Current Issues In Construction Contracts

Current Issues In Construction Contracts

December 01, 2001

A longstanding tenet of project finance dogma is that a project must be constructed pursuant to a lump-sum, turnkey engineering, procurement and construction or “EPC” contract where the risks of delayed completion and failure of the plant to meet performance standards rest squarely on the EPC contractor’s shoulders.

Market developments, cost considerations and the changing perspectives of developers have caused some cracks in the doctrinal wall.

Turbine Wraps

Many project developers placed large orders for gas turbines with Siemens Westinghouse Power Corporation, General Electric and other turbine suppliers in anticipation of using these turbines in projects under development. For a long time, turbine slots were in short supply; the situation has now turned around to a point where 100 turbines or turbine slots are reportedly for sale. Developers typically enter into purchase orders for turbines prior to negotiating an EPC contract.

If the developer anticipates financing a project on a limited recourse basis, when it negotiates an EPC contract it typically asks the contractor to assume the turbine purchase order and provide a turnkey “wrap” of the turbine supplier’s obligations in the same manner as if the contractor had negotiated and entered into the turbine purchase order itself.

This approach has opened the door to contractor claims that the turbine purchase orders are insufficient in certain respects to allow a full wrap and may lead to negotiations about exceptions to the turnkey wrap. The most significant exceptions a contractor may seek relate to the amount and timing of, and triggers for, liquidated damages payments. For example, if the liquidated damages payable under the turbine purchase order for late performance or for failure to meet guarantees of electrical capacity and heat rate are less than those otherwise payable for such events under the EPC contract, then the contractor may seek to limit its liability under the EPC contract for such amounts to the amounts payable under the purchase order where the turbine supplier is responsible for the delay or performance shortfall.

However, the determination of which party is responsible for a delay or performance shortfall is not necessarily a simple exercise. Project construction involves numerous subcontractors and suppliers performing thousands of tasks. A solution is to allocate responsibility for the delay or performance shortfall between the contractor and turbine supplier and to adjust the liquidated damages accordingly. This is a complex task and is likely to result in delays in finally determining the amounts due. This issue can be partially addressed by providing that the contractor must, at a minimum, pay liquidated damages in the amounts provided under the turbine purchase order.

Other mismatches between the obligations of the turbine supplier and the EPC contractor may lead to other contract adjustments. For example, where guaranteed equipment delivery times under the turbine purchase order do not support the contractor’s milestone schedule, the EPC contract may provide for a change order if the turbines are not timely delivered. Broader force majeure provisions in the turbine purchase order may find their way (as to the turbine supplier only) into the EPC contract.

These sorts of exceptions to the turnkey wrap of an EPC contract should not render the contract unfinanceable. Rather, the lenders will analyze the EPC contract in light of the additional risks the exceptions pose and will look to the developer to cover those risks. For example, if the EPC contract contemplates scenarios under which liquidated damages may be payable at the rate provided for in the turbine purchase order, lenders will analyze whether liquidated damages payable at the lower rate adequately cover the costs to the project of delays or performance shortfalls. If they do not, then the lenders will likely require that the sponsor provide a contingent equity commitment to cover potential shortfalls.

Construction Management Agreements

Some developers have been taking a very different approach. They are not looking for the contractor to wrap the turbine contract and in certain instances are not looking for the contractor to provide liquidated damages or minimum performance guarantees. These developers, including those that are the offspring of electric utilities, may have substantial histories of constructing power plants other than on a turnkey basis and managing the construction process. They are accustomed to putting their balance sheets behind the construction effort. The payoff is a substantial reduction in the EPC contract price; contractors charge significant sums for full turnkey wraps. Another payoff may be a shorter period of time to get a contract in place and construction underway.

The clear downside to this approach is that these contracts are not financeable without sponsor support. One way to provide this is through a sponsor construction guarantee or a contingent equity funding commitment in favor of the lenders. Another approach which may avoid balance sheet recognition of the contingent liabilities of a guarantee or equity funding commitment is for the sponsor to enter into a construction management agreement. This agreement is drafted to fill the gaps in the EPC contract — to provide for the payment of liquidated damages or for minimum performance guarantees where the EPC contract is lacking.

The construction management agreement is entered into by the sponsor with the developer— not the lenders — and it makes no mention of project debt. Hence, it is not a financial guarantee or equity funding commitment. This may have the effect of permitting the sponsor to exclude these obligations from its financial obligations for purposes of determining whether certain of its financial covenants are met under its corporate financing agreements. The construction management agreement is collaterally assigned to the lenders. The bargain struck by developers taking this approach is clear: substantial savings on construction costs come at the price of substantial recourse.

The lump-sum turnkey EPC contract is far from dead and is still the preferred approach of developers for managing construction risks. However, where the circumstances require or where the savings of taking other approaches are compelling, developers have shown a willingness to look at other approaches to managing construction risks.