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UNIQUE CONSIDERATIONS FOR
LUMP SUM EPC PROJECTS

Eric L. Nelson
Smith, Currie & Hancock LLP
1.404.521.3800
www.smithcurrie.com

I.          Introduction

Engineer, procure and construct (EPC), and its several variations, have become the project delivery systems of choice for large process and power facilities domestically and internationally.   The use of EPC is most notable for projects requiring complex design and engineering work and the procurement of specialized equipment, and especially where the owner desires to contract with a single entity for a turnkey delivery.  Not surprisingly EPC contracts are frequently used on projects such as liquid natural gas facilities, steel mills, petroleum and petrochemical facilities and power plants.  The use of EPC, however, is not limited to these traditional types of process facilities, but has also found its way into large infrastructure developments such as airports, water treatment facilities and telecommunication systems.  Consequently, it is important for those undertaking these types of projects to understand the unique characteristics and risks that are associated with the EPC form of delivery. 

It is neither the purpose of this paper to discuss EPC construction generally nor to recite general construction law principles, but instead, to highlight a few of the more noteworthy risks and legal issues associated with the EPC form of contracting.

II.        EPC Construction Generally

Often, EPC construction contemplates a turnkey approach to project delivery.  In other words, the project owner or employer will look to the EPC contractor as the single point of contact for all facets of the project, i.e. from basic design through commissioning and start-up of the facility.   In essence, project owners have attempted to shift more risk on the contractor, understanding, at least theoretically, that this risk allocation carries a higher price tag.  Risks that have traditionally been handled by the owner in design-bid-build and even design-build contracts are no longer under the owner’s umbrella of responsibility.  For example, the contractor may be required to account for existing site conditions (including sub-surface conditions), and in some cases, may even be responsible to account for events that would often be viewed as force majeure (i.e. beyond the control of either party). 

But, the greatest risk for the contractor in entering into the EPC contract is not necessarily anything inherent in the EPC form of contracting.  For example, a contractor taking on such a broad scope of services on a cost reimbursable basis may end up in a very profitable position at the end of the job, without ever being exposed to any unusual financial risk. Rather, the problems most frequently arise when the contractor has been asked to submit a bid or proposal for the work on a lump sum or fixed price basis.  It is the lump sum, turnkey contract with which this paper is primarily concerned.

Despite the inherent risks to the contractor associated with lump sum contracting, the project owner cannot take the position that due to the lump sum nature of the pricing, that it is now insulated from cost overruns for changes or delays to the project.  Project owners must not mistake the EPC lump sum, turnkey approach as a license to do anything they want, without the threat of causing an increase to the project’s cost or completion period for which they may be liable.  As with any project, there are always certain things on a project that the owner typically controls and it must assure that its responsibility for these tasks is carried out so as not to impede the EPC contractor’s work.

As with any type of construction, the best way to appreciate and manage risks in an EPC contract is to clearly allocate those risks in the contract documents.  Standard forms of contract for EPC, such as the FIDIC Conditions of Contract for EPC/Turnkey Projects – FIDIC’s “Silver Book” – are available and often used on both public and private projects.   Many private and public owners, however, have opted to draft their own form of documents, and the terms and conditions can vary widely.  But, the importance of the contract frequently is not in the boilerplate; rather it is in the technical scope and project definition.  Even the FIDIC contract conditions contemplate that the parties will add project-specific terms that may drastically impact risk allocation between the owner and contractor.  Consequently, the emphasis in developing the contract documents should be on a collective effort in defining the scope of work and services with sufficient detail so that the owner’s and contractor’s expectations are in agreement to the greatest extent possible.  Pre-contract negotiations, scope review and clarification sessions, preliminary P&ID and other design drafts are each helpful in reaching an understanding of the true project definition.  It is also noteworthy that these pre-contract discussions should not be limited to the project personnel, but should include the end-users of the project, such as operations personnel.  In short, there is no substitute for candid and clear communication with all those who have an interest in the project.

III.       Responsibility for Design

In traditional lump sum, turnkey EPC contracts, basic and detailed design of the project is the contractor’s responsibility.  The design is typically based on design criteria furnished by the owner and the criteria can range anywhere from generic and broad to very detailed.  The problem most frequently arises when the owner’s design criteria are open-ended or subject to varying interpretations.  This problem is often easily addressed without significant impact to the project.  But, there are times when the interpretation of the design criteria can drastically impact the project’s cost and completion period.

From the contractor’s perspective, once the owner accepts the contractor’s proposal for the design of the facility – which the contractor usually contends occurs at the execution of the contract – then the owner has agreed to the contractor’s interpretation of those criteria.  This result is not necessarily inconsistent with U.S. law.  See e.g. W.G. Cornell Co. of Washington, D.C., Inc. v. United States, 376 F2d 299 (1967)(court recognized general contract principle concluding that when the government draws specifications that are susceptible to more than one interpretation and the contractor interprets the specifications in a particular way, then the contractor’s interpretation, if reasonable, will be adopted).  The owner, on the other hand, typically relies on contract provisions that require the contractor meet all of the design criteria, regardless of what the contractor’s proposal or design documents contain.  In other words, the owner will argue that it is not obligated to “catch errors” in the contractor’s design documents and that any revisions to the design documents that are made to reflect the owner’s design intent must be made at the contractor’s expense.

The contractor must recognize that relying on certain design data or information supplied by the owner may not exonerate the contractor from its obligations to meet the owner’s performance requirements.  (see e.g. FIDIC Silver Book Paragraph 5.1).  As such, if owner-supplied design information or data is critical to the contractor’s design of the project, then the contractor should include this fact in its proposal and require that the information or data be included as part of the contract documents.  See e.g. Dohahue Electric, Inc. 03-1 BCA ¶ 32,129 (in design-build contract, owner may be responsible for design deficiencies where it prescribes design criteria that must be met).  Likewise, if the owner’s design criteria are obviously (or “patently”) ambiguous, then the contractor will likely have an obligation to clarify this ambiguity prior to submitting its price for the works.  See e.g. United Excel Corp., VABCA No. 6937, 04-1 BCA ¶ 32,485.

In light of this, it is imperative that issues of design scope are addressed as completely as possible through negotiations and discussions and prior to the contract execution.  The substance of any clarifications or discussions pertaining to the design prior to contract execution should be included in the contract documents.   Moreover, if the contractor is relying on its technical proposal as the basis of design, then it should assure the proposal becomes part of the contract documents.  The ultimate goal is to assure that the owner’s design intentions are articulated clearly prior to establishing a final contract price and schedule for the works.

IV.       Changes (or Variations)

Even when the design criteria are clear, EPC contracts allow for owner changes or variations during the course of the project.  (see e.g. FIDIC Silver Book, Paragraph 13.1; DBIA Document No. 535, Article 9)  Conceptually, this is not a problem; rather, the problem arises when there is a question as to who is responsible for the cost and time impact associated with the change.  The problems can be exacerbated when the timing of the change is at issue.  For example, a change in the P&ID’s on a power plant may have little cost and schedule impact if it is made during basic design or early during the detailed design.  If, however, this change is made during construction, the ramifications can be significant.

For the contractor, the mere fact that a design change occurs may not automatically result in an adjustment to the contract price or time.  For example, a loss of labor productivity in construction activities under an EPC contract may result from changes in the basic design that occurred late in the project.  But, in order to recover additional costs for these labor overruns, the EPC contractor must still meet the standards of proof for a general contractor under a traditional form of project delivery (i.e. design-bid-build) by showing that the design documents changed, which in turn impacted the cost of the work. See e.g. Hensel Phelps Construction Co. v. General Services Administration, GSBCA No. 14,744, 14,877, 01-1 BCA ¶ 31,249 (contractor entitled to adjustment to lost productivity costs due to numerous owner changes and failure of the owner to furnish information timely to contractor).  But, with an EPC contract, the contractor must also show that the change was beyond the minimum performance or design criteria contained in the bid documents consequently impacting its area of responsibility and its cost of performance.  See Koppers Co., Inc., v. Inland Steel, Inc., 498 N.E.2d 1247 (Ind. App. 1986)(field changes caused by engineering errors in a design-build contract were not compensable changes and were made at the contractor’s expense).

On the other hand, the project owner is not necessarily insulted from liability for changes, even if changes are necessary to meet the design intent of the contract. Rather, in some cases, the fact that the changes were made late in the process could, in itself, warrant an adjustment to the contract price.  In such a case, the contractor will argue that its initial design was not an unreasonable interpretation of the owner’s design criteria; and if the owner was insistent on the change, it should have made the change much earlier in project.  For example, who is responsible for changes that occur well after the basic design “freeze” date?  This is not a question that has an absolute answer.  The contractor may contend that the once the owner gives its input into the basic design and allows the contractor to proceed with detailed design and equipment procurement, the owner accepts the basic design concepts and any changes must be accompanied by an appropriate adjustment to the contract price and schedule. 

One way to address this problem is to have an extensive owner and contractor working sessions for basic design review, where, at the end of the review process, final changes are made and the parties are required to approve, in writing, the basic design documents.  Or, the parties may build in a contingency in the contract price to cover the inevitable, post-basic design changes.  Regardless of the means employed to mitigate this problem, it is one that exemplifies one of the greatest disagreements between the owner and contractor concerning the scope and nature of lump sum, turnkey EPC projects, and it should be addressed as early in the project as possible.  A failure to do so can lead to costly disputes later in the job.  See e.g. O’Brien & Gere Tech. Serv., Inc. v. Fru-Con/Flour Daniel Joint Venture, 380 F.3d 447 (8^th Cir 2004)(court found that in design-build contract, the parties never agreed on the design documents that established scope of work and never agreed on the design stage from which changes would be measured, which, in part, lead to court’s conclusion that contractor was entitled to compensation for the work)

Late or excessive design changes may also have an impact on start-up activities and the contractor’s ability to meet performance guarantees. In fact, often the full effect of design changes will not be realized until the commissioning and start-up period.  The effects can be disastrous, causing a planned 30-day commissioning and start-up activity to extend several months.

In the event changes in the scope of work do occur, the EPC contractor must not only demonstrate that the change should result in an adjustment to the contract price and time, but it must also be able to track the cost and schedule impacts associated with the change.  This should be of particular concern to design and engineering firms that are serving as the EPC contractor.  Many design/engineering-oriented firms are not, historically, set up to track additional engineering and construction costs because they are usually accustomed to charging for professional services on an hourly basis.  But, the failure to adequately track labor, material and equipment costs on large EPC projects can have devastating financial consequences for the EPC contractor.  Consequently, engineering and design firms involved in these types of projects should be prepared to implement measures for tracking additional engineering, procurement and construction costs, just as they would in tracking the effects of changes and other events on the project schedule through use of periodic updates and time impact analyses.  The use of discrete cost codes for keeping track of lost productivity in labor and equipment, as well as material overruns are advisable for each and every change or event for which the contractor believes the owner or others are responsible.

Finally, although project changes are not out of the question, owners and contractors alike must realize that the goal of lump sum, turnkey EPC contracts is to allow the work to proceed without the disruption of changes throughout the project.   Otherwise, many of the benefits of this type of delivery system are lost.

V.        Payment and Performance Assurances

The issue of payment to a contractor is of utmost importance.  With the owner’s ever-increasing use of single-asset or single-purpose entities to serve as the de facto “project owner,” it is critical for the contractor to assure that if it performs the work, it will be paid according to the contract.  Lien rights are certainly one form of security, but they are difficult to enforce, and do not guarantee that the contractor will have a sufficient interest in the property to satisfy its claims. 

Moreover, EPC projects are often structured so that the land on which the project is located may not be actually owned by the “project owner.”  Rather, the land may be under a lease agreement with a local development authority, in which case, the land may not be subject to lien.  Consequently, the lien rights available may be limited to liens against the leasehold interest of the entity with which the EPC contractor has contracted.  Therefore, if the contractor has concerns about the financial viability of the owner, then the contractor may want to obtain any one or more of several payment assurances such as, a parent guarantee, pre-payment for certain services, or a letter of credit from the project owner.

Owners likewise want to assure that they receive a project within budget, on time, and that meets the contract performance guarantees.  This can be secured through a variety of ways, including, performance bonds, parent guarantees and letters of credit. Should the contractor then fail to meet its obligations, the owner will be able to utilize one of these means of performance security to finance corrective work or pay for late project delivery.  Owners, however, must be aware that not all of these means are equally effective.  For example, an owner’s contention that the contractor has defaulted on its obligations will not assure that the contractor’s surety on a performance bond or the contractor’s parent company on a parent guarantee will step in to cure the purported default.  The availability of a letter of credit, on the other hand, is very close to “money in the bank” up to the value of the letter of credit.  But, a letter of credit usually only covers a small portion of the contract price and contractors will often resist posting a letter of credit due to the fact that once the letter of credit is posted, there is little that can be done to prevent an owner from drawing on it.

VI.       Schedule Delay

Construction contracts frequently require schedules or programs for tracking work progress and delay.  Although regularly updated CPM scheduling programs have not historically been required on international projects for the purposes of proving delay, this is changing.  For example, in 2002 The Society of Construction Law in the United Kingdom issued its Delay and Disruption Protocol.  The Protocol offers guidance to project participants for dealing with schedule extensions and compensation for delay and disruption.  The requirements in the Protocol are generally consistent the legal and contractual burdens imposed on a contractor doing work in the United States. 

Several United States courts have concluded that in order for a claimant to be entitled to delay damages, it must demonstrate that the other party actually delayed work on the “critical path” of the project.  Consequently, a general statement that a schedule disruption or impact occurred, without any showing through updated CPM schedules, fragnets and other credible and specific project data or testimony, will not suffice to meet a party’s burden of proving delay.  Essex Electro Eng’rs, Inc. v. Danzig, 224 F.3d 1283, 1295 (Fed. Cir. 2000); Sauer Inc. v. Danzig, 224 F.3d 1340, 1345 (Fed. Cir. 2000); PCL Constr. Servs., Inc. v. U.S., 47 Fed. Cl. 745, 801-02 (2000).

With respect to EPC contracts, tracking delay can be even more demanding.  Because of the types of projects that typically use the EPC form of project delivery, schedules can be complex, having thousands of activities and multiple critical paths.  The schedule update process requires a time commitment and discipline to assure that schedules maintain their accuracy throughout the project.  Contractors will likely be required to provide a time-impact analysis (i.e. real time analysis) of the impact that each delay is having on the project’s schedule throughout the course of the project.  These progress/update schedules should then be submitted to the owner on a regular basis so that all of the project participants are apprised of work progress and event that are impacting the project’s completion date.  Simple as-planned versus as-built or collapsed as-built analyses will not likely be accepted by the owner as a basis for a time extension or extended project costs; and these types of analyses will certainly be viewed with skepticism by a court or arbitration tribunal.

VII.    Force Majeure

Force Majeure provisions are common in most construction contracts and are of special import in large EPC projects.  These clauses cover an array of events (e.g. war, terrorism, labor strikes, radiation, changes in the law, and natural catastrophes) that are considered outside the parties’ control, but end up having an impact on the project’s cost or schedule. 

Most contracts that are governed by United States laws specifically enumerate the types of excusable delays for which a time extension is due.  see Section 8.3 (Delays and Extensions of Time), AIA Document A201-1997; 48 C.F.R. § 52.249-14.  Because contracts allocate differently the risk of both nonperformance and unanticipated occurrences beyond the control of the parties, the precise terms of the contract are critical.   Some contracts list each type of excusable delay and limit the granting of time extensions to the listed delays.  For example, Section 52.249-10 of the Federal Acquisition Regulations sets forth the standard default termination clause for all federal government fixed price contracts:

(b)       The Contractor’s right to proceed shall not be terminated nor the Contractor charged with damages under this clause, if –

(1)       The delay in completing the work arises from unforeseeable causes beyond the control and without the fault or negligence of the Contractor.  Examples of such causes include — Acts of God or of the public enemy, Acts of the Government in either its sovereign or contractual capacity, Acts of another Contractor in the performance of a contract with the Government, Fires, Floods, Epidemics, Quarantine restrictions, Strikes, Freight embargoes, Unusually severe weather, or Delays of subcontractors or suppliers at any tier arising from unforeseeable causes beyond the control and without the fault or negligence of both the Contractor and the subcontractors or suppliers; and

(2)       The Contractor, within 10 days from the beginning of any delay (unless extended by the Contracting Officer), notifies the Contracting Officer in writing of the causes of delay.  The Contracting Officer, shall ascertain the facts and the extent of delay.  If, in the judgment of the Contracting officer, the findings of fact warrant such action, the time for completing the work shall be extended.  The findings of the Contracting officer shall be final and conclusive on the parties, but subject to appeal under the Disputes clause.

Parties must not only identify what events are included within the definition of force majeure, but also who will bear the risk of force majeure events and whether such events allow for an increase to the contract price or merely an extension to the contract period.

VIII.    Insurance (including LD insurance)

When most people talk about insurance on construction projects, they have in mind commercial general liability, workers compensation, and builders risk policies.  But, on EPC and other large projects, where the stakes can be tremendously high, the insurance products available are much more comprehensive and sophisticated:

            Force Majeure Coverage: Coverage can include labor disputes, changes in the laws, and even events related to war or terror acts.

            Liquidated Damages Coverage: Contractors can purchase coverage to protect them from liquidated damages or penalties due to late completion of the project.

            Cost Overrun Coverage: Owners may want to consider cost overrun insurance where there is the potential that the contract price will be exceeded significantly.

            Project Specific and Hybrid Policies (including OCIP, CCIP and Subguard): These policies are issued on a project-by-project basis and can often offer coverage benefits beyond those traditionally used in the construction industry.

EPC contractors and owners should consider the wide array of these products.  But, these policies need to be approached with caution; policy terms are often complex and deductibles can be high and often coverage is limited by a variety of exclusions.

IX.       Owner-Controlled Activities

Even though the EPC lump sum, turnkey agreements look to the contractor to provided a “turnkey” project, there are certain activities that often remain under the owner’s control and can have a significant effect on the project’s cost and schedule.  Most contracts provide that the project owner has responsibility to provide adequate site access for the contractor.  But, the owner’s obligations do not necessarily end there.   For example, and as mentioned earlier, the EPC contractor will look to the owner to assure that basic design issues are addressed early in the project and before detailed design and equipment procurement.  In many cases, the contract may require that the owner approve the basic design before the contractor proceeds to the next phase of the project.  The reason for this is that changes made during basic design are generally incorporated more easily into the project than changes made after detailed design or procurement is underway.  Late changes in the design can have a ripple effect through the rest of the project, even through commissioning and start-up. 

Likewise, the contractor may look to the owner to provide certain facilities or products that are necessary for commissioning and start-up activities.  This may include the operation of facilities that are outside the limits of the project, or it may be the supply of feed gas, water, etc. necessary for plant start-up.  This issue is more pronounced in hybrid EPC contracts, where the owner retains the obligation to perform certain design functions or equipment procurement for the facility.  Where delays occur on such types of projects, the owner will inevitably lose the benefits of a turnkey approach because the contractor will often point to the owner’s failure to meet its milestones as the primary basis for the delay in the overall project.

The principal behind this is simply that the owner has an obligation not to interfere with the contractor’s work.  Generally this is both a contract obligation as well as a legal obligation. see FIDIC Silver Book, Paragraph 10.3; Kinetic Systems, Inc. v. Rhode Island Industrial Facilities Corp.,  2003 WL 2208520 (R.I. Super. 2003)(it is a breach of contract to violate a contract provision or interfere with another party’s performance of the contract); SIPCO Serv. & Marine, Inc. v. United States, 41 Fed. Cl. 196 (1998)(contractor has valid claim for interference when owner imposes excessive supervision and testing procedures beyond those contemplated in the contract); Gymco Const. Co., Inc. v. Architectural Glass & Windows, Inc., 884 F.2d 1362 (11^th Cir. 1989)(general contractor breached agreement by failing to deliver timely, to subcontractor, template needed for subcontractor’s work); UNIDROIT Principles of International Commercial Contracts, Art. 7.1.2. Owners must be cognizant of not only their obligations, but also their limitations, in order to facilitate the construction process and avoid costly delay and disruption disputes.

X.        Limitations of Liability

Limitations of liability clauses are common in EPC contracts, especially lump sum, turnkey contracts.  Due to the significant cost associated with the construction of large industrial facilities and the potential financial losses for late delivery of these facilities, most EPC contracts will provide for liquidated damages provisions for late delivery with a maximum amount of liquidate damages that the EPC contractor will pay in the event the project completion date is extended.  (see e.g. FIDIC Silver Book Paragraph 8.7).  These clauses are generally enforceable, unless there is intentional misconduct or gross negligence by the contractor.  See e.g. Mistry Prabhudas Manji Eng. PVT, Ltd. v. Raytheon Engineers & Constructors, Inc., 213 F. Supp. 2d 20 (D. Mass. 2002)

XI.       Conclusion

EPC projects offer a mutually beneficial and exciting form of project delivery for both the owner and the contractor.  But, with the EPC contract come many new risks that are often severe due to the complex nature and high cost frequently associated with this type of project.  Understanding these risks and some of the other unique characteristics of EPC contracting is critical to a successful project where both the owner and the contractor obtain the high rewards for the risk.