3 May 2020 11:34 AM GMT
The entire world has been severely impacted by the unexpected outbreak of the COVID-19 pandemic. As the impact of this pandemic continues to expand, the infrastructure projects are facing historically significant challenges regarding financial pressure, labor shortage, hindrances in the supply chain and so on. The outbreak of COVID-19 is already disrupting the project development and...
The entire world has been severely impacted by the unexpected outbreak of the COVID-19 pandemic. As the impact of this pandemic continues to expand, the infrastructure projects are facing historically significant challenges regarding financial pressure, labor shortage, hindrances in the supply chain and so on. The outbreak of COVID-19 is already disrupting the project development and finance markets in profound ways. The pandemic has created an enormous amount of uncertainty as the contractors are facing an unenviable decision whether to close sites or to keep them open. Some business entities may be functioning because they fall under the criteria of essential service, however, this pandemic is not a friend to them either.
The rights and obligations of parties, under their respective contracts, are surrounded by doubt. Disputes will inevitably arise regarding the interpretation of existing complex contractual provisions, and the applicable statutory and equitable principles of law. It is important that the parties understand the provisions of applicable laws, respective contracts as well as legal issues that may come into play due to this pandemic. The legal consequences of this pandemic may differ from contract to contract. On the contractual side, four areas that are likely to receive great attention over the coming period are Force Majeure, Change in Law, Frustration of Contract, and material adverse effect.
If the force majeure clause, as stated in the contract, applies then the contractors can get a relief in the form of extension of time. however, in the absence of a force majeure clause, parties may invoke the Doctrine of Frustration enshrined under Section 56 of the Indian Contract Act, 1872, which operates from the date of the impossibility and puts the contractual obligation to an end.
Change in Law provisions confer rights relating to both extension of time and compensation for the unavoidable costs incurred, however, whether the contractor has such right or not will depend upon the drafting of the provision. It is significant to mention here that the International Federation of Consulting Engineers (FIDIC) provides the definition of law as follows: "Laws" means all national (or state or provincial) legislation, statutes, acts, decrees, rules, ordinances, orders, treaties, international law and other laws, and regulations and by-laws of any legally constituted public authority. It should also be noted that this definition covers a wide range of legislation as well as regulatory actions from 'any legally constituted public authority'. The World Bank Group provides checklists and sample wordings for commercial terms for PPP contracts. For Change in Law it provides that if the contractor suffers delay and/or incurs additional costs as a result of a Change in Law, then the contractor will be entitled to an adjustment to the contract price.
Change in Law, unforeseen event or political event clauses in a contract are like peas in a pod. You may call the legal changes due to COVID-19, including the lockdown, by any of these names. At the end of the day, it provides a great basis for raising a claim if it has caused some actual disruption, inefficiency, increase in costs and/or delay. The covenant here is that the contractor must show that they sought to mitigate such adverse effects, however, they were inevitable.
The protagonist of this story is a well-drafted claim. A claim must be presented with sufficient detail, including the factual basis, calculations, and evidence. Claim management is paramount, especially due to the increase in financial hardship in the current scenario. As the Burden of Proof lies on the party raising the claim, the party must demonstrate that there is a direct link between COVID-19 and the loss thereby sustained. It is not sufficient to solely mention the pandemic and expect relief without demonstrating the actual loss suffered. Such loss is not just a vanilla monetary estimate. It is the risk adjusted time value of money.
As we all know, the value of money reduces with the passing of time because money has a time value. The money we have in our hands now is more valuable than money which we receive later. But how can an organization compare the amount of money received in the future with its value today? By calculating the Net Present Value (NPV). A contractor accepts all feasible projects with a positive NPV, however, once the parties have entered into a contract and the positive NPV has converted into a negative NPV, due to COVID-19 and related Changes in Law, then the investment must be protected. As we all are aware that due to the sudden outbreak of COVID-19 the Government has taken several measures, including the lockdown, which qualify as Change in Law. These Government orders coupled with the event of COVID-19 have turned positive NPVs of most projects negative.
A sine qua non for calculation of NPV is the component of risk. A project's future flow of money is associated with risk. It can be the risk of increase in costs, fall in revenue, technological changes, etc. All such risks can be accounted for in adjusting the NPV. However, adjusting for an unforeseen event, like the Great Depression of 1929 or COVID-19, is just not feasible.
This was about the risk adjusted NPV while computing the value of a project. What about the NPV of future flow of money, when an unforeseen event, like COVID-19, occurs while the project is going on. The infrastructure projects, after the date of the award, can primarily be divided into pre-appointed date, pre-COD and post-COD. Here is where it gets interesting. The future cash inflows from a project, for the contractor, are provided in the contract. Therefore, in the occurrence of an event like COVID-19 in the middle of a project, an NPV sensitivity analysis is required to calculate the loss of revenue. However, the project's future costs are suddenly uncertain. If a contractor computes their claim based on the NPV of future costs on historical basis, they will not arrive at the most probable loss to be suffered. If they run their costs through something like a Monte Carlo stimulation, they will get the most probable future costs, based on historical value and adjusted for risk, individually.
Now how to factor in the risk? Risk has a very variable value. On top of everything else, it is based on the individuality of the person associating with the risk. Risk is nothing but the inverse of the confidence level of a person. If the contractor's confidence level, i.e. the probability they associate with, for example, increase in costs based on historical value is 5% then their risk is 95%. This individual risk needs to be adjusted for all individual parts of a claim separately. This combination of NPV sensitivity and risk adjustment gives the claim the strength it needs.
After doing this whole exercise, a contractor will finally arrive at the most probable loss they are to suffer due to COVID-19, given that the scenario normalizes the day after they calculate these values. However, as stated above, adjusting for an unforeseen event is not feasible. What is feasible is associating a past or present event with its probability of reoccurrence. COVID-19 can be over by tomorrow or go on for another year depending on when a vaccine is available. It is not an uncertain event anymore. It can be adjusted for now based on studies of its impact, its reoccurrence and the probabilities we associate with them.
For the computation of the claim in the present situation, such risk adjustment of COVID-19 is required. Different scenarios, ideally based on the probabilities of its reoccurrence at equal intervals, need to be assessed. Further, the delay in coming back to a normal working schedule, after COVID-19, also needs to be assessed for every such scenario. This is not a case of just risk adjusted time value of money, it is a case of risk adjusted time value of money further adjusted with the probabilities of those risks. This is how a contractor will compute the most probable loss they will have to suffer, and this will perhaps form the basis of their claim.
In addition to the above, there are some crucial steps that the parties must follow to assess their ability to make a claim in respect of COVID-19 related events and to manage any risks accordingly. The contractor should carefully pay attention to the notice provisions under their contracts, and the actual impact of COVID-19 on the works in progress should be monitored carefully. Parties should keep up to date with Government directions and guidelines, and any issues surrounding the supply of materials or labor should be communicated at the outset. The contractor must ensure that record keeping is up to date and that adequate project records are maintained going forward, this will be very important if disputes arise over COVID-19 as the contemporaneous records will be relied upon to demonstrate the events taking place on the project on a day to day basis, and will provide evidence of any circumstances giving rise to delays that may be encountered.
Further, it is pertinent to mention here that as the pandemic unsettles industries, expenses must be managed against the available revenue, many businesses will survive the consequent decline in profit and/or subsequent loss. However, getting through the pandemic successfully requires the organization to have enough cash to do so. It is significant to identify ways and sources from which the contractors can improve their cash flow. These may include increasing revenue and reducing costs. Parties should renegotiate payment terms of the contracts with the employers either for pre-determining monthly cash flow by securing payment in advance or within a specific time period.
The cost compensation is paramount for every infrastructure project, and generally remedies for cost compensation are embodied in the contracts for force majeure event or Change in Law due to unforeseen events. However, the entitlement of the parties for cost compensation heavily depends on the wording of the contract.
COVID-19 presents an unprecedented challenge to the infrastructure sector and has caused grave commercial hardship. Therefore, in these present circumstances, it is important to relook at the provisions of the contracts and to take adequate and speedy measures pertaining to the entitlement of cost compensation as well as the extension of time for completion of the projects.
Manoj K Singh is the Founding Partner of Singh & Associates. Author's views are personal.