Annual Review on Construction Dispute Resolution in China Part 3

PART 4. PRACTICAL AND ACADEMIC FOCUS

 4.1 Arrangement for Payment of Labor Costs

On 30 December 2019, the State Council officially issued the Regulations on Ensuring Wage Payment to Migrant Workers (State Council Order No. 724) (“Payment Regulations”), which came into effect on 1 May 2020. Chapter 4 of the Payment Regulations sets forth a series of special provisions on the construction industry. Article 24, Paragraph 2 stipulates:

“Where a project employer and a construction general contractor enter into a written construction contract according to the law, they shall agree on the calculation cycle for the construction project price, method for settling the interim payment, and payment period for labor costs, and agree on labor costs in accordance with the requirements for timely and full wage payment to migrant workers. The payment period cycle for labor costs shall not exceed one month.”

As the first national model text for construction contracts published after the implementation of the Payment Regulations, the Model Text 2020 provides useful exploration and practice in transforming the mandatory provisions on the payment of labor costs in the Payment Regulations into contractual agreements between the employer and contractor. For example, the first item of Article 14.3.1, i.e., “Application for Labor Costs”, provides that:

“Labor costs shall be paid monthly, and the engineer shall, within 7 days of receiving the application for labor costs and relevant materials from the contractor, complete the verification thereof and submit the application to the employer. The employer shall, within 7 days upon receipt, complete the approval and issue the payment certificate of labor costs to the contractor. The employer shall pay the labor costs within 7 days of the issuing of the payment certificate. Labor costs which have been already paid shall be deducted accordingly from the interim payment paid by the employer.”

Considering that it is common in EPC projects for both parties to establish a “milestone” payment schedule, the Model Text 2020 specially emphasizes that the “payment period and payment schedule shall be determined on a monthly basis for the labor costs” in Article 14.4.2 “Preparation and Approval of the Payment Schedule”. According to this provision, the labor costs shall be paid monthly regardless of the agreement on the payment period or payment schedule between the employer and contractor.

Except for the above provisions in the Model Text 2020, the following provisions contained in the Payment Regulations need to be taken into consideration as a whole:

First of all, the first paragraph of Article 29 of the Payment Regulations stipulates that the employer shall “promptly allocate the full amount of labor costs to a special account for the wages of migrant workers, and strengthen supervision over the general construction contractor for the timely payment of the full amount of the wages of migrant workers”. In practice, both the employer and contractor shall pay special attention to incorporating the above mandatory provisions into the particular conditions of contract or “employer’s requirements”.

Second, the third paragraph of Article 29 of the Payment Regulations further stipulates that “the employer shall establish a project-based coordination mechanism for the payment of the wages of migrant workers and a mechanism for the prevention of back pay, supervise the general construction contractor to strengthen employment management, and properly handle conflicts and disputes relating to the payment of the wages of migrant workers.” The above provision not only imposes the statutory obligation on the employer, but also confers the right of the employer under the contract. The general conditions of contract in the Model Text 2020 do not cover any relevant details, which need to be added in the particular conditions of contract or employer’s requirements.

Therefore, the Model Text 2020 is a significant step forward in implementing the Payment Regulations. However, considering that the Payment Regulations established a series of compulsory obligations for the employer, it is necessary for the employer and contractor to convert the provisions of the Payment Regulations into the detailed conditions of construction contracts in order to implement the Payment Regulations effectively. 

 4.2 Obligation for Employer to Provide Proof of Fund Source and Payment Guarantee

4.2.1   Proof of fund source 

Article 2.5 “Proof of Fund Source and Payment Guarantee” of the Engineering, Procurement and Construction Contract for Construction Project (Model Text) (GF-2013-0201) (“Model Text 2013”), which makes references to Article 2.4 “Employer’s Financial Arrangements” in the 1999 version of FIDIC’s Conditions of Contract for Construction, established for the first time the obligation of providing “proof of source of source” for employers in China’s standard forms of construction contract. The provision in the Model Text 2013 reads as: “Unless otherwise stipulated in the particular conditions of contract, the employer shall, within 28 days upon receiving the contractor’s written notice to provide proof of source of source, provide the proof of source of source to prove the employer’s capacity to pay the contract price in line with the contract to the contractor.” The purpose of the above article is to strengthen the restraint and supervise the employer to fulfill its payment obligations in time.

Based on the Model Text 2013, the Model Text 2020 makes further references to Article 2.4 “Employer’s Financial Arrangements” in the 2017 version of FIDIC’s Conditions of Contract for Construction, and stipulates in Article 2.5.2 that:

“The Employer shall make a plan for the arrangement of funds, and unless otherwise stipulated in the particular conditions of contract, if the employer intends to make any material changes for the arrangement of funds, the employer shall inform the contractor of the details thereof. If the contractor receives an instruction to execute a variation with a price greater than 10% of the accepted contract amount, or the accumulated total of variations exceeds 30% of the accepted contract amount, or if the contractor does not receive payment according to Article 14 “Contract Price and Payment”, or if the contractor becomes aware of a material change in the employer’s arrangement of funds for which the contract has not received any notice from the employer, then the contractor may at any time request the employer to provide proof of source of fund to prove its capacity to pay the agreed contract price within 28 days.”

Please note that the Model Text 2013 does not further set forth the consequences to be borne by the employer due to the breach of such an obligation, so the above mechanism in the Model Text 2013 fails to play its due role effectively in practice. In view of this, the Model Text 2020 endeavors to remedy this defect by stipulating in Article 16.2.1 “Termination for Employer’s Default” that the contractor is entitled to terminate the EPC contract if the employer violates the obligations to provide proof of source of fund, which more effectively protects the contractor’s rights by establishing the connection between providing proof of fund source and performing the obligation to pay the contract price in time.

However, it is slightly regrettable that the employer’s failure to provide proof of source of fund is not listed as one of the circumstances stipulated in Article 15.1.1 “Circumstances of Employer’s Breach” in the Model Text 2020, which may result in the contractor being unable to suspend the work directly according to Article 15.1.2 “Notice to Remedy”. In such a scenario, granting the contractor the right to suspend work would be a more effective remedy than only granting the contractor the right to terminate the contract.

4.2.2   Payment guarantee  

Most standard forms of the construction contract implemented prior to the promulgation of the Model Text 2020 stipulated the employer’s obligation to provide the contractor with a payment guarantee. Nevertheless, the performance of such an obligation in practice is not ideal due to the lack of regulation by the superordinate laws and the construction contract per se.

However, with the implementation of the Payment Regulations, the flaw of the lack of superordinate laws was fundamentally corrected. The first paragraph of Article 24 of the Payment Regulations clearly stipulates that “the employer shall provide the contractor with a payment guarantee for the payment of the construction contract price”. This provision creates a statutory obligation for the employer to provide a payment guarantee within the framework of administrative regulations.

In terms of the regulation by the contract per se, in addition to retaining the employer’s obligation to provide the contractor with a payment guarantee by Article 2.5.3 of the Model Text 2020, it further stipulates that if the employer fails to perform said contractual obligation, it will constitute a circumstance under Article 16.2.1 “Termination for Employer’s Default”. Under this mechanism, a “closed loop” is formed between breach of contract and adverse legal consequences which can effectively motivate the employer to perform the payment guarantee obligation.

Considering the fact that the market positions of the employer and the contractor of a construction project are equal, despite that the Payment Regulations establishes the statutory obligation of the employer to provide a payment guarantee within the framework of administrative regulations, it remain to be further observed in practice whether that obligation can be truly implemented, or even whether it may increase the complexity and difficulty of handling problems caused by “black and white contracts”.

4.3 Employer’s Requirements

4.3.1  Definition and function of   “Employer’s Requirements” 

As part of the integral documents of a construction general contracting contract, the “Employer’s Requirements” is not only the key to defining the scope of the contractor’s obligations, risks and responsibilities, but also the key to defining the variations of the project and determining whether the employer can achieve the contractual purposes. Article 9 of the Measures for the Management of Engineering, Procurement and Construction Projects also stipulates that tender documents for EPC contracting shall include “... (4) the Employer’s Requirements, specifying the objective, scope, engineering and other technical standards of the project, including detailed requirements for the content, scope, scale, standards, functions, quality, safety, energy conservation, ecological environmental protection, construction schedule, inspection and acceptance, etc.”.

In the history of construction contract model texts in China, the definition of “Employer’s Requirements" was mentioned earliest in the 2012 Standard Tender Document for General Contracting (“2012 Standard Tender Document”). In the process of drafting the 2012 Standard Tender Document, one of the key tasks and important achievements was to learn from the good practices of the “Employer's Requirements” in FIDIC’s Conditions of Contract for Construction and form Employer's Requirements suitable for the development needs of the Chinese general contracting market.

Further to the 2012 Standard Tender Document, the Model Text 2020 clearly specifies that the documents forming the entire contract shall include the Employer’s Requirements. “Employer’s Requirements” are defined as follows:

“1.1.1.6 Employer’s Requirements refers to the document named ‘Employer’s Requirements’ which forms a part of the Contract Document, specifying the purpose, scope, engineering and other technical standards and requirements of the Project, and the modifications or supplementations made by the Parties to the Contract.”

Annex 1 “Employer’s Requirements” of the Model Text 2020 completely inherits the contents of the 2012 Standard Tender Document regarding the details of the Employer’s Requirements, providing that:

“The Employer’s Requirements shall be as clear and accurate as possible. For work that can be quantitatively evaluated, the Employer’s Requirements shall not only specify its capacity, function, purpose, quality, environmental protection and safety as well as the scope of deviation and calculation method, but also the specific requirements for inspection, testing and commissioning. For equipment and services provided by the contractor, the training of the employer’s personnel and the provision of some consumables shall be clearly stipulated in the Employer’s Requirements.”

The Employer’s Requirements cover 11 aspects, including function requirements, scope of work, process arrangements or requirements (if any), time schedule, technical requirements, test on completion, inspection on completion, test after completion (if any), document requirements, project management regulations, and other requirements.

In addition, in order to further highlight the importance of the Employer’s Requirements, in terms of the priority of contract documents, the Model Text 2020 revised the priority arrangement in the 2012 Standard Tender Document that the Employer’s Requirements are inferior to the particular conditions and general conditions of contract. According to Article 1.5 “Priority of Contract Documents” of the Model Text 2020, the “Employer’s Requirements” is taken as one of the annexes of the particular conditions of contract; as such, it takes precedence over the general conditions of contract and is in parallel with the particular conditions of contract.

4.3.2   Allocation of risk caused by errors in Employer’s Requirements

Due to the importance of the Employer’s Requirements for an EPC contracting project, the allocation of risk caused by errors in the Employer’s Requirements is always the core of risk allocation between the employer and contractor in EPC contracts.

There are differences in the risk allocation principles stipulated in the Model Text 2011, the 2012 Standard Tender Document and the Model Text 2020. It should be noted that the 2012 Standard Tender Document drew upon the risk allocation mechanism of the 1999 version of FIDIC’s Conditions of Contract for Construction, and creatively set up two risk allocation schemes:

Scheme (A) stipulates that if any errors in the Employer’s Requirements result in additional costs and/or delay to the construction schedule, the employer shall bear the additional costs and/or delay, and pay the contractor reasonable compensation.

Scheme (B) stipulates that the contractor may claim a variation or claim for damages if it finds any errors in the Employer’s Requirements, however if later on no error is found in the Employer’s Requirements, the contractor shall bear the risks of additional costs and/or delay of the project.

Obviously, Scheme (A) is more favorable to the contractor than Scheme (B).

Generally, the Model Text 2020 has adopted the risk allocation principle of the above Scheme (A), which is more favorable to the contractor. Article 1.12 “Errors in Employer’s Requirements and Basic Information” reads as:

“The Contractor shall carefully read and review the Employer’s Requirements and basic information provided by the Employer as soon as possible, and if any errors are found, the Contractor shall promptly notify the Employer in writing to correct them. If the Employer makes corresponding amendments thereof, it shall be dealt with in accordance with Article 13 ‘Variations and Adjustments’.

If an error in the Employer’s Requirements or the basic information provided by the Contractor results in any additional costs and/or delay to the construction schedule, the Employer shall bear the additional costs and/or delay and pay the Contractor reasonable compensation.”

Both the 2012 Standard Tender Document and the Model Text 2020 stipulate that the contractor has the obligation to review the Employer’s Requirements in a timely manner, but does not further specify the consequences that the contractor shall bear due to its failure to review the Employer’s Requirements in time. In comparison, in the Model Text 2011, the risks of errors in the basic information provided by the employer are borne by the employer in general, but Article 5.2.2 also provides that the contractor shall have the obligation of review within 15 days of receiving the materials provided by the employer; if the contractor fails to perform the review obligation within this period, it shall solely bear the risks of delay and additional costs caused by errors. The authors believe that the above risk allocation mechanism determined in the Model Text 2011 has certain practical reference value. 

4.4 Inspection and Acceptance on Completion

In the practice of resolving construction general contracting disputes, especially in the field of industrial EPC projects, a considerable proportion of disputes arise from unclear agreements on the critical points at the final stage of test on completion, takeover etc., resulting in unclear agreements on a series of corresponding consequences, such as an unclear completion date, unclear deadline to claim delay liquidated damages, unclear applicable conditions for performance liquidated damages, unclear conditions for completion settlement and payment, unclear allocation for the responsibility for care of work, unclear time for the transfer of risks, unclear commencement date of the defect liability period and/or warranty period, unclear dates for return of performance guarantee and/or release of retainage, etc. These unclear agreements easily give rise to difficult and complicated disputes between the parties. The reasons for the ambiguity of such agreements can be summarized as follows.

4.4.1 Defects of the contract text  

The Model Text 2011, which is widely used in general contracting projects at present, has prominent problems in practical application in all milestones points at the completion stage of the works, such as unclear logical relations among the definitions of “test on completion”, “construction completion”, “completion date”, “project takeover”, “test after completion”, “commissioning test” and “inspection on completion”. With respect to “completion date” and “inspection on completion”, Article 8 “Test on Completion” of the Model Text 2011 provides that the completion date can be determined when the project passes the test on completion (i.e. “completion of construction”), but inspection on completion can only be passed after the project takeover, test after completion, commissioning test, completion of outstanding works and defect repair by the contractor, or even after submitting the completion settlement documents. The mechanism from “completion of construction” to “project inspection on completion” set forth in the Model Text 2011 may be applicable to the trading habits of certain specific industries, but for most other industries it is easier to cause confusion and contradiction between the inspection on completion mechanism of the Model Text 2011 and the mechanism formed in the industries in practice, thus causing complex disputes. In fact, even if the parties do not adopt the Model Text 2011, similar problems are likely to arise in practice.

4.4.2 Differences between the management systems of inspection on completion and transaction practices in various industries   

Subject to the different construction management systems of different authorities in different industries in China which have formed over a long period, the construction management systems and transaction practices of different construction industries are quite different, and this is particularly prominent in such aspects as the implementation subject, preconditions and implementation procedures of “inspection on completion”. For example,

in the field of building construction, inspection on completion is organized and implemented by the construction owner (employer);

in the field of highway construction, the inspection organized by the construction owner is the “takeover inspection”, while the “inspection on completion” is organized by the competent transport authority; and

in the field of municipal infrastructure construction (such as sewage treatment plants), the inspection on completion procedures are significantly different from those in the field of building construction, especially where municipal infrastructure construction often involves more complex inspection and acceptance procedures for environmental protection.

In view of these, in the process of drafting the 2012 Standard Tender Document, the concept of “national inspection and acceptance” was created in consideration of differences in the management systems of inspection on completion in various industries, and it is provided that “inspection on completion” is a part of “national inspection and acceptance” to make it compatible with the contracts of different industries to a certain extent.

4.4.3 Limitations of China’s existing construction laws and regulations regarding the relevant rules of inspection on completion

The relevant provisions on inspection on completion in the Construction Law of the People's Republic of China (“Construction Law”), the Contract Law, the Regulations on the Quality Management of Construction Projects and the Civil Code are crafted mainly based on the inspection on completion system in the field of building construction. As mentioned above, the inspection on completion system of different construction industries are quite different. Therefore, in practice, rigid application of the current rules on inspection on completion will easily provoke the discrepancies in the construction of terms of contract and the errors in the application of law.

In light of the above three issues concerning the unclear understanding of inspection on completion, the clauses of the Model Text 2020 are drafted according to the normal process sequence of “test on completion → inspection on completion → project takeover → test after completion”, thereby solving the problem caused by the unclear agreement in the Model Text 2011, which is worthy of affirmation. However, considering the different transaction practice of various industries regarding inspection on completion and the constrains of the current laws and regulations, parties to the Model Text 2020 shall pay close attention to the potential adverse impacts, and formulate detailed clauses on test on completion and take over according to the specific requirements of specific projects. This is particularly significant to prevent construction general contracting contract disputes.

 4.5 Limitation of Liability

In international construction contracts, the “Limitation of Liability” clause is usually one of the most important provisions. It includes at least three elements:

(1) maximum compensation limit;

(2) types of losses which may not be indemnified, such as loss of use, loss of profit, indirect loss, consequential loss, etc.; 

(3) exclusions of limitation of liability, such as fraud, willful misconduct, gross negligence, etc.

In the previous model texts of construction contracts in China, due to the different construction of Chinese compensation rules for breach of contract in the construction project dispute resolution practice, complete limitation of liability clause was not included. The only relevant clause is Article 10.8 “Loss of Value for Production and Use” of the Model Text 2011, which stipulates that where the contractor fails to pass the test after completion due to the contractor’s fault, resulting in a loss of the value for the production and use of the whole project, the employer is entitled to claim against the contractor for its non-performance provided that the claim does not include “joint and several contract losses”. As for “joint and several contract losses”, the Model Text 2011 defines it as “the loss of market sales contracts, anticipated market profits, interest on production working capital, contracts for the supply of raw materials, auxiliary materials, power, water or fuel signed beyond the test after completion and commissioning test evaluation period, and loss of transportation contracts, etc., unless otherwise provided by the applicable laws”. This article is a specific agreement on types of losses that may not be indemnified, which is one of the three elements of the “Limitation of Liability” clause.

With reference to FIDIC’s Conditions of Contract for Construction and in consideration of the needs of the construction project dispute resolution practices in China, the “Limitation of Liability” clause has been officially added to the Model Text 2020 as Article 1.13 “Limitation of Liability” to provide that:

“The liability of the Contractor to the Employer shall not exceed the maximum amount of the Limitation of Liability stipulated in the Particular Conditions of contract. If there is no agreement in the Particular Conditions of contract, the liability of the Contractor to the Employer shall not exceed the Contract Price. However, for losses caused by misconduct such as fraud, crime, willful gross negligence or personal injury, the liability shall not be limited in the maximum amount of the Limitation of Liability.”

“Limitation of Liability” clause includes two elements, namely, the maximum compensation limit, and exception of the limitation of liability. However, this clause does not cover the element of “types of losses which may not be indemnified”, which is more likely to cause disputes in practice. Therefore, it is necessary for parties to pay attention when adopting the Model Text 2020, especially to enumerate the types of losses which may not be indemnified. This is of great significance for the parties to predict the scope of liability for breach of contract in a more effective manner when entering into the contract, and to balance the allocation of risks between the parties and prevent potential disputes. 

PART 5. CONCLUSION AND PREVIEW

Looking back over 2020, with the implementation of the Civil Code and the New Judicial Interpretation I on Construction Contracts, and the repealing of the former Contract Law and the Original Judicial Interpretation on Construction Contracts I and II, the practice of construction dispute resolution in China enters a critical transition period. During this transition period, the new laws and old laws coexist, different understandings of the laws coexist, and the new and old adjudication rules coexist, and such coexistence is a task and challenge for both the construction industry and the legal community.

In the field of EPC contracting, with the implementation of the Model Text 2020, the model texts of construction contracts in China have been further integrated with international good practice, and dispute resolution in China is developing to a higher level, which will further promote the contract management level of Chinese overseas construction projects.

Looking forward to 2021, in the field of legislation, the two basic laws of the construction industry, namely, the Bid Invitation and Bidding Law and the Construction Law, will be comprehensively revised. Specifically, a series of significant revisions has been made to the NDRC’s draft of the Bid Invitation and Bidding Law for soliciting opinions in terms of the scope of projects subject to public tender by law, procedures for determining the winning bidder, applicable scope of the evaluated lowest bidding price, performance guarantee, etc., which has attracted extensive attention and discussion in the industry community. In addition, preparations for the comprehensive revision of the Construction Law have entered a substantive stage, and business environment reform for the qualification of construction enterprises is ready to commence. In this context, the authors believe that the comprehensive revision of the Bid Invitation and Bidding Law and the Construction Law will have significant and far-reaching influence on the conclusion, performance, and dispute resolution of construction contracts. 

The report is the research outputs of the Annual Review on Construction Disputes in China （2021）by the authors, which will be included in the Commercial Dispute Resolution in China: An Annual Review and Preview (2021) compiled by the Beijing Arbitration Commission. The book has been published by Wolters Kluwer Hong Kong Limited. Welcome attention.