Introduction

A recent decision of the Supreme Court of South Australia examines numerous issues of relevance to the construction industry.[1]  This Update deals only with the dispute over the nature of the subcontract.

Playford B power station was to be refurbished by Alstom under a turnkey head contract with Flinders Power (“FPP”).  The head contract sum was $148.5 million.

The refurbishment contract involved bringing the 1950’s power station up to date.  No structural or mechanical rebuilding work was intended other than the replacement of the boiler burners.  A component of the works was the installation of electrical, control and instrumentation systems in order to allow remote operation of the power station.

Alstom subcontracted the electrical, control and instrumentation works to Yokogawa and EDI (“YDRML”).  The subcontract was for $33.88 million.

The refurbishment was problematic.  It was delayed and Alstom blamed defective coal mills in other parts of the power station.  FPP said that Alstom was contractually required to bring the project to completion.

FPP withheld over $13m in liquidated damages plus claimed other damages.  Ultimately, FPP and Alstom settled their disputes at a cost of over $20m to Alstom.  Alstom blamed YDRML and sought to recover its losses by issuing proceedings in the Supreme Court.  YDRML counterclaimed for unpaid money.

The turnkey head contract

The head contract was described in its terms as a turnkey contract.  The Court commented that the use of the expression “turnkey” now goes “a long way to establishing the intention of the parties.”  Briefly, a turnkey contract is one where the employer makes known their requirements and the contractor then produces the design before building it.  The completed design must perform at the required level.

In the case of the Alstom head contract, the described scope was extensive and made it abundantly clear that Alstom was to provide a fully operational refurbished power station as required by the technical specifications.

Performance guarantees required that the refurbished power station had to perform to the standards required.  On any view, it was clear that the obligation on Alstom was to design and construct the refurbishment.

There was no term in the head contract giving relief for Alstom even if deficiencies in the mechanical or other sections of the old power station that were not to be refurbished made it difficult to meet the performance guarantees.

The preliminary subcontract

Initially, Alstom and YDRML entered into an interim agreement to get the works started while they worked out the terms of the subcontract.  This preliminary contract was to terminate if the subcontract was signed.

The preliminary contract said that the parties were to negotiate to attempt to reach agreement based on a “back to back” arrangement with the head contract.  Back to back subcontracts are commonly used by head contractors to try to pass on to the subcontractor the risk faced by the head contractor.

The subcontract

Even though the value of the subcontract was $33.8 million, rather than drafting a custom contract to match the head contract, Alstom used the head contract and added special conditions to modify some definitions and terms.

Incorporating all of the terms of a head contract into a subcontract has been a relatively common practice by some lawyers and contractors.  The practise is fraught with danger as illustrated by this case although the Court here noted that it is not necessarily a poor drafting technique if done “competently, in appropriate circumstances and with care”.

However, in this instance the result was “numerous ambiguities, inconsistencies, lacunae and in some cases grammatical nonsense”.  It stood as “an appalling indictment against those responsible for its drafting”.

The critical issue

The critical issue arose in the description of the scope of works to be performed by YDRML under the subcontract as compared with Alstom’s turnkey obligations under the head contract.

YDRML said it had done what it agreed to do and sought payment.  It was not disputed that the performance guarantees had not been met by Alstom under its head contract with FPP.

Alstom said that the subcontract was back to back and that YDRML was liable for its failure to meet the performance guarantees and therefore its loss by way of settlement with FPP.

Alstom said that in order to interpret the subcontract, it was necessary to look at the whole context of the parties’ dealings.  This included the preliminary agreement that required YDRML to attempt to agree a “back to back” subcontract.  Alstom said that when the preliminary agreement was considered alongside the subcontract, it was clear that YDRML was also obliged to carry out the works on a turnkey basis and to meet the performance guarantees in respect of its work.

The Court referred to the numerous cases that establish that parties are bound by the terms of their contract.  Further, in this case, the subcontract contained an “entire contract” clause.   An entire contract clause states that the parties’ agreement is to be entirely found within the written terms of the contract.

The linchpin clause

In what the Court described as the linchpin clause of the head contract, Alstom was required to:

“ensure that the refurbished [power station] achieves the Performance Guarantee”

By inserting the modifications contained in the special conditions to the subcontract the Court found that Alstom had modified this clause to read that YDRML was to:

“ensure that Performance Guarantees in any area which fall within the [YDRML] works scope that the Refurbished Facility achieves the Performance Guarantees (sic)”

The clause was nonsense.  The Court found that this clause was not so much ambiguous as uncertain in concept.  On that basis, the Court found the clause to be void for uncertainty.  The obligation was therefore removed from the subcontract.  As a result, the subcontract was not a turnkey or performance based contract.

YDRML was entitled to be paid and Alstom did not recover its losses.

Conclusion

There is a high degree of risk associated with a turnkey contract, especially a refurbishment contract.   It is difficult for a head contractor to pass through all the risks associated with a turnkey refurbishment contract in view of the potential claims between respective subcontractors for contribution where the ultimate performance requirements are not met.

To incorporate the terms of a head contract into a subcontract may appear cost effective at first instance.  However, the likelihood of ambiguities or uncertainties is high.  On contracts of significant value, competent legal drafting of subcontracts is essential.

On lower value contracts, the standard form contracts and their corresponding subcontracts provide an economic means of ensuring that the issues of risk allocation and mitigation are addressed.

Contributors:

Tom Grace



[1] Alstom Ltd v Yokogawa Australia Pty Ltd & Anor (No. 7) [2012] SASC 49.