Asia construction newsletter

Back-to-back contracts
Back-to-back agreements, by which a main contractor seeks to pass its obligations and
liabilities towards the employer through to its subcontractor(s), are becoming an increasingly
common feature of construction projects. While they can be a convenient means of
transferring risks and obligations down the chain of responsibility, inadequate drafting can
give rise to disputes which are particularly complex and difficult to resolve.
In this newsletter we discuss the key reasons why back-to-back contracts can be particularly
contentious and the main drafting issues that need to be considered and addressed in order
to minimise the risk of disputes.

The back-to-back scheme

April 2011
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Contacts

Large international construction projects often require the collaboration of several

participants with different capabilities. However, the owner (employer) of the project, often
will require the project to be structured such that it has only a single contractual relationship
(the main contract) with one of the participants (the main contractor) and not with all of them
individually. From the employer's perspective, there is much attraction in structuring the
project such that the main contractor acts as the single point of responsibility.
The main contractor, having assumed responsibility for all aspects of the project vis--vis
the employer, will aim in turn to pass on its obligations and liabilities to its subcontractors so
that it is left with only minimal, or no, obligations or liabilities to meet on its own.
There are therefore obvious benefits for contractors in implementing back-to-back
arrangements. However, in practice drafting back-to-back agreements can be a difficult
task.

Peter Godwin
Managing Partner
Registered Foreign Lawyer
Tel: +81 3 5412 5412
E: peter.godwin@herbertsmith.com

Drafting back-to-back contracts

There are, in broad terms, two ways of structuring back-to-back subcontracts:
(1) by incorporating by reference all the terms of the main contract save for certain parts
of the main contract which are expressly excluded or varied (often these are limited to
clauses which are obviously not applicable to the subcontract, for example clauses
relating to price); and
(2) by drafting a stand-alone set of terms and conditions specific to the particular
subcontract.
The first approach is often seen by contractors as being the easiest and therefore most costefficient means of passing down liabilities. However, without careful attention such an
approach can often result in difficulties. Particular care needs to be taken when drafting the
back-to-back provisions. For example, a general provision stating that all references in the
main contract to the "Employer" and "Main Contractor" are to be read in the subcontract as
being references to the "Main Contractor" and "Subcontractor" respectively, may not be
appropriate for every obligation and could result in rendering what should be an essential
term of the contract either ineffective or subject to an interpretation that was never intended.
Further, where there are long and detailed main contract specifications (often in the form of
employer's requirements) it can be a very complex, and indeed contentious, task to
separate out the obligations that are relevant to each individual subcontract; the
subcontractors' greatest concern being that they will inadvertently be taking the risk for
matters that are inappropriate given the size and scope of their particular subcontract.
These issues should be capable of being overcome by proper drafting of a standalone
subcontract. A further obvious advantage of standalone contracts is that in executing the
subcontract the parties only have to refer to the one subcontract, rather than having to also
cross-refer to the main contract which itself can cause confusion. However, drafting
standalone contracts should by no means be considered to be an easier task; again
considerable care needs to be taken.

Dominic Roughton
Partner
Registered Foreign Lawyer
Tel: +81 3 5412 5412
E: dominic.roughton@herbertsmith.com

David Gilmore
Partner
Registered Foreign Lawyer
Tel: +81 3 5412 5412
E: david.gilmore@herbertsmith.com

Emma Kratochvilova
Senior Solicitor
Registered Foreign Lawyer
Tel: +81 3 5412 5412
E: emma.kratochvilova@herbertsmith.com

Common drafting issues

Irrespective of which drafting approach is taken, there are a number of issues that require
particular attention:

Conditional payment clauses

A common feature found in back-to-back contracts is a provision that payment to the
subcontractor will be conditional upon the main contractor receiving payment under the main
contract. However, such "pay-when-paid" clauses are not enforceable in construction
contracts under the laws of certain jurisdictions, including England and Wales and
Singapore. Sometimes a "pay-when-certified" clause will be seen as an appropriate
compromise if not also outlawed in the relevant jurisdictions, as it will shortly be in England
and Wales. Even if such clauses are not prohibited under the applicable law, they are often
resisted by subcontractors who expect to be paid once they have rendered due performance
of their obligations under the subcontract irrespective of the position further up the chain.

General or liquidated damages?

Will the main contractor be seeking to pass on liquidated damages levied by the employer
under the main contract to the subcontractor as general damages? If so, it will be desirable
from a main contractor's point of view to specify in the subcontract that, without prejudice to
its right to recover general damages, any claim by it for general damages may include some
or all of the liquidated damages levied by the employer under the main contract. This is
because it might otherwise be questionable whether the liquidated damages levied against
the contractor by the employer constitute direct or indirect/consequential loss as against the
subcontractor and therefore irrecoverable under the relevant exclusion clauses in the
subcontract. It will, of course be necessary to apportion the full amount of liquidated
damages applicable so as to provide for recovery of only those in respect of which the
contractor can legitimately claim against the subcontractor.
The subcontractor may, of course, resist inclusion of this item as likely to tempt the
contractor to seek to levy the full amount of liquidated damages against an individual
subcontractor. Instead, the subcontractor may prefer to negotiate a rate of liquidated
damages that covers all of the subcontractor's liability for the relevant breach (e.g. delay)
under the subcontract. While liquidated damages carry certain advantages for the main
contractor, particularly in terms of certainty of recoverable damages and not having to prove
actual loss, the main disadvantage lies in the risk that the rate of subcontract liquidated
damages will not ultimately cover the actual loss and/or damage sustained by the
subcontractor's breach.

Contractual deadlines
It is imperative that deadlines in the subcontracts are aligned to those in the main contract,
for example in terms of document approvals, delivery/completion dates and claims
notification periods. Some form of early warning procedure may be desirable.
Gaps in the claims procedures across the two contracts are of particular risk to main
contractors. This is because in many contracts the main contractor's right to claim in full
against the employer will be contingent on complying with the main contract notice
requirements. Those notice requirements therefore need to be adequately reflected in the
subcontract. In particular, the main contractor will need to ensure that it is not prevented
from claiming in full against the employer by reason of not receiving the necessary claim
details from the subcontractor in time, while remaining liable to the subcontractor for the
same claim.
To avoid such a predicament, main contractors will need to ensure that the subcontract
contains notification periods that are shorter than those provided for in the main contract, so
as to ensure that the main contractor has sufficient time to pass on a subcontractor's notice
of claim to the employer. In addition, the subcontract should require the subcontractor to
provide exactly the same information about the claim as the main contractor is required to
provide under the main contract.

Dispute resolution
In a back-to-back scheme, a dispute between the main contractor and the employer is likely
to have significant implications for the relationship between the main contractor and the
subcontractor, and vice versa.
Depending on the nature of the subcontract, claims that are commonly passed up and down
the chain include those relating to defects, performance failures and delays, and variations
(both in terms of scope and valuation). In all cases, the main contractor will want to ensure
that it is not shouldered with a liability in respect of matters outside its control that it cannot
pass on to its respective counterparts. The main contractor's greatest concern will be to
ensure that it is not exposed to differing decisions by the courts or tribunals appointed under
the two contracts.
The following are some of the main issues that will need to be considered:

To what extent should the findings of a dispute adjudication board or arbitral tribunal
in a dispute between the employer and the main contractor be binding between the
main contractor and the subcontractor and vice versa? This is something that is likely
to be strongly resisted by subcontractors and employers respectively.

Clauses providing that a party is to be bound by the outcome of proceedings under a

contract to which it is not party could be acceptable if that party is given a contractual
right to participate in the main contract proceedings. In this regard, consider whether
the third party should be given the right to participate directly (preferable for the main
contractor and subcontractor) or indirectly (preferable for the employer) in those
proceedings.

Under what circumstances will the main contractor be obliged to pursue the
subcontractor's claim against the employer and what is the sanction for a failure to
pursue such a claim? This is a common concern of subcontractors as the main
contractor may often be less interested in pursuing claims in which it has little or no
interest, particularly if it has a commercial interest in maintaining good relations with
the employer in order to secure future projects.

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The FIDIC Subcontract

In response to industry demand, FIDIC is in the process of preparing a Subcontract for
Construction for Building and Engineering Works Designed by the Employer to be used for
subcontracts intended to be back-to-back with the FIDIC 1999 Red1 and Pink2 books. In
November 2009 FIDIC released a test edition of the Subcontract for comment. The test
edition is largely well-drafted however certain of the pass-down provisions could do with
some revision in the final version that is due to be published for use this year. The dispute
resolution clauses in the test edition attempt to address the three issues referred to above
however, regrettably, they are somewhat lacking and contain substantial risks for both the
main contractor and the subcontractor. Again, it is hoped that these issues will be resolved
in the final version. For a more detailed commentary on the FIDIC test Subcontract please
click here.

A rigorous drafting process across all subcontracts

There is no one-stop solution to the various possible pitfalls associated with back-to-back
contracts. Whichever approach to drafting back-to-back contracts is chosen, the decision
should never be based with the intention of short-cutting what should necessarily be a
rigorous drafting process. Both main contractors and subcontractors will have a vested
interest in ensuring that the subcontract is properly drafted. In addition, where there are a
number of subcontracts the main contractor will need to ensure that its main contract
obligations are properly allocated between the various subcontractors and none unwittingly
omitted.

The contents of this publication, current at

the date of publication set out above, are
for reference purposes only. They do not
constitute legal advice and should not be
relied upon as such. Specific legal advice
about your specific circumstances should
always be sought separately before taking
any action based on this publication.
Herbert Smith, Gleiss Lutz and Stibbe are
three independent firms that have a formal
alliance.
Herbert Smith, 41st Floor, Midtown Tower,
9-7-1 Akasaka, Minato-ku, Tokyo 1076241.

1
2

FIDIC Conditions of Contract for Construction (First Ed. 1999), For Building and Engineering Works designed by the Employer.
FIDIC Conditions of Contract for Construction (Multilateral Development Bank Harmonised Ed. Version 3: June 2010). For
Building and Engineering Works designed by the Employer.

Herbert Smith 2011