Legally Bound

Issues with ‘target cost’ contracts

Jordan ... TCC has potential complications.

Earlier this year, we looked at ‘target cost’ contracts (TCCs) and considered whether they offer advantages over lump-sum or cost-plus pricing models. A recent dispute relating to rail works has now highlighted some interesting potential complications with the TCC model.

To recap, parties might choose a TCC in order to promote collaborative working, through the sharing of cost overrun or cost savings. In this model, the parties first agree a target cost for completion of the works. Throughout the build, the contractor’s interim payments are based on the actual cost to the contractor plus a margin for overhead and profit, in the same way as in the cost-plus model. The difference comes only at the end when the final outturn cost is compared to the target cost. If the outturn cost is higher than the target cost, the contractor will receive only part of that difference. If the outturn cost is lower, then the contractor receives part of that difference effectively as a bonus on top of the cost-plus receipts.

This painshare/gainshare can be very simple (for instance, a 50 per cent share either way) or (more usually) it can have different share rates in bands around the target cost, and/or it can operate within a hard cap either side, or one side, of the target cost.

The more complicated part is in dealing with intervening events which affect the outturn cost of the works – and this area might also bring to the surface a difference of opinion about the philosophy behind a TCC; specifically, how much risk should be shared? Including:

• Should the additional cost of owner breach or change orders instructed by the owner be wholly at the owner’s cost, and not be taken into the sharing mechanism?

• Should the contractor be entitled only to the ‘allowable cost’ of carrying out the works, therefore excluding any cost incurred through the contractor’s inefficient working, as in the cost-plus model?

This second question was tested in a dispute between a railway operator and a contractor arising from upgrade works which were completed late and substantially over budget. Their TCC provided that the contractor should be paid the ‘total cost’ for the works, subject to the target cost adjustment. ‘Disallowed cost’ (to be excluded from ‘total cost’) included “any cost due to the negligence or default on the part of the Contractor...”. The contractor, nevertheless, asserted that some £13 million ($16.68 million) of additional cost, incurred due to their breach, should remain part of ‘total cost’.

The dispute (Network Rail Infrastructure Ltd versus ABC Electrification Ltd) came to the English High Court. ABC did not deny their responsibility for the additional cost but argued that it should be treated as ‘disallowed cost’ only if it were incurred due to wilful and deliberate breach – which they had not committed. The contractor’s interpretation was partly based on considering context and the ‘overall purpose’ of the provision on ‘disallowed cost’ within a TCC.

The court disagreed, holding that the definition of ‘disallowed cost’ was clear and unambiguous: in the absence of the contractor showing any reason to decide otherwise, ‘default’ in the above clause should have its ordinary and natural meaning. The additional cost was due to breach by the contractor; and the contractor should have no entitlement to it.

This judgement was predictable, in my view, and therefore maybe not worth discussion – except that the dispute does flag up two interesting points on TCCs:

First is the contractor’s argument that choosing a TCC was a material part of the context for interpreting the relevant clause. The contractor appears to have been suggesting that agreement to a TCC implies an intention to pool the risk of cost overrun due to simple default by one party. This argument, of course, did not sway the court, but it shows that some parts of our industry might consider a TCC to be a form of partnering contract.

Second, the TCC used here was the ICE Conditions of Contract: Target Cost Version. The inclusion of ‘default’ in the definition of ‘disallowed costs’ was through a bespoke amendment. Without that amendment, “disallowed cost” would have covered only cost arising from ‘negligence’ of the contractor. It is difficult to say what kind of actions or failures that is intended to cover (in the context of contractual performance) but, putting aside any lack of clarity, this standard form contract might also intend some sort of sharing of the consequences of contractor breach.

Whatever your view of the ‘true nature’ of a TCC, we can’t rely on the label. The contract needs to be clear on the contractor’s entitlement (or non-entitlement) to cost when there has been simple default, willful default or no default at all.


* Stuart Jordan is a partner in the Global Projects group of Baker Botts, a leading international law firm. Jordan’s practice focuses on the oil, gas, power, transport, petrochemical, nuclear and construction industries. He has extensive experience in the Middle East, Russia and the UK.