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Prospective analysis of compensation events under NEC: shutting one’s eyes and groping in the dark?

The NEC contract is built on the spirit of mutual trust and co-operation. One area in which this plays out is in the context of applications for an extension of time or a change in the prices by a contractor. The project manager is required to assess these applications on a prospective or forecasted basis, at the time the relevant compensation event occurs.

However, one issue that the courts have not yet fully grappled with is how that assessment works when the contractual mechanism relating to quotations is not followed and the time and money effects of the compensation event fall to be considered after the impact of the event has played out. This post considers that scenario in the context of two recent cases: Northern Ireland Housing Executive v Healthy Buildings (Ireland) Ltd and Fluor v Shanghai Zhenhua Heavy Industry Ltd.

The prospective approach to assessments under NEC

In determining the impact of compensation events on the contractor’s entitlement to time and money, clause 63 of NEC4 ECC requires a project manager to adopt a prospective analysis. The focus of NEC is on the employer, project manager and contractor working together, at the time of events occurring, to determine the impact of compensation events on a rolling basis. This is part of the NEC’s wider focus on dispute management as opposed to leaving all disputes to the end of a project. The intention is for potential disputes to be dealt with as and when they occur to ensure the project runs smoothly. A further benefit of this approach is that it helps a contractor to manage its cash flow by allowing recovery for variations at the time they are instructed. The NEC Guidance Notes state (at page 76) that, if a compensation event occurs, it is not a matter for which the contractor is responsible, and therefore it should be entitled to recover its costs for that event:

“No compensation event for which a quotation is required is due to the fault of the Contractor or relates to a matter which is at his risk under the contract. It is therefore appropriate to reimburse the Contractor.”

The tension between NEC and the general law of damages

In relation to a change to the prices, clause 63.1 envisages a scenario where the assessment is made at or near the time of the instruction, in other words, when the contractor has yet to complete the work associated with the instruction or notification. This is evident from the time periods set out in the contract (3 weeks to submit a quotation after being instructed to do so by the project manager; project manager to reply within 2 weeks).

However, where the project manager and the contractor do not adhere to the prescribed time periods, the prospective approach can run into difficulty. In adopting a prospective assessment, the assessor must close its eyes to any costs that have actually been incurred but which only became known about after the compensation event. Therefore evidence of actual costs is ignored. This is inconsistent with the general rule that the measure of damages should be equal to the loss suffered.

As an example of why the law only allows recovery of actual losses, let’s say I ask you to build me a conservatory and you give me a quotation for 6 weeks work at a cost of £10,000. On a prospective assessment, that is the amount that you shall be paid. Therefore if it only took you 4 weeks and cost you £8,000, on a prospective assessment you would profit. Conversely, if it took you 8 weeks and cost you £12,000, you would lose money. In contrast, if a retrospective assessment is made in accordance with the general rules of damages, in either scenario you would be paid an amount commensurate to the level of work undertaken.

Although a prospective assessment may be appropriate in assessing an extension of time (as it ensures that a contractor that adapts to employer delay throughout the project can still recover in full for the time impact of the compensation event), there is a clear tension between the general rule that a wronged party should only be able to recover its actual losses and the purely prospective approach advocated by the NEC (particularly where the mechanisms for submitting quotations are not followed).

Healthy Buildings and Fluor

Until recently there were no cases considering whether the impact of a compensation event could be assessed retrospectively under an NEC contract. However, two recent decisions have considered that issue. Healthy Buildings was a case heard by the Northern Irish high court and is therefore persuasive but not binding on the English courts.

It concerned an NEC3 Professional Services Contract. Under that contract, the Housing Executive instructed a change to Healthy Building’s (the consultant) scope of works but did not notify it as a compensation event or instruct Healthy Buildings to submit a quotation. Several months later, the Housing Executive asked Healthy Building to submit a quotation. Healthy Buildings sought to exclude evidence of its actual costs and time incurred, on the basis of the prospective approach required by the NEC. However, the judge found that, in accordance with business common sense, the information as to the actual time and cost expended by Healthy Buildings should be made available to allow the court to fairly assess the cost of the compensation event.

Despite the prospective wording of the contract, the judge permitted a retrospective approach, in line with the general approach to assessment of damages. He asked why he should “shut my eyes and grope in the dark when the material is available to show what work they actually did and how much it cost them”.

The prospective versus retrospective approach was also considered in passing by Sir Antony Edwards-Stuart in Fluor. He commented that, when considering how to value a change in the prices, a prospective approach was not always appropriate:

“There has been an extensive debate about the correct approach to delay analysis. Mr Morgan said, and I would accept, that a prospective analysis – in other words considering the critical path at any particular point in time as viewed by those on the ground at that time – does not necessarily produce the same answer as an analysis carried out retrospectively. The former is the correct approach when considering matters such as the award of an extension of time, but that is not the exercise with which the court is concerned in this case. I agree that some form of retrospective analysis is required”.

Those two decisions concur with Keating on NEC3, which argues that the general principles in relation to the assessment of damages apply to clause 63. That is, if there is real factual evidence of the costs that have been incurred, this evidence should be preferred to a speculative approach.

The reasoning behind the decisions is the courts’ view that a purely prospective approach is inappropriate after the impact of a compensation event has played out. An assessment should either be carried out prospectively at the time or, if that is not done, retrospectively once the impact of the compensation event has been felt. Although the purpose of the NEC suite is to avoid disputes and improve cash flow, if the parties have failed to follow the contractual mechanisms (instructing and submitting quotations) and a dispute has arisen, those benefits of NEC are lost. In these circumstances the courts revert to assessing damages in accordance with the general principles of English law; that only actual costs can be recovered. To do otherwise would be to encourage a contractor not to follow the NEC contract management mechanisms: if it adopted a “wait and see” approach to the impact of compensation events, it could then look back over the project and isolate the impact of compensation events which caused it to incur additional cost and ask for only those events to be looked at prospectively, while asking the court to close its eyes to the impact of any subsequent contractor delay event (as that delay would have been unknown at the time and therefore would not be looked at from a prospective perspective).

However, the approach in Healthy Buildings and Fluor runs counter to those who advocate that the spirit of NEC requires a purely prospective approach to be taken to assessments. Further, if the retrospective approach adopted in Healthy Buildings is applied to all NEC contracts then there would be no incentive for a contractor to comply with the requirements to submit quotations. If it decided not to and later pursued a claim, it could then recover its actual costs, which are invariably higher. Similarly if a project manager does not instruct a contractor to submit a quotation the employer may only need to compensate actual time and costs.

Since Healthy Buildings is a Northern Irish decision, and Fluor only mentioned the matter in passing, we will need to wait for a decision by the English courts. But it is important to note that if parties follow the contractual mechanism for assessing changes in prices, they won’t need to concern themselves with this tension between the prospective method and the general law of damages. It is only where they fail to follow the contractual mechanism or when an arbiter has to re-open the assessments made at the time that it arises.

Bryan Cave Leighton Paisner LLP Daniel Giberthorpe

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