How can it be that as record funds are being spent on public- and private-sector projects, so many construction firms are finding themselves in financial difficulties?
To some extent, the legal environment may be to blame. In Poland there is no mandatory or at least no commonly used construction works contract standard, such as FIDIC or the German VOB. Such statutory standards applied in the past, but were abolished in the 1990s as the foundations of the free market economy were being laid in Poland. The market evolved towards the widespread use of a variety of contracts, with different provisions and approaches to the legal and economic risks involved in construction projects. Most contracts, however, share similar features – remuneration is defined as a fixed fee, without any adjustments of benefit to contractors during the construction period. Fixed fees are widely used both for ‘build’ as well as ‘design and build’ contracts.
The fixed-fee scheme is typically connected with contractual provisions that tend to transfer as many construction-related risks as possible to the contractor.
There are many reasons for such an approach. The contractor is generally perceived by the investor as the professional, experienced party. Thus, the investor recognises that the contractor should actually also be better placed to deal with the risks than the investor. When different contractors compete on price (both in the private and public sector), the investor then chooses the most beneficial offer, striving to ensure that the financial conditions offered do not change as the construction work progresses. If this gets out of hand, the consequences become very severe for the investor.
Bank financing of construction projects also imposes limits on price adjustments or the execution of amendments to the original construction contract. As bank-approval procedures are long, complicated and, sometimes, costly, the investor tries, as far as possible, to limit the need for bank consent to a minimum. Typically, the bank will also assume a 10% overrun to be covered by the investor directly. If additional bank financing is necessary, once this overrun limit is exceeded, obtaining such additional funds may be difficult, depending on the business parameters of the project.
Additionally, in state-funded investments, formalised tender procedures lead to longer periods between contracting and project execution. This leads to an aggravated risk of price increases, as contractors need to propose pricing for works which will be executed at least several months or even years ahead in time. Polish public procurement law also limits the legal possibilities of amending contracts during the execution period.
Another legal challenge is the investor’s risk of double payments for construction works – first to the contractor, then to its subcontractors. Under the Civil Code the investor is jointly and severally liable with the contractor for payment of the subcontractors’ remuneration. This implies that a subcontractor may raise a legally valid claim against the investor if the contractor did not pay the subcontractor’s due remuneration, even if the investor had already paid the corresponding amount to the contractor. This principle cannot be changed by the parties’ agreement. To mitigate the double-payment risk, investors implement complex contractual provisions on monitoring payments to subcontractors. Recent Supreme Court case law and amendments to the Civil Code have eliminated some of the most severe risks of payment to entities which were not clearly notified to the investor as subcontractors. Nevertheless, the investor’s liability for payment of a subcontractor’s remuneration is also one of the factors that promotes the application of fixed fees in construction contracts and may lead to delays in payments of the contractor’s remuneration until the contractual monitoring requirements are fulfilled.
In recent years, the increase of demand for construction works coincided with labour shortages and increased costs of materials and subcontractors’ remunerations. With fixed-fee contracts, the contractors secured investors against such increases. But as costs began to increase significantly, profitability proved difficult to maintain.
Legally, unless provided for specifically in the contract, there are very limited circumstances which allow the contractor to unilaterally terminate an agreement or effectively demand a price increase. Statutory Civil Code provisions, which allow for judicial adjustments are difficult to apply and involve costly and time-consuming court proceedings. Such a measure is therefore not sufficient and quick enough to save a failing company facing current liquidity problems.
Even if globally, various contractual solutions are applied to calculating and paying a contractor’s remuneration, such as GMP (Guarantee Maximum Price), cost-plus or unit pricing, the Polish market standard still operates on a fixed (lump-sum) fee basis. Statutory regulation of construction contracts is very limited and does not elaborate on risk allocation between investor and contractor to a degree commensurate with the requirements of a modern construction market. As a contractor has very limited legal means to change the contract without the investor’s consent, if market conditions change and the cost base increases, contractors become trapped in non-profitable contracts. This in turn may cause a systemic risk of insolvencies across the construction sector, as large general contractors employ groups of subcontractors and suppliers, who depend on liquidity provided by general contractors. Delayed payments may render such entities insolvent, while the legal system does not provide for adequately quick and simple solutions on enforcement of remuneration claims.