Follow the Money

Written by: Iain Wishart

Introduction

In August 1974, in what was one of the biggest political scandal of the late twentieth century and less than two years after being re-elected, the most powerful man on earth, US President Richard Nixon announced on US television “I shall resign the Presidency effective at noon tomorrow”.

Two years earlier during the election campaign there had been a break-in at the Democratic Party’s headquarters at the Watergate office in Washington D.C. and five men linked to the Republican Party and the Committee to Re-elect the President (CRP) had been arrested. Because of subsequent attempts to cover up its involvement in the break-in, the Nixon administration had been hounded by the American press including two Washington Post investigative reporters Bob Woodward and Carl Bernstein. Apart from the President’s resignation, 43 people, including many of Nixon’s officials were jailed.

Woodward had been advised by a very influential Government official known for decades afterwards only by his pseudonym of Deep Throat and only recently revealed as former FBI Deputy Director Mark Felt.

One part of his advice to the journalist was reputed to have been to “follow the money”. Very interesting you may well ask, but what has that got to do with the construction industry? It’s good advice that’s why.

The construction industry is a perilous one and no respecter of size or longevity in business and its history is littered with examples where one bad project can prove highly damaging or even fatal for a contractor’s very existence. Frequently the inherent risks in construction are totally out of proportion to the potential rewards involved and I cite three examples.

Example: A contractor denied an extension of time despite entitlement faced liquidated damages so high that a six weeks delay would wipe out the contractors group profits for five years. The contractor felt that he had to accelerate to mitigate the effect of the Owner’s delay and avoid the potential imposition of liquidated damages. The dispute to recover the delay and subsequent enforced acceleration costs lasted years and cost the contractor substantial amounts of money.

Example: A specialist contractor was awarded a contract on a Lottery funded Arts Project in the UK. Its work was part of a major reconstruction costing over £200 million. The specialist contractor’s contract was worth £13.5 million. Its anticipated profit was under £250,000. Its outturn cost was over £34 million. A direct cost loss of £21 million. That level of profit margin would require £1 billion of successful projects to recover that single loss on one project. I was the mediator on that project and it had a reasonably happy ending, the next example did not.

Example: In July 1988 the UK Contract Journal reported:

“Britain’s Davy Corporation is the world’s leading contractor exporting work to foreign markets, according to a US survey. Davy’s overseas contracts in 1987 added up to $3.52 billion. Davy is the first non-US contractor to win the top position […] second in the foreign work survey is the Bechtel Group[…]”

In 1991 Britain’s Independent newspaper reported on a contract between Davy and an oil company called Jebsen.

“In early 1989, Jebsens signed a pounds 118m contract with Davy Corporation […] it was in effect a fixed-price contract. In November 1990, three months after the deadline, Davy was promising delivery in the new year. Davy sued the oil company for pounds 88m for supposed changes to specifications; it had lost so much money that this was its only hope of recouping anything. But the following May a judge threw its claims out, and Davy’s directors concluded the company could not continue on its own. The pounds 118m contract had overrun by more than pounds 100m. In June 1991, Davy ended its 161-year history as an independent firm.”(Emphasis added)

A sobering tale. Note the words in italics. One bad contract brought the world’s largest contractor to its knees in less than two years and its only hope was to raise claims.

Contractors can and do lose money in four distinct stages of a construction project:

1. during the estimating stage;
2. during the negotiating stage;
3. during the construction stage; or
4. during the dispute stage.

If they are really unlucky they can lose money in two, three or all stages. Contractors need to keep a close watch and “follow the money” all the way through each of the four stages.

The estimating stage

It is not the purpose of this article to tell contractors how to estimate. That is a completely different subject. Apart from estimating the contract price correctly and adequately, sensible contractors will carry out a number of checks before the bid price is settled. They include:

• checking and understanding the contract and taking legal advice;
• carrying out a pre-bid review;
• undertaking a strengths, weaknesses, opportunities and threats (SWOT) analysis;
• clarifying ambiguities;
• checking the specifications;
• attendance at pre-bid meetings;
• defining subcontract scope properly;
• binding subcontractors properly to their own bid;
• restricting obligations and risk;
• establishing final price;
• being very careful in negotiations; and
• restricting the negotiating team’s authority.

Most international construction contracts are based on standard forms. All too often however they are made more onerous. Sometime it is not what is in the contract that needs careful consideration but what has been changed and/or is not in it.

Example: A $1.4 billion major defence related project with enormous civil works had the FIDIC clause 12 (Fourth Edition) (unforeseen ground conditions) removed altogether.

Example: A “standard” overseas government form in one contract provided entitlement to additional time and money in the event that the subsea conditions were different from those indicated in the contract or were different from what an experienced contractor might anticipate. A follow-on contract changed the “or” to “and”. We didn’t spot the change until we were denied payment for differing subsea conditions.

It is essential that international contractors become familiar with the common standard forms; how they work; the essential elements and how they need to be operated.

Many international contracts are in English and for people whose native language is not English it can be very difficult to understand.

My advice to contractors and consultants is to train your senior people in the basics of understanding contracts and contract administration and for contractors, seek good legal advice on any contract that is unfamiliar or has been “tampered with” before signing it; or just as simple good practice.

During the estimating stage the contractor’s estimating department will estimate what its direct costs will be: the cost of its direct labour, materials, direct equipment and subcontractors. Most contractors will subcontract the whole or part of the works, managing the process.

To its direct costs it will add on-site overhead costs including staff costs, general equipment, offices, stores, general labour and the like.

To its direct costs and its on-site overheads it will apply off-site (or head office) overheads; and to the total of all of its costs, it will add profit.

Off-site overheads are normally established by a percentage to cover the costs of the contractor’s head office(s). There is a certain amount of science in it, as the actual cost of the contractor’s head offices(s) can be established with a reasonable degree of accuracy. However the contractor has to guess at its turnover for the year ahead which is a mixture of knowns and unknowns (with an acknowledgment to Donald Rumsfeld). The “knowns” is its current workload, the unknowns is how much work it will win in the year ahead. Having said that, the overhead percentages tend to be reasonably consistent from year to year.

The contractor’s estimators will arrive at the estimated cost of the project and in large organisations, it is normal practice for the estimate to go to the Directors who will decide the level of overheads and profit. They might apply a “better buying discount” (the assumption being that in practice the contractor can buy the subcontractors and suppliers at less than they have been quoted). They might however also apply a “risk factor”, or uplift to estimated costs to cover for unforeseen risks.

At the end of the process the Director’s will add a profit.

However, sometimes directors will reduce a bid below what they see (or guess) will be a level acceptable to the owner.

On one estimate that I was involved in, the project director decided to reduce the final bid by an amount that someone described to me at the time as “buttock clenching”. Much to my relief we came third, beaten by companies trying to break into a new market.

In times of boom when demand is high, contractors will increase their profit margins. In times of low demand, profit will be reduced or even eliminated altogether.

In the race to the bottom contractors need to adopt sometimes drastic measures to maintain as much of their business as they can. That process is repeated all the way down the construction chain to all subcontractors. Margins, never really as healthy as they ought to be, simply shrink. The trouble is of course that all contractors need to make a profit and they also require to recover their overheads.
If they don’t that means a loss.

In really hard times, contractors will also reduce the overhead element in their tender and, if appointed, start the project with a projected loss. It has to make this up somehow and with negative margin contracts, the contractor will apply considerable efforts during the contract to establish profitability. This means claims are inevitable and contractors will put in place a strong commercial team.

Before contractors submit a tender, if they have cut money out of their offer, they need to know how much they stand to lose and have a rough idea of the opportunities for recovery.

What else can go wrong during the estimating stage? Lots. Any estimate of any size will contain errors, but hopefully the errors may well be compensating.

As much of the specialised work will be subcontracted, contractors need to be careful as to the level of competency of a subcontractor and to ensure that their bids to the contractor are on the same conditions and level of commitment as the contractor makes to the owner.

Example: A process engineering contractor obtained prices (as opposed to a binding tender) from a subcontractor on a refinery project. There were substantial amounts of Inconel piping, a metal that contains very high amounts of Nickel. After the contractor submitted its bid there was a world shortage of Nickel and the price of Inconel piping rose by enormous amounts. The subcontractor refused to carry out the job using its quoted prices. The result was that the contractor lost several million pounds before the contract even started as its fixed price bid was open for acceptance for three months and it was committed to it.

The negotiating stage

In my experience this is the most dangerous stage of any project. Contractors have submitted bids and they are called into negotiations. It is very tempting to make major concessions but the consequences can be and frequently are disastrous. Often contractors will make concessions on price and conditions to “stay in the game”. This can be particularly true of area and/or country managers chasing turnover.

Example: An international contractor qualified its bid on a marine project in respect of tidal, current and subsea conditions detailed in the contract and stated that its prices were based on the assumption that those conditions were accurate. During negotiations the country manager agreed to remove the qualifications and accept responsibility for the marine conditions. It turned out that the conditions were drastically wrong to such an extent that the estimate to change the design to accommodate the actual conditions would cost an extra $29 million. The country manager was fired but the contractor almost went bankrupt.

Example: A slightly different scenario. During negotiations on a “turn-key” hospital project the employer demanded that the final selection of the hospital equipment by the contractor not only had to meet the specifications but they had to be “state of the art”. I advised the commercial director not to accept that condition, but he knew that a close rival had put in a bid just over $1 million more than ours. His response was that if he didn’t accept it their rival would. We signed the contract and fortunately the offending clause did not prove to be the problem that I had feared, but only because the contractor pointed out the high maintenance problem and costs of one particular piece of equipment that the employer’s representative had said we should supply.

Wise contractors keep a close watch on what may be discussed during negotiations by limiting powers of the negotiators and considering carefully what may be and what may not be conceded, and evaluate the potential consequences. Major concessions may require board approval.

The construction stage

I read an article once that contained this surprising piece of bit of information:

“On flights between Earth and the Moon, the Apollo ships were off course more than 90% of the time. It did not matter that the lunar voyagers were actually on the correct trajectory only 10% of the time, what mattered was results. They got to the moon and they got home thereafter. They did it by having control to get themselves back on course, repeatedly. They were not on a perfect path but a critical path. While people guiding the astronauts had to be precise, they were not hung up on perfectionism – the dreaded ‘paralysis by analysis’.”
[Charles Garfield, Peak Performers (William Morrow Paperbacks, 1986)]

As with the people who sent the Apollo astronauts to the Moon, contractors, employers and their consultants should be heading in the right direction which is to bring the project in on time and on budget to the correct quality. They will not be on the correct trajectory all of the time, but they must be able to make changes of direction in order to get back on course repeatedly.

It has to be said however that when a construction project starts to go wrong and delays occur the twin objectives of time and price will not be achieved, but timely and sensible interventions and compromise can limit the damage.

Sensible contractors keep a close check on physical progress and check on the profitability of a project by cross-checking budgets with achieved progress and assessing profit/loss on a section by section basis; spotting potential losses and forecasting final outcomes. The expression “a stitch in time saves nine” is very pertinent.

Contractors that “follow the money” on a regular, progressive basis identify problem events and give themselves the ability to:

• put in place timely damage limitation exercises;
• comply on a timely basis with contract notice provisions; and
• keep adequate contemporaneous records.

The cost of researching records to determine the effect of problems after the event is a multiple of the cost of what it would be if investigated at the time.

During my career I have seen contractors who lost financial control of a project by not following a few simple rules.

Example: A contractor ran into severe problems on a project. About one-third of the way through the project I was brought in to assess a potential claim against a defaulting virtually sole source supplier whose erratic, incomplete and late material supply was creating havoc on the project.

The contractor’s cost reporting, however, indicated that the predicted losses were not as great as the performance indicators on site would signify. I found the reason for the lower than expected reported losses. The cost engineers had assumed that although the contractor had lost money on the project to date, all the remaining work activities would achieve planned budget efficiency levels. To compound matters the planners or schedulers had also predicted completion dates on a similar basis.

What they ought to have done was to put in place trend forecasting, i.e. if the current loss of efficiency (and therefore loss) was also to apply to the work still to be done, what would be the likely outturn cost and completion date of the project actually look like?

I put in place rudimentary trend forecasting structures and unsurprisingly produced startlingly different loss projections. Several months later, my projections proved if anything to be optimistic as the project continued to be hampered by lack of materials. The contractor ultimately lost just under $30 million compared with a projected loss by the cost engineers of under $3 million a few months earlier.

The cost engineers had failed to follow the money and thereby failed to alert management on a timely basis to the true extent of the unfolding fiscal disaster.

Taking profit too early

There is an all too common practice of assuming revenue before it has been earned. This practice in a sense is worse than that of underbidding as it is doomed to failure without any chance of recovery. As the project progresses the income versus cost dynamic switches from profit to inevitable loss.

Example: On one project I was called in to examine some years ago, the contractor consistently forecasted a profit. At the end of year one it reported progress at over 85 per cent complete. It wasn’t. During the second year of the project as the projected profit diminished and converted into loss it became obvious to the contractor that its progress reporting had been overly optimistic. Subsequent research by myself and my colleagues indicated that the progress at the end of the first year was a little over 60 per cent. The anticipated (and reported) profit of $2 million vanished and the eventual loss exceeded $6 million.

By the time the directors realised what had happened it was too late. The contractor tried to raise claims but it struggled with incomplete records.

The dispute stage

Causes of construction disputes

I was given a copy of a book recently identifying causes of construction disputes in different countries. There was a marked similarity between the various countries identified by the authors as to the reasons for the raising of the claims in their countries. None of them caused me any surprise. What did surprise me was that not one of them identified money as the cause of the disputes.

In my experience, the single underlying cause of all construction disputes and the reason as to why there are so many, is simple—it is money! One party to a contract wants more; the other does not want to pay. The remainder—a variation on a near identical theme.

The root cause of the money problem in my opinion is that there is simply not enough of it in most construction contracts. A construction company has to balance a need to win contracts in competition with the absolute need to make a profit.

It is a constant source of surprise to me how many contractors submit claims without due regard to the facts and how often employers’ consultants attempt final settlement without a thorough knowledge of the facts and without knowing what the contractors actual costs are.

I have been “following the money” for years; giving that self-same advice to my clients; and following it (with much less dramatic results than Woodward and Bernstein achieved it has to be said).

Establishing where and when money has been lost is an essential first step, but ultimately those losses must be linked to the why, the cause of the loss. By focusing on the money, one establishes “the effect” and it alerts everyone where to look for “the causes”.

Sometimes however contractors and/or their advisors overlook the obvious.

Example: A contractor constructing a new headquarters complex in the UK brought a claim for several million pounds. I was retained with my team to undertake the time and money analyses. The substance of the draft Statement of Claim was almost entirely focused on the extension of time.

Amongst other matters we checked the contractors cost reports and the underlying support documents. We concluded that the delayed parts of the contract were not where the contractor had sustained the bulk of its losses.

Its principal site overhead losses were incurred during the currency of the original contract period. More detailed investigation into those losses identified that the contractor had increased its site resources in an effort to recover lost time. In short, the contractor had implemented an acceleration effort to try to recover lost time. In the draft statement of claim however, the word mitigation or acceleration did not appear.

Example: A contractor seeking to recover substantial amounts of money on a complex in a remote location employed initially a claims consultant who had prepared all the figures that went into the statement of claim. The amounts included claims for delay, and disruption and unrecognised and / or undervalued changes. It mentioned construction inflation almost as an afterthought and valued it as a few million pounds sterling. The contract contained an inflation mechanism based on contract indices. During my investigation I asked if anyone had done the calculation using the indices. They had, but for reasons that were totally beyond me that value did not feature in the claims consultant’s figures. Using the value of the work executed, the indices and the results of the programme analysis undertaken by my colleague produced an inflation calculation of over £25 million, approximately 50 per cent of the total amount that the contractor was seeking and several million pounds more than the claims consultant had included in its claims. That claim in my opinion was like low hanging fruit, just waiting to be harvested.

I adopt a targeted approach and my advice is the same whether I am retained by the claimant, or the respondent. I do not immerse myself in detail from the outset but look at the overall cost summaries. I have long ceased to be surprised by preliminary opinions that turn out to be remarkably accurate and reached by looking at the bigger picture first.

Example: Wildly exaggerated claims of over $300 million that was almost four times the value of the original contract. The contractor had hoped to negotiate the claims but had to go through a five year arbitration to end up with a final award of under $30 million, including interest and return of liquidated damages. Even after deducting the interest that dispute ought to have been achievable through negotiation if the initial claims had been realistic. Five years of wasted time and cost!

A fourfold increase in the contract price was simply not credible. The amounts claimed which forced a client into defending an arbitration were brought about by gross exaggeration. The contractor’s claims consultant complained to me that he thought that the employer would negotiate with them. My response was that the numbers were far too high and they virtually made it impossible to negotiate a settlement.

Had the contractor priced its claim realistically and supported it properly from the outset, it may well have been resolved through negotiation. However the excessive nature of the claim meant that my client was forced to defend in arbitration what in reality were claims for indefensible amounts.

Example: I was sent a twelve-item financial summary at my request following an enquiry from a lawyer representing a contractor on a complex of very high rise buildings. He asked for some discrete advice. Amongst other matters I advised:

• “The figures as summarised do not on the face of things add up;
• By my assessment (the contractor) appears to have invoiced some €30m of work;
• The claim is for an additional €20m excluding overheads, finance and administration costs; that seems disproportionate;
• I have concerns about the possibility of duplication on the structure of the claims.”

I was subsequently appointed as an expert and one of the first tasks that I and my colleagues undertook was to check the figures and see if there was indeed duplication. There was.

These examples and the way that they were put forward went against what is my first advice to contractors if they are putting forward a claim, namely: the entire purpose of a claim is to get paid! When I am retained as an expert by my contractor clients, I always ask to see the contractor’s estimate; its project accounts; its internal cost and management reports. I also ask for access to primary source cost documents as spreadsheets and reports are not proof of costs.

When I am retained by my employer clients (or contractor clients in receipt of a subcontractor claim) through those that instruct me, I also ask to see precisely the same documents. The same basic principles of looking for linkage between entitlement, causation and effect, are involved and all go to the same point: construction claims are about money! I am not suggesting that there are not many causation issues but ultimately construction disputes are always about money.
Contractors want more of it and the employer does not want to pay!

Equally I am not suggesting that focussing on money is the complete answer.

Programme or schedule analyses are essential elements of the process, as are engineering and / or architectural studies and an understanding of facts and events. When delay occurs it is obvious, some of the other claim types, however, are not.

Focussing on the money can and does identify the extent of the losses; the periods when losses were incurred; and where the bulk of the contractor’s losses were incurred. These pinpointed areas of loss can and do assist the delay and engineering experts in their research and my advice is always to focus attention on high value items.

Types of claim

There are four principal categories of claim on construction contracts:

1. delay;
2. loss of productivity (so-called disruption);
3. acceleration; and
4. changes sometimes assessed using contract rates and prices.

All four types of claim are totally different from each other in terms of evaluation; they are reliant upon completely different records and they are analysed in completely different ways. [I. Wishart, “Delay and Disruption — a Separable Duo” (2012) 28(7) Const. L.J. 570–582].

They are normally based on actual cost incurred and that is where my key advice comes in. If you do not know:

1. what the costs actually were;
2. the details of the costs incurred;
3. when the additional costs were incurred;
4. how the incurred costs compare with the budget; and
5. why there is a difference;

then, you cannot follow the money and you cannot provide a true evaluation of a claim’s potential worth.

Contractor’s costs may be broadly categorised into several headings that will normally mirror its estimate and budget breakdowns.

The categorisation of amounts that go into the make-up of a contractor’s estimate (and ultimately the contract price) varies slightly from contractor to contractor but in broad terms they fall into the following four principal heads comprising:

1. direct costs—labour, materials, equipment and subcontractors;
2. on-site overheads—staff, general labour and general equipment, on site offices and temporary facilities, site running costs ;
3. off-site overheads—insurances, cost of head and regional offices, bonds, finance, specific costs incurred off site for the project; and
4. profit.

As a general rule (and to every rule there are exceptions):

• claims for delay are priced using on-site overhead costs (and sometimes some elements of off-site overheads);
• loss of productivity claims are priced using direct costs; and
• acceleration claims are priced using direct costs for labour and equipment and, potentially indirect costs for additional supervision, site facilities, or indirect equipment.

I frequently see contractors’ claims which:

• assume that delay and disruption are essentially one and the same thing;
• include direct costs in prolongation claims;
• assume that all on-site overhead costs are “time sensitive”;
• include the entirety of additional labour and equipment in acceleration claims;
• are not based on actual costs; and
• rely too heavily on formulae based “head office overhead” claims.

Unless they are blessed with an accommodating tribunal they may well be in for a major disappointment because:

• delay and disruption are totally different claims and need to be assessed quite separately;
• direct labour and equipment costs do not belong in prolongation claims, but in loss of productivity claims;
• an acceleration claim can only include the additional costs of direct labour and equipment (e.g. hiring in labour and/or equipment from third parties that costs more) as the presumption must be that the additional labour and equipment must be (at least partly) productive (otherwise what is the point of increasing resources?); and
• an acceleration claim can however include the totality of additional indirect site overheads such as additional supervision and/or indirect equipment e.g. an additional tower crane.

As for formulae based “head office overhead” claims, some claims that I have seen bear little resemblance to reality.

Example: A contractor working on a relatively small contract (circa £25 million) produced a head office overheads claim for £500,000. The delay claimed was a maximum of six months.

Assisting the employer in its negotiations, I asked the question of the contractor:

“If I assume that the average staff salary and benefits was £50k per annum, the £500k claim was the equivalent of 20 staff members for the full 6 months; did the contractor have 20 head office staff working on the project full time for 6 months; or did it hire in 20 additional staff members? Did the contractor turn work away?”

The contractor’s responses convinced no one and it was no surprise that that claim did not achieve its basic purpose—to get paid!

My first experience of what might be called an informal dispute review board, was when I arrived on site many years ago and found that the contractor that I was working for was in dispute with a subcontractor belonging to the same group.

The dispute raged on until eventually a main board director was brought in. He listened to both of the companies for an hour, and I remember to this day reading his decision awarding payment of an amount from one company to the other. He wrote in a concluding paragraph: “That is my decision, and I trust that neither one of you is satisfied, because that is the sign of true compromise”.

Wise words and I have never forgotten them. There is a lesson for us all in compromise.

Conclusion

In summing up, construction is a perilous game for contractors and often an unfair one. Contractors need to make a profit and sometimes they lose money through totally unforeseen and / or unavoidable circumstances; sometimes however they lose money by entering into contracts with crossed fingers; and sometimes they lose money through errors on their part or the part of their subcontractors or suppliers.

I frequently see employer representatives’ responses to claims as reactionary and unnecessarily negative. All too frequently contractors’ legitimate complaints are rejected out of hand; or simply not dealt with by consultants that appear to adopt a “wait and see” attitude particularly to complaints of delay. This is grossly unfair to contractors and leaves them in a state of uncertainty particularly in delay situations where the cause of delay is frequently obvious; and the cost of delay including the imposition of LD’s (Liquidated Damages) or delay penalties potentially business destroying.

My advice is that these matters are too important to be ignored and contractors’ claims need to be dealt with promptly and fairly. If some matters are unclear or if more information is required consultants need to address it, but if they can see that there is a liability then they ought to assess it with what they have and agree an interim “safe” value including if required an interim “safe” extension of time, firming up and adjusting both if and when more information becomes available. However contractors need to help themselves by producing realistic and well supported claims and to show a willingness to assist the employer’s consultants check it.

At all times contractors need to keep their eye on the money; following it all the way through the contract and, like the lunar voyagers take remedial action as soon as they are aware that they are off course, which is to make a profit.

Returning to my opening paragraphs, (and with apologies to my Democrat friends), in his first term Richard Nixon was arguably a very successful President and his administration was responsible for some remarkable achievements.

As Nixon was re-elected in 1972 by a landslide, the entire dirty tricks campaign by the CRP prior to his re-election and the destruction of Nixon’s reputation on the face of it appears to have been totally unnecessary.

In the same vein, many protracted construction disputes are totally unnecessary and much time, effort and money is simply wasted by contractors (and by employers and their consultants) by not following my few simple general principles.

• Get the contract right and/or understand the underlying risks.
• The entire purpose of a claim is to get paid!
• All construction claims are about money.
• Learn to compromise.
• Follow the money!

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