Commercial contracting – risks and red flags

Analysis

Commercial contracting: Risk and red flags

Issue 17, March 2014

In this article, we look at key trends in commercial contracting and highlight some of the red flags and key commercial terms which should be considered to mitigate contract risk and assist parties to realise the intended value embedded in contracts.

The contracting environment in Australia is currently in transition with major capital projects in the resources sector having reached their peak and moving towards operation of the assets constructed. Combined with a continued focus on efficiency in public and private sector investment, this transition has contributed to a shift in the balance of power in contract management and negotiations. Throughout the contract lifecycle all parties should be aware of commercial terms and red flags that impact the value derived and the quality of commercial relationships. Examples discussed below include: the importance of confirming and documenting key definitions and verbal decisions during contract negotiations; the risk of errors and misstatements in contractor claims and performance assessments; and the time and cost of negotiating appropriate break costs at the end of a contract.

Current market trends

Major capital projects in resources industry plateau

The December 2013 quarter edition of Deloitte Access Economics’ Investment Monitor highlighted that many sectors of the Australian economy faced a difficult 2013 and the outlook for growth in 2014 remains below trend, especially in mining and engineering investment spending. Australian Bureau of Statistics data indicates that investment spending in these areas was relatively flat during 2013 with an anticipated gradual fall expected over the next 12 months.

At the same time as new investment has plateaued, a number of current open projects have experienced significant cost increases. For example, the expected construction costs for Chevron’s Gorgon Liquefied Natural Gas project have blown out by almost 50 percent since it was launched in 20091. One of the contributing factors to the cost creep of major capital projects has been the shift in risk from contractor to principal to secure resources, evident in the increasing use of ‘cost plus’ commercial contracts.

Transition from construct to operate

As many construction projects transition to business as usual operations, asset owners continue to outsource these activities in many commercial frameworks such as joint ventures, alliances or traditional principal:contractor relationships. Many of these operate and maintain contracts have similar ‘cost plus’ commercial terms, including financial and non-financial performance incentive regimes such as  risk or reward, painshare/gainshare and balanced scorecard.

Public infrastructure projects

Investment Monitor also highlights the recent focus of state and federal governments on the cost, funding and financing of infrastructure projects such as roads, ports and railways. It is expected that these projects may fill some of the investment spending gap created by the slowing of the mining and oil and gas sectors.

Yet, despite the different nature of these investments, the nature of contacts negotiated is  surprisingly similar.

Key commercial terms and red flags

Summarised below are some of the key commercial terms and red flags to consider through the contract lifecycle.

Although the items presented below may appear biased towards the protection of the Principal, our fundamental approach is to assist both sides of the contracting relationship to continue to work together effectively and derive the intended value from these relationships.

Contract negotiation

The overriding emphasis during this phase should be to confirm and document all key definitions and decisions made during the negotiations.

Relationships can become strained when one party relies on undocumented, ‘workshop’ discussions as the basis for charges and compensation under the contract. For larger projects and contracts, this phase may also include some due diligence of the proponent’s tender submission, including the independent evaluation of historical performance of other contracts.

A common area that can be overlooked during the negotiations is agreeing the nature, format and timing of reports required. Specifying electronic reports and invoice support can significantly improve the efficiency and accuracy of financial analysis and invoice verification.

During developing relationships, considering consequences and responsibilities when the relationship comes to an end are not always front of mind. However, any unresolved ambiguity during the negotiation phase will inevitably lead to uncertainty, and often disputes, during the close out of contracts, even where the contract terminates at the planned expiry of its term.

Performance assessments (periodic or end of contract)

Performance assessments can be simple comparisons of budget against actual cost (which feeds into a risk or reward calculation), or could be a more complex balanced scorecard (with multiple financial and non-financial performance measures).

Regardless of the complexity, both parties are normally incentivised to portray performance to benefit their own organisation.

  • Target cost  - Although appearing rudimentary, errors or uncertainty around the agreed target cost between parties can be resolved by:

    • Checking the completeness and mathematics of the original scope approval and each variation
    • Confirming whether all variations have been appropriately approved pursuant to the contract
    • Confirming that appropriate allocation of risk has been applied to extensions of scope/time
  • Actual cost - Actual cost is often incorrectly reported, with errors and misstatements in areas such as:

    • Completeness - Do the reported values include all amounts contained in the contractor’s accounting system and/or billed to the principal? A common error with performance assessments is the preparation of calculations prior to hard close of the accounting system
    • Appropriate - Are all costs claimed by the contractor permissible under the contract?
    • Retentions - Has the contractor retained the benefit of sub-contractor retentions or passed the benefit to the principal and made the appropriate adjustment to cost?
    • Refunds - Do costs reflect the benefit of any refunds received by the contractor, such as fuel tax credits and supplier discounts?
    • Contractor internal costs - Have internal plant and labour costs been calculated correctly, with reference to approved rates, hours and resource requirements?
    • Foreign currency - How have the gains/losses on these transactions been accounted for and reported?
  • Calculations and adjustments - Due to the size and complexity of some calculations, errors in logic, consistency, undocumented assumptions or non-compliance with contract methodology can occur and  which are not immediately apparent in the headline values
  • Balanced scorecard - This performance measurement tool captures multiple financial and non-financial measures using detailed calculations and weightings to calculate target and actuals scores for each element. Misstatements can result from:

    • Use of incorrect or redundant source data
    • Exclusion of some measures in the calculation of the combined result
    • Incorrect application of weightings
    • Errors in mathematical logic
    • Contract non-compliance.

Termination

All good things must come to an end, but even after a great commercial relationship, the parties can disagree on the responsibilities and appropriate compensation at termination.

If the relationship has not been good during the term of the contract, the time and cost of negotiating the appropriate break costs can increase significantly. Issues to consider to assist with a smooth contract termination process include:

  • Demobilisation and site clean-up - Does the contract specify who is responsible for these costs?
  • Redundancy costs - Does the contract have provisions to deal with claims for redundancy costs when a contract is terminated ahead of the end of the natural expiry of the term?
  • Surplus assets - What mechanisms are in place to identify, value and dispose of surplus assets that have already been paid for by the principal?
  • Engineering drawings - What mechanisms are in place to ensure that all engineering drawings are current and in the custody of the principal?
  • Refunds and credits - On termination, contractors may receive the benefit of multiple refunds and deposit returns that were charged to the principal earlier in the lifecycle of a ‘cost plus’ contract. These might include project specific insurance policies, trade account deposits, and bank deposits required for bank guarantees or cashflow purposes.

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