The good, the bad and the ugly

By Katrina Van Houtte, special counsel, and Stuart Robertson, partner, Dentons Kensington, construction law team.

The resilience of the construction industry is extraordinary, highlighted none more so than during the pandemic.

Contractors are to be congratulated on their level-headedness and pragmatism in dealing with the contractual fallout from being completely shut down in Level 4 and constrained working conditions under Levels 3 and 2.

The initial skepticism of whether the Construction Accord would actually deliver has proved, unwarranted as it is unlikely that the approach taken by the Government in issuing its Guidance Notes on contractual entitlements would have occurred had the Accord not been in place.

That said, MBIE’s most recent Guidance Note on the valuation of lockdown claims is not as much of a step forward as the industry hoped it might be.

This article examines this Guidance Note and current trends we are observing in the market from engineers to the contract in the application of the wage subsidy.

The good

The MBIE issued a Guidance Note on 7 April guiding Government agencies as to the application of NZS 3910:2013 (General Conditions only) as to the effect of the move to Level 4.

While not going as far as to say that this was a suspension under clause 6.7.1, the Government did confirm that there had been a change of law under clause 5.11.10.

This approach was of interest as there had been considerable debate in the market about whether the measures the Government had implemented, could amount to a change in ‘statute, regulation or by-law’.

On 11 May the MBIE issued its second Guidance Note for public sector agencies, this time dealing with how to value variation claims arising from the Level 4 lockdown periods. For the most part, the Guidance Note takes a sensible and pragmatic approach, including identifying the types of costs that need to be considered and giving some guidance on the process for valuing variations.

This includes the following:

• It is for the Contractor to submit its valuation of the Variation to the Engineer (9.3.2);
• As far as possible, the value of each Variation shall be determined by agreement between the Contractor and the Engineer. In the absence of that agreement then the balance of the process under clause 9.3 should be followed (9.3.4);
• Where the contract includes Schedule of Prices which contain applicable rates, then you use those rates (9.3.5);
• Where the Schedule of Prices does not include applicable rates, but rates can be derived from them, then you apply the derived rates (9.3.6); and
• There is no Schedule of Prices or rates cannot reasonably be derived, then the value shall be determined on the basis of Net Cost (9.3.7).

 

Whether On-site Overheads, Off-site Overheads and Profit are to be added falls to be determined either under clause 9.3.8 or, if the valuation is by way of the Net Cost approach, then under clauses 9.3.9 and 9.3.10. ‘Net Cost’ is defined as ‘the reasonable, actual or assessed expense or direct cost to the Contractor, plus return on investment and Plant, after deduction of trade discounts and exclusive of the Contractor’s On-site overheads, Off-site Overheads and Profit.’

Given that Level 4 projects (except those that were an essential service) were completely shut down across all of New Zealand, contractors were unable to off-hire equipment to other projects, or divert resources to other projects.

Some head office resources were able to be utilised in catching up on project planning, claims preparation, and tendering for new work. However, in the main, for the five-week period of Level 4, contractors found that their labour costs could not be mitigated (subject of course to the wage subsidy and any other mitigation steps taken).

The bad

The Guidance Note says: ‘In the case of a variation arising under general condition 5.11.10, the government’s interpretation is that the principal is not required to effectively indemnify the contractor for all Costs associated with the lockdown. What is compensable is an increase in the Costs incurred by the contractor in performing the Contract beyond that contemplated in the contract.’

The first issue is in MBIE’s interpretation of clause 5.11.10. Clause 5.11.10 states: ‘If, after the date of closing of tenders the making of any statute, regulation, or bylaw, or the imposition by Government or by a local authority of any royalty, fee or toll increases or decreases the Cost to the Contractor of performing the Contract, such increase or decrease not being otherwise provided for in the Contract, the effect shall be treated as a Variation.’

In our view, MBIE has confused the gateway or hurdle that must be met before a deemed Variation is granted under clause 5.11.10. The qualifying change in law simply needs to increase or decrease the Costs to the Contractor of performing the Contract. Once that occurs the effect of the change in law is treated as a Variation (not an increase in Cost).

However, that is what MBIE is suggesting, that the Variation valuation mechanism in 9.3 is ignored and the valuation is calculated by an increase or decrease in the Cost. In our view this is not the effect of 5.11.10, and if it was it would be unique across other deemed Variations in NZS3910:2013.

Instead, clause 9.3.4 states that in the absence of agreement between the Contractor and the Engineer as to the value, ‘the value shall be determined by the Engineer in accordance with 9.3’.

In most instances labour costs are not a separate item within a Schedule of Prices as they will be included in the rate for any particular activity (earthworks, laying of pipe, etc.).

Accordingly, many contractors have moved to the third option of applying Net Cost. In doing so, the definition of Net Cost requires a credit of any trade discount. Acting reasonably, contractors have been crediting any wage subsidy that they have received from the Government for the lockdown period amongst other items of expenditure that have not been incurred due to the nature of the lockdown.

Once the Net Cost is established, On-site Overheads and Off-site Overheads and Profit are to be added in accordance with clauses 9.3.8 and 9.3.10. Where a percentage is nominated in the Schedule of Prices then that percentage is applied and if no percentage is nominated then a reasonable percentage shall be used.

Where, as a result of the nature or circumstances of the Variation, such percentage would be clearly inequitable to use, then a reasonable percentage shall be used (9.3.12).

The ugly

We are seeing the treatment of the wage subsidy in the Net Cost exercise causing some issues.  In some cases, the view is being taken that a credit for the full 12-week wage subsidy needs to be applied to claims for the Level 4 lockdown period.

In our view, this is not the correct approach. The wage subsidy is available ‘to support employers, sole traders, impacted by Covid-19, in facing laying off staff or reducing hours’.

Once the eligibility criteria are met, the payment is made for all listed employees for a period of 12-weeks (and at the time of writing is being further extended in some circumstances), notwithstanding that the initial subsidy was paid in one lump sum.

An employer’s obligations on receipt of the subsidy varies depending on the date the subsidy was applied for, but the focus is on retention of employees, rates of pay, hours and leave entitlement.

If a Level 4 Variation claim is approached on a Net Cost basis, then the subsidy applicable to those five weeks should be credited only.

However, once we moved into Level 3 it was essentially business as normal, albeit it with additional health and safety and social distancing constraints. The Contract Works are being performed in return for payment of the Contract Price and all the usual provisions under the Contract are applicable.

The fact that retaining staff during Level 4 and beyond has been incentivised by the Government, if employers meet the subsidy criteria, should not be a basis for a reduction in payment for performance of the Contract Works as originally contracted.

There is no requirement under NZS 3910: 2013 to credit the balance of seven weeks of the subsidy (or any other subsidy amounts) nor is it appropriate. If it transpires that the contractor did not suffer the required revenue drop in any one month, then the MBIE may require some or all of the wage subsidy to be repaid.

To put it another way, if there was an increase in tax rate either in a budget or due to a change of Government, could the Contract Price be increased to account for the net drop in profit to the Contractor on an existing contract? The answer would be quite clearly, no.

The Construction Accord has provided a platform for industry to rapidly engage in a constructive dialogue with Government and, in general terms, has produced a lot of goodwill and common sense in dealing with the contractual consequences of the COVID-19 events.

We support MBIE’s initial guidance on how to apply the General Conditions of NZS 3910:2013 from an entitlement perspective.

However, MBIE’s interpretation on how to value the costs arising from a change in law under clause 5.11.10 is unfortunate as it confuses the gateway test for a deemed Variation under clause 5.11.10 as having amended the valuation process under clause 9.3.

As for the wage subsidy, there is no basis for the full 12-week wage subsidy to be credited back for a Level 4 claim, if you are approaching the valuation by way of Net Cost.

 

Dentons Kensington Swan offers 15 minutes of free advice on construction issues to CCNZ members.

 

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