17 Sep 2010

Alliance contracts - a commercial framework requires a commercial lawyer

by Owen Hayford

Unlike some traditional contracts, the commercial framework of an alliance contract is carefully tailored to the specific objectives of the project - for this you need a legal adviser who is commercially astute, and willing to roll up their sleeves.

Alliance contracting has developed significant momentum in Australia, initially as a response to the inherently adversarial nature the traditional methods of construction contracting, and more recently as a delivery model well suited to projects:

  • involving significant risk which is best managed collectively;
  • with significant scope for value adding through innovation;
  • where the scope is not yet sufficiently developed to enable sensible pricing, or where the likelihood of scope changes is significant; or
  • with tight timeframes which require scope definition, design and construction to occur concurrently.

It might seem counterintuitive to say this, but the process of attempting to align the commercial interests of the parties to an alliance contract can actually lead to unintended and sometimes perverse outcomes. This is because not only are participants creating their own (often complex) arrangements and cannot rely upon precedents and standard form contracts, but the flexibility and uniqueness of each commercial framework also adds a layer of complexity. Seemingly simple decisions made by the project team at the start of the process can have subtle and unanticipated effects which might only become apparent much further down the line. So what's the solution?

From our experience, involving a commercially savvy lawyer as early as possible in the process cannot only prevent some problems arising, it can also provide a useful perspective which can lead to a more commercially sound outcome for all participants.

The basics - and challenges - of alliance contracting

Alliance contracts seeks to align the commercial interests of the parties by incorporating three key concepts:

  • performance-based remuneration (based on direct costs with a margin/fee and a "painshare/gainshare" regime)
  • unanimous decision-making
  • no blame.

In combination, these three elements create a commercial model where all parties, owners and non-owner participants alike, bear collective responsibility for the project's success or failure.

Before commencing the alliance, the project team will sit down and identify the key project objectives, and the possible spectrum of performance between failure at one extreme and outstanding performance at the other. The team will also spell out the minimum targeted standard of performance required - often called the minimum conditions of satisfaction.

A major advantage of alliance contracting is that it avoids the blunt common law mechanism of damages for breach of contract. Instead, participants can shape a commercial framework which precisely allocates gainshare or painshare payments depending on performance in those aspects of the project which matter to the client most. These consequences can be very specific for specific events (for example, a specific dollar or percentage penalty if a serious adverse environmental event occurs) or more broad brush, reflecting the performance of the project during the whole design and construct period (for example, timeliness of delivery, or the extent to which the local community feels engaged by the project).

So what good is a lawyer in alliance contracting?

This level of individual detail means that standard form contracts will not protect participants. If the contract were a suit, it would need to be bespoke, not off-the-rack. It's at this point that participants will benefit from a lawyer's involvement as a key member of the project team to grapple with issues such as the attribution of financial consequences for project performance, whether these are apt to drive outstanding performance, and the balance of interdependency between the different project objectives and their remuneration consequences.

The legal practitioner can have a role in strategising the terms of the commercial framework and its interaction of the general terms and conditions that adds substantial value because:

  • The best construction lawyers will have experience from a number of alliance contracts which they can contribute to the project team, which in many cases is less experienced.
  • Lawyers are trained to be logical and rigorous. While other members of the project team may come up with ideas that will serve the project well, a lawyer is well placed to test and refine those ideas within the project team.
  • Lawyers also have a natural tendency to consider extreme situations, whether they be worst case or best case. Commercial people by nature more often consider the more likely outcome and as a result consider outcomes nearer the middle of the probability curve.
  • Lawyers can assist with the preparation of a strong business case. One of the crucial points raised in our March article Is public sector alliancing dead? was that business cases need to address value for money outcomes on projects to get through Treasury.

Some examples may illustrate areas where value can be added by using a commercially minded lawyer to structure an alliance along with the project team.

Variable margins - There are currently different views in the market on whether participants' margins should be variable (depending on the outturn cost of the project) or fixed (as a percentage of the budgeted target costs). Whatever the outcome of this debate, you should consider the consequences for the commercial framework. For example, if a variable fee is used, is it consistent with alliance principles that the participant shouldn't receive a margin on significant third party claims?

Timing of gainshare payments - There are a number of questions regarding the timing of gainshare or painshare payments which need to be answered consistently by the general terms and conditions and the commercial framework:

  • When is gainshare or painshare paid - interim payment at practical completion, reconciled at final completion?
  • Can the owner retain payments if painshare becomes likely?
  • Is there a reconciliation of gainshare if significant costs are incurred after final completion, such as third party claims or defect rectification - how long is the ledger kept open?

Direct costs - These usually include a number of exclusions which must be consistent with the general terms and conditions, including:

  • wilful default;
  • breach of intellectual property rights; and
  • GST input tax credits

Other exclusions require careful legal analysis, such as the reimbursement of statutory fines and penalties.

Gainshare modifiers - A growing trend in alliance contracting is the use of gainshare modifiers. These are often used for project objectives that have significant downside risk, but arguably little upside opportunity, such as a no-harm outcome in the safety or environmental context. If significant adverse events occur under these headings, the entitlement to gainshare is reduced by a fixed percentage.

There are dangers in the overuse of gainshare modifiers. The fundamental issue with gainshare modifiers is that they only modify gainshare. If the project is failing, and painshare is likely, the gainshare modifiers will have no effect.

Moving too many project objectives under the gainshare modifier regime will have the effect of minimising the pool of gainshare that can be created to be modified by the gainshare modifiers.

Insurance - While alliancing remains a relatively new form of contracting, insurances will continue to be the subject of some discussion. Two issues which tend to arise are:

  • DIC cover - Contractors often seek to claim as a direct cost an allowance for "difference in conditions" (DIC) cover due to the difference in the level of coverage provided by principal arranged insurance and insurances taken out by the contractors.

At this stage, a lawyer will be able to see if these differences are real and whether it is appropriate in the alliance contract paradigm for these allowances to be charged.

  • Professional indemnity insurance - The need for particularly tailored professional indemnity insurance for alliance contracts is well documented. Also important, however, is the need for a practitioner who understands the practical implications of an alliance professional indemnity policy on the likely project outturn cost. As PI is usually taken out during the development phase of the project it may be necessary for contract drafting to deal with which contingencies are allowable in the target outturn cost. An experienced lawyer is well placed to identify the relevant risks.

 

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.