Adjustment Clauses in Services and Construction Agreements [Gaille Energy Blog Issue 92]
- Posted by scottgaille
- On July 11, 2020
- 0 Comments
A Contractor’s pricing and schedule are based on a variety of factors, including the scope of work, site conditions, and seasonal weather risks. Sometimes nothing changes. More often than not, though, the Owner makes changes to the scope of work—or the Contractor encounters conditions that delay its Work. Should the Contractor be paid more? Should the Contractor receive an extension to its schedule?
The contractual mechanism for addressing post-signing changes is an “Adjustment” clause. A “Price Adjustment” increases or lowers the Contractor’s compensation. A “Schedule Adjustment” (or “Time Adjustment”) extends or shortens the amount of time the Contractor has to complete the Work.
Energy construction/services agreements have two approaches to handling Adjustments:
- Enumerated Adjustments. Agreements with enumerated Adjustment clauses will list each and every circumstance for which the Contractor is entitled to a Price Adjustment and/or Schedule Adjustment. As such, the Owner has limited discretion to deny the Contractor’s claim when one of these circumstances arises—and the Contractor will be unable to pursue Adjustments due to any other circumstances.
- Discretionary Adjustments. Agreements with discretionary Adjustment clauses generally do not list the specific grounds for Adjustments; instead, the Agreement has a general standard, such as “changed circumstances that are beyond the Contractor’s control.” These types of clauses grant the Owner considerable discretion to say “yes” or “no” to a Contractor-requested Adjustment—but the Contractor may be able to seek Adjustments for a wider range of circumstances.
Over the course of my 25-year career, the general trend in construction/services contracts has been toward enumerated Adjustments. The main reason for this is that both Owners and Contractors prefer predictability. It’s easier for Contractors to bid on projects when they know in advance what circumstances they will receive Adjustments for. It’s easier for Owners to create project budgets when they know in advance what types of circumstances they will have to grant Adjustments for.
The discretionary Adjustment clause can be unpredictable. Contractors are at the mercy of the Owner’s project manager. Whether or not an Adjustment is granted may depend on how much a manager has remaining in the project budget. Owners are potentially at the mercy of the Contractor, too. A Contractor that has underbid the project (or is suffering from poor productivity) may exploit the ambiguity of the discretionary Adjustment clause to make up lost dollars.
Once the enumerated Adjustment approach has been selected, what grounds should give rise to a Price Adjustment and/or Schedule Adjustment? Adjustment grounds can be categorized as either being within, or outside of the Owner’s control:
- Within the Owner’s Control. If the Owner causes the need for an Adjustment, then the Contractor generally should be entitled to both a Price Adjustment and a Schedule Adjustment.
- Outside the Owner’s Control. If something outside the Owner’s control causes the need for an Adjustment, then the Contractor should (generally) only be entitled to a Schedule Adjustment (sometimes referred to in the industry as “time-no-money”).
The below table categorizes types of enumerated Adjustments based on whether the Owner caused them:
“Time-no-money” for events that are outside of the Owner’s control is the industry standard for a good reason: placing the cost of dealing with such events on the Contractor incentivizes it to take efficient steps to mitigate. It places the risk on the party (the Contractor) best-positioned to reduce costs for circumstances such as weather and force majeure.
Of course, the Contractor is compensated for bearing these kinds of risks in the form of additional payments (i.e., contingencies). For example, a Contractor that bears weather-related costs will usually be paid higher rates than a Contractor that has the right to receive Price Adjustments for weather. With “time-no-money,” the Contractor self-insures against weather. When such higher rates exceed the actual costs incurred for weather, the Contractor makes excess profit—which can be used as a rainy-day fund (for those future projects in which weather costs may exceed the Contractor’s contingency).
The alternative to “time-no-money”—that is, Price Adjustments for circumstances beyond the Owner’s control—means that the Owner is insuring the Contractor for these costs. In such cases, the Contractor’s rates will almost certainly be lower, as the Owner will no longer permit the Contractor to include contingencies for any items for which it is entitled to a Price Adjustment.
When does it make sense for an agreement to offer a Price Adjustment for a circumstance that is beyond the Owner’s control? The short answer is when there are known events that generate highly variable costs. Such variability can drive up Contractor contingencies (for self-insurance), potentially leading to Contractor windfalls if the risk comes in on the lower side of its known range. For example, consider a project in the Gulf of Mexico during September. The Contractor may have to build in excessive amounts of contingency dollars to cover the 1-in-3 risk of a hurricane. If it ends up being a quiet year (a 2-in-3 chance), this contingency would be a windfall for the Contractor. The Owner may decide that it is more likely to come out ahead if it strips the weather contingency from the Contractor’s compensation and just grants Price Adjustments for a hurricane, if and when one comes.
It also is important that each of the enumerated grounds for an Adjustment be clearly defined. There should be minimal discretion involved when determining whether a ground has been triggered. For example, “Change” should only be applicable if the Owner actually modifies one of the exhibits attached to the Agreement. This is an objective standard that is triggered only by the execution of a written change order (or change directive).
The combination of an enumerated Adjustment clause and clear standards for when each of the enumerated grounds is triggered is a form of “contract completeness.” Having more complete contracts generates a variety of benefits for both parties, including:
- Meeting of the Minds. Detailed agreements address more risks, leading to discussion about which parties should be allocated which risks—and what the compensation should be for bearing them. Negotiation of detailed agreements prevents issues from being swept under the rug.
- Predictability. Managers must live within their budgets, and one’s career (or at least one’s annual bonus) can be in trouble if a project incurs costs that were not built into the project’s original economic model and budget. It is better to, for example, pay a counterparty to accept a risk at the outset than it is to lose a dispute and have to ask for more funds from one’s investors or board of directors.
- Better Relationships. The energy industry is one in which companies often engage in long-term relationships—whether manifested by a single, long-term contract or a series of repetitive, short-term contracts. Clarity on the front end, therefore, pays ongoing dividends to the relationship. When an issue arises that the Agreement failed to address, feelings of surprise and unfairness are more likely to arise.
- Ease of Renegotiation. Detailed contracts clearly allocate rights and obligations among the parties. This means that each party to the contract knows what it owes and is entitled to. This clarity of ownership facilitates renegotiation because trades can more easily be orchestrated. Where contracts have not allocated all possible rights and obligations, there are fewer possible trade combinations, making renegotiation harder.
- Less Litigation. The more risks that are clearly allocated by an agreement, the less likely that litigation will result. Litigators cannot do much with a clear contract because courts are very likely to enforce it according to its terms.
There also is empirical evidence to support the proposition that complete contracts increase profitability. In Measuring Contract Completeness: A Text Based Analysis of Loan Agreements, Bernhard Ganglmair (University of Texas at Dallas) and Malcolm Wardlaw (University of Georgia) analyzed more than 3,000 loan agreements from financial institutions. They used “several measures of contractual detail” to compare the performance of the banks based on how detailed their loan agreements were:
“Consistent with the idea that more complete contracts create less holdup and therefore allow for greater investment efficiency, we find that subsequent annual return on assets and sales growth are higher for firms which sign more detailed loan contracts, conditional on other contractual features such as loan size and covenant makeup. The overall evidence suggests that firms which are able to sign more complete loan contracts are better able to exercise their growth opportunities.” Id. at 4.
There is every reason to believe that similar benefits also exist for construction and services agreements which, like loan agreements, play out over the course of many months or years.
About the Gaille Energy Blog. The Gaille Energy Blog (view counter = 159,282) discusses issues in the field of energy law, with periodic posts at www.gaillelaw.com. Scott Gaille is a Lecturer in Law at The University of Chicago Law School, an Adjunct Professor in Management at Rice University’s Graduate School of Business, the author of three books on energy law (Construction Energy Development, Shale Energy Development, and International Energy Development), and co-author of the award-winning travel compilation, Strange Tales of World Travel (Bronze Medalist, IPPY Awards for Best 2019 Travel Essay; ForeWord Magazine Finalist for Best Travel Book of 2019; North American Travel Journalists’ Honorable Mention for Best Travel Book of 2019).
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