Construction

14 Sep 2010

With the recent earthquakes in Canterbury, many queries have surfaced as to liabilities and obligations of the parties under construction contracts based on NZS3910:2003.

Unfortunately, the situation is not as clear as it could be ....

Contractor's entitlement to an Extension of Time

One thing is clear: the Contractor will be entitled to an extension of time to the Due Date for Completion if the Contract Works have been delayed by a seismic event. This is expressly provided in clause 10.3.1(e).

What about compensation for additional costs?

Extension of time may be one thing, but clause 10.3.7 provides that "The Contractor shall not be entitled to compensation for time related Costs where an extension of time is granted on grounds other than the net effect of a Variation."

This applies not only to time related costs - if a Contractor wishes to recover any costs or losses incurred as a result of an earthquake from the Principal, it will generally need to establish an entitlement to a Variation covering those costs (unless the Principal is insuring the Contract Works, in which case the Principal will be liable for (at least) costs and losses up to the level of the deductible - as discussed below).

Unfortunately (for contractors) it is by no means clear where this Variation will come from. Looking at the contractual provisions relating to excepted risks, insurance, unforeseen physical conditions and frustration, none give the Contractor any clear entitlement.

Is an earthquake an excepted risk?

To some extent the Contractor's entitlement to a Variation will depend on whether the seismic event is an "excepted risk".

Excepted risks are sometimes listed in the Special Conditions of contract, but are not usually mentioned because clause 5.6.6(f) provides that the excepted risks include "Any such operation of the forces of nature as an experienced contractor could not foresee or reasonably make provision for, or insure against."

Certainly an earthquake would be something that an experienced contractor could not be expected to foresee. But most contract works policies do cover earthquake damage. Because earthquakes are something that an experienced contractor could reasonably obtain insurance for, generally they will not be an excepted risk.

What if earthquakes are an excepted risk?

A Contractor would have considerably greater entitlement under NZS3910 if earthquakes were an excepted risk.

Under clause 5.6.5 the repair of damage or loss to the Contract Works, Materials or the Site arising from an excepted risk is deemed to be a Variation.

The Contractor is also not obliged to indemnify the Principal under clause 7.1.1 in respect of any loss, liability or costs incurred by the Principal in relation to an excepted risk (clause 7.1.2(d)).

Also, the Contractor is not required to insure for excepted risks, and the relevant clauses provide that such risks "are to be carried by the Principal".

What if earthquakes are not an excepted risk?

If, as is most likely the case, earthquakes are not an excepted risk (ie because earthquakes are something that an experienced contractor could reasonably have insured against), then clause 5.6.5 provides that "Except where loss or damage has the effect of terminating the contract by frustration, should any loss or damage occur to the Contract Works or Materials or the Site ... the Contractor shall repair the loss or damage to the extent needed for the completion and handover of the Contract Works ...".

Where damage has been caused by an earthquake, it may seem unreasonable for such repairs to be something that the Contractor has to carry out at its cost. But the key here is that it is only at the Contractor's cost where the earthquake is a risk that the Contractor could reasonably have insured against. So, most of the Contractor's costs and losses incurred as a result of the earthquake (eg the costs of repairing the Contract Works) will be covered by the Insurance. It is only the amounts not covered, whether by way of allowable exclusion, limitation or deductible, that will be at issue.

What if the Principal is insuring the Contract Works?

If the Principal is responsible for insuring the Contract Works, clause 8.6.1 provides that "Any existing structure, its contents, the Contract Works and Materials should be at the sole risk of the Principal as to loss or damage to be insured under clause 8.6.2."

But does this include earthquake risk?

Unfortunately clause 8.6.2 only applies to where the Contract Works are in the nature of additions, alterations, repairs or maintenance to an existing structure, or where the Contract Works are in the vicinity of another structure. Clause 8.6.2 also relates only to cover for the replacement value of existing or other structures and any contents which are owned by the Principal. Consequently on a strict interpretation it appears that clause 8.6.1 only puts limited losses at the sole risk of the Principal.

However, given that the Contractor is liable for insured risks (usually including earthquake risk) when it is insuring the Contract Works, and given that excepted risks are expressly required to be carried by the Principal where the Contractor is insuring, it seems that the proper interpretation of clause 8.6.1 would be broad enough to provide that the Principal is similarly liable when it is insuring the Contract Works.

Even where the loss or damage is primarily the liability of the Contractor, the Principal will be liable for the deductible under clause 8.8.2 when it is insuring. Unfortunately however, clause 8.8.2 is not so clear as to who is liable for any loss or damage not covered by reason of any allowable exclusion or condition in the Principal's insurances. Such losses, along with losses which are not of the nature of what would normally be covered by a contract works policy (such as consequential losses arising from wider market effects of the earthquake) are likely to rest with the party incurring them.

Is an earthquake an unforeseen physical condition?

Clause 9.5.1 provides "The term physical conditions shall include artificial obstructions but shall not include weather conditions or conditions due to weather unless those conditions occur as a result of weather away from the Site".

Clause 9.5 goes on to provide that if the Contractor encounters on the Site physical conditions which it considers could not reasonably have been foreseen when tendering and which increase its Costs, the effect of the conditions shall be treated as a Variation.

Certainly an earthquake could not reasonably have been foreseen by the Contractor when tendering, but is an earthquake a "physical condition"?

Just to clarify - the question is not whether landslides or big cracks in the site caused by an earthquake are a physical condition (they would be). The question is whether an earthquake is itself a physical condition (and therefore its effects (ie damage to the works etc) would entitle the Contractor to a Variation).

An earthquake is not an "artificial obstruction" but in making reference to conditions which occur as a result of weather away from the Site, clause 9.5 clearly goes beyond underground conditions and obstructions.

Unforeseen physical condition clauses such as these are often limited to material physical conditions encountered on or under the site. However those that experienced the ground shaking would surely be of the view that it was a physical condition that they were experiencing. But the law does not always follow common sense!

Unfortunately there is no case law in New Zealand on the issue of whether an earthquake would be considered to be a "physical condition" under clause 9.5 of NZS 3910.

There is case law from the United States finding that an earthquake is not a "subsurface or latent physical condition at the site" (on the wording of the relevant U.S. clause). However it is not clear whether that case law would apply in New Zealand and to the specific wording of NZS3910.

So, as the saying goes, "the jury is still out" on this question.

Can an earthquake lead to frustration of the Contract?

Frustration is a relatively narrow concept at law. Clause 14.1.1 provides that "In the event that either the Principal or the Contractor considers that the contract has become impossible of performance or has been otherwise frustrated, one may notify the other that it considers the contract to be terminated."

This clause does not apply where the performance of the contract has merely become more expensive or unexpectedly difficult (eg because the works have been damaged because of earthquake, or other event). Rather, the circumstances need to be such that it has become "impossible" to perform the contract, or performance of the contract has become "otherwise frustrated".

But what if the performance of the Contract is not impossible, just more difficult and expensive (eg the damaged works can, with time and money, be repaired or demolished and re-built)? What does the term "otherwise frustrated" mean?

At law, the 'classic statement' of the doctrine of frustration is that it occurs when "without default of either party, a contractual obligation has become incapable of being performed because the circumstances in which performance has been called for would render it a thing radically different from that which was undertaken by the contract".

So, if as a result of an earthquake the performance of a Contractor under a contract is made more difficult than agreed but not incapable of performance because it is so radically different from that which was originally undertaken, the contract will not have been frustrated and the Contractor's obligations will continue.

Such legal definitions may not however be of relevance. The law also provides that if a contract deals with and allocates the risk of an event (eg via a force majeure clause) then that event cannot be found to frustrate the contract. NZS3910 expressly deals with "seismic events" under clause 10.3.1 and "operations of the forces of nature" under clause 5.6.6(f). Contracting parties under an NZS3910 contract have therefore contemplated and provided for the occurrence of an earthquake - so on this basis "seismic events" cannot frustrate the contract. In other words the contract cannot be "otherwise frustrated" by a seismic event, which is expressly dealt with by other provisions of the contract.

In the event that frustration did apply (ie the contract was truly rendered impossible of performance), then clause 14 provides the contract can be terminated, and the Contractor is entitled to be paid compensation for costs incurred and reasonable disruption, but no entitlement for loss of profit from the balance of the contract.

Variation in the event of suspension

Under clause 6.7.1 the Engineer must suspend the works if suspension of the whole or part of the contract works becomes necessary. There may be a question as to whether or not such a suspension is necessary in the event of an earthquake, but where this happens the suspension is treated as a Variation.

If the damage is such that a suspension has become necessary, Contractors would certainly be entitled to request the Engineer to suspend under clause 6.7.1. However it is then only the suspension that is the Variation. The costs of such a suspension would not extend to the costs of remediating the Contract Works or the site due to the earthquake.

Conclusion

Unfortunately NZS3910 is not as clear as it could be in relation to the allocation of the risk of seismic events and their aftermath. While the contractual provisions relating to excepted risks, unforeseen physical conditions and frustration could possibly apply, none give the Contractor any clear entitlement. The Insurance provisions do not help much either.

Cold comfort then for Contractors that at least they are clearly entitled to an extension of time if they are delayed due to a seismic event, or to treat any suspension required as a result of a seismic event as a Variation.