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25 January 2018

Post Carillion: Back to basics

As Karen Kirkham pointed out in her blog post last week, ‘when the dust has settled on the Carillion liquidation, conclusions as to the cause will be drawn’.

The briefing paper produced for the House of Commons on 18 January 2018 suggests that Carillion’s liquidation was due to questionable financial decisions following losses from seemingly profitable contracts. However, what was clear from discussions in the media, was that there were underlying contract issues. The procurement process, including aggressive bidding, the way payment was dealt with and the balancing of risks under the contract seem to have been the key themes emerging. In Carillion’s July 2017 Trading Update, Keith Cochrane highlighted what needed to change to improve Carillion’s performance as follows:

  • high degree of uncertainty about key assumptions;
  • success dependent on performance of others outside of their control; and
  • agreed design changes without incremental cost and value.

If this is how Carillion was approaching contracts, it is no surprise that there were unexpected losses. Whilst limits on liability and duty of care clauses are fiercely negotiated, the real backbone of construction contracts is often deferred in the hope that it can be ‘negotiated if the situation arises’. But to minimise financial surprises and delays, lessons should be learnt about the fundamental commercial elements of a contract which need to be considered and documented. Whilst many of these issues may seem contractor centric, the fundamentals apply to all those when negotiating contracts and it is better for the project to ensure you have a healthy construction team throughout the project.

Procurement and contract structure

Like all good construction, getting the foundations right is imperative.

Carillion had entered into contracts that were based on uncertain assumptions and therefore, the anticipated costs and programme were not accurate.

Make sure your procurement documents are as complete as possible and do not hide areas of uncertainty. Nothing has changed since Egan espoused the requirements for proper planning and design development before the project got to site. It is as important for the employer/developer to know the scope of the project it wants to procure as it is for the contractor/consultant/suppliers to know what is being asked of them. Design development once you have started on site leads to delays and is costly. Missing information and lack of understanding at this early stage leads to incorrect assumptions being made when resourcing and pricing the project. The impact can be catastrophic. For public sector employers, this can be imperative because without knowing what your project is, it is difficult to evaluate the tenderers effectively. Contractors/consultants/suppliers, you will need to proactively request missing information. Without full information, it is difficult to provide a realistic costing and programme or even to assess whether it is commercially sensible to continue to tender for the project.

The right procurement route needs to be considered carefully. The employer / developer needs to be realistic about its own experience and that of its professional team. Whilst a design and build route will allow a single point responsibility of a contractor, it may be slightly more expensive as the contractor is charging for the time of managing that contract. As we have seen with Carillion, this approach can leave an employer in difficulties if the contractor fails. Provided your contracts are correctly set up, there will be the ability to step into the shoes of the contractor and have a direct relationship with subcontractors and suppliers. Alternatively, a traditional route may give more direct involvement in the project but it requires a lot of time and project management experience. If you do not have this expertise in-house, it may need to be outsourced, reducing any potential savings. It also requires the employer/developer to take on a greater level of risk rather than it resting with the main contractor. Therefore, this needs careful consideration and appropriate input from professional team and legal advisers.

Payment – Change is inevitable, plan ahead to avoid nasty surprises

Carillion had taken on contracts which were long term, fixed price with no scope to change prices for unforeseen circumstances, leading to losses. This is unusual in a construction contract but highlights the importance of making sure that variations are anticipated.

What is included in the proposed contract price? A price is only as good as the scope it is based on. As noted above, the scope needs to be clear. To avoid costs creeping up, it needs to be clear exactly what the proposed cost will cover and what assumptions that is based on. Where there has been information omitted which leads to an additional cost, or assumptions made which are not correct, then how this is to be priced should be carefully considered and documented in the contract.

If you deviate from the scope of works, is it an additional cost? Make sure it is dealt with in the contract before the project starts. Variations often cause delays and cost money. Sometimes no-one could have predicted them and are outside all the parties control. Sometimes it is because the employer/developer has changed the design or it is because the contractor has found a cheaper alternative approach. No matter how well planned a project is, there will be changes because you cannot plan for EVERY eventuality. Where possible, a costing should be pre-agreed or, alternatively, a method for calculating the change to the costs. In most standard construction documents, there will be a process included for agreeing variations. However, it is worth remembering that when having agreed a process, it needs to be followed. If a dispute arises and the process has not been followed, the parties may have forfeited their rights.

Risk – Risk should be placed with the party that can best manage it

In one of the many articles on Carillion’s collapse, a quote from a former senior exec stood out: ‘The skill to plan and manage these projects and risks had pretty much left [Carillion]’.

Balancing risks. Some clients transfer as much risk as possible to its contractors and this is often passed to subcontractors. Sometimes it feels a little like a construction hot potato. Allocation of risk to any party, other than one which is best placed to manage it, is unlikely to benefit a project. If a party can manage the risk, it is more likely it can reduce its impact on the project. If the contractor is forced to take on risk it cannot manage, it is likely that it will result in a higher contract price, as well as delays.

Whilst some will read this article and deem it to merely be full of ‘common sense’, it is worth reminding ourselves that sense is rarely common and Carillion shows that even the big players can forget the basics.

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