Source: Building World (september 2022)
Authors: Martin Ráž, Jan Šplíchal
There are many factors that significantly affect the costs of construction – steadily increasing inflation, shortage of building materials, rising energy prices, shortage of labour in the construction industry, and last but not least the war started by Russian aggression in Ukraine. In order to avoid the unpleasant surprise of finding that during the construction process you as a construction company will lose out on the contract due to the rising costs or, on the other hand, as a customer you will pay an exorbitant price, we recommend that you make adequate provisions for price increases in your contracts.
Construction usually takes many months to complete, or even years in more complicated cases, and it is very likely that price and cost increases will still continue during this time. The interests of the contracting parties as to the price at which the construction is to be carried out are different. The customer wants the construction to be carried out and completed at the price originally agreed in the contract, and that price to remain unaffected. Conversely, the contractor’s interest is to be able to demand a reasonable increase in the price of the work if the costs of the construction increase during the construction period. No contractor wants to subsidise the construction for its customer, but rather wants to carry out their work at a profit. So how should the price increases be reflected in contracts?
From the customer’s perspective, it seems to be simple. Just having a total price fixed (preferably expressly declared as fixed or not to be exceeded), i.e. having a contract not containing formulations such as that the price of the material will only be determined based on real prices or without force majeure clauses. The contract should also contain a formulation that the contractor assumes the risk of a change in circumstances (see below). But the most important thing is to find a trustworthy contractor who cares about its reputation and will not breach the contract so easily. And this can be much harder.
The question is also whether or not a company can negotiate a force majeure clause in the contract for work as a safeguard against rising costs. As a rule, the client does not want the construction to be prolonged in any way or the price to increase during the course of the construction. Therefore, force majeure clauses usually work for the benefit of the contractor, as the contractor is usually the one who, based on a force majeure event, claims some relief, in particular an extension of the construction period or an increase in the price of the work.
Force majeure is usually understood as an “act of God”, as it is often referred to in older contracts in English. It is a situation beyond our control, typically a natural disaster. In the standard international understanding, force majeure releases from or suspends an obligation (e.g. to complete construction within a deadline). As long as the force majeure or its consequences continue, the obligation does not apply, so it cannot be breached and there are no adverse consequences (such as fines, damages, and the possibility of withdrawal).
However, the Czech Civil Code knows such force majeure; it contains only a very limited exemption from liability for damages in Section 2 913(2) (formerly called circumstances excluding liability). Nevertheless, this has no impact on other adverse consequences, especially contractual penalties or the possibility of withdrawal. It therefore depends almost 100% on the text of the specific contract whether and how force majeure applies.
However, according to the vast majority of common contractual arrangements, an increase in construction costs in the market is not in itself force majeure. That would require the contract to contain a provision that directly envisages the increase in construction costs.
This is why various inflation or indexation clauses are more likely to be used, which provide for automatic, regular price increases according to predetermined criteria derived from the current market situation. Companies use this method to protect themselves against unpredictable price developments. However, the application of inflation clauses is certainly not mandatory and depends on the agreement of the parties, so both the company and the customer must agree to it in the contract.
However, no law says what such an inflation clause should look like. It is always an agreement between the parties, in the sense that everything that is not forbidden is permitted. The important thing is to focus on the exact definition of inflation, i.e. under what circumstances the company may demand payment of higher cost prices. In practice, therefore, the construction price, construction work prices or construction production cost indices are used, which are regularly issued by the Czech Statistical Office. Alternatively, contracts work with sectoral or stock exchange indices for the most important items, such as steel or concrete. These are realistic and concrete parameters on the basis of which the parties can determine the exact procedure.
The inflation clause should also include the frequency with which prices will be increased, if necessary. Again, it is up to the parties how they set this parameter. If the contract deals with year-on-year price increases based on the average annual inflation rate, it should be borne in mind that the results of the average annual inflation rate are not known immediately after the end of the given year, but perhaps only in March. Thus, with the current dynamic price developments, it seems preferable to choose a shorter period of time for comparison. This could be a calendar quarter or even a month.
The inflation clause can also be defined in the contract so that it is activated automatically when a certain inflation rate is exceeded and can thus work as a safeguard against dynamic market events.
In a situation where a fixed price is agreed at the beginning for the construction and the construction costs increase significantly during the construction period, the question could also be asked whether or not this is a material change of circumstances.
The provisions of the Civil Code (Sections 1764-1766 and Section 2620(2) specifically for contracts for work) provide for situations where there is a material change in circumstances during the term of a contract. However, their application is quite challenging. The change must occur after the execution of the contract and, under Section 1765, must cause a particularly gross disproportion in the rights and obligations of the parties by disadvantaging one of them. Section 2620(2) then requires a wholly extraordinary unforeseeable circumstance that makes completion of the work materially more difficult.
If these conditions are met, the party adversely affected by such a change in circumstances may seek in court to “balance out” the relationship between the parties and modify the contract accordingly – or, alternatively, to terminate it. Section 2620(2) also provides, specifically for works contracts, an express right to increase the price of the work.
However, the contractor encounters several problems when referring to the above provisions. First of all, a large number of contracts exclude their application altogether, such as by stating that the contractor (or both parties) “assumes the risk of a change in circumstances”. If the provisions are not excluded, they can only be invoked in court immediately after the change has occurred; moreover, under Section 1766, it is deemed to be too late after 2 months.
Furthermore, a material change in circumstances does not justify postponement of performance – in other words, the contractor may not interrupt the work. Also, the deadlines, penalties, etc. are not suspended for the contractor. In practice, bringing an action means a bet for the contractor that in a few years’ time it will be able to recover an increase in the price of the work from the customer, or, even more uncertainly, that it will obtain some relief from the court in the form of a preliminary measure valid for the duration of the dispute. For these reasons, although a “material change in circumstances” is often used as a threat in letters or by the contractor as an argument for a “voluntary” price increase by an amendment to the contract, actual litigation rarely occurs.
