Claims against subcontractors under ‘target cost’ contracts

Target cost contracts are often used where the final cost of the work is unclear, perhaps because the scope of the work is not fully defined or there are uncertainties as to risk. Such contracts allow the parties to share financial risk and reward, and incentivise the contractor to deliver the works in a cost efficient way.

The contractor gets paid for the work it carries out as it goes along based on cost ('Defined Cost'), plus an additional fee ('Fee'). Once the final cost of the works is known, this is compared with the target cost as adjusted by compensation events, and a contractual 'pain/gain' cost share mechanism is applied. The contractor and client share the cost savings or overrun relative to the target in the proportions set out in the contract.

A problem with this mechanism is that in the event of a breach by a subcontractor the contractor won't know - or at least is likely not to know - what negative impact the subcontractor's breach will have on the 'pain/gain' share up the line under its Option C/D main contract until the end of the job, when the share calculation has been done.

What then is a contractor to do, midway through a project and faced with a breach by a subcontractor in respect of which the contractor wants to make a set off, or deduction, from sums claimed by a subcontractor - but the contractor has no clear idea what its loss will be?

Let us say the contractor's claim against the subcontractor is for delay. Because of the delay, the contractor has incurred additional liabilities to other subcontractors as well as additional costs of its own.

However, these additional costs do not represent the contractor's loss under an Option C/D contract where, subject to the share, the contractor gets paid its costs. To the extent that the additional costs the contractor has incurred due to the subcontractor's breach are 'Defined Cost' under the Option C/D contract - and most of them probably will be - and subject to the share provisions, the contractor recovers those. So they can't very well be set off from the amount owed to the subcontractor.

The contractor's loss will instead arise under the share arrangement. The final 'price for work done to date' (PWDD) claimed by the contractor will be higher to the extent of those costs, but the target cost under the main contract will not have increased. Generally, the target will only increase following a compensation event assessment, and subcontractor breach is not a compensation event. So the contractor's loss - which it will want to set off from the subcontractor's claim for payment – is the negative impact of the subcontractor's breach on the share under the main contract.

Set off from subcontractors appears to involve two possibilities here:

• the contractor treats the addition to its defined cost and overall PWDD as a loss of gain or as pain under the share arrangement based on the then current forecast of how things will turn out; or
• it treats the addition as the top slice, worse case for the contractor, impact on the share arrangement.

The trouble is it is hard to justify either approach until the share calculation has been done and the actual impact of the subcontractor's breach is arguably known. I say arguably because there may still be scope for debate as to within which share range(s) the cost of the subcontractor breach should be placed.

In any event, faced with an adjudication by the subcontractor for a sum alleged due, the contractor will want to make the most reasonable quantification it can. If that is rejected by the adjudicator, the contractor may have to seek to recover its damages after the share calculation is done and actual loss is known. However, that is likely to be too late to make a set off.

Similar considerations would apply to the client's losses. Bear in mind that the client also has potential losses due to the subcontractor's breach: its loss of gain or increased share of pain under the main contract as a result of the increased PWDD, which the client will have paid out to the contractor due to the subcontractor's breach. The client will need an appropriately drafted direct agreement (or collateral warranty) with the subcontractor to recover these losses.

The reader may also be wondering whether the above analysis applies to NEC4 as well as NEC3. I believe that the answer is yes. None of the changes introduced by NEC4 should impact on this analysis.

What about the position under an Option A main contract? Things are altogether easier here, given Option A is lump sum with no share arrangement. Any set off from the subcontractor would constitute losses incurred by the contractor from the subcontractor's default in the usual way. Nothing need await the outcome of the share arrangement as there is none.

To protect itself against being unable to effect a valid set off, a contractor employed on an NEC3/4 ECC Option C/D contract should include some bespoke drafting in its subcontracts. This wording could, for example, permit the contractor to set off its claims for breach based on an estimated forecast of loss: perhaps the estimated impact of the breach on the pain/gain share at the time the set off is to be made. Alternatively - and more favourably to the contractor – the right could be drafted so that the claim is treated as the worst case impact on the share arrangement.

Mark Collingwood is a construction disputes expert at Pinsent Masons, the law firm behind Out-Law.