DBIA Holds Forum on Risk Allocation

Las Vegas, NV — At the 2005 Professional Design-Build Conference, owners, design-build practitioners and representatives from the insurance and bonding industry held a lively and informative discussion on risk allocation. Although the primary topic was specific to the water/wastewater industry, the issues raised resonate through the entire design-build industry. Michael Loulakis, Esq., of Wickwire Gavin and Doug Herbst of CH2M Hill moderated the forum. In addition to airing differences of opinion, the forum attempted to come to a consensus for an industry standard on several common risks associated with design-build.

At the outset of the session the various groups were asked to describe their concerns regarding risk allocation. Public owners feel that they have a duty to protect the public from increases in costs on a project. In addition, several experienced public owners noted the need for educating public owners and, particularly, elected officials so that they understand that they cannot control every aspect of the process. Elected officials set the parameters within which owners can function, and concerns caused by cost overruns can be an overriding issue. Further education would allow design-build practitioners to overcome the general atmosphere of distrust of the design-build process.

Design-build practitioners noted the current trend to shift much of the risk in a design-build project to the design-builders. They noted that the purpose of the design-build delivery method is not to transfer every risk. The owner needs to recognize that risks must be reasonable and that proper risk allocation places the risk with the party most able to handle or insure the risk. One interesting observation was that the design-build process is a “leap of faith” for both the owner and the design-builder and involves trust by both parties. With every project, practitioners are examining the risk and attempting to quantify them. At the end of the day, practitioners will make a “go/no go” decision based on their ability and appetite for the risk.

Participants from the surety industry weighed in with their own observations. One of the primary problems that the surety industry is facing with newer trends in design-build is the inability to insure or bond a project with an extended duration. Sureties have a difficult time looking 10 to 15 years in the future and taking the risk that a design-builder will still be viable. Another problem with longer duration projects is the inability to predict price escalation and the effect of extended warranties. The industry noted that it is also having difficulty with joint and several liability for unrelated trades and the inability to insure geotechnical risks. The representatives from the industry highlighted the need for practitioners and owners to make sure that their insurance and bonding is handled by a professional familiar with the industry involved and design-build risks in particular. All agreed that it is extremely helpful to get the surety and insurance representatives involved in the project at an early stage.

The participants discussed the process by which a design-builder decides to bid on a public project. Practitioners acknowledged that bidding on a project is often an expensive process and agreed that they are considering the costs and benefits more strictly before deciding to invest in the procurement process. The factors they examine include (1) the procurement process itself, (2) the contract and the amount of risk, (3) the owner and its reputation for fairness, and (4) the project and whether the design-builder has previous experience with this type of project.

In looking at the procurement process, the design-builders examine the cost of the competition and the risk of losing the competition. Several design-builders noted that they are unlikely to bid on a competition if there is no short list process or if the short list has too many participants. The design-builders noted that both they and their sureties want to see the contract at the outset so that they can quantify and price the risk. Design-builders are unlikely to propose again if their previous experience with the owner was perceived as unfair or biased. Finally, design-builders are more likely to propose for a project where they have more experience and will put less emphasis on the risk involved. Of course, private owners do not have the bidding restrictions inherent in public work. For these procurements, the group agreed that it is best to negotiate the terms and conditions of the contract as early in the process as possible.

The consensus among the group was that risk should be placed with the party most able to price, insure or absorb the risk. There are certain risks that vary with each industry that the group agreed could not be priced. The group then had an interesting discussion regarding the practice of owners testing the appetite of practitioners by putting a project out to bid with significant risk just to see if anyone would bid. The theory is that someone will bid on the project and the successful bidder will get “stuck” with the risk. Generally described as the “greater fool” theory, the consensus of the group was that this method of procurement was not a best practice of the industry. Neither owners nor design-builders are served by an unfair allocation of the risk. Further, sophisticated design-builders would likely choose not to respond to unbalanced procurements, thereby significantly reducing competition.

The participants then broke into smaller discussion groups to attempt to come to an “industry consensus” on common issues associated with risk allocation.

Liquidated Damages and Incentives - The group agreed that liquidated damages provide a valuable way of measuring and allocating risk as long as the liquidated damages are reasonable, an owner’s sole remedy for the delay, and contain a clear trigger. The group also agreed that incentives for early performance are a productive way to motivate and reward performance. There was a discussion but no consensus regarding reverse liquidated damages, liquidated damages as a cap on the design-builder’s delay costs.

Water Quality Input - This group discussed the risk associated with the sources of water in a water project. First, the group agreed that both the design-builder and the owner must understand the type and quantity of sources available. The group also agreed that the industry best practice is to shift the risk of the input to the design-builder only when the input is within a defined range. If the input is outside of that range, the risk would be on the owner. If there is no defined range, the design-builder cannot accurately quantify or price the risk. Either the project will be unnecessarily expensive or competition will be severely limited.

Subsurface Conditions - The subsurface conditions group agreed that if conditions can be quantified and priced then the risk can be shifted to the design-builder. The industry best practice is for the owner to obtain as much information at the outset of the project regarding the subsurface conditions. If quantities or the existence of a condition are unknown, the parties could request or agree upon a contingent unit price for possible risks. The goal is to provide a mutual understanding of the site conditions at the pricing phase so that the owner can compare apples to apples in a competitive bidding environment and so both parties understand and quantify the risk in a negotiated setting.

“Uncontrollable” Conditions - The next group, which discussed “uncontrollable” conditions, focused on a few common problems. For price escalation of specific materials the parties should first determine the materials for which price escalation is a possibility and then agree on a neutral third-party trigger that would indicate that the price escalation is outside the normal range for the project. If the price escalation is abnormally high the parties can then either agree on an allowance for the item or tie reimbursement to a neutral index.

With respect to changes in the law or applicable regulatory scheme, the parties can look to the date when the price was set. If the change is prior to that date, the risk is appropriately on the design-builder. If the change occurs after that date, the risk should be on the owner. With respect to changes or differences of opinion regarding regulatory agency interpretation of the plans or other approval needed by a regulatory authority, the participants agreed that the design-builder is responsible to design and build a project that meets the regulatory authority’s requirements; however, if the issue is one of interpretation, then the design-builder’s responsibility is to meet the standard of care in the contract. The design-builder has met its standard of care if it provides a reasonable interpretation of the agency’s requirements.

Finally, the group discussed force majeure or acts of God. The participants agreed that the first order of business is to quantify what constitutes an abnormal situation in any given area in the country. For example, snow in Florida in winter would be treated differently than snow in Denver. Once the assumptions are stated, then the parties share this risk. The design-builder gets an extension of time but does not get delay damages. In addition, in their insurance package, the parties determine who will insure these types of damages.

Conclusion

The overwhelming consensus arising out of the meeting was that all parties need to take a closer look at the risks associated with each project. Owners need to allocate risk fairly and practitioners need to carefully evaluate and accurately cost risk to protect themselves. The best result is that all parties clearly understand the assumptions under which the project is bid or the contract is negotiated. If there are any questions regarding the risk, discuss them prior to signing on the dotted line. Also, get the insurers’ and sureties’ input into the process as soon as possible, particularly if the project is large or unique and insurance or bonding may be difficult to obtain. DBIA will incorporate the suggestions and comments that arose out of this risk allocation meeting into a set of industry best practices. The Risk Allocation Forum was a great success to begin development of these best practices thanks to the meeting facilitators and lively input by all participants. The 2006 Design-Build for Water/Wastewater Projects Conference in Albuquerque, NM, January 25-27, will further these lessons learned with a separate track focused on risk allocation issues. If you are interested in participating in the development of risk allocation best practices or would like additional information, please contact Brian Perlberg, DBIA Director of Government Affairs and General Counsel at (202) 682-0110 or email bperlberg@dbia.org.

In addition, DBIA is in the process of revising the entire Design-Build Manual of Practice and is looking for both authors and peer reviewers for this comprehensive revision. If you are interested, please contact Richard Belle, Vice-President of Public Affairs/ Information, at (202) 682-0110 or by email at rbelle@ dbia.org.