Renegotiating Contracts

In tough economic times similar to the situation prompted by the current pandemic, it is sensible for companies to take measures to protect their cash positions. Organizations are scrutinizing both their capital and operating expenditures to identify areas for optimization to help weather the storm. Real estate developers and asset owners are no different.

In our work with a wide spectrum of developers and owners, a common recurring question in the last few weeks has been, “Can we renegotiate our contracts with our main contractors?”

As an owner’s project manager, our main focus is to protect the owner’s best interests on capital projects. Naturally we look for ways to reduce costs and time-to-market to improve the quality of the product and help deliver not just a functional building, but a viable capital investment. Part of our role in protecting an owner’s interest is providing them with sound advice on their contractual rights and obligations, and how to protect their reputation. When faced with a question of whether or not a main contractor’s contracts can be renegotiated, we have to balance all these considerations.

Start with the contract

The starting point for any commercial or contractual discussion should definitely be the contract between the parties. The first question to ask is whether there is, in fact, an executed contract or is work progressing based on a Letter of Intent (LOI). If the latter, then the owner has some leverage to renegotiate rates and conditions. If, however, the contract has already been executed, then the parties have a binding agreement that can only be renegotiated by mutual consent. The main contractor is not obliged to enter into renegotiation discussions, but there are other considerations as noted below, which might influence the decision.

Main contractor’s business decision

When faced with a request to renegotiate an executed contract, the main contractor will likely assess the termination clauses and the terms that are offered as they decide on the best path forward. If the contractor refuses to renegotiate, the owner may choose to terminate the contract and re-tender the work based on the cost of termination under the terms of the contract (e.g. if it is permitted to terminate for convenience, under force majeure, or other provisions in the contract). The owner may also consider their right to de-scope some of the main contractor’s works through a variation order.

The main contractor’s decision to enter into a renegotiation discussion becomes largely a business decision, weighing the owner’s offer against factors such as the contractor’s project backlog, cashflow situation and relationship with the owner. Owners are more likely to be successful in renegotiating contracts if they seek a fair allocation of net costs.

Facilitating the negotiation

Assuming both parties agree to renegotiate the contract, the role of the owner’s project manager becomes critical in facilitating these conversations. The project manager can help evaluate the contractor’s sunk costs versus costs that have not yet been incurred. For example, materials already delivered to a site and procurement commitments placed for long lead materials are generally sunk costs.

The project manager can also help the main contractor understand how the owner’s financial feasibility has changed due to market conditions. In the current situation, for example, financial feasibilities are being rewritten, and the return on investment that was predicted for many asset classes has been lowered. If the main contractor has a better understanding of the owner’s revised feasibility and cashflow position, this may encourage the main contractor to negotiate a solution if it does not generate the originally desired profits.

To renegotiate a contract successfully, both parties must find ways to minimize their losses. They will need to work collaboratively and openly to establish areas where cost savings can be achieved without being unduly onerous to either party. Areas where such cost savings may be found include:

• Unprocured items: A natural place to start is to renegotiate items that have not been procured. The costs for many common construction materials such as cement, blockwork, steel, waterproofing and some wood products have declined and may be lower now than when the contractor won the bid. The prices of many finished products have also fallen due to downward pressures on book orders around the world. Owners should look to their project managers to quantify the savings the main contractor will realize through upcoming purchases.

• Substitute materials: There may also be opportunities for savings through cost-effective alternatives for unprocured provisional sum and provisional cost items. These savings can be realized through normal contract change management processes and don’t technically require a renegotiation of the whole contract.

• Preliminaries: The main contractor’s preliminaries typically account for 5% to 10% of the contract price and allow for the contractor’s site staff, welfare facilities, vertical transportation, utilities, scaffolding and other preliminaries. The main contractor can assess these allowances against actual site requirements, as well as renegotiating rates with their vendors. It is worth noting here that main contractors are having to incur additional costs to comply with COVID-19 precautions and new government regulations.

It’s not all about the price

The owner and main contractor should consider other contract conditions that may help both arrive at the desired results, such as:

• Payment cycle: In a market where cashflow is limited, contractors appreciate owners who can reduce the payment cycle through shorter payment periods or the acceptance of fortnightly applications. This plays a significant role in improving the contractor’s liquidity and contractors could be willing to accept a reduction in profit margins in favour of a steady cashflow position.
• Early release of retention: Similarly, if the owner is willing to accept the partial release of retentions based on project progress milestones, this may improve liquidity even further.
• Bonding: Owners can also reconsider the contract bonding requirements against the status of the project and whether these bonding requirements can be relaxed.

In summary

Parties can agree to renegotiate contracts. Main contractors will most likely be willing to renegotiate if they are given a fair offer. Owners should be ready to minimize losses and seek cost savings through normal contract mechanisms and negotiate solutions that ‘share the pain’. A knowledgeable project manager can support an owner with their better understanding of termination costs and cost savings, as well as the value of improved cash flow and reduced risk.

I have always admired the simplicity and universality of what is known as the Golden Rule: “Treat others as you wish to be treated”. I believe that, in times like these, and when embarking on a task such as renegotiating a contract, a critical success factor is for both parties to take a fair and equitable approach and not try to over-leverage the situation.