Subcontractor audit and termination rights need thought on major projects

On the one hand, there are various legal regimes globally under which project owners could face liabilities for activities in their supply chain.

On the other hand, the bulk of responsibility for the oversight and management of subcontractors is, contractually at least, placed with main contractors.

This raises the question of how project owners can effectively oversee subcontractor arrangements and prevent themselves from being exposed to legal liabilities, regulatory sanctions, and reputational harm from the activities subcontractors may engage in.

The answer is complicated: not only will project owners seeking inclusion of broad rights of oversight over subcontractor activities in their contracts with main contractors be likely to face pushback during negotiations, where contractual entitlements are specified in main contractor agreements, there will be an increased onus on project owners to exercise those rights – to demonstrate their commitment to compliance to enforcement authorities.

As we explain below, thought must also be given to the realities on the ground where project works are being carried out, so that contractual solutions reflect the practical issues subcontractors might face in performing works.

Risks arising in project supply chains

It is common for project owners to engage a main contractor, to take on overall responsibility for delivering complex, major projects on a turn-key basis. In turn, it is common for the main contractor to engage subcontractors to carry out all or some of the works on projects, such as design or installation works.

However, when subcontractors engage in unethical or illegal practices, it can have significant collateral consequences for the project owner. These practices can include fraud or paying bribes to local bad actors or public officials to secure permits or safeguard the project from delays or disruptions caused by local community unrest. In addition, some subcontractors may resort to modern slavery to reduce costs, exploiting vulnerable workers through forced labour or poor working conditions. Such actions not only undermine the integrity of the project but also expose the project owner to legal liabilities, financial penalties, and reputational damage.

Ensuring that subcontractors adhere to ethical standards and legal requirements is crucial to mitigate these risks and maintain the project's integrity.

How the risks are typically managed

Project owners commonly rely on general clauses in their agreements with main contractors, to address subcontractor-associated risks.

For example, main contractors will owe a contractual duty to project owners to have policies and practices in place to guard against corruption and there will be an expectation on main contractors to flow those requirements down into their own agreements with subcontractors. Prior approval of subcontractors by the project owner is also sometimes required to ensure compliance with these standards.

In an era of increased focus on ESG and corruption, project owners may also insert audit and reporting rights into their contracts with main contractors, giving them entitlements that enable them to monitor for ESG and compliance risks and meet their own disclosure obligations under, for example, legislation such as the EU’s Corporate Sustainability Reporting Directive (CSRD), where corruption and modern slavery risks are among the issues businesses are expected to report against.

It is also increasingly common for project owners to include termination clauses in their contracts with main contractors, requiring main contractors to terminate agreements with subcontractors in the event of a breach of ESG requirements or anti-corruption laws

The limitations of this approach

A problem with general clauses is that project owners might find that arguments pertaining to ‘paper compliance’ are not sufficient to avoid liabilities that could arise over compliance failures of subcontractors under a suite of legislation in force around the world that they may be subject to.

For example, the UK Bribery Act includes a failure to prevent bribery offence that foreign companies, as well as those based in the UK, can fall foul of – it they failed to prevent an act of bribery which was, at least in part, intended to benefit the commercial organisation, by persons associated with it. The concept of ‘associated persons’ is broad and applies, among other things, to contractors.

The only defence a commercial organisation has if charged with the failure to prevent bribery offence is the defence of 'adequate procedures' – a concept that has been mapped out into practical guidance issued by the UK government, which covers everything from governance and risk assessment, to due diligence, communication and, perhaps most crucially in the scenario explored in this article, monitoring and review.

In a similar vein, Sapin II in France sets out obligations on qualifying French companies to conduct due diligence and monitoring of contractors in relation to corruption risks and, like the UK Bribery Act, has extraterritorial effect.

Businesses also have statutory obligations in many jurisdictions to report suspicions of crime, like money laundering.

Providing for contractual certainty

In consideration of their own legal obligations and the expectations of both enforcement agencies and the courts, many project owners will consider that they need to do more than simply point to the inclusion of general clauses in their agreements with main contractors as evidence of them meeting required standards around subcontractor due diligence and monitoring.

In our view, specific project owner entitlements pertaining to subcontractors, in particular around audit and termination rights, should be provided for in the contracts with main contractors.

This would have advantages for both project owners and main contractors and avoid the potential for disputes to arise over the precise scope of general clauses.

It is possible to imagine, for example, that main contractors would seek to push back on attempts by project owners to assert contractual rights to review subcontractor invoices under generic audit rights clauses in the project owner-main contractor contract.

Main contractors might consider this to not only go beyond what the contract provides but as exposing them to potential risks, from subcontractor claims to uncertainty associated with how the contractual rights being asserted would be given effect in practice – including over the extent to which they would be expected to step aside to allow project owners to audit subcontractors directly and over the level of evidence of illicit activity the project owner would need to uncover to trigger a contractual duty on them to terminate their arrangement with the subcontractor.

In some parts of the world such as South Africa, main contractors may seek to push back against what they may see as a form of common law unlawful interference with their subcontract relationships.

With the potential for relationships to become soured and for disputes to arise, adding cost and delays to project delivery and threatening scheduled payments to main contractors, and with the underlying legal and regulatory compliance duties to think about, it is in the interests of both project owners and main contractors to agree specific contractual entitlements relating to subcontractors at the project outset.

Addressing the practical realities facing subcontractors

Contractual certainty must be matched with the implementation of other measures that reflect the realities facing subcontractors delivering works.

Any high-value, major project is at risk of attracting people who see an opportunity to extract their own value from such projects, whether corrupt public officials or bad actors like the ‘construction mafia’ in South Africa. Addressing such risks in the contracts between project owners and main contractors will not make them disappear for subcontractors engaged locally on the ground.

A range of measures should be considered, from training subcontractors on compliance risks and how to deal with them, to insisting they follow robust procedures – like avoid meeting public officials alone.

Ensuring local communities and companies benefit from major projects is also likely to engender goodwill towards projects and mitigate the risk of disruptive protests, while engaging independent security experts to oversee site security measures will also reduce the risk that subcontractors feel pressured to make payments to bad actors to ensure works progress without damage or disruption. In some jurisdictions, businesses may find they need to go to court to obtain injunctions to prevent disruption to works and compel local law enforcement into action. 

In addressing the practical and commercial realities of projects as well as the contractual position, project owners, main contractors and subcontractors are all likely be able to get on with focusing on delivering projects, on time and on budget.