Our experience in consulting construction projects, many of which are EPC - contract based, shows that many disputes and conflicts between the customer and the contractor are repetitive and typical for most projects. The conflicts arise regardless of the industry, be it electric power, oil and gas, petrochemical, or other. Identifying such systemic problems allows for the development of strategies that can significantly reduce their number and negative impact, thereby reducing delays in the project and budget expenditures.
In case of EPC contracts with a fixed price (EPC Lump Sum), if the EPC contractor is a large international company, the customer has minimal opportunities to influence the selection of subcontractors. The EPC contractor undertakes obligations at a fixed price and term, so they are given the right to choose their own subcontractors. In contracts, in case of a non-fixed price contract the approach changes: the customer can either directly participate in the selection of subcontractors or coordinate their candidacies, which can lead to a number of conflicts.
This analysis presents the most common contentious situations and recommendations for their prevention or reduction of negative consequences.
1. Legal Restrictions on the Use of Subcontractors
The legislation of the country where the project is being implemented may contain certain restrictions on the possibility of subcontracting part or all of the works. For example, according to paragraph 11 of Article 66 of the Law on Architectural Activities of the Republic of Kazakhstan, the construction contract must specify the types and scope of work (services) that the contractor (or general contractor) intends to subcontract. It is not allowed to subcontract more than two-thirds of the total contract price.
In practise, the question often arises: What is meant by the contract price?
According to paragraph 8.1 of MCCS RK 8.01-08-2022 "Procedure for Determining the Estimated Cost of Construction in the Republic of Kazakhstan", the estimated cost of construction is divided into construction works, costs of equipment, furniture, and inventory, and other costs. The cost of construction materials shall be included in the construction works. Therefore, the contract price includes all these costs as part of the construction estimated cost.
2. Participation of the Customer in the Selection and Involvement of Subcontractors
An EPC lump sum turnkey contract allows the customer to completely relinquish control over the project. The EPC contractor is fully responsible for the organisation and project implementation, including the selection of subcontractors. The customer must only pay for the work and accept the completed project. However, in practise, customers (especially in Kazakhstan) are rarely ready to provide such a degree of trust and prefer to have intermediate control, especially when using open pricing (open book) or cost-plus-fee, where the cost of subcontracting contracts directly affects the overall project budget.
Paragraph 1 of Article 619 of the Civil Code of the Republic of Kazakhstan provides for the right of the general contractor to engage subcontractors to perform work. This right may be modified by the introduction of appropriate clauses in the contract. The law also allows for intermediate solutions, where the contractor has the right to engage subcontractors but with limited powers in favour of the customer.
Restrictions on the EPC contractor's right to choose a subcontractor may include:
- Establishing criteria for the selection of subcontractors, while the customer retains control over compliance with these criteria.
- Requiring the customer to coordinate subcontractor candidates.
- Negotiating subcontract terms, including price terms.
- Allowing the customer to appoint a subcontractor for certain works, with the EPC contractor concluding an agreement with them.
3. Distribution of Responsibility Between Project Participants
According to paragraph 2 of Article 619 of the Civil Code of the Republic of Kazakhstan, the general contractor is liable to the customer for the non-fulfilment or improper fulfilment of obligations by subcontractors. Approval of subcontractor candidates by the customer should not be considered as taking responsibility for their actions. Even in case the customer chooses the subcontractor, the EPC contractor who entered into the contract with them will remain responsible for their shortcomings. However, the EPC contractor may seek to reduce the liability in court if the customer’s choice of subcontractor contributed to an increase in losses based on Article 364 of the Civil Code of the Republic of Kazakhstan.
4. Conflicts Related to the Terms of Subcontracts
The terms of subcontracting contracts must be synchronised with the terms of the EPC contract. An EPC contract may contain mandatory conditions for subcontracting contracts (e.g., termination terms, transfer of rights and obligations, and quality requirements). However, there are situations when a subcontractor or equipment supplier refuses to include the terms and conditions required by the EPC contractor in the contract.
5. Transfer of Subcontracted Contracts to the Customer
In the event of termination of a large EPC contract, the customer or a new EPC contractor may need to reassemble a team of subcontractors and conclude new contracts. An alternative is the transfer of previously concluded contracts from the withdrawing EPC contractor to the customer. The transfer can be provided for as the customer’s right in the EPC contract. It is not advantageous for the customer to assume obligations under contracts with significant debts, so the transfer requires the subcontractor's consent.
An EPC contract may provide for two options for the transfer of subcontractors:
- Transfer based on separate transactions between the customer and the EPC contractor.
- Transfer of rights and obligations under contracts based on a unilateral statement in the event of a significant breach of the contract by the EPC contractor, simultaneously with the termination of the contract.
It is recommended to include the option of transferring rights under subcontracts in the EPC contract (option 2 above). If the EPC contractor provides constructive interaction in the event of default, option 1 can also be implemented.
6. Transfer of Rights Under Quality Guarantees
If the warranty period for equipment purchased from the subcontractor or the result of the subcontractor's work exceeds the total period under the EPC contract, it is advisable to provide for the transfer of rights to warranty claims from the EPC contractor to the customer upon the expiration of the EPC contract.
7. Termination of Subcontracts Upon Termination of an EPC Contract
An EPC contract usually grants the customer the right to unilaterally withdraw from the contract. The EPC contractor also has the right to withdraw from the contract in the event of a material breach of terms by the customer. In such cases, the customer must compensate for the EPC contractor's losses, including the amounts paid to subcontractors.
To minimise compensation payments from the customer, the EPC contract should include requirements for subcontracts aimed at reducing payments in case of their termination due to the termination of the main contract.