Understanding Contract Terms: Mechanisms for Starting Early

Ideally, parties would not commence construction activities before they unconditionally commit to a complete contract and a full scope of work. In reality, whether on the basis of practical or commercial considerations, parties are often keen to proceed before all terms are agreed or all related arrangements are in place: time is valuable and getting a good start can make all the difference.

To limit the risks in starting early, parties can implement a number of preliminary mechanisms, including Conditions Precedent/Subsequent, Notices to Proceed, and Early Works Agreements.

This article will examine each of these options by:

explaining their meaning;
providing examples of their application in the context of an engineering, procurement and construction contract (EPC Contract); and
discussing the risks inherent in using them inappropriately.

Conditions Precedent/Subsequent

Conditions Precedent are used when contract terms have been agreed. They are conditions which must be satisfied for the agreed obligations to become binding and effective. If they are not satisfied, the contract does not come into existence.

Conditions Subsequent are also used when contract terms have been agreed. However, they are used when a contract is formed and binding on execution. If the Conditions Subsequent are not satisfied, the contract ceases.

For example, a Condition Precedent which must often be satisfied in an EPC Contract is the achievement of financial close. Parties (particularly, the contractor) will seldom want the risk of being bound by obligations to develop a project without having financing committed through binding financing agreements.

The strict use of Conditions Precedent/Subsequent can be legally awkward, and the terminology somewhat confusing, because parties usually want some, but not all, terms to be immediately binding. In those situations, they can agree that a contract is formed for a limited purpose, but that the whole contract will not come into full force and effect until Conditions Precedent to the full operation have been satisfied.

The terms which are of immediate effect are “Day One Clauses”. These clauses often include the Conditions Precedent themselves, and the terms surrounding them, as well as terms relating to insurance, compliance with law, termination and security.

It is also possible to define a limited scope of work to which the whole of the contract applies, but on the basis that the full scope is not activated until the relevant Conditions Precedent have been satisfied.

For Conditions Precedent/Subsequent to be effective, they must be clearly drafted. In drafting each Condition Precedent/Subsequent, the parties should clearly set out:

the party responsible for satisfying the condition;
the party who has the benefit of the condition (that is, who can elect to terminate the contract on failure to satisfy the condition or waive compliance);
any condition to a party being able to exercise the termination right (for example, a requirement that the party has complied with an obligation to use reasonable endeavours to satisfy the condition);
how that party will notify the other of satisfaction;
the time limit on satisfaction;
if and how the condition can be waived; and
the consequences of failing to satisfy or waive the condition.

Notices to Proceed

A Notice to Proceed process is used when contract terms have been agreed and are effective.

A Notice to Proceed is a notification issued by the principal to the contractor authorising the contractor to perform some or all of the works under the contract. For example, if an EPC Contract obliges a contractor to develop a project in distinct stages, it may require the issue of a Notice to Proceed by the principal prior to the commencement of each stage. As in this example, Notices to Proceed are usually in the discretion of the principal.

A Notice to Proceed must typically set out:

the scope of activities to be performed;
the time limit on performance; and
the amount payable in relation to the activities performed.

A Notice to Proceed which activates part of the scope of work is “limited”; one which activates the entire scope of work is “final”. The issue of a Final Notice of Proceed might also be subject to Conditions Precedent, such as the condition that the contractor delivers an advance payment guarantee to the principal to underpin its obligation to complete the whole scope of work.

The parties must also consider the consequences of non-issue, or delay in issue, of a Notice to Proceed. Critically, the timing of issue might affect the contract sum and program, including any contract dates which are defined by reference to the issue of the relevant Notice to Proceed.

Early Works Agreements

An Early Works Agreement is used when contract terms have not been agreed. It is an agreement, possibly in letter form, authorising the commencement of certain preliminary activities, such as demolition, ground works or design.

An Early Works Agreement must set out the terms under which preliminary works are performed, such as terms relating to payment, insurance, security, quality, safety, and timing. It might expire by a certain date to motivate the parties to finalise a complete contract.

Further, it will usually provide that the works performed under it will be subsumed within the complete contract if it is formed, and, importantly, set out the parties’ obligations in the event that it is not finalised, such as obligations to return information.

Conclusion

The choice of mechanism is driven by:

whether the contract terms have been agreed;
the extent of activities to be performed; and
the time required for the matters delaying unconditional contract formation to be resolved.

If contract terms have been agreed, the Conditions Precedent/Subsequent or Notices to Proceed mechanisms can be used. Further to this, if full contract formation is hampered by external factors or third parties, the use of Conditions Precedent/Subsequent is most appropriate. If the reasons for not immediately committing to the full scope of work are matters within the discretion of the principal, the Notice to Proceed process is more suitable.

If contract terms have not been agreed, an Early Works Agreement is appropriate.

Nevertheless, in the application of each of these mechanisms, drafting must be unambiguous. Critical considerations include:

the scope of work;
the responsible party;
the time limit on performance;
the consequences of proceeding with a complete contract (including whether adjustments need to be made if the scope, timing or cost is different from that initially contemplated and whether any activities performed need to be incorporated into the complete scope of work); and
the consequences of not proceeding with a complete contract (including payments to be made, ownership of intellectual property and other materials, novation of subcontracts, and responsibility for partially completed activities).

Ensuring that drafting addresses each of the aforementioned considerations will significantly reduce the risks inherent in commencing construction in anticipation of the complete contract.

Understanding Contract Terms: Mechanisms for Starting Early

Conditions Precedent/Subsequent

Notices to Proceed

Early Works Agreements

Conclusion

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