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By Jesse B. Grove, III

To an American lawyer specializing in construction law, the idea that the contractor should have an equitable adjustment of commercial terms to account for unforeseen and unforeseeable subsurface conditions is axiomatic. To the extent that construction law is taught in our law schools, the federal standard forms are taken as the norm. Received wisdom, embodied in the federal form since 1926, is that "Type I and Type II" 1/ changed conditions justify contractual relief.

Type II changed conditions justify relief because it seemed to our forebears that it is inherently unfair to burden a lump sum contractor with the costs of overcoming obstacles that no one, that is no reasonably experienced estimator, could have foreseen. For those who are commercially driven, the justification is that without such relief all bidders will include contingencies for the unknown, thereby burdening the employer with the obligation to pay for a risk that may not (usually will not) ever materialize.

Type I changed conditions have two additional justifications. First, it is unseemly for the employer to benefit by publication of (even unintentionally) misleading information, i.e., it smacks of fraud. Second, the fairness of the low bidder scheme of procurement is compromised unless all bidders can rely on the information given and thus occupy a level playing field.

The rest of world mostly agrees. 2/

The Hong Kong Exception

Hong Kong does not agree and has not for the past decade or so. Government's standard forms of contract for construction place the risk of unforeseen and unforeseeable sub-surface conditions on the contractor regardless of whether the contractor was misled by insufficient or inaccurate information given him by Government. Thus, the contractor must bear the financial consequences (including liquidated damages for consequent delay) of discovering the unexpected, whether it be natural (e.g., faulting, fracturing, quicksand, vice rock, rock vice soil, voids, material prone to settlement, peaks and valleys in rock profile); toxic or hazardous (e.g., military ordnance, asbestos, hydrocarbons, PCBs, industrial and human wastes); or manmade (e.g., utilities, pilings, artifacts, antiquities, out-of-specification embedments in reclamation areas).

The author served as consultant to the Government of Hong Kong Special Administrative Region in 1998 to make a "fundamental review of the GCCs [General Conditions of Construction] and in particular the allocation and management of risk in the procurement of works projects... with recommendations on any modifications necessary in the interests of public finance based on international best practice." One of the recommendations in the Final Report 3/ was that Government should accept the risk of unforeseen and unforeseeable physical conditions. The following justification was offered:

12.5 The most important way to deal with this risk is to eliminate it through pre-tender sub-surface and site explorations, and designs that allow for suspected adverse conditions. I understand from interviews that Government's designers are up to the mark in this area. The fact remains that there will always be some risk of unexpected adverse physical conditions despite highly professional design efforts having been applied. If the conditions should have been appreciated but were not because of professional error or if the design is unreasonably aggressive, the risk will accrue to the designer (or design/builder).

12.6 The second most important mitigator is to make sure the tendering contractors have adequate opportunity to make a visual inspection of the site and consider all available geological and exploratory information. This means that Government should take the initiative to gather such information and give it to the contractors with explicit warnings of indicators of difficult conditions. Contractors may be required to make their own interpretations, but that is not a basis for withholding interpretations by Government's experts. Since a well-drafted clause will prevent entitlement to extra compensation in connection with conditions actually foreseen, it is important to give the contractor every opportunity to foresee.

12.7 It may occur that the contractor is misled by justifiable reliance on insufficient or inaccurate information supplied by Government. If this occurs by reason of professional negligence, the risk will fall on the designer. In any event, the risk should not fall on the contractor. The first principle of risk allocation -- the Fault Standard -- applies. It is unconscionable for Government to transfer the risk of its own misrepresentation, and possibly not enforceable at law. It should be noted that accepting responsibility for representations made as to physical conditions brings with it an alternative risk sharing mechanism. Where Government wishes the contractor to bear risk up to a certain level (e.g., one foot of soil settlement) but is willing to accept the risk that conditions will turn out to be worse, it can achieve this by representing that conditions will be no worse than the specified level.

12.8 The risk that a truly unforeseeable and unforeseen physical condition will be encountered remains to be considered. Those who adhere to the Foreseeability Standard (which includes the majority of international employers) have no difficulty concluding that this risk should not be transferred to the contractor. Those who prefer the Management Standard argue that this risk belongs to the employer because the employer has the best opportunity to control and avoid the risk through pre-tender site exploration. (It cannot seriously be argued that the contractor has similar opportunity, and anyway employers do not want multiple tenderers performing site explorations for a whole host of practical reasons.) The Incentive Standard can be argued either way, but it is noted that this is an employer's risk under the ECC.

12.9 A compelling consideration is that this risk has potentially catastrophic consequences beyond that which even a large international contractor can bear. Thus a contractor who has accepted the risk may have no alternative to an attempt to pass it back to the employer through some stratagem such as a strained theory of impossibility.

12.10 The risk is also impossible to quantify by estimate and allow for in pricing. This means that contractors will either throw a "guesstimate" contingency into the tender price or take a gamble that all will be well. The effect is that the winning tenderer will either be the gambler or the low guesser. Frequently this will be the thinly financed, low asset contractor who has little to lose. It is not in Government's interest to attract this calibre of contractor, nor to discourage highly competent, conservative contractors.

12.11 On a practical level, contractors refuse to accept that this risk should be borne by them. If forced to accept the risk, they will strive mightily to offset the burden. Excessive claimsmanship and adversarial conduct can be expected. This creates the breeding ground for disputation and its notorious consumption of resources.

12.12 Another reason for changing Clause 13 is that it is difficult for the employer to administer, and it is probably being administered inconsistently. When an unforeseen physical condition -- say, an utility clash -- is encountered, Government has two choices: leave the solution up to the contractor or issue a variation order to overcome the difficulty. The former leaves the financial burden on the contractor, and the latter transfers it to Government. Government's representative is thus motivated not to vary the works even if that is (i) the most desirable or cheapest solution or (ii) the best technical solution. This could even lead to a viable contractor claim of impossibility notwithstanding that a minor specification variation would obviate the problem. 4/

The foregoing convinced the Construction Industry Review Committee, chaired by the Honourable Henry Tang, to recommend in its January 2001 report that Government seriously consider adopting the recommendation. 5/ So far, Government remains unmoved.

Government has not explained its position, but the countervailing considerations are somewhat obvious. They are: (1) protection of the public fisc, and (2) avoidance of disputes and litigation (or arbitration). These are legitimate and important reasons.

Protection of the Fisc

Government is entitled to insist on forward pricing of its contracts in order to maintain appropriate control of its budget. To the greatest extent possible, it is legitimate for Government to avoid contracts that allow for surprising cost escalations. The Central Artery Project in Boston, Massachusetts, has come under serious political fire recently, not so much because of the cost of the project as for the fact that the potential cost was seriously under-appreciated until near the end of construction. Many major projects in recent memory might not have been commenced if the outturn cost had been accurately predicted. Those with approval authority resent the appearance of being gulled. Finally, the experience in Hong Kong shows that Government can get away with transferring changed conditions risk to the contractor. The contractors may be howling, but they still are bidding.

It is difficult to make the case that employer acceptance of the risk of changed conditions actually will produce greater value for money. This is the way it was argued in Grove Report. 6/

23.1 To the extent that contractors are including contingencies in their tender pricing for the risks in question, then Government is paying for the risk whether it materializes or not. Over many projects, this could be a substantial waste of public funds as it will aggregate to a greater amount than the direct costs of rarely occurring materialized risk.

23.2 To the extent that contractors are not including contingencies, the current risk allocations tend to encourage gambling and guessing, which in turn leads to lower calibre contractors receiving Government awards. These contractors will consume more Government management resources and deliver lower quality work less reliably than their more conservative and competent competitors. They are more prone to financial failure during performance and more likely to embroil Government in disputes. Over many projects, this too could be a net waste of public funds.

23.3 Even the most reputable and competent contractors will do their utmost to transfer risk back to the employer or recoup losses by other means if the risk allocation is viewed by them as inappropriate, unfair by international standards or threatening to company survival. This means disputes. And the disputes likely will be hard to resolve because they will be thin on legal and contractual justification and long on desperation. The cost to Government of dispute-ridden projects is enormous. The direct costs of defending alone are very high. The indirect costs of losing focus on and control of the construction process can be much greater. In my opinion, these costs will be higher than the direct costs of accepting the risks which I have identified as candidates.

23.4 I cannot prove the cost equation by empirical evidence, and I do not believe that others can. Moreover, I do not fully trust surveys of contractors, even though the contractors have the best information. But, I can say that many who have studied these issues agree with my conclusions.

23.4.1 To begin with, every Government, every international employer and every financing party (such as the World Bank) that has adopted GCCs with risk allocations congruent with those I recommend has done so not out of altruism but because of a conclusion that there is financial justification.

23.4.2 The sponsors of the international forms of contract identified in paragraph 3.5 (ICE, FIDIC, etc.) can be taken to agree.

23.4.3 The Mass Transit Railway Corporation can be taken to agree.

23.4.4 The Construction Industry Institute, the Center for Public Resources, the American Society of Civil Engineers, and the Risk Allocation Subcommittee of a Joint Working Party of the Australia National Public Works Conference and the National Building and Construction Council all agree.

23.4.5 A plethora of respected industry savants have expressed agreement in their published works.

23.5 To the contrary, however, many employers take the view that their interests are best served by transferring as much risk to the contractor as the market will bear. I suggest that there usually are special reasons for this which do not apply to Government public works. Certainly the rationalia are different for the one time or occasional employer than for a repeat employer on the scale of the Government of the Hong Kong SAR.

One can hardly blame the protectors of the public fisc for focusing on the admission in the first sentence of paragraph 23.4.

Avoidance of Disputes

Critics of changed conditions entitlement point out that the usual contract clauses are difficult to administer because they embody a subjective standard. The test of entitlement is foreseeability, i.e., that which is foreseeable by an experienced bidder does not qualify whereas that which is not, and which was not actually foreseen, does. This puts contract entitlement into the murky realm of tort law. It invites the engagement of experts who can be expected to have opinions favoring the party writing the paycheck. The end result is an unwelcome lack of predictability. Only a judge, jury or arbitrator can say for sure. Thus, most cases will wind up consuming the large resources necessary to obtain third-party dispute resolution.

There is merit to this argument but not as much as might appear facially. Again, having to admit lack of empirical evidence, it could be said that most changed conditions situations present circumstances that are easy to evaluate against a foreseeability standard. One should expect to encounter sand in the Middle East but not perched water. In fact, most changed conditions situations that involve the presence of a wholly different material than expected are easy to evaluate. The rub comes when the risk of what was encountered was known generically but not to the degree of occurrence.

The Channel Tunnel (if one glosses the facts to suit) illustrates the problem. Everyone knew what the tunneling medium (chalk marl) would be and the suitability of that material for using tunnel boring machines (TBMs). Everyone knew, as well, that some water infiltration would occur because the marl is somewhat fractured and fissured, especially near the shore, although otherwise quite impervious. What no one knew for sure is just how much water infiltration over what length of tunnel might occur. This was extremely important because there are two kinds of TBMs: those that can stand water infiltration and those that cannot. The former are expensive to build and slow and expensive to operate; not ideal for what everyone knew most of the Chunnel length would be like. The latter are cheaper to build and can run like a greyhound, but could get stuck in a bad area with disastrous cost consequences.

The French chose the tortoise; the British chose the hare. The French encountered conditions that were a little more favorable than a pessimistic bidder would have expected, and the British hit ground that was a little worse than either an optimistic or a middle view would have predicted. The French proceeded ponderously without incident, and of course the British hare got stuck, had to be rebuilt and, only after huge cost consequences, got through the bad ground and then set records for daily progress.

The British wanted changed conditions relief. The employer took the view that conditions were not changed (or unforeseen, much less unforeseeable), just a little worse than the contractor consciously gambled. The British pointed out that the employer would have paid, and did pay the French, for being conservative. Moreover, the British machine eventually performed so well that it shot right by "Point M" (the planned meeting point) while the French machine still was plodding ahead. In the circumstances, the employer could be said to be not disadvantaged by a somewhat daring British decision.

It is hard to say how many tough cases like the Channel Tunnel arise each year, but experience suggests that it is not a few. This raises the question whether some better formulation of the changed conditions clauses could be found.

A Better Way Forward

The possibility of encountering unexpected subsurface conditions now is frequently treated as a risk that should be allocated on a case-by-case basis. While a Government cannot negotiate purpose-built clauses in all of its hundreds of procurements a year, private parties frequently do, and Governments can to some extent. Certainly Governments can custom craft the allocation of subsurface risk for huge infrastructure projects. In fact, that is exactly what happened with the Hong Kong Airport project.

There are any number of ways to carve the risk. It can be done by quantity, as when the contractor takes the risk of ground settlement up to a point (say 3 feet) and the employer beyond that point. In the Chunnel case, it could have been done by establishing a break point in terms of cubic feet per second. In a pipeline project, the contractor could be directed to assume a certain footage of rock ditch in its bid, and the employer would then pay an unit price extra for exceedance.

No matter how it is done, project-specific risk allocation brings with it the opportunity for shared risk. "Dead bands," "bogeys" and less-than-adequate unit prices are the most common devices. The idea is to keep the contractor incentivized to manage and overcome the risk while relieving it of disastrous cost exposure.

It should not be forgotten that specific risk allocation still leaves open the question of who takes the default position if something happens that was not mentioned at all. To illustrate, consider that the typical pipeline contract provides for unit price protection if the contractor hits rock, high water tables or obstacles that prevent normal sequencing of the work. Every other kind of subsurface risk is left to the contractor, and that has proven to be commercially acceptable. By comparison, generic changed conditions clauses require the employer to assume the default position. This may be commercially unnecessary.

Conclusion

Changed conditions clauses are here to stay and are desirable for fairness, commercial benefits to both parties and congruency with public bidding. They mostly work well, but the subjective standard employed can lead to disputation. An improvement that is obvious for a major project is to use a project-specific risk allocation scheme that will provide necessary protection even though the default position may remain with the contractor.

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ENDNOTES

1/ Type I = different than represented; Type II = unforeseeable.

2/ Appended to this paper is a survey of changed conditions clauses in well-known forms of contract.

3/ Known today as the "Grove Report" and available at:
www.constructionweblinks.com/Resources/
Industry_Reports_Newsletters/Nov_6_2000/grove_report.htm

4/ "Grove Report," supra at:
www.constructionweblinks.com/Resources/
Industry_Reports_Newsletters/Nov_6_2000/grove_report.htm

5/ "Tang Report," January 2001, p. 74

6/ "Grove Report," supra at: www.constructionweblinks.com/Resources/
Industry_Reports_Newsletters/Nov_6_2000/grove_report.htm

APPENDIX

A. Contract Forms Referenced:

1. Fédération Internationale des Ingénieurs-Conseils (International Federation of Consulting Engineers, or FIDIC), Conditions of Contract for Works of Civil Engineering Construction, Part I, General Conditions, Fourth Edition (1987, reprinted in 1988 and 1992 with amendments) ("FIDIC").

2. Australian Standard, AS 4000 - 1997, General Conditions of Contract (1997) ("Australian Standard").

3. The Institution of Civil Engineers (United Kingdom), The Engineering and Construction Contract, Second Edition (1995, reprinted with corrections May, 1998)
("ECC").

4. Federal Acquisition Regulation (United States), Title 48, Subpart 52.2, Code of Federal Regulations, Text of Provisions and Clauses (1997) ("FAR").

5. American Institute of Architects (United States), AIA Document A201-1997, General Conditions of Contract for Construction (1997) ("AIA").

6. Engineering Advancement Association of Japan (Japan), ENAA Model Form International Contract for Power Plant Construction (Turnkey Lumpsum Basis), Vol. I, General Conditions (1996) ("ENAA").

7. Construction Industry Development Board (Singapore), Public Sector Standard Conditions of Contract for Construction Works (1995) ("Singapore").

8. GC/Works/1 Without Quantities, Contract for Building and Civil Engineering Major Works, General Conditions (1998) ("GC/Works/1").

9. The Institution of Civil Engineers (United Kingdom), The New Engineering Contract, First Edition (1993) ("EC 1993").

10. The World Bank, Standard Bidding Documents, Procurement of Works (1995) ("World Bank").

11. Joint Contracts Tribunal for the Standard Form of Building Contract, Standard Form of Building Contract, Private With Quantities (1980 Edition, incorporating amendments issued through April 1998) ("JCT 80").

12. Joint Contracts Tribunal for the Standard Form of Building Contract, Standard Form of Building Contract With Contractor's Design (1981 Edition, incorporating amendments issued through April 1998) ("JCT 81"),

13. Institution of Civil Engineers, Association of Consulting Engineers and Federation of Civil Engineering Contractors, ICE Conditions of Contract, (Sixth Edition, January 1991; reprinted with amendments, November 1995; reprinted November 1997) ("ICE 6th Edition").

B. Ground Conditions Provisions

FIDIC, World Bank: Contractor entitled to additional costs for expenses and time extension for delays resulting from physical obstructions or conditions, except climatic conditions, not reasonably foreseeable by an experienced contractor (Sub-Clause 12.2) or resulting from fossils, coins, articles of value or antiquity and structures and other remains or things of geological or archaeological interest discovered at site (Sub-Clause 27.1).

Australian Standard: Contractor entitled to additional costs incurred upon encountering minerals, fossils or relics (Subclause 24.3). Contractor entitled to variation pricing (set by agreement, in contract or as otherwise reasonable, including amount for overhead and profit) for costs resulting from latent physical conditions on or near site, including artificial things but excluding weather conditions, that differ materially from physical conditions which reasonably should have been anticipated by competent contractor after reviewing tender information (Subclauses 25.1 to 25.3, 36.4). Time extension also is provided as a form of relief for delays resulting from such conditions (Subclause 34.3).

ECC, EC 1993: Contractor entitled to adjustment of contract price and/or schedule for costs/delays resulting from physical conditions within site, other than weather conditions, that an experienced contractor would have judged at time of contracting to have such a small chance of occurring that it would have been unreasonable for it to have allowed for them (Clause 60.1.12).

FAR: Contractor entitled to equitable adjustment of contract price and/or time for costs/delays resulting from sub-surface or latent physical conditions at site differing materially from those indicated in contract or unknown physical conditions at site that are of unusual nature and differ materially from those ordinarily encountered and generally recognized as inhering in work of character provided for in contract (Section 52.236-2).

AIA: Contractor entitled to equitable adjustment of contract price and/or time for costs/delays resulting from sub-surface or otherwise concealed physical conditions that differ materially from those indicated in contract documents or unknown physical conditions of unusual nature that differ materially from those ordinarily found to exist and generally recognized as inherent in similar construction activities (Subparagraphs 4.3.4, 8.3.1; Paragraph 10.3).

ENAA: Contractor entitled to additional costs for expenses and time extension for delays resulting from physical conditions, other than climatic conditions, or artificial obstructions on site not reasonably foreseeable by experienced contractor on basis of information provided by owner and information obtainable through visual site inspection (GC 35.1 to 35.3).

Singapore: Contractor entitled to additional costs for expenses and time extension for delays resulting from artificial obstructions that are encountered while carrying out sub-surface works and are not reasonably foreseeable by experienced contractor (Clauses 5.2; 22.1 (g)).

GC/Works/1: Contractor entitled to adjustment of contract sum for value of work carried out or omitted and/or extension of time for delays due to ground conditions (excluding those caused by weather but including artificial obstructions) that he did not know of and that he could not reasonably have foreseen having regard to any information that he had or ought reasonably to have ascertained. (Conditions 7 (2) to (5); Condition 36 (2) (d)). Contractor entitled to variation pricing for actions taken upon discovery of fossils, antiquities or objects of interest or value (Condition 40 (2) (n)).

JCT 80 and 81: These are remeasurement forms that effectively place much of the ground condition risk on the employer. The only express provision requires that the amount of Contractor's direct loss and/or expense resulting from discovery and specified treatment of fossils, antiquities and other objects of interest or value at site shall be added to Contract Sum, and time may extended for delays resulting from Architect's variation instructions with respect to such items (Clause 34.3).

ICE 6th Edition: Contractor entitled to additional costs plus reasonable profit and an extension of time for delays resulting from physical conditions (other than weather conditions or conditions due to weather conditions) or artificial obstructions, which conditions or obstructions could not reasonably have been foreseen by an experienced contractor (Clauses 12 (1), 12 (6)). Even if Engineer believes such conditions were reasonably foreseeable, any resulting variation ordered by Engineer shall be valued according to specified rates or prices or approximations thereof and included in contract price (Clause 12 (5)).


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