The Use and Abuse of Disallowed Costs

Much has been written about the improper use of additional Z clauses in NEC contracts and their adverse effect on standard contracts. However, less attention has been given to the amendments which are now commonly made to disallowed cost provisions to change risk allocation in NEC target-cost contracts.

Disallowed costs are a feature of NEC4 and NEC3 Engineering and Construction Contract (ECC) Option C (target contract with activity schedule), Option D (target contract with bill of quantities) and Option E (cost-reimbursable contract). It is therefore necessary to consider the impact of disallowed costs in the context of the target-cost mechanism, where the parties agree to share any cost overspend as well as costs savings to align their interest and promote collaboration.

In that context, disallowed costs appear to serve two purposes. First, they encourage certain behaviours which ECC forms require, for example use of early warnings (costs incurred because of a failure to issue an early warning are disallowed) as well as efficiencies, such as discouraging excessive ordering of materials. Second, they prevent recovery of costs due to a non-compliance by the contractor (unlike inefficiency, which iscovered by the pain/gain mechanism as a shared risk).

That sharing of risks under ECC Option C is based on the assumption that both parties are incentivised to work together for the benefit of the project and assist each other to increase any gains and avoid overspend. Disallowed costs sit outside this mechanism and are borne in full by the contractor, so the extent of disallowed costs will have a substantial impact on the underlying commercial bargain.

Amendments to disallowed costs

In practice, disallowed costs have sometimes been used to reduce project costs and avoid the client having to bear a share of an overspend, as would normally be the case under ECC Option C. This has led to closer scrutiny by project managers who, for example, seek to disallow costs under the first bullet point of clause 11.2(26) in NEC4 ECC Options C, D and D or clause 11.2(25) in NEC3 ECC Options C, D and E 11.2, not just when cost records are not available but also when they are inconsistent or incomplete.

It is however common for clients to introduce bespoke amendments, adding to or changing the categories of disallowed cost in clause 11.2 (26) / (25).

A common example is the addition of a new category based on whether costs are ‘not properly incurred’ or ‘are due to a failure by the Contractor to comply with the terms of this contract’. While on their face they may seem unobjectionable, in practice they can be used to disallow costs beyond existing categories and on a wide basis.

Another example is the treatment of defects. Under NEC standard forms, the cost of correcting defects before completion is generally only disallowed when it is caused by failure to comply with a constraint. Some clients have used amendments to expand the scope of disallowing costs incurred in relation to defects. This ignores the fact that the costs of correcting defects will affect the contractor’s share, so there is already an incentive in place to reduce such costs and it is effectively a shared risk under ECC target-cost options.

Other amendments include costs being disallowed in relation to compensation events under subcontracts or the approval of subcontractors. These amendments are not part of NEC standard forms and contractors need to be aware of their potential impact.

The significance of the disallowed costs provisions has been recognised in NEC4, where the NEC3 words ‘which the Project Manager decides’ have been deleted from the first line of 11.2(26). This suggests that there was a need to highlight that disallowed cost should be decided on an objective basis and are not a matter for the project manager to decide.

Conclusions

The NEC disallowed costs provisions have been drafted carefully as part of the overall allocation of risk and to achieve a commercial balance which motivates both parties and aligns their interests. If not used correctly or if amended, that commercial balance is disrupted and the incentives for better performance under ECC Options C, D and E contracts will be less effective.

Writte by Anne-Marie Friel, Pinsent Masons