Construction contracts and risk allocation

Introduction

The construction industry in both Canada and the United States is the single largest non-governmental employer. In 1997, the industry was estimated in Canada to have a value of about $90 billion, representing 15% of the gross domestic product. However, within the last 20 years considerable cost wastage has been identified by the Construction Industry Institute (CII, 1986). A significant portion of this cost wastage may be attributed to inappropriate risk allocation in contracts, as cited in various examples analyzing risk allocation in the construction industry and the underlying causes of disputes conducted in Canada and the U.S. (American Consulting Engineers Council (ACE) and Associated General Contractors of America (AGC), 1991; Enger, 1997; CII, 1988).

Risk is a major element in the construction industry and actually it is one of the main elements that can significantly affects the final cost of any project. The risk inherent in the construction process has grown substantially over the past 50 years due to a myriad of factors. Despite this, the process of allocating risk has not changed in the same proportion (Hartman, 2000). Risk allocation always occurs in any situation where more than one party (owner, contractor, consultant, etc.) is responsible for the execution of a project. Making sure that every risk is recognized and managed is good practice in any project. This activity is an important step in that this allocation can significantly influence the behavior of the project participants and hence impact both project performance and final cost.

Contracts and Project Risks

In any certain project, the owner's goal can best be achieved by selecting the contract type that will most effectively motivate the contractor to the desired end. This step is also dependent on completeness of information for the bidder(s) at tender time and the extent that the owner wishes to take specific risk. In this context, contract risk can be divided into performance and cost (Hartman, 2000). In this context, every contract allocates risk. Not all contracts allocate risk equitably or such that the power and authority to manage the risk is allocated along with the risk itself. Given the opportunity, an owner should favor efficient allocation of risk between parties to a project that simultaneously reduces risk and improves project performance. However, in an owner-contractor relationship at least, a common aim of owners appears to be to avoid risk as far as possible by allocating as many risks as it can to the contractor (Gransberg et al., 1997).

Risk Allocation in Contracts: Disclaimer Clauses

Any construction project involves risk and there is no possibility to completely eliminate all the risks associated with a specific project. All that can be done is to regulate the risk allocated to different parties and then to properly manage the risk. Owners tend to shift most of the project risk to another contracting party (usually the contractor) through disclaimer (exculpatory) clauses. Such clauses attempt to transfer one party's risk (which may be a legal liability) to another by contractual terms (Hartman, 2000). In other words, these clauses are intended to exclude an owner's liability in contract and also often in tort for cost incurred by a contractor (Goldsmith, 1995).

As soon as the contract includes a disclaimer clause to shift certain type of risks to the contractor, this is the time that problems begin. When a risk is shifted to the contractor and the contractor has no means by which to control the occurrence or outcome of the risk, the contractor must either ensure against it or add a contingency to the bid price (Jergeas et al., 1994). Two recent studies indicate that using disclaimer clauses in Canadian contracts carries a premium of between 8% and 20%, depending on whether business conditions were favorable or adverse (Khan, 1998; Hartman, 1998; Zaghloul, 2001). On multimillion-dollar projects, such an increase can obviously be very significant. An additional but less visible, cost of shifting risk to the contractor through disclaimer clauses presents a number of hidden costs including restricted bid competition, increased potential for claims and disputes and above all, more adversial owner-contractor relationships. These studies examine the five most common disclaimer clauses in construction contracts that include (1) Uncertainty of work conditions, (2) Delaying events, (3) Indemnification, (4) Liquidated damages, and (5) Sufficiency of contract documents.

In this paper, the authors present some of the findings of a study conducted across the Canadian construction industry including owners, contractors, and consultants and appear to be generalizable to the United States construction industry. These findings identify the relationship between trust and risk allocation practices in construction contracts and how can a strong trust relationship affects the final cost of any specific project by improving the risk allocation method between the contracting parties.

Exhibit 1. Perception of Disclaimer Clauses Risks Under Low and High Trust Relationships

Perception of Disclaimer Clauses Risks Under Low and High Trust Relationships

The Color of Trust Model

The concept of trust is very complex and multidimensional and there has been much debate within academic circles regarding a common definition or model (Hosmer, 1995; Mayer et al., 1995; Hartman 1999). In an attempt to advance the conceptual understanding of the topic, Hartman (2000; 1999) developed a model of trust that enables a more simplified understanding of the concept. This model has been used to examine the relationship between trust and risk allocation in construction contracts. The model specifies three colors (types) of trust: Blue, Yellow, and Red trust.

•   Blue (or competence) trust is all about ability and competence, which is based on the perception of the other's capacity to perform what is required. It is simply the answer for the question, “Can you do the job?

•   Yellow (or Integrity) trust is based on integrity, which is founded upon the perception of the other's attitude to act ethically, to adhere to values that we hold important, and to be motivated to not take advantage of the other party. It is simply answer the question, “Will you consistently take care of my interests?”

•   Red (or intuitive) trust is based on intuition, which is the result of a combination of emotional response and rapid processing of information and may be described as the instincts or “gut feelings” that one person has about the other, a situation, or an artifact. It simply answers the question “Does this relationship feel right?”

Just as the primary colors can be mixed to make diverse colors, so too can the different types of trust. Different types of trust (or combinations of the three) are important for different relationships and situations.

The Industry Survey

In order to collect the data for this study, an industry survey was conducted in the Canadian and the United States construction industries. The survey solicited qualitative and quantitative information on individuals' perception of the most common disclaimer clauses in the Canadian contracts identified in recent research and studies. These clauses include:

•   Uncertainty of work conditions

•   Delaying events

•   Indemnification

•   Liquidated damages

•   Sufficiency of contract documents.

The results of the study were based on more than 300 respondents to the survey. The study sample includes owners, contractors, and consultants from both private and public industry sectors, working in different types of projects; civil, industrial, commercial, residential, and others such as pipelines.

Results and discussion

The study suggests that contracts prepared and drafted by the owner are mainly used in owner-contractor agreements. Results show that these contracts, whether negotiated or prepared, typically include one or more of the five most common disclaimer clauses mentioned before. In other words, these clauses exist in more than 75% of the survey respondents' contracts, which means that using disclaimer clauses to allocate risk in construction contracts is still a general industry or corporate practice.

Another major finding from the results was that risk premiums associated with the five most common exculpatory clauses were validated with an average of 8% to 20% based on ideal or adverse market conditions in the construction industry. The ideal market conditions include low need for work, low technical complexity, fair contract administration, negotiated contract, and complete design work. Meanwhile, adverse work conditions include high need for work, high technical complexity, unfair contract administration, unnegotiated contract, and uncomplete design work. To a great extent, the findings are very similar to the work of Hartman and Khan reported by Hartman (1998).

Trust and Risk Allocation

Erikson and O'Conner (1978) suggest that the amount of risk premiums associated with disclaimer clauses in contracts are based on the risk behavior of the contractor. In other words, a risk averse contractor would assume larger premium for a disclaimer clause than a risk taker contractor. However, results form this study show that this is not the only factor. The amount of the premium is based on the contractor's perception of the disclaimer clause risk. This means that if the contractor's perception of the disclaimer clause risk is high, the premium will be large. One of the most important finding of the study is that a significant relationship exists between the amount of the premiums associated with the disclaimer clauses and the level of trust between the contracting parties. The perception of disclaimer clauses' risk under low trust relationships is very high (average of 4.4 out of 5 points scale). The perception of disclaimer clauses' risk under high trust relationships is very low (average of 2.3 out of 5 points scale). Exhibit 1 shows these averages (based on 5 points scale).

Exhibit 2. Averages for the Level of Each Type of Trust Required to Eliminate Disclaimer Clauses From Construction Contracts

Averages for the Level of Each Type of Trust Required to Eliminate Disclaimer Clauses From Construction Contracts

Another interesting finding of the study is that the trust level that generally exists in the construction industry contracts between contracting parties is low (average 2.3 out of 5 points scale), which reflects the level of mistrust in the industry contracting practice. As the results report, owners and contractors risk allocation contracting practice is mainly a function of their trust (or mistrust) relationship between each other. If the owner-contractor contract is based on a strong trust relationship, the amount of the premiums associated with disclaimer clauses is very low, or even better; the disclaimer clauses would not exist on the contract from the outset.

Types of Trust / Disclaimer Clauses

Results report that there is a significant relationship between each type of trust in the Color of Trust Model (competence, integrity and intuitive trust) and the ability to eliminate disclaimer clauses from contracts and/or reduce the risk premiums attached to the clauses. Survey respondents show that with the existence of high level of competence and integrity trust (average 4.3 out of 5 points scale). With intuitive trust, which answering the question “Does this relationship feel right?”—the case is little different. Survey respondents show that the need for intuitive trust to exist as a reason to eliminate disclaimer clauses and/or reduce risk premiums attached to the clauses is not extremely important (average of 3.3 out of 5 points scale). However, it is the authors' belief that intuitive trust is very important to better risk allocation process. There are two main parts for intuitive trust, the chemical reaction between two people and the rapid process. The authors argue that construction industry uses intuitive trust without recognizing this usage. Regarding risk allocation in contracts, it's the authors' belief that construction industry uses intuitive trust to judge the allocation methods and then post rationalize this judgment by using the other two types of trust. Exhibit 2 shows the averages for the levels of each type of trust required to eliminate disclaimer clauses form construction contracts and/or reduce the risk premiums associated with them (based on 5 points scale).

Other than the problem of risk premiums associated with disclaimer clauses, there is one more major problem. The existence of disclaimer clauses in contracts may destroy yellow and/or red trust (integrity and intuitive). Disclaimer clauses can send a clear message about how much one party trust or value the other party or the contracting relationship itself. As a result, the contractor would be very creative in finding ways to get more money as much as possible from the owner. This can be through different ways such as risk premiums, change orders, overheads, inflated estimates, and more other ways.

In general, the process of risk allocation through disclaimer clauses does not encourage any creative ways of doing business between the contracting parties and destroy the level of trust between them. Above all, the existence of a disclaimer clause in any contract would affect the relationship negatively and make both contracting parties work on different sets of personal objectives instead of common ones.

Conclusion and Recommendations

Recent research and industry experts have indicated that inappropriate risk allocation through disclaimer clauses in contracts is a significant reason for increasing the total cost of a project. Any improvement in the process would result in significant savings for the construction industry. This paper examined the affects of the Color of Trust Model on risk allocation process through disclaimer clauses. The most important findings of this study identify that the existence of a trust relationship is significantly important for better risk allocation processes and methods. The study also indicates that there is a certain level of each type of trust (competence, integrity, and intuitive) is required to reduce the amount of risk premiums associated with disclaimer clauses or even better; to eliminate the disclaimer clauses from the outset.

The survey respondents report that to reach a better risk allocation process, a trust relationship between the contracting parties should exist first. This can be done through certain stages as follow:

•   A clear understanding of the risks being born by each party and who owns or can manage the risk

•   More time and effort in the front-end of a project and sufficient experience to manage or mitigate the risks and administrate the contract

•   A negotiation phase prior to the start of the contract should exist, this phase is required to built a trust relationship between the contracting parties, then this negotiation phase can be part of the contract itself

•   Adequate risk-sharing or risk-reward system should exist to share the benefits if the risk does not occur during the project life cycle.

The rationale for better risk allocation between owners and contractors ought to be based on meeting these conditions as far as possible. Missing one of these criteria is very likely to trigger inappropriate risk allocation process for any given project and hence bring additional cost for the contracting parties.

References

ACE & AGC. 1991. “Owner's Guide to Saving Money by Risk Allocation.” American Consulting Engineers Council and Associated General Contractors of America, Washington, pp. 6–12.

Construction Industry Institute (CII). 1986. “Impact of Various Construction Contract Types and Clauses on Project Performance.” Publication # 5–1, pp. 1–14.

Construction Industry Institute (CII). 1988. “Impact of Risk Allocation and Equity in Construction Contracts.” Publication SD – 44, pp. 1–7.

Enger, T. 1997. “Beyond NORSOK and CRINE.” Transaction of the Annual EPCI Conference. Stanvanger, Norway, June 11–13.

Erikson, C., O'Connor, M., & Boyer, L. 1978. “Construction Process Risk Allocation.” Transaction of the American Association of Cost Engineers, July 9–12.

Goldsmith, I., & Heintzman, T. 1995. “Goldsmith on Canadian Building Contracts,” 4th Edition. Carswell, Ontario, Canada.

Gransberg D., & Ellicot M. 1997. “Best-Value Contracting Criteria.” Cost Engineering. Morgantown, Jun., Vol. 39, Issue 6, pp. 31–34.

Hartman, Francis. 2000. Don't Park Your Brain Outside—A Practical Guide to Improving Shareholder Value With SMART Management. Newtown Square, PA: Project Management Institute.

Hartman, F. 1999. “The Role of Trust in Project Management.” Proceeding of the PMI research Conference.

Hartman, Francis. 1998. “The Real Cost of Weasel Clauses in Your Contracts.” Proceeding of the 29th Annual Project Management Institute Seminars and Symposium, October 9 to 15.

Hosmer, L. T. 1995. “Trust: The Connecting Link Between Organizational Theory and Philosophical Ethics.” Academy of Management Review, Vol. 20, Issue 2, pp. 1–25.

Jergeas, G., & Hartman, F. 1994. “Contractors' Protection Against Construction Claims.” American Association of Cost Engineers, AACE Transactions.

Khan, Z. 1998. “Risk Premiums Associated With Exculpatory Clauses.” Masters Thesis, University of Calgary, Calgary, Alberta, Canada.

Mayer, R., Davis, C., & Schoorman, F. 1995. “An Integrative Model of Organizational Trust.” Academy of Management Review, Vol. 20, pp. 709–734.

O'Reilly, Michael. 1996. “Civil engineering construction contracts.” Thomas Telford Publication Inc., London, England.

Zaghloul, R., & Hartman, F. 1999. “How To Reduce Your Project Cost.” AACE (American Association for Cost Engineers) Annual Conference, Calgary, Canada.

Zaghloul, R. 2001. Contracts' Hidden Costs: A Trust/Risk Allocation Approach. Unpublished PhD Dissertation, Project Management Specialization, University of Calgary, Canada.

This material has been reproduced with the permission of the copyright owner. Unauthorized reproduction of this material is strictly prohibited. For permission to reproduce this material, please contact PMI or any listed author.

Proceedings of the Project Management Institute Annual Seminars & Symposium
October 3–10, 2002 • San Antonio, Texas, USA

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