maintained a focus on conflict management systems that push problem solving up to the earliest possible time in the life of a dispute or a potential dispute. Such systems include conflict prevention mechanisms and conflict control devices that promote collaboration between business partners so they can solve problems early and avoid more costly end-point conflict resolution processes.

The Risk Allocation concepts described in this Briefing have been shown to be effective conflict prevention approaches in construction matters. In other complex contractual arrangements, realistic assessment of risks and allocation of responsibility consistent with control over risks should be the first step and the foundation stone in an effective dispute prevention and resolution system.

The following complementary charts, showing dispute resolution steps and construction contract options, demonstrate how Realistic Risk Allocation fits into a system of superior conflict management that starts with prevention and ends with efficient conflict resolution devices. They provide a guide for the construction sector and should prove useful in other industries.

Dispute Resolution Stages and Steps Chart (see above to download chart)

Construction Contract Options

To effectively prevent and manage disputes, contracting parties should consider selecting and using at least one process from each of the following multi-step conflict management categories. When entering into contracts, parties can agree to use initial collaboration and preventive practices, to be followed by one or more efficient on-site conflict management techniques such as Step Negotiations, DRBs or Standing Neutrals, before resorting to costlier external non-binding or binding processes.

Contract for Dispute Prevention

•   Equitable Risk Allocation Provisions (See CPR’s Realistic Risk Allocation Briefing)
•   Incentive Agreements for Cooperation
•   Disputes Potential Index (Created by the Construction Industry Institute)
•   Partnering (See CPR’s Partnering Briefing)

Contract for Early Non-Binding In-Project Processes to Control Disputes
Additional contract terms allow early in-project nonbinding intervention appropriate to the particular project and can enhance ability to solve problems efficiently:

•   Negotiation
•   Multistep Negotiation
•   Single Standing Neutral or Dispute Review Board (See CPR’s Dispute Review Board and Standing Neutral Briefing)
•   Initial Decision-Maker (See AIA Forms, 2007) or Project Neutral (See Consensus.DOCS Forms, 2007)
•   Dispute Review Board
•   Alternatively, in special situations the Standing Neutral could be a Standing Arbitrator or Standing Mediator
•   Arbitrator or Standing Mediator; or the parties could name a dispute specialist to recommend processes when disputes arise
Contract for External Non-Binding
Resolution Processes


Contract provisions can incorporate external non-binding processes if in-project intervention fails, such as:
•   Mediation
•   Early Neutral Evaluation
•   Expert Nonbinding Evaluation
•   Mini-Trial
•   Advisory Arbitration (Non-binding)
Each of these can loop back to negotiation
Contract for External Binding
Resolution Processes


Binding processes are available if in-project intervention or external nonbinding processes fail:
•   Private Judge
•   Arbitration or
•   Litigation

Before final decision, each of these can loop back to negotiation

Construction Fact Sheet

A.   Facts about Construction, from a 2009 National Research Council Study2  

Yearly U.S. construction
Yearly worldwide construction
Value of U.S. construction as % of GDP
Percentage of U.S. workforce employed
Estimated yearly transactional costs of disputes                                
$1.16 Trillion
$4.6 Trillion
10%
8%
$4 Billion to $11 Billion


B.   Mean Transaction Costs of Negotiation, Mediation & Arbitration3 

In his 2006 Ph.D thesis researcher Richard J. Gebken reported on a study of the direct and indirect transactional costs required to resolve disputes on 44 projects involving 57 contracting organizations. The dispute resolution methods used to resolve those disputes were Negotiation, Mediation, and Arbitration. He found that the relative mean transaction costs of resolving disputes through these three methods were:

Negotiation Cost Mean in 18 projects:
Mediation Cost Mean in 15 projects:
Arbitration Costs Mean in 11 projects:                                        
$330,199
$1,212,433
$1,167,182

While Gebken found that the stand-alone processes of Arbitration and Mediation differed only slightly in costs, Negotiation costs were 75% less costs of Mediation. He attributed the relatively higher costs of Mediation in large part to the fact that the mediations of the disputes that were resolved by that method occurred late in the dispute resolution process, and involved prolonged discovery and depositions.

C.   Percentage of Various Transaction Costs for Resolving Disputes via Negotiation, Mediation & Arbitration4

During the course of analyzing the sources of transactional costs incurred in the three methods of dispute resolution that he studied, Mr. Gebken found that as the hostility of dispute resolution increased from Negotiation to Arbitration (see page 1, above), outside counsel fees increased. He also found that expenditures for Negotiation involved substantial in-house costs.

Transactional Costs in
Construction Disputes               
Aggregate Costs
of Arbitration,
Mediation
& Negotiation5                     
 Only
Arbitration
Costs6                   
 Only
Mediation
Costs7                
 Only
Negotiation
Costs8                 
 Outside Counsel  61%  75%  58%  40%
 Management & Staff  16%  8%  8%  41%
 Consultants/Expert Witnesses  11%  6%  6%  10%
 In-House Counsel  5%  3%  3%  6%
 Forum Fees  3%  8%  8%  1%
 Other Costs  4%  8%  0%  2%

Realistic Allocation of Risk:  The First Step in Dispute Prevention

What Is Realistic Allocation of Risk?

Realistic allocation of risks is a management best practice when negotiating construction contracts and is the foundation for prevention of problems and disputes. It complements, but should precede, other dispute prevention devices such as partnering and standing neutrals.

Risks are inherent in any commercial activity, so businesses need to identify, understand, anticipate, assess, analyze, and learn to manage risks. An important part of the risk management and planning process in any business transaction or project is the allocation of risks among the parties. Wise decisions about allocation of risks improve efficiency, reduce costs, reduce the potential for disputes, and promote project goals.

Starting with the 1979 landmark industry conference on “Construction Risks and Liability Sharing,” (American Society of Civil Engineers, Construction Risks and Liability Sharing, volume II at 2 (1980)), the construction industry has recognized the basic principles of risk allocation, which are:  

•   Risks belong with those parties who are best able to evaluate, control, bear the cost, and benefit from, the assumption of risks.

•   Every risk has an associated and unavoidable cost which must be assumed somewhere in the process.

•   Many risks and liabilities are best shared.

Further studies into risk allocation conducted by the Construction Industry Institute have concluded that:

•    The ideal, or most cost effective, contract is the one that assigns each risk to the party best equipped to manage and minimize that risk, recognizing the unique circumstances of the project.

•   Each project should be assessed individually to determine, for each risk, the allocation considerations that will ultimately reduce the project’s total cost of risk.
(Impact of Various Construction Contract Types and Clauses on Project Performance 6, Construction Industry Institute (1986)).

These principles are well-documented and are widely accepted in the industry.

Many different adjectives have been used to define the nature and quality of the kind of risk allocation that achieves maximum economic efficiency. Some of the adjectives that have been used are “ideal,” optimum,” “wise,” “smart,” “balanced,” “appropriate,” “reasonable,” “sensible,” “equitable,” and “fair.” However, these terms have been criticized as being either too vague, too subjective, too judgmental, or too weak in a competitive business world.

We have come to the conclusion that the most accurate adjective to use is the word “realistic,” because the true test of the quality of risk allocation provisions is the relationship they bear to the realities of the particular construction project and their impact on maintaining a productive working relationship among the relevant parties.

Why Should Risks Be Allocated Realistically?

Cost, Efficiency, and Dispute Control Benefits of Realistic Risk Allocation

Numerous construction industry studies have shown that realistic allocation of risks between parties involved in a construction project will improve efficiency, promote a much more positive working relationship between the parties, and reduce the overall cost of the project. The result in nearly all cases will be fewer disputes and a greater chance for project success.

Construction projects and their participants will benefit significantly from routinely taking a systematic, structured approach to risk allocation. It is axiomatic that realistic risk allocation should result in fewer misunderstandings and unfulfilled expectations, less acrimony, and therefore less time and money spent dealing with attempts to mitigate the adverse consequences of unanticipated risks. The end result is that many disputes will be avoided and others will be susceptible to resolution at the site. On the other hand, no form of alternative dispute resolution can overcome a fundamentally flawed allocation of risk.

It has been estimated that better contracting practices, of which risk identification and allocation are major components, can result in a 5% savings in the project’s total cost. Construction Risk Allocation and Cost-Effectiveness, Construction Industry Institute Publication 5-1 (1986). More recent survey data from the Construction Industry Institute suggests that inappropriate allocation of risk results in at least a 3% contingency or risk premium in bids. Equitable Risk Allocation, Research Summary 210-1, Construction Industry Institute Research Team on Contracting to Appropriately Allocate Risk (2006). These increased costs can be saved by observing the principles of realistic risk allocation.

Dynamics and Impacts of Unrealistic Risk Allocation

Fixing the cost of the project at the outset and avoiding “surprises” has become an overriding objective of many owners and their lenders. Pursuit of these objectives has caused many owners to use their superior bargaining power to attempt to shift risks unrealistically to others (notably contractors and design professionals), without considering the potential consequences.

Owners’ lawyers have sometimes unwittingly supported these objectives, without advising their clients of the potential adverse consequences that arise from misallocation of risks.

For better or worse, many contractors who are eager for new business, when dealing with owners whose contract terms are presented on a “take it or leave it” basis, are tempted to enter into contracts containing provisions which they and most fair-minded and objective persons would consider unrealistic and inequitable. However, contract documents with inappropriate allocations of risks send bidders the message that the owner does not honor accepted realistic risk allocation principles. This has been shown to cause bidders to include substantial risk contingency premiums in their bids, thus escalating all bids. Clauses which misallocate risks create an adversarial relationship on the project from the very start. Moreover, the owner who believes that it has successfully laid off to others risks which the owner should assume has less incentive to effectively manage the project. The resulting vacuum of project management has an adverse effect on the project.

As the parties build fences rather than bridges, the likelihood of legal conflict is greatly increased. In order to level the playing field contractors have sought increased legal assistance to pursue creative legal measures to recover what they thought were legitimate costs. They not only expand or develop new and imaginatively conceived tort theories, but also use more traditional contract theories of recovery. They also are tempted to disregard the risk-shifting provisions and to litigate with the owner or to sue other parties in the construction process for costs flowing from breach of duties under a tort or third party beneficiary theory.

When a risk materializes, the party that had shifted the risk hardens its position in an effort to retain what it perceives to be its contractually bargained-for right to have the other party bear the risk. The party to whom the risk was shifted, on the other hand, seeks ways to avoid bearing the consequences of misallocated risk.

Ironically, when those carefully drafted contract provisions are tested in arbitration or litigation they may not actually achieve the result envisioned by the contract drafter. For example, onerous site conditions clauses requiring contractors to assume risk for unforeseeable conditions and “no-damage-for-delay” clauses may not be enforced when the arbitrator or court considers that conditions are beyond the contemplation of the parties. Similarly, clauses that seek to require the contractor to assume liability for the owner’s negligence are likely to be strictly construed and may be held void as against public policy. Moreover, juries are prone to release a contractor or subcontractor from a bargain that the jury considers grossly inequitable, particularly if inequality in bargaining power is perceived. Even arbitrators and judges are influenced by the same considerations.

The likely result of such unrealistic risk shifting is project trouble, if not failure.

Studies conducted by organizations interested in major construction, such as The Business Roundtable and the Construction Industry Institute (CII) (Contract Risk Allocation and Cost Effectiveness, Construction Industry Institute Publication 5-3 (1988)) have confirmed that the imposition of onerous contract conditions is not cost-effective because:

•   it reduces contractor competition,
•   it increases bid prices due to increased contractor contingencies,
•   it causes a high-quality contractor to be replaced by a lesser-quality contractor who is more likely to unknowingly accept grossly inequitable
     risk allocation,
•   it creates an adversarial owner-contractor relationship,
•   it is more likely to increase requests for change orders and claims for extra compensation, and
•   it increases the likelihood of disputes.

Disputes reduce efficiency, divert management resources, and incur the substantial transaction costs of hiring consultants and lawyers. The combination of these factors has an adverse impact on the project in terms of final product cost, quality, reputation, public relations, and ultimate project outcome.

In short, misallocation of risks is not cost effective. It is contrary to the interests of the party with superior bargaining power who dictates the misallocation of risk and to the success of the project or business enterprise. The conclusion is inescapable: imposing risks on contractors when they cannot manage or control them is a primary cause of construction disputes.

Examples of Major Risks that Are Sometimes Misallocated

A recent study by a CII Research Team (Contracting to Appropriately Allocate Risk, Construction Industry Institute Research Report 210-11 (2007)), identified a number of “hot-button” contract provisions that are most frequently allocated in an unrealistic and inappropriate manner. Following are some of the most troublesome examples:

Differing Site Conditions

Information such as subsurface data is commonly furnished to bidders. The contractor normally expects to assert a claim for extra compensation if actual conditions differ and cause additional expense. However, some owners seek to require the contractor to assume the risk of all differing site conditions in the contract.

If the existing site conditions are materially different from those that are indicated in the contract documents or from those expected by the contracting parties, the costs of performing the work, as well as costs of delays and mitigation efforts, can increase materially, and at an alarming rate. If the risk of differing site conditions is not adequately covered in the contract, the contractor may dramatically increase its contingency to account for the risk. The realistic way to allocate this risk is to have a differing site conditions clause which clearly and appropriately allocates the risk of encountering such conditions.

Force Majeure

Often contracting parties will rely on insurance companies to provide protection from force majeure (“Acts of God) events. However, the potential for insurance company insolvency in the case of a force majeure event – such as the catastrophic damage to the U.S. Gulf Coast in August-September 2005 from Hurricanes Katrina and Rita -- makes it even more important that the contract documents clearly address the risk factors surrounding force majeure events. Force majeure events should be clearly and unambiguously defined, along with the allowable compensation, in order to eliminate the risk for potential disputes.

No Damages for Delay

Contractors typically base their bids on the assumption that they will have full access to the site and that the owner will not interfere with the contractor’s work schedule. Delay in completion of the contractor’s work can cause substantial additional cost to the contractor. When delay is caused by the owner or other contractors hired by the owner, the contractor normally expects reimbursement of such additional costs. Some owners attempt to include contract clauses that severely limit or exclude recovery of damages for owner-caused delays, called “no damages for delay” clauses. Exacerbating the problem, the primary contractor also may attempt to shift the risk of contractor-caused delay damages onto lower-tier sub-contracted parties with similar clauses. As a result, lower-tier parties may be forced to assume the majority of the financial responsibility for all delays on a project. Few subcontractors can survive the likely consequences if a project were severely delayed. The U.S. judicial system has frowned upon the inclusion of “no damages for delay” clauses since such clauses attempt to shift the responsibility for wrong- doings from the higher-tier to lower-tier parties.

Consequential Damages

Many construction projects have the potential to produce high indirect or special damages, commonly referred to as consequential damages, which are frequently associated with delay. Consequential damages for an owner include loss of business reputation, loss of revenue, and loss of beneficial occupancy that can arise from delay. Consequential damages for a contractor include loss of business reputation, loss of potential business, and loss of advantageous weather conditions in which to perform construction work. Many owners feel that contractors have a low incentive to perform in a timely manner if the contract waives the owner’s right to its consequential damages. In contrast, many contractors feel that it is inequitable for owners to attempt to hold the contractor responsible for consequential damages that could reach excessive amounts and drive the contractor out of business.

Indemnification of the Owner

Since the contractor is in control of the project site and responsible for job site safety, it is reasonable to expect the contractor to indemnify the owner against claims of personal injury at the job site by employees of the contractor and its subcontractors, without regard to fault on the part of the owner. However, many indemnification clauses now require the contractor to hold the owner harmless against all third party claims, including injuries and property damage to third parties caused in whole or in part by the owner’s negligence over which the contractor has no control. In these cases, even if the owner is 100 percent responsible for the damaging event, the contractor could be forced to indemnify the owner.  

In some states, indemnification clauses are not legally enforceable due to “anti-indemnification” statutes. Elsewhere, contractors try to avoid indemnification clauses that provide full indemnification for the owner without qualification. Some owners feel that indemnification clauses that provide mutual, comparative indemnification for both contractors and owners are unfair to owners since there is a higher likelihood that a contractor employee will be injured than an owner employee. Owners know that if a contractor employee is injured, the contractor’s responsibility is usually limited by worker’s compensation statutes. So, even if the owner is responsible for only part of the injuring event, it may end up paying for the majority of the loss.

Due to the potential for personal injury lawsuits to reach millions of dollars, it is imperative that indemnity clauses are equitably and cooperatively drafted.

Ambiguous Criteria for Acceptance of Work

If a contract contains ambiguous acceptance criteria (especially troubling in design-build and process-oriented contracts), costs can increase quickly. Frequently, acceptance criteria may include phrases that specify that the work be completed so that it is “fit for the purpose” or “to the owner’s satisfaction.” This can lead to a situation where the contractor may feel that it has achieved the acceptance criteria, but the owner views the contractor’s performance as falling well short of acceptance. Some contractors feel that ambiguously defined acceptance criteria can lead to the owner using the punch list as a “catch-all” to modify or fine-tune the design to make it “acceptable.” All parties will benefit when the acceptance criteria avoid qualitative statements and contain measurable, quantitative criteria.

New or Unfamiliar Technology

With new or unfamiliar technology, it is important that the risk of its performance is appropriately allocated in the event of failure. Contractors do not want to take on responsibility for owner-specified technology that the contractor has never before encountered. However, when the contractor chooses to employ new technology in its means and methods, the contractor should retain the associated risks. Although it may seem clear which party should take the responsibility for new or unfamiliar technology, contracts often do not clearly specify how this risk should be allocated. As technology in the construction industry advances, it will become increasingly important that the functionality risk of new technology is properly allocated.

Schedule Acceleration

Accelerating the schedule can quickly increase costs. Contractors feel that clauses that allow the owner to mandate acceleration at any time without providing relief from resulting indirect costs due to lost productivity are inappropriate. Owners feel that there should be a limitation on the indirect costs that contractors are allowed in case of acceleration. Ultimately, many projects have fixed end dates. It is important that compensation for mandated, constructive, and recovery acceleration costs are appropriately specified up front in the contract documents since there is a high likelihood that acceleration efforts will be required on many projects.

Suggested Methodology for Systematically Addressing Risk Allocation

During the course of negotiating and drafting a construction contract, good practice would be to address risks in the following logical categories:

•   Risks of availability of resources and project pre-requisites that are fundamental to the viability of the project.

•   Risks arising out of the performance of participants in the project.

•   Risks that arise from influences and sources outside the project participants.

The following three tables identify and allocate some of the more commonly-experienced risks in these categories.

Table A:  Allocating Resource and Project Pre-requisite Risks

Risk    To whom allocated & why   How allocated/mitigated    
Adequacy of Project Funding         Owner—it’s the owner’s project                      Include contract language giving the 
contractor the right to confirm
availability of funds
 Adequacy of Labor Force Contractor—can best assess at
time of bidding
Owner should consider known labor
shortage in a particular trade (e.g.,
ironworkers) in making decisions on
alternate materials; owner should
consider projected surplus/ shortage
in determining project performance time
Permits and Licenses Shared—both parties have some
ability to control
Owner should identify all
requirements to extent possible;
contractor has some lead role in
compliance
 Site Access Owner—it’s the owner’s site Owner should identify requirements
early and then delineate site
availability/ constraints in bidding
documents                                                              


Table B:  Allocating Performance Related Risks

Risk  To whom allocated &why   How allocated/mitigated
Inadequate Plans Owner—funds design Retain a qualified design
professional; fund adequate design effort
Underestimation of Costs Contractor—controllable Use a competent estimating staff
Owner-furnished Material
and Equipment
Owner—elects to use this method Preplan for purchases, expediting;
include contractual remedies for
quality or delay problems
Contractor-furnished Material
and Equipment
Contractor—typical scenario Preplan for purchases, expediting;
use remedies from vendors
Means and Methods of Construction               Contractor—area of expertise Use/follow “standard” language
Delay in Presenting Problems Claiming party—controls ability to
give notice
Use/follow/enforce notice provisions
Delay in Addressing and
Solving Problems
Party receiving claim—has
obligation to respond
Delegate decision-making authority;
empowerment
Subsurface Conditions Owner—owns site Use a differing site conditions clause;
eliminate disclaimers on geotechnical data
Worker and Site Safety Contractor—controls means/methods                Use clear contract language assigning
responsibility


Table C:  Allocating Outside Influence-Type Risks

 Risk To whom allocated & why  How allocated/mitigated 
Governmental Acts             &nb
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