Legally Bound

Jordan ... informal contracts an “increasing problem in the region”.

Jordan ... informal contracts an “increasing problem in the region”.

The risks of adopting informal contracts

September 2015

STUART JORDAN* highlights the pitfalls of using informal contracts – which are growing in popularity in the region – and the risk involved in not formalising proper agreements.

What proportion of construction projects in the Middle East are carried out under informal contracts, which would include verbal and partially written contracts, preliminary statements such as a memorandum of understanding (MoU), heads of terms (HoT) or some sort of letter of award (LoA)?

While I don’t have figures for this but from my experience it is a lot – maybe half. More worrying, my main experience of this comes from dealing with disputes.

All of these contracts are useful tools in construction procurement, when properly written and correctly used. The danger is where they are used in place of actual construction contracts. There are so many unnecessary risks in failing to formalise agreements properly, and what is surprising is that the mistakes are always the same and are repeated so often.

We all know that putting together a construction project of any size is an arduous and lengthy task in which it is easy to lose sight of all the moving parts in the negotiation. In any project, a MoU or HoT document is a useful staging post for the parties in setting out the bare bones of their in-principle agreement to that point and in setting the course to complete the negotiation. The problem lies in the notion that the MoU or HoT document is the final contract or a good enough substitute for it, temporary or otherwise. It never is.

I am generalising here, of course, as these documents can take any number of forms but I can say that I have never seen any such short form document which is clear and detailed enough to support design and construction activities.

The above is a statement of the obvious and almost everyone in our industry would agree that we should use real contracts. The question is why we do it. The problem is that the practicalities often get in the way: principally lack of time. Parties spend months developing contract documents. This is always longer than was planned and at some point, work needs to start. It is also understandable that project teams on both sides will concentrate on pulling together the commercial and technical parts of the contract rather than the legal conditions. Once they have an agreement on a detailed specification of the works and a price for them, there is maybe not much enthusiasm for delving into legals before a spade goes into the ground.

Parties might decide that they need more than the MoU or HoT in order to mobilise resources and start works. At this point, we often see the LoA. These have become more common and they also can take any number of forms. An LoA also has a proper use, conventionally as a notification (usually by a public body following procurement rules) to a bidder that they have been selected as preferred bidder and that negotiations will continue with them alone. Crucially, in this situation, there is no legal commitment to the contractor other than to negotiate exclusively.

More often, however, a LoA is used as a means of communicating acceptance of terms (specification, price and programme) and authorising works to begin, but with contract terms incomplete – or expressly disagreed!

Sometimes, an LoA will refer to contract conditions as intended to be based on a named standard form with details to be agreed; or it will state that the parties will agree to the terms (a legally empty obligation) and will sign up the full contract – whether or not this actually then happens.

The dangers for the employer are too obvious to state in detail: the commitment of the entire capital expenditure on incomplete contract terms is no way to manage quality or the risks of time and cost overrun.

The dangers for contractors are less discussed but there are legal provisions which contractors these days consider to be essential, for instance liability caps, exclusive remedies provisions, exclusion of implied fitness-for-purpose obligations and employer-warranted information. Apart from this, a contractor would want to be certain that, without a full contract, he is still covered by professional indemnity insurance, all risks, employer’s liability and public liability insurance.

And of course, lack of clarity generates disputes.

Based only on the anecdotal evidence I mentioned above, this is an increasing problem in the region. I can only guess at the reasons for it. Most would agree that good practice in contracting has increased in the region since the financial crash, indeed as a result of it. The disputes which came out of that did highlight the generally poor state of the contracts being used. Once the money stopped washing construction problems away, parties resolved to tighten things up. Maybe with a few years of better times behind us, there is less concern about this now.

One other factor might be Chinese and other Asia-based involvement in the region – as contractors, developers and funders. We have seen in emerging markets that funder involvement (western commercial banks and development banks) has driven higher contracting standards because they insist on it. Our experience so far is that Chinese participants are less reliant on fully-detailed contracts domestically and rely more on commercial relationships.

Whatever the current mood in the industry, it’s worth saying that the rules still apply: if you have the full ingredients for a contract (that is, agreement on fully detailed terms – legal, technical and financial) then write the contract.

If you don’t have the ingredients yet but you need to mobilise, than a good letter of intent is one solution; authorising limited works (for limited payment) undertaken on interim (but complete) agreed terms, with clear directions should the final contract be agreed or not.


* Stuart Jordan is partner and co-head construction for the international law firm King & Wood Mallesons (KWM). Based largely in Dubai, UAE, he specialises in engineering and construction matters, cross border, both front end and disputes.

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