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Managing change in construction subcontracts: 5 risks to watch out for in variation clauses

Onerous variation clauses are the bane of many a subcontractor’s and designer’s existence. Disputes over variation claims can strangle cash flow, particularly at the lower end of the supply chain where small businesses are least able to weather long-winded wrangling over adjustments to the contract sum.

In October 2018, WA barrister John Fiocco handed down his report into Security of Payment Reform in the WA Building and Construction Industry. The report acknowledged the seriousness of variation payment disputes at subcontractor-level, attributing their impact to two factors:

  1. Subcontracting businesses tend to be undercapitalised, and may bid for work on low or negative margins in the hope of collecting variations to cover costs. Difficulty recovering variation claims may cause such businesses to collapse.
  2. Subcontractors are often in a weaker bargaining position and therefore potentially experience greater exposure to sharp practices by head contractors.

Mr Fiocco’s recommendations preferred freedom of contracting between the parties over a prescriptive legislative regime regulating variations, with security of payment further down the supply chain to be supported by a legislative payment schedule regime.

It remains to be seen precisely what impact these recommendations will have with regard to the WA Construction Contracts Act. So, in the meantime, what should you be looking for when negotiating the variation procedure in a construction subcontract? To protect both margin and cash flow, designers and subcontractors should be paying careful attention to the proposed variation clause at tender stage, with particular emphasis on 5 major risks.

1.   Is there a requirement for variation orders to be in writing?

Construction can be unpredictable, with program and scope both at the mercy of site or design issues that unexpectedly emerge mid-project. Subcontractors operating a skeleton team at low margins dread emergency telephone calls from the contract administrator demanding extra scope items to be acted upon “immediately”. Being in a (perceived or genuine) weaker negotiating position, subcontractors will often comply and then find themselves lacking documentation to support a claim for additional costs further down the line.

Managing the risk

Make sure the variation clause in the subcontract stipulates that any variation order must be evidenced in writing prior to commencement of the varied services, and identified as a “variation order”.

2.   How do you deal with variations that are disguised as “directions” or “instructions”?

Many construction contracts provide for the project manager or superintendent to give “directions” in relation to the subject matter of the contract. The risk is that contractors will resist a variation claim on the basis that it was merely a direction, order or site instruction, rather than a variation to the scope of services or works.

Managing the risk

Introduce a procedure whereby the subcontractor can notify the contractor or principal of its belief that a direction is in fact a variation. This should be backed up with an obligation for the contractor to confirm (in writing, naturally) the true nature of the direction. If it is a variation, the clause should stipulate that the appropriate variation clauses apply. If the parties can’t agree, the next logical step should be the dispute resolution procedure (which you will introduce if it doesn’t already appear in the contract– but that’s another blog post!).

3.   Are there unrealistic timeframes for submitting variation claims?

Typically, even contracts with a reasonable variation procedure will prescribe a time by which variation claims must be submitted. Failure to do so may mean that the entitlement to claim is lost or “time-barred”.

Large-scale construction projects may involve a hierarchy of contractors, with the principal at the top and potentially multiple layers of sub-subcontractors down the line. Each level of contractor may shave a bit more the time for responding to variation orders, so that small businesses at the bottom of the chain are left with an impractical period for making a claim and end up time-barred with no way of claiming substantial costs.

Managing the risk

Consider what the actual practical steps are in formulating a variation claim. For example:

  • Will there be a lag in communication between a site team and a project manager in your office?
  • Do you need to liaise with suppliers or other subcontractors?
  • Are there regular site meetings during which such claims need to be discussed before submitting?

Apply those factors to the development of your position on a reasonable time period for submitting variation claims. Use that position to resist any arguments that “it’s driven by the head contract”: the parties to the subcontract are you and the contractor who directly engages you (i.e., not you and the head contractor or principal), and that’s the relationship that needs to be managed in the terms of the subcontract. Just quietly, 24 hours is most definitely nota reasonable period for submitting a claim.

On a related note, make sure the subcontract contemplates a schedule for submitting claims. Nothing will strangle your cash flow more than being forced to wait until practical completion to realise substantial variation claims. This can be as simple as providing for variation claims to be submitted, agreed and paid in the course of the next progress claim.

4.   Will costs be agreed in advance of commencing varied scope items?

Many subcontracts contain an obligation for the subcontractor to proceed with a variation order even if the associated adjustment to the contract sum has not yet been agreed. The obvious risk here is that the subcontractor delivers the varied scope and incurs the costs, and then the client later disputes the value or worse, refuses to pay at all.

Managing the risk

Ideally, you want a firm contractual obligation to agree the costs of the variation prior to commencing the varied services or works. That said, in the hurly burly of scheduling pressure, it isn’t always possible to take the time to submit a proposal, quibble over it and get a price adjustment settled before getting on with an urgent variation. One way around this is to add “or as otherwise agreed in writing” to the obligation to agree the price. That way, you can at least confirm the time for agreeing the price case-by-case and there is a contractual incentive for the client to deal with the claim in a timely manner.

5.   Is there a process to value variation claims?

It’s all very well that the head contractor or principal is obliged to pay for variations to the scope, but what happens if there is no set process for establishing how much the payment should be? You could find yourself in something of a pickle.

Managing the risk

In construction contract utopia, the parties will amicably agree a change to the contract sum and everyone makes a profit and lives happily ever after. Sadly, in the real world this rarely happens. So, what then?

A cascading clause may be the most appropriate means of balancing the parties’ interests. Typically, it will look something like this:

  • the parties agree on the adjustment to the contract sum (in advance of commencing the varied scope as per item 4 above); but if not…
  • the client requests and the subcontractor provides a quotation for the variation, then the parties negotiate in good faith to reach a mutually agreeable outcome; but if not…
  • the client or superintendent, obliged to act reasonably, determines the amount of the variation by reference to some agreed or objective measure (e.g., similar scope items or a schedule of rates or works that you include in the price schedule prior to executing the subcontract).

One very important thing to note, there are two terms related to pricing variations that you should neveraccept:

  1. An overall cap on variations to the contract sum (e.g., variations to the contract sum must not exceed 10% of the contract sum, etc).
  2. A “threshold price” that the subcontractor must absorb before it can claim additional fees for variations to scope.

If all else fails, try some old-fashioned project management strategies

Let’s be honest, sometimes (most of the time?) subcontractors enter into construction contracts with few or no changes to the contractual terms. If this is you, here are some other practical project management strategies that might help you to protect your margin.

Agree a suite of documents at kick off stage

If the variation clauses in the subcontract that you’ve already signed are a bit sparse or even completely AWOL, here’s a step-by-step guide to what you should do:

  1. Draw up a suite of documents that set out a practical variation procedure. This might be as simple as some kind of “scope change form” with some lines for describing the requested change plus a tick box at the bottom for the contract administrator to sign off on. Even better if you can do this in some kind of email template form, that allows you ask the contract administrator to “confirm agreement by reply email”. The easier you make it, the more likely it will lead to a good outcome.
  2. At the project kick off meeting, share your suite of documents with the relevant decision makers in the client project team, explain how it will benefit both of you to document the project properly and ask them for feedback. Promptly incorporate the feedback and (prior to commencement) jointly agree that this is how you will manage variations during the course of the project. Declare at the outset that no varied services or works will be undertaken until the relevant confirmation is received.
  3. Firmly insist on the procedure being followed for the first few relevant scope changes, no matter how minor they are. Before you know it, it will be the accepted course of conduct and you will have a clearly documented history to incorporate into variation claims.

Include a very detailed scope

The scope (of works for contractors, services for designers) is where the rubber hits the road. It sets the client’s expectations for what you will deliver, and your expectations of how much you have to do to get paid. The more detailed it is, the better the overall project outcome will be.

If you are entering into a subcontract with a client who you know to be a repeat offender for scope creep, you should be careful to say what you will do, but also emphasise what you won’t be doing. That is, include a set of assumptions and/or exclusions to make it crystal clear what sorts of changes to scope will attract an associated adjustment to your fee.

Variation procedure flowchart

The subcontractor is as much a party to the subcontract as the principal. It is therefore important that you read, understand and act upon your contractual obligations. One way of making sure you and your project team have a good grasp on what is required is to develop a flow chart that visually represents the steps that need to be taken and who is responsible for each action. This will look a little bit different for every contract, but here is an example for AS4000.

Assistance with contract negotiations

Here at SoundLegal, we love reviewing construction subcontracts, identifying risks and workshopping practical solutions for you to discuss with your clients. We will happily assist you to prepare a detailed schedule of clarifications or departures to include in your tender, and then to negotiate a mutually satisfactory contract when the time comes.

At the end of the day, entering into a clear contract at the outset means a better project outcome – that’s a win for you and a win for your client.

Get in touch next time you are bidding for an exciting project:

e: admin@soundlegal.com.au

m: 0408 143 606

 

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