Construction market when there is a war abroad | In Principle

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Construction market when there is a war abroad

The construction market is facing more challenges. After many problems associated with the pandemic, other major difficulties have arisen due to Russia’s war on Ukraine. This presents the second recent case of force majeure affecting the economy. Although the construction sector did well in the pandemic crisis, this time the outlook is much more pessimistic. Thus the new reality requires a rapid response and search for solutions to mitigate numerous risks.

Bidding problems

Right now, the biggest problem of the construction industry is rising inflation and soaring prices for building materials and fuel. This is coupled with great uncertainty about how prices will evolve in the coming weeks, months and years. This causes great difficulty in calculating bids for construction works. Contractors face a significant risk that the bid they submit today will become outdated in the course of performing the project or even sooner, before construction even begins. The seriousness of this risk is confirmed by the significant price fluctuations occurring often from one day to the next. This problem also concerns investors, as they are not sure whether the budget prepared for a given project will prove sufficient. But ultimately it is the investor that will receive the completed project, the cost (and indirectly the value) of which turned out to be higher than anticipated at the beginning of construction. Therefore, contractors do not want to bear this risk and finance the effects of economic changes.

The end of lump-sum bids?

The lump-sum approach most often used in construction contracts in Poland now seems to be exhausted in the current reality, causing the need to look for new solutions that can keep up with the high market dynamics. This trend should be particularly noticed by contracting authorities in public procurement proceedings, where the contractors have little influence on the shape of the contract and the cooperation is based on a template prepared by the investor. If public contracting authorities do not take market changes into account, their inaction may jeopardise the further ability to carry out projects. Shifting all risk to the contractor can result in an inability to complete construction, as well as numerous contractors’ bankruptcies. Currently, many public contracting authorities are trying to wait out the crisis and hoping for the situation to stabilise, as evidenced by the extension of time to submit bids in already open tenders. But this action may not be enough.

Contractual indexation

New contracts (in both private and public sectors) should include appropriate contractual indexation to reflect progressive price increases. One frequently mentioned method is a reference to the prices of building materials from the Sekocenbud indices in Poland. A shortcoming of this solution is that these indicators are published retrospectively, so the parties should expect data from a specific, elapsed timeframe. Also, many businesses argue that these rates, in particular labour costs, are understated and out of line with actual market conditions. Thus, what emerges is the need to develop an appropriate mathematical model and to develop bids or payment terms in a much more complex way than has been done to date. In many situations, this will require resorting to qualified external entities.

Judicial indexation: a legislative postulate

When it comes to existing contracts, the situation is much more difficult, even more so if they do not contain an indexation clause. Judicial indexation, applicable in connection with a sharp decline in the purchasing power of money, is excluded for operators of businesses if the consideration is connected with operation of the business (Civil Code Art. 3581 §4). Currently, this exclusion has no practical or principled justification, and it should be quickly repealed by the parliament. The profound economic changes now underway affect businesses first, and in practice, the use of this institution in consumer relations is less important. Therefore, in its current wording, this provision cannot be used where it is most needed. However, its application will be possible only when the purchasing power of money significantly changes, which is not the case at the moment.

Rebus sic stantibus clause

Another remedy for existing contracts affected by rapid price increases is application of the rebus sic stantibus (change of circumstances) clause (Civil Code Art. 3571 and 632 §2), which authorises the court to change the amount of consideration (increase the fee) or even terminate the agreement.

But in practice this solution entails a number of difficulties, and pursuing claims based on these provisions is complicated. In particular, it must be shown that an extraordinary change in relations has occurred, causing contract performance to be connected with excessive difficulties or threat of a gross loss. An additional ground is the unforeseeability of this situation at the time of concluding the contract. This usually constitutes the main axis of defence of contracting authorities, who cite the contractor’s professional status and argue that the contractor should anticipate many economic risks.

But the greatest difficulty is in proving a gross loss. First, this does not mean just any loss. The law does not guarantee that the contractor will complete the contract with a positive financial result. The loss must be “gross,” which is an evaluative standard and requires an individual examination in each situation. It has been argued that a gross loss is one that threatens the contractor’s financial condition. Also, a loss comparable to the expected profit from the contract may be considered gross (e.g. if the expected profit margin was 5%, a 5% loss may be considered gross). But this approach may be more difficult to pursue in court practice.

Furthermore, the provisions do not prescribe how the loss should be made up: whether it should be brought down to zero, or to a level where the loss is no longer “gross,” or whether the loss should be replaced by a market profit. The courts take different approaches to this problem. Therefore, the recognition that there are grounds for applying the rebus sic stantibus clause does not guarantee that an amount will be awarded that would give any profit from the contract.

Also, pursuing this claim requires submission of complex calculations as to the profitability and outcome of the contract (in particular, presentation of the cost side and assumptions on the generation of profit). In many cases, this will require the use of an external professional (e.g. a chartered accountant). This also means that the contractor must refer to the method of preparation of its bid and provide evidence and explanations of its methodology in this regard. Usually, investors defend by claiming that the price in the bid was too low and the contractor miscalculated it from the beginning, which should be charged only against the contractor. In many situations, it will not be possible to reconstruct how the bid was calculated and what assumptions accompanied it (due to the passage of time, a change in the personnel preparing the bids, or a failure to archive such materials). So it is very important to secure this knowledge and documentation for potential use years later when a dispute might arise.

Also, it is sometimes stated in the case law that claims under the rebus sic stantibus clause can be pursued only as long as the contract is being performed—in other words, when the contract ends, the claim expires. In this respect, it is understood that it is sufficient if the claim is filed before the end of the contract. But the extreme view is that the judgment must be rendered before the end of contract performance, which in practice may not be possible due to the considerable length of court proceedings.

An additional difficulty arises when on the contractor’s side there are several entities acting as part of a consortium. The courts have differed in their approach as to whether a gross loss can be suffered by only one consortium member or must be evaluated through the lens of all consortium members collectively. This is of great practical importance, particularly when one consortium member has made a high profit and another has made a loss, and only the losing consortium member is interested in a fee increase. It can also be very difficult to obtain financial data on the outcome of a contract from other consortium members. Besides, if they are unwilling to participate in the proceedings, and the court requires the participation of all consortium members on the claimant’s side, it will dismiss the case. These positions have also been expressed in the case law and will be considered by the Supreme Court of Poland in the near future.

Force majeure clause

A change in market conditions requires an appropriate response and adjustment to prevailing conditions. Many contracts include a force majeure clause, which may warrant renegotiation of the contract. Such clauses often include information obligations, particularly notification to the investor of the potential impact of the war on the ability to perform the contract (e.g. the outflow of workers to Ukraine, a significant increase in the price of materials, or unavailability of materials). Therefore, it is worth reviewing existing contracts from this angle and identifying further possible scenarios for action. It is worth initiating talks with the investor about the impact of the war on contracts now being performed.

Dr Marcin Lemkowski, adwokat, Agata Jóźwiak, attorney-at-law, Dispute Resolution & Arbitration practice, Wardyński & Partners