CHAPTER 10
Who Should Control Contracting Strategy?
Within industrial owners there is no consensus about roles and responsibilities in contracting. The lack of clarity is not benign—it causes confusion and in some cases significant damage to capital projects. The following owner functions have some claim to control of contracting:
- The business sponsor
- The legal organization
- The procurement or supply chain management organization
- The capital projects organization
- An individual project team and its leader
The overlapping of responsibilities in these five entities has often resulted in turf fights and no one in charge of getting essential work done. The most common and heated of the disputes is usually between the procurement and projects organizations. In this chapter, I will argue that every function listed here can and perhaps should have a role in the contracting process for projects. The problem is that the best role is not always the role the function desires.
The Role of the Business Sponsor in Contracting
To be direct, the business sponsor of a project has no business in contracting. The business sponsor should not be selecting the contracting approach, should not be dictating terms and conditions, and certainly should not be deciding which particular contractors to select. Why? Because all of those activities require deep expertise that the business sponsor almost never has. With that said, the business sponsor has an indirect role in selecting contracting approach that must be respected by those selecting the strategy: the business sponsor sets the project objectives, and the project objectives may have an important role in contract strategy selection.
It is the business sponsor's remit and obligation to tell the project team the priorities for the project. For example, if the paramount goal for the project is getting to market as quickly as possible to beat a rival to the market, that should shape the contracting strategy. Conventional EPC‐LS is probably off the table. A Re/Re strategy with schedule incentives for the engineering firm is probably the best solution as it is the fastest strategy generally available.
The most pernicious sort of business sponsor involvement is in contractor selection. Some EPCs make it a regular habit to cultivate owner businesspeople with the goal of winning work they would not be awarded by anyone else involved in the process. The business sponsors are wined and dined and taken out for golf. When the EPC is repaid for their kindness, the owner project teams respond by stuffing as much money into the cost estimate as they possibly can. That is a perfectly rational response to the wrong contractor being selected for a project. Business sponsors should be informed regarding the contracting strategy for the purpose of ensuring that it accords with project objectives. Beyond that, no further involvement is warranted.
Owner Legal Organization
Among project people, I may be a bit of an odd duck in that I believe that lawyers have an incredibly important role to play in contracting on both the owner and contractor sides. Alas, this is not the usual role they play. Lawyers, of course, have a role in writing or reviewing contract documents and advising their clients about proposing, accepting, or rejecting various terms and conditions in the engineering and construction contracts their clients must execute in the course of business.
Lawyers for contractors are much more likely to be construction lawyers than their owner counterparts. That is a distinct disadvantage for owners. If an owner has a substantial capital spend, bringing specialized construction attorneys in‐house probably makes economic sense. If not, hiring outside construction counsel is probably a better option than turning the work over to corporate legal. The disadvantage of outside counsel is that they are likely to be used too late and too sparingly because they represent an out‐of‐pocket cost.
In my experience most owner and contractor lawyers view their remit of protecting their client's interests rather narrowly. Their goal is often to transfer as much responsibility and risk to the other side of the table as possible. Both owner and contractor lawyers seek to write an unbalanced contract with respect to risk; they just have diametrically opposing views of the proper balance. In the spirit of advocacy, they may suppose that a “fair and balanced” contract results, although experience tells us that often is not true. Lawyers are sometimes motivated to go for “the win” in contract negotiations in much the same way that they want to win in court. But if a “win” in contract negotiations is shifting all of the risks to the other side, the lawyer's win is usually the project's loss.
But what if lawyers for both sides viewed their client's interest in terms of generating the best possible project rather than narrowly interpreting their client's best interest as avoiding all risk? In other words, what if they were lawyers for the project in addition to their clients?1 It is, after all, reasonable to suggest that the interests of both owners and contractors are usually met when a successful project results from their joint efforts. Of course, we have seen examples as discussed in Chapters 4, 5, and 6 in which owners gained at a contractor's expense and vice versa. And no amount of lawyering for the project will ever make the principal‐agent misalignment of objectives go away. However, in the great majority of cases, good projects—projects that are delivered as promised—benefit both owner and contractor alike.
So what does it mean to be a lawyer for the project? To act as a lawyer for the benefit of the project requires that attorneys understand the costs as well as the obvious benefits of transferring risks to the other side. Risk transfer is never free. In the simplest case, the risk is priced by the contractor in their bid. Conversely, an owner keeping a risk that could have been transferred will result in lower bids. In some cases, a contractor may accept responsibility for a risk knowing full well that the risk will be transferred back to the owner. This happens, for example, when a contractor sees the holes in the ITB that will enable risks to be returned with ease. In the worst case for both owner and contractor, the contractor accepts a risk they cannot reasonably carry because they need the work too much to push back. Attorneys must really accept that there is no free lunch.
To be an effective lawyer for the project, the attorney must understand not only how projects work generally but the specifics of the project at hand. What may have been an appropriate term in the last project may not work for the current project at all. What was a reasonable term in a cool market may generate a lot of pushback or a very high price in the current market. Perhaps most important, the effective lawyer for the project knows the source of the primary risks in the project, who controls them, and who is best positioned to manage them effectively.
Lawyers for the project use the contract negotiation process as an opportunity to facilitate the risk management of the project. Contract negotiations are all about risk, but rather than clarifying risk assignment for a project, the contract terms and conditions and the negotiation process often obfuscate risk assignment. Having suffered through a number of these negotiations, I am led to suspect that muddying the water was sometimes the intent, perhaps thinking that a lack of clarity suits their client's interest. It never suits the interest of a good project.
I believe that contract clarity should be the first obligation of every lawyer working on project contracts. “Contracts should say what they mean and mean what they say.” Projects are the joint product of many functions within many organizations working together to create an asset. Contracts should help sort out who is responsible for what and should be written in language understood by all. When contracts are written clearly, it is a little more likely that all concerned will see what is needed to make the project successful.
The most difficult task for attorneys working on projects is often figuring out who the client is. This can be especially difficult for owner attorneys. Is the client the corporation? Is it the business sponsor? Is it the supply chain director? Is it the project manager? All four “clients” have an interest in a successful project but are likely to have very different views of contracting and the lawyer's role. One can be a lawyer for the project while reporting to any of the four potential clients, but only if it is clear which one it is.
Very few IPA clients employ industry‐wide standard contracts such as FIDIC or AIA. Some clients start with a standard contract and then modify it so extensively that the standard form all but disappears. Industry‐standard contracts attempt to craft balanced terms and conditions, and that may be why they are not popular in industrial projects. The failure to adopt industry‐standard contract provisions may be an opportunity lost as standard provisions might be understood more universally than bespoke terms.
The Proper Role of Procurement in Capital Project Contracting
If the role of the lawyer is often too small, the role of the corporate purchasing organization, which we will dub procurement, often has the opposite problem. Procurement is always an essential player in capital projects. Some owners have developed specialized capital project procurement organizations, but most have central procurement that performs some critical project functions. The ordering of long‐lead equipment, for example, is generally procurement's remit. Many owners have standardization programs in their equipment selection across facilities, and the frame agreements that underpin these programs are usually run by procurement.
In some owner companies, the procurement organization has assumed responsibility for all or most contracting for engineering and construction services. Usually, that responsibility had to be wrestled away from the projects organization, most of which deeply oppose procurement taking contracting leadership. Procurement's argument is that they buy more or less everything for the company, they are deep experts in purchasing a whole range of goods and services, they know how to get the best deals, and that engineering and construction services are not fundamentally different than other things that they buy. The argument is certainly plausible, and in many owner organizations, procurement is a much more powerful corporate function than capital projects with much better access to the C‐suite.
We have not undertaken a systematic study of our clientele in terms of who controls contracting and how that affects project outcomes. We do, however, have a great deal of anecdotal evidence that suggests that procurement's role in contracting should be carefully circumscribed. The following example suggests why.
The case was a very large greenfield megaproject. The competition for the utilities system, which was to be executed on an EPCM reimbursable, came down to two finalists. One of the two, a well‐known Tier 1 contractor, had executed the FEED on the utility systems. The project director considered their FEED work excellent and preferred to continue with that contractor. The other, also a well‐known Tier 1 contractor, was looking for entry into this regional market. The owner's chief procurement specialist on the project had the remit of making the decision. The contractor bids were extremely close, but the deciding factor was that the second contractor offered to execute the work with no fee. That “bargain” persuaded the procurement officer to award them the utilities contract. The result was an utter fiasco; the contractor's work on the utility systems was so bad that it prevented the startup of a multibillion‐dollar complex for well over a year and hemorrhaged untold millions in net present value.
I submit that a competent projects person would not have made that mistake. The procurement specialist saw little danger in handing the contract to the firm that offered no fee because it was a well‐known Tier 1 contractor (a “brand name” after all) and they were offering a bargain. If a solid, well‐known vendor offers a lower price on a piece of equipment, one would be a fool not to take it! The difference, of course, is that a piece of equipment is easily inspected for quality; a contractor is not.
A project professional would also have known that Tier 1 contractor's offices are often anything but uniform in capability and that the office out of which this work was to be done was at best marginally competent. Sometimes, all that an office has in common with the headquarters office is a logo. A project professional would have been unimpressed by the offer to do the project at no fee, because a project professional would know that the fee is often the smallest source of profit for a contractor working on a reimbursable basis. A project professional would never look at EPCs and see interchangeable commodities. A procurement specialist is much more likely to.
We see this type of scenario play out on projects repeatedly where procurement rather than projects controls contractor selection. Like so many things, the difference in viewpoints between procurement and projects comes down to the incentive systems behind their organizations. The most important key performance indicator for procurement is cost savings. In many purchasing organizations, savings achieved on each transaction are carefully documented. Savings may be used to incentivize individuals and is almost always used to demonstrate the success and value of the procurement organization to the C‐suite. This is not to say that many procurement organizations do not have more holistic, value‐based KPIs. But savings as a percentage of transaction value is by far the easiest to measure, and easy‐to‐measure KPIs usually win out in the end. (Remember how the businesses love those cost underruns on projects; ease of measurement wins out.)
Indicators of value to procurement are not always indicators of value on projects. For example, procurement is likely to look favorably on lower hourly rates. But project professionals know that a contractor's hourly rates are indicative of almost nothing unless productivity is taken into account.2 We see analogous problems with procurement controlling the purchase of major equipment on projects, where cost savings are often given priority over timely delivery despite timely delivery often being much more important to total project cost.3
What constitutes a good project is always more complex than what constitutes a good purchase. The quality component of value is always large with cost or schedule coming second. More important for contracting is to recognize the joint product nature of the owner/contractor relationship. Contracting for engineering and construction services takes deep knowledge of project management to do it well. If procurement had the level of project management expertise required to do a good job of hiring contractors, it would be the projects organization.
The Projects Organization Should Control Contracting
Contracting is very possibly the most difficult single aspect of project management. Contracting is sensitive to the particular challenges posed by a project. Contractor selection is sensitive to the strengths and weaknesses of the owner team. Contracting strategy, of course, is sensitive to the state of the market and the particulars of the location.
Projects should control the following:
- Contracting strategy decisions
- Prequalification
- Contractor selection
- Contract terms and conditions that affect the management of the project
The projects organization may have a contracts advisory group or may leave contracting entirely up to their project teams with the project manager playing the key role in the three previous activities. My experience is that leaving the tasks to the project manager/director works fine if the PM is familiar with the location in which the project is being executed and the specifics of the local markets. If the company has a geographically dispersed project portfolio and moves PMs to new locations frequently, a contracts advisory group may be essential.
Procurement can play a very useful role in contractor market assessment. Procurement usually has market assessment procedures and expertise that need not be fully replicated in the projects organization. Procurement sometimes has the responsibility for maintaining contract templates with standard terms and conditions. My only caveat with this last assignment is that procurement should not replace legal. The lawyers have a role to play in risk assignment as it pertains to the negotiation of terms and conditions that nonlawyers probably cannot fill. Furthermore, construction law is a constantly evolving area, and only legal is likely to stay abreast of developments. Despite all of the functions that have a role, contracting must stay firmly in the hands of the organization responsible and accountable for project success: the projects organization.
Notes
- 1 For an extended discussion of this topic, see Andrew Ness and Edward W. Merrow, “Becoming a Lawyer for the Project,” Proceedings of the 33rd Annual Meeting of the American College of Construction Law, Laguna Beach, CA, February 2022.
- 2 In fact, higher rates are often indicators of higher value in contractors. IPA studies of productivity repeatedly show that contractors that command higher hourly prices can do so because they are more productive.
- 3 Owner procurement of equipment and materials is the only example of maintaining a project activity in‐house that is associated with poorer project performance. When in‐house procurement buys all equipment and materials for a project, the projects are 8 percent slower in execution than when the purchasing is done by the engineering contractor (Pr.|t|<.01). There is no off‐setting cost advantage. In fact, costs are directionally higher, but it is not statistically robust. When it comes to buying for projects, engineering contractors are better because they have much more buying power than even the largest owners, they have long‐standing relationships with many more vendors, they bring inspection and expediting capability, and they are not incentivized to generate cost savings over timeliness.