FAQ: NEC Main & Secondary Options

The main difference is that, strictly speaking by the rules of the contract, the Contractor
does not get paid for an individual activity until it is complete whereas, for lump sums, the
Contractor is paid on percentage completion. This encourages the Contractor to break down
their operations into smaller activities, thus improving planning, and to then stick to their
programme in order to get paid for work done in the last month.

The first thing to say is that option is actually a ‘lump sums &/or bills of quantities’ contract, so certain activities can be priced as a lump sum and those where quantities might vary using bills of quantities. And that is the hint as to when option B should be used: when there are likely to be significant variations in quantities of work of a known type, whereby transferring the quantity risk to the Contractor would result in a large premium or, alternatively, the worst gambler winning. An example might be a contract to remove asbestos where there are limited surveys on the quantity.

The opposite is true for option A: you use it where the work type and quantity is reasonably well known so the Contractor can price and deliver it with a fair amount of certainty. Note that the works do not have to be fully defined, just sufficiently defined for the tendering contractors to price. Consequently, this option is used for the ‘Design and Build’ contracting route where functional and/or performance specs are used to partly or wholly specify what the asset has to do.

Lastly, a quick word of warning, the option B, bill of quantity clauses for changes to quantities are not, in our view, written with consideration for how they are operated in practice. Consequently, we suggest that clauses 60.4 and 60.5 are carefully re-drafted and improved..

In terms of the words used in the contract, the target cost options are virtually the same as option E, cost reimbursable contract, but with additional words to cover the pain / gain arrangement. In practice, this means the Contractor, like option E, is reimbursed Defined Costs plus its tendered fee percentage as the contract progresses. Under option E, the Prices is a forecast of the ultimate amount that the Contractor will be paid, so while it should be adjusted as the contract progresses via the compensation event clauses, it does not affect how much the Contractor is ultimately paid i.e. there is no point having arguments over the adjustment!

However, under the target cost contract, the Prices is the fulcrum around which the pain / gain share operates. It therefore needs to be kept up to date as the contract progress. This means that compensation events need to be ‘implemented’ in accordance with section 6 as the contract progresses.

The answer is rarely because in an ideal world you can define what the Contractor has to do and the constraints which it has to comply with, thus enabling it to price the work with some degree of accuracy.

However, circumstances arise where this is not the case. For example:
— Emergency works where a delay in putting together a detailed Scope and Site Information, tendering the works and evaluating the responses mean a crucial asset is out of action for longer and/or the asset deteriorates further. Thus the Scope and Site Information are out of date on entering the contract!
— Where there is likely to a high degree of change during the contract. This could be because the starting point is unknown, the constraints are likely to change during the contract and/or the end user requirements are unclear or evolving.
— Where quality is paramount and no incentive is wanted to reduce it by cutting corners.

The first two are time-dominated projects and all three could be present in the same contract. All three scenarios will result in a high degree of change i.e. compensation events, where change is layered upon change upon change etc with the focus going on trying to administrate the contract rather than on the management of the works. However, a golden rule for the use of any cost-based contract, including target cost contracts, is not to use them with a contractor that cannot do good ‘open-book’ accounting in accordance with requirements of NEC. If this is the case – or it is not set-up correctly to balance achieving value for money with appropriate level of auditing – it can be become a bureaucratic quagmire of fighting over what is/isn’t a Defined or Disallowed Cost. Regardless of how well it is set up, it needs to be recognised that administrating open book arrangements is more ‘QS heavy’ than priced based contracts.

Target cost contract were originally used for less risky situations compared with pure cost reimbursable contracts, where the contractor could put an approximate price to the works. It was found that the ‘open-book’ nature promoted openness and transparency not just in cost, but other areas, while the shared pain / gain arrangements promoted collaboration. Consequently, target cost contracts under NEC became the ‘go-to’ arrangements for partnering or collaborative arrangements with some good justification.

However, what people often ignore or forget is that the target Prices and Completion Date are still adjusted through the compensation event process, which can be contentious. This needs to be recognised as an area to manage during the contract. It also needs to be recognised pre-contract as sometimes people have the attitude that a poor-quality Scope document is OK as “it’s a target cost contract, so we can sort it out during the contract”. The Scope still needs to include the whole breadth of what is required to be done and defined to a level detail that is sufficient for the Client to get what it wants with the remaining detail worked out collaboratively. Likewise with constraints on how the Contractor Provides the Works. If this is not the case, then the amount of change upon change can effectively mean that a target cost contract reverts to a cost-reimbursable contract, but after a lot of argument. Note that this can also be true under a priced contract, but with even more argument!

You can divide the answer into two sub-sections: those that have to be specified by UK law and those that a commercially aware contractor would pretty much refuse to contract without them specified.
 
In terms of those that have to be specified by law, we have :

— Option W2, which has the adjudication clauses which comply with the UK’s ‘Housing Grants, Construction and Regeneration Act 1996’ as modified by the ‘Local Democracy, Economic Development and Construction Act 2009’ – collectively known as the ‘Construction Acts’ – which apply to all ‘construction operations’ as defined in the first act and;

— Option Y(UK)2, Housing Grants, Construction and Regeneration Act 1996 which covers the required terms relating to payments. This clause overlays the Construction Acts requirements on top of the unamended core clauses.
 
In terms of those that a commercially aware contractor would refuse to enter into a contract without, we have:

— Option X1, Price adjustment for inflation. Until recently, with inflation relatively benign, this would not have been necessary. However, at the time of writing (October 2022), this would be the minimum requirement with many contractors wanting addition clauses written to cover the (sometimes daily) risk of price fluctuations.

— Option X7, delay damages. This puts a cap on the daily liability that the Contractor has for each day of over-run or, in contract language, Completion is later than the Completion Date. Without this specified, not only does the Contractor have unlimited liability i.e. can be charged what the damage is, but you would likely have arguments over what the damages are.

— Option X15, the Contractor’s design. This is not necessary if the works are fully designed. However, if there is any element of design to be done by the Contractor and its Subcontractors (which includes a design consultant), then this needs to be included. While it covers more than NEC3’s X15, it is still deficient on the ownership and use of intellectual property so additional ‘option Z’ clauses may need to be written for more complex contracts.

— Option X18, Limitation of liability. Without this clause, the Contractor has unlimited liability for indirect/consequential loss, damage to property and Defects due to its design. Contractors are unwilling to accept this.

— Option Y(UK)3: the Contracts (Rights of Third Parties) Act 1999. Without this specified, any third party who benefits from the performance of the contract can either enforce a term of the contract from which they benefit on the Contractor or sue for compensation. Especially for projects involving public benefit, contractors are not prepared to accept this risk.

It is normal to want to have one of the two secondary options which give redress in case of Contractor insolvency. These are:

— Option X4, Parent Company Guarantee, which means that if the parent company of the legal entity that you are in contract becomes insolvent and/or is closed down, then the parent company is liable for the costs of completing the works and other liabilities. Use of this presumes that there is a parent company. Sensible use of this presumes that the parent company is reasonably solvent and can bear the costs. If the latter is not the case, then an alternative guarantor can be specified.

— Option X13, Performance Bond, whereby the Contractor takes out a bond with a financial institution which can be called upon in the case of substantial default, including that caused by insolvency. The Contractor has to pay out money for this bond and this will be reflected somewhere in the Prices.

More recently, due to Brexit, COVID-19 and general world events, it has become more common to specify option X2, Changes in the law which means a change in the law is a compensation event. A change in the law can be due to an act of Parliament, a change to regulations by a delegated body and arguably, change in published guidance. Consequently, the scope of what changes in law apply is usually reduced.

Option X16, retention is often specified. However, its use is decreasing especially in frameworks where the biggest incentive to correct Defects is repeat order work. Otherwise, the Contractor and its supply chain have to finance the loss of working capital which adds to the tendered Prices.

Lastly X11: termination by the Client is now often specified. This allows the Client to terminate for any reason although, if used, the Contractor will get the maximum payment as defined in the contract. Previously, in NEC3, this provision was included in the termination clauses as a core clause. While you do not enter a contract without the intention of terminating, specifying this option costs nothing and gives you that option.