Construction Arbitration: Navigating Risks, Resolving Disputes, and Securing Damages

Construction contracts — A general introduction

A construction contract is a formal agreement that delineates the terms, conditions, and obligations governing the execution of a construction project, typically involving multiple parties from the public and private sectors. It serves as a legal framework, addressing various aspects such as project scope, timelines, costs, and risk allocation.

A host of factors have played an essential role in the worldwide surge of construction contracts, particularly those entailing collaboration between public and private entities for public infrastructure development. Factors contributing to this growth encompass rising demand for public services, diminished capacities of States to fully finance public infrastructure initiatives, a growing interest among enterprises in private funding opportunities, and the standardisation of international legal benchmarks to encourage private sector participation in public infrastructure projects.

The collaboration between the State, acting through government institutions, and a private enterprise to enter a long-term contract is called a public-private partnership, commonly abbreviated as the “PPP” model.

There are multiple ways by which a private company and a public sector undertaking may collaborate and join hands to enter a PPP contract. The first of the many types of PPP projects are build-operate-transfer (BOT) contracts, wherein a private enterprise is awarded a concession to build and operate projects such as power plants, toll roads, sewage/water treatment plants, and other public infrastructure facilities. Towards the culmination of the concession period, the private company hands the control and ownership of the project to the State. BOT contracts have variations such as BLT (build, lease and transfer), DBO (design, build and operate), BOO (build, own and operate), BOOT (build, own, operate and transfer).

The kinds of construction contracts that may be entered amongst a private company and the State includes: (i) project or concession agreements; (ii) off-take or purchase agreement; (iii) EPC (engineering, procurement, construction) contract; and (iv) O&M (operation and maintenance) agreements.

Disputes in construction contracts — An inevitable phenomenon

The complexity of the underlying contracts, instruments, and other documents, combined with the long-term nature of the construction projects, creates an ideal environment for disputes to emerge. Such conflicts may arise during: (i) the execution of the contract; (ii) the tenure of the project; and (iii) after the completion of works as long as the parties remain bound by the contract in some capacity.

Disputes may trigger amongst parties due to varying interpretations of the contractual clauses and inconsistencies within comprehensive contract documents. Resolving these disputes often necessitates the engagement of factual, domain, and legal experts to assess facts, assign risks, and determine liabilities appropriately. While it is challenging to avoid disputes in complex contracts altogether, meticulous structuring of a project through corresponding contractual covenants can mitigate the frequency, magnitude, and complexity of conflicts.

Apart from issues pertaining to the interpretation of contractual terms, disputes may also arise due to breach of contract. For instance, unforeseen variations in project specifications by the employer can lead to additional costs, expenses, losses, delays, or claims for extensions of time. Similarly, inexplicable, and unwarranted delays by the concessioner can also lead to disputes. Other types of disputes encompass breach of contract, wrongful termination, improper invocation of bank guarantees, unjust withholding of retention amounts, and failure to rectify defects during the defects liability period.

Conflicts are also prone to arise within construction contracts, not necessarily due to deficiencies in performance or varying interpretations of the contractual covenants and applicable laws. Instead, disputes commonly spring from shifts in the project’s economics or the negotiating power of involved parties, coupled with evolving circumstances throughout the contract’s lifespan. These challenges are frequently addressed through stabilisation or renegotiation clauses. However, even these provisions may lead to prolonged disputes.

In essence, the success of a construction contract lies in sustaining the complex relationships among the parties amidst economic, political, and legal changes, alongside technical or commercial challenges. To grapple with the inherent challenges in construction contracts, arbitration and pre-arbitral dispute resolution mechanisms, such as dispute boards, are employed in conjunction with carefully crafted multi-tier dispute resolution procedures.

Once a dispute arises, the next steps include identification of the issues, examining the agreed allocation of risks, and determining the available remedies under the law.

1. Allocating risks

Risk is characterised by uncertainty regarding cost, loss, or damage and represents an unpredictable variation in value that can negatively impact the anticipated benefits of contract performance. The exposure to risk varies for each party involved and is contingent on their roles and obligations within the project.

Since risks have the potential to hamper revenue generation and even create losses in a construction project, enterprises need to carefully chalk out the allocation of risks followed by a robust mitigation plan.

The types of risks that a party may face in a given construction project can be broadly classified as below:

(i) Country-based risks: These risks stem from the socio-economic, political, and legal ecosystem of the host country where the project is to be implemented. Examples of such risks include drastic changes in legal and regulatory regimes, cancellation of concessions, and nationalisation of the projects.

(ii) Construction and completion risks: These risks encompass the potential challenges that may be posed due to the non-completion of projects in time or within the estimated cost.

(iii) Operating risks: They arise from deficiencies in operations. Examples include the non-achievement of performance standards, faulty infrastructure, and inability to meet expected demand. The factors that contribute to operating risks include poor management, fluctuation of demand and supply, and design-based or technical faults.

Upon identifying risks, the next step involves the allocation of risks. This is guided by the fundamental principle that the party most capable of controlling, influencing, and bearing the costs associated with a risk should assume the responsibility. Parties assuming a specific risk generally take proactive measures to avoid or mitigate its impact.

Any risks left unallocated would, unless provided otherwise in the contract, typically fall under the purview of the project sponsor, who bears them in exchange for the anticipated economic returns from the project’s operation. The relationship between the risk borne and the expected return on investment must not only be reasonable but also sustainable. An imbalance in the risk-reward equation can also lead to the emergence of significant disputes.

Following the allocation of risks, a diverse range of mitigation measures can be employed. The specific measures adopted depend on the unique characteristics of the project, the involved parties, and the allocated risks.

2. Risk mitigation measures

The common risk mitigation strategies in construction contracts include: (i) contractual mechanisms; (ii) guarantees; and (iii) insurance.

Contractual mechanisms encompass milestone payments, retentions, and liquidated damages. Milestone payments involve payments at specific contractual events, demanding synchronisation with the work schedule. Retained amounts are typically a specified percentage of milestone payments that secure and ensure the timely completion of works of the desired quality. The retained monies are paid only upon the satisfaction of performance parameters in terms of the contract. Liquidated damages are pre-established amounts levied in case of delays or defective performance. These damages aim to compensate the owner or employer company for damage due to delays, revenue decrease, and increased operating costs resulting from subpar performance. Typically, liquidated damages are calculated based on the delay against the scheduled/intended date for completion and have prescribed maximum threshold.

Guarantees in construction projects include down payment, performance, and defects liability guarantee in the form of bank guarantees, standby letters of credit, or surety bonds. Down payment guarantees safeguard the owner’s down payment for material purchases. Performance guarantees protect against substandard contractor performance, with the guarantee amount potentially equal to or less than corresponding liquidated damages. Defects liability guarantees cover hidden defects emerging after final acceptance, usually limited to the warranty period of the project.

Mitigating operating risks, like force majeure, facility loss or damage, and liability risks, involves insurance. Property damages insurance covers material loss or damage to works, completed projects, and incorporated materials. Similarly, insurance protection is also available for delays and financial costs incurred due to delays. Third-party liability insurance safeguards against indemnity payments for bodily injury or property damage.

Management risk is addressed through supervision and training, while supply risk is mitigated by securing long-term contracts for quality supplies at stable prices. Technical risks are addressed through pre-contractual due diligence and measures concerning deficient performance, maintenance, repair, and quality control procedures. In addition to these risks, the ever-present risk of material non-performance can be addressed through effective dispute resolution mechanisms.

Parties to a construction contract also have the option to include clauses governing the limitation or even the exclusion of liability. Occasionally, the parties may also agree to be accountable for the results stemming from a contractual breach only up to a specified threshold limit. For example, if a promisor is safeguarded by a clause that absolves liability for damages, the promisee is understood to have acknowledged and accepted the risk of potential damages and, therefore, is precluded from holding the promisor responsible for the consequences explicitly addressed by the limitation of liability clause. In the absence of such provisions, the courts commonly rely on the criterion of remoteness and infer the parties’ implicit acceptance of their respective levels of responsibility. In cases involving mutual promises, there is a presumed mutual allocation of risks, wherein the contracting parties willingly assume responsibility for the typical repercussions of a promise breach.

Recurring themes in construction disputes

Delays

Many construction agreements incorporate a specified time frame for the completion of projects. When the completion time is not explicitly outlined, there is a general understanding that the project works should be performed within a reasonable period. Typically, contracts permit the pursuit of liquidated damages claims against the contractor if the project surpasses the specified completion time. Nevertheless, the contractor may avoid such consequences if the delay is attributed to the employer or factors beyond the contractor’s control, such as breaches, sub-contractor issues, or unforeseen events like force majeure, armed conflict, or strikes. Consequently, it is customary for construction contracts to address the treatment of various delay types.

The consequences of delay are ordinarily set out in, amongst other covenants, in the liquidated damages clause. In the absence of any guidance from contractual provisions, general contract law principles come into effect, granting the employer the right to claim damages from the contractor for not completing the project on time. Under Indian contract law, the employer must establish actual loss to be eligible for damages. Disputes commonly emerge between employers and contractors regarding the party responsible for delays. If the delay is attributable to the employer, the contractor may be entitled to an extension of time, exemption from liquidated damages, and potentially recover direct losses or expenses. Conversely, if the delay is the contractor’s fault, liquidated damages may be applicable. Delays may, on occasion, be concurrent, signifying that events attributable to both the employer and the contractor contribute to or cause a delay.

Extension of time

In the context of construction contracts, the contractor is mandated to complete the works within the agreed upon completion date specified in the contract. However, situations may arise where the contractor becomes eligible for an extension of time, releasing them from the obligation to pay liquidated damages for delay. These situations may include delays attributed to parties other than the contractor or any other delay set out in the contract, justifying an extension of time, such as variations. The assessment of a request for an extension of time requires a thorough examination of surrounding circumstances and the applicable contractual clauses by the relevant authority responsible for making such decisions. The evaluation centres on comprehending the impact of the delay on the overall completion of the entire construction project. It is crucial to differentiate whether the event causing the delay qualifies as a critical event, as this distinction plays a pivotal role in determining the extension of time.

Variations in scope

In construction contracts, adjustments or changes are often made to the original agreement, involving alterations to design elements, quantities, or the scope of work. Given the intricate and prolonged nature of construction projects, it is vital to incorporate “change in scope” or “variation” clauses into contracts. These clauses endow employers with the authority to request essential changes while simultaneously ensuring that contractors are duly compensated for directed modifications and are not penalised for any resultant delays.

Naturally, unauthorised variations, when demanded by the employer, can present a significant challenge to the contractual relationship. As a global best practice, a request for variations is executed in writing by the employer or an authorised agent/principal engineer designated in the contract. Some construction contracts may also mandate a comprehensive analysis of the cost impact associated with variations. This analysis encompasses not only the direct consequences but also the collateral changes in work resulting from the variation.

Damages under Indian contract law

A “damage” is a disadvantage or loss suffered by a person on account of an act or omission of another. Such damage may be pecuniary or non-pecuniary¹ in nature.

Not all kinds of damage may be subject to compensation under law. Only some forms² of damage give rise to a right in law to recompense and others³ do not. The term “damages” refers to a form of pecuniary compensation arising from the breach of a contract.

Liquidated and unliquidated damages

The term liquidated damages refers to those damages that have been pre-assessed/pre-determined and fixed by the parties through a contractual agreement. This predetermined sum represents what the parties deem to be payable in the event of a default by one of them. Section 74 of the Contract Act, 1872 (Contract Act) pertains to such damages.

In contrast, for all other situations, the court, or arbitrator, as the case may be, determines and evaluates the damages or losses, which are categorised as unliquidated damages. It is important to note that parties can set a specific amount as liquidated damages for a particular type of breach. If a different type of breach occurs, the affected party may pursue unliquidated damages resulting from that breach.

3. Fundamental elements for assessing damages

Causation

In order to assert a claim for damages, a clear cause-and-effect relationship must exist between the breach of contract by the defaulting party and the resulting loss suffered by the aggrieved party. This loss must be a direct consequence of the breach itself and not the result of how the breach occurred. Put simply, the breach should not merely serve as the backdrop for the loss accrued by the aggrieved party. The breach shall not merely serve as an opportunity for the aggrieved party to harm themselves.

Causation is made out if the breach was the cause of the loss; and not where despite there being a breach of contract, some other event is the only real or effective cause of the loss in question, irrespective of whether it breaks the chain of causation. On another view, where the loss is caused by several causes including the breach of contract, and all causes operate together in causing the loss, the aggrieved party can recover damages only if the breach of contract was the dominant or effective cause of their loss.

The commonly applied benchmark in this context is the “but for” test, which examines whether the damage would have occurred but for the defaulting party’s breach of contract. However, the “but for” approach possesses its own set of limitations, as it does not accommodate situations involving multiple causes. A more effective perspective is to assess whether the loss would not have materialised in the absence of the breach.

Irrespective of the criteria for evaluating the validity of a damages claim, such a claim would typically not be allowed in the following scenarios:

(i) When no loss is shown to have been incurred.

(ii) If the suffered loss is primarily attributable to an independent event beyond the control or responsibility of the party in breach and such an event disrupts the causation chain.

(iii) Where the loss predominantly results from a breach of duty by a third party unrelated to the defaulting party in the contract.

In cases involving multiple contributing factors, the pivotal consideration is to identify the dominant cause responsible for assigning liability for the resulting loss.

Breaks in the chain of causation

The chain of causation is broken where an unforeseeable extraneous event occurring after the breach has the effect of preventing any loss, or any further loss, accruing from the breach. Such an extraneous event may be an act of nature, an act of a third party, or even an act of the defaulting party. The real moot point in such circumstances is whether the extraneous event is a new and independent cause or further damage accruing in nature. Typically, the party committing the breach will be liable for the loss which accrued before the event broke the chain of causation.

Remoteness

The “remoteness of damages” pertains to the legal standard utilised to determine which category of losses resulting from a breach of a contract are eligible for compensation. The principle established in Hadley v. Baxendale⁴ encompasses two main aspects. Firstly, the party in breach of the contract is responsible for damages that arise in the ordinary course of events. Secondly, the party in breach is also accountable for damages that may have been reasonably foreseen by both parties when they entered the contract as a likely outcome of a contractual breach.

Section 73 within the Contract Act encapsulates the principle established in Hadley case⁵, granting the injured party the right to seek compensation for any loss or damage inflicted upon them. This compensation may encompass situations in which: (i) the harm naturally occurred as part of usual circumstances; or (ii) when the involved parties were aware, at the time of contract formation, that the breach would likely lead to such consequences. Section 73 of the Contract Act also clarifies that the compensation envisaged in the provision would not be given for any remote or indirect loss or damage sustained by reason of the breach.

It is essential to recognise that determining the remoteness of damage is a question of fact, and the contract law jurisprudence can only set out the overarching principles. Consequently, the fundamental criterion is whether, in the parties’ contemplation, the damage constitutes a “potential consequence” of the breach. If the damage meets this criterion, it should not be considered excessively distant.

Damages under the Contract Act, 1872

Section 73 of the Contract Act addresses damages that are unspecified i.e. unliquidated damages. It reinforces the established common law stance regarding damages. The first prong of the provision pertains to compensation for loss or damage resulting from a contract’s breach. It specifies that in the event of a contract violation, the aggrieved party is entitled to compensation from the defaulting party. Such compensation is recoverable for loss or damage that: (i) naturally occurred in the ordinary course of events; and (ii) was reasonably foreseeable by the contracting parties when they entered into the agreement as a likely consequence of a breach. The subsequent facet of the provision reiterates that no compensation is owed for losses that are considered remote or indirect. Section 73 also applies the same principles where breach occurs in terms of obligations resembling contracts.⁶

Section 74 of the Contract Act addresses scenarios in which parties, at the time of entering a contract, establish a predetermined sum of damages that the defaulting party must pay in the event of a breach. In essence, Section 74 deals with liquidated damages, which represent a genuine pre-estimate of the damages expected to arise from the breach.

In the landmark decision in Fateh Chand v. Balkishan Das⁷, the Supreme Court observed that Section 74 of the Contract Act establishes the legal framework for liability in cases of contract breaches where compensation is predetermined by mutual agreement or when there is a stipulation that serves as a penalty. Section 74 does not confer any special advantage to any party. Rather, it proclaims the principle that notwithstanding any term in the contract for determining damages or penalties, the Court will only grant reasonable compensation to the aggrieved party, which should not exceed the predetermined amount or penalty.

Under the purview of Section 74, the assessment of damages falls into two distinct categories. First, it encompasses cases where the contract specifies a particular sum to be paid in the event of a breach. Second, it encompasses situations where the contract includes any other provision serving as a penalty. In either scenario, the quantum of damages awarded should constitute reasonable compensation, which must not surpass the predetermined amount or penalty specified in the contract. Section 74 obviates the need for demonstrating actual loss or damage, but it does require the party to prove that a breach has occurred. It should be emphasised that this provision does not validate the award of compensation when the breach has not resulted in any legal harm or injury. Granting liquidated damages to the aggrieved party in the absence of actual loss would constitute unjust enrichment and is prohibited by law. Although parties entering contracts have significant authority to establish the terms of their agreement in writing, parties in India cannot agree to preclude judicial review of the amounts sought under liquidated damages.

In Kailash Nath Associates v. DDA⁸, the Supreme Court emphasised that if a contract designates a specific sum as liquidated damages, the party alleging breach can receive the predetermined amount only if it represents the genuine pre-estimated damages agreed upon by both parties. In instances where the predetermined amount is deemed not to be a genuine estimate, the courts will award only a reasonable amount as compensation. Similarly, when the fixed amount serves as a penalty, the Court can only award reasonable compensation, which should not surpass the stated penalty amount.

The existence of a concluded contract and its breach is sine qua non for claiming damages. If there is no concluded contract between the parties, a claim for compensation under Sections 73 and 74 would not be maintainable. Similarly, the obligation to pay damages only arises when there is a breach of a contract. To establish a breach, it must be determined by formal adjudication rather than being solely decided by the involved parties. A contract is considered breached when a party contravenes/deviates from the agreed upon terms or when a promise made within the contract is not upheld.

Damages can also be sought in cases of anticipatory breach of contract. An anticipatory breach occurs when one party to the contract declares their unwillingness to fulfil their obligations under the contract moving forward. In such situations, the other party can choose to either continue with the contract or terminate it. In the event of an anticipatory breach of contract, the plaintiff can claim damages by demonstrating the intention to fulfil the contract before the contract’s rescission.

Conclusion

Disputes, an almost inevitable facet of construction contracts, stem from the complex nature of the underlying agreements and the lengthy duration of construction projects. Whether arising from variations in project specifications, allegations of fraud, breach of contract, or other factors such as evolved socio-economic dynamics, disputes demand careful and thorough resolution. In this context, arbitration and pre-arbitral mechanisms play a crucial role in maintaining predictability and reducing the risk of prolonged disputes.

Effectively managing long-term construction contracts involves the critical task of allocating and mitigating risks. A host of risk mitigation measures, including contractual mechanisms, guarantees, insurance, and indemnities can be employed to navigate the challenges inherent in construction projects. Apart from the contractual covenants, principles such as: (i) causation; (ii) breaks in the chain of causation; and (iii) remoteness guide the assessment of damages.

Construction disputes often revolve around common themes, such as delays, extension of time, and variations in scope. Delays, subject to liquidated damages clauses, may lead to disputes over responsibility and entitlement to compensation. Extension of time provisions, often present in contracts, allow for adjustments due to critical events impacting project timelines. Variations in scope, vital for project adaptability, require clear authorisation to avoid unauthorised demands that can strain the contractual relationship.

In essence, navigating the complexities of construction contracts involves a delicate balance between risk management, dispute resolution, and adherence to legal frameworks. A thorough understanding of the foundational principles, coupled with effective contract drafting and risk mitigation strategies, is essential for successful construction project management and the prevention or swift resolution of disputes.