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Another blow for FM Co?

The Outer House of the Court of Session recently considered the allocation of availability/performance deductions in PPP/PFI projects and concluded that these deductions related only to failures in the provision of operational services, not failures in design or construction.

Allocation of deductions

The project was a schools PPP project in Scotland and the contractual structure was complex, albeit a standard PPP/PFI project structure. The contract structure is set out in the diagram below.

For a more detailed summary of the case click here. For the purposes of this post, the key issue concerned the liability of the construction sub-contractor (Construction Co) for deductions levied by the Authority against Project Co. The deductions had arisen from availability and performance failures under the project agreement between the Authority and Project Co.

Construction Co alleged that tables supplied by KCC, the sub-sub-contractor, did not conform to the specification, which in turn had caused Project Co to levy deductions against it under the construction contract. The issue before the court was simple: could Construction Co pass on these deductions to the sub-sub-contractor? The short answer from the court was no. The court concluded that deductions levied on Project Co by the Authority could not be passed on to Construction Co under the construction contract (and could not therefore be passed on again to the sub-sub-contractor). This was because the right to make deductions under the project agreement did not relate to the design and construction aspects of the project.

On its face, this is a surprising decision. PFI projects are structured so that Project Co can allocate, and pass on to either Construction Co or the FM sub-contractor (FM Co), as the case may be, deductions levied against it by the Authority under the project agreement.

The construction contract appeared to have covered all the bases in this sense. In essence, it provided that Construction Co would be liable for any deductions suffered by Project Co under the project agreement that were caused by Construction Co or any defect, fault or omission in the construction works.

What was the reasoning behind this decision?

The judge, Lord Glennie, made much of the distinction between the construction and operational elements of the project. He commented that under the construction contract, Construction Co’s obligation was simply to complete the works by a specified date, so that the operational period could commence at that date. He accepted that Construction Co was under an obligation to remedy snagging items within a specified period of completion, but he did not see any direct link between Construction Co breaching its obligations under the construction contract and Project Co suffering a deduction under the project agreement. In his view these deductions related to failures in the provision of operational services and not to the design and construction aspects of the project. In other words, the breach of the construction contract did not directly cause Project Co to suffer the deduction.

The judge concluded that the deductions were likely to arise from failures by FM Co and that, in the first instance, deductions made by the Authority under the project agreement should be passed down through the FM contract and not the construction contract. This may send a chill through FM Cos who, in our experience, already face an uphill battle to convince Project Co to allocate deductions to Construction Co once the services have commenced, even where the deductions have clearly been caused by a construction defect.

Does this mean that availability/performance deductions can never be allocated to Construction Co because, by definition, these will only ever be applied during the operational period?

Even if this case was binding authority in England, the answer to this question would be no.

The decision in this case seemingly turned on the basis of Construction Co’s pleaded case. The judge was right that, to the extent the failure to install the tables led to a deduction during the operational period for poor performance, Construction Co had no immediate liability for poor performance and no immediate liability for the deduction.

However, as acknowledged by the judge, Construction Co’s breach may have caused (a) Project Co to incur a deduction or (b) FM Co to incur a deduction. On Hadley v Baxendale grounds, Construction Co could be liable for a sum equivalent to that deduction. The problem for the court was that Construction Co did not raise that argument. In seeking to pass the deduction on to the sub-sub-contractor, KCC, Construction Co simply argued that it had primary responsibility for the deduction.

What lessons we can learn from this?

  • Where a certificate of service commencement (or its equivalent) has been issued, make sure that Construction Co is liable for sums equivalent to any deduction made against Project Co in the operational period, where the deduction is caused by a breach of the construction contract by Construction Co (including latent defects).
  • Where a deduction is levied on Project Co during the operational period in these circumstances, make sure that the construction contract is clear that Construction Co is liable for sums equivalent to the deductions levied on Project Co and not primarily liable for the deductions.

Next week we look at issues arising out of the interface agreement.

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