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Local dealings between employers and nominated subcontractors

The recent case of Hong Kong Housing Authority v Rotegear Corporation Ltd concerned an unusual question, the answer to which will comfort employers of nominated subcontractors. The case is a timely prompt to reflect on the different ways of engaging subcontractors in Hong Kong, and how these important distinctions can affect the rights and remedies parties have during the course of construction work.

Know your subbies

Traditionally there have only been two categories of subcontractors: domestic and nominated.

A domestic subcontractor is selected and appointed by the main contractor without input from the developer. The works method adopted and the choice of subcontractors may not be important to the developer, provided these risks are drafted (as is usually the case) so as to lie clearly with the main contractor.

Nominated subcontractors (NSC) are selected (i.e. nominated) by the developer, who then instructs the main contractor to contract with the NSC for the specified element of the works. The developer may need certain elements of the works to be performed by particular companies (ground works, the façade or the M&E packages, for example) or, in the case of design and build projects, designed by particular consultants (nominated sub-consultants). However, the developer has no direct liability to the NSC for payment, even if the main contractor should become insolvent.

In Hong Kong and the UK the system of nomination has given rise in the past to difficulties particularly where older forms of standard form contracts have been used, which are sometimes incomplete or unsatisfactory. Establishing the limits of the contractual relationship between the developer and the NSC has been a fertile field for disputes. Fortunately, in Hong Kong the 'new' private sector standard form of building contract for use in Hong Kong, released in 2005, replaced the one that had been in use (with ever expanding bespoke amendments) for over 25 years. It removed many of these problems and the position of the nominated subcontractors once appointed, so far as responsibility on the part of the main contractor is concerned, is now almost the same as that of domestic subcontractors.

Under the new form, clause 29.13, if the NSC is terminated for a valid reason, and with the architect's agreement (which cannot be unreasonably withheld) the architect must re-nominate, following the same procedure. The main contractor is entitled to any increased cost caused by the replacement NSC's price, and an extension of time if the replacement cannot meet the main contractor's programme.

Rotegear in brief

Which brings us to Hong Kong Housing Authority v Rotegear Corporation Ltd where the Authority claimed that its NSC, Rotegear, had breached a warranty on performance related issues by failing to carry out its electrical works with due diligence. As a result the main contractor terminated its contract with Rotegear and engaged a substitute subcontractor. The Authority claimed against Rotegear damages for the added cost of having these electrical works completed by the substitute subcontractor.

Rotegear claimed there was no direct contractual link between itself and the Authority, and denied that its performance lacked due diligence as alleged or at all.

Reyes J. found that – despite the absence of a conventional collateral warranty - correspondence between the Authority and Rotegear in the process of Rotegear being selected as a NSC satisfied the standard test of offer and acceptance, and that a contractual relationship existed between the parties. Rotegear in its tender response had, for example, generally offered 'to execute, complete and maintain the whole of the above-mentioned Sub-contract Works in conformity with the said Main Contract (in so far as it apply to Nominated Sub-contractors)'. Other similar offers were made and, when the Authority accepted these in writing, Rotegear was duly deemed to be an NSC under the main contract.

There was no requirement for an express sentence acknowledging the Authority's entitlement to sue an NSC directly. If Rotegear failed to comply with the main contractor's project timetable and caused delay, this would amount to a breach of Rotegear's promise to the Authority and Rotegear could be found liable.

Reyes J. duly found 'ample evidence' that Rotegear had indeed caused delay, and that the main contractor had proper reason to terminate the subcontract. It followed that Rotegear would be liable for such additional cost as the Authority reasonably and foreseeably had to expend in order to finish off Rotegear's uncompleted work, that is, to mitigate its loss.

The damages claimed were assessed almost entirely in the Authority's favour: HK$8.78 million.

Why is this relevant?

In the context of some construction projects, the issue in the Rotegear case ought not to arise. The main contractor may be required to deliver formal collateral warranties to the developer signed by every NSC that is appointed, for example, as in clause 29.3 of the 'new' private sector standard form. This approach is recommended because it provides greater certainty for all parties. Similarly, private standard forms of contract used in Hong Kong by the MTR Corporation also require collateral warranties from all subcontractors.

In practice, however, a main contractor may take time to deliver such documents, or may never have done so. Indeed, under the original terms of the Hong Kong Government standard forms there is no obligation on the main contractor to obtain a collateral warranty from the NSC to pass to the employer. Nor is this a term in the FIDIC Yellow or Silver Book forms, which are used internationally.

For employers using such forms the Rotegear case provides some comfort that, in similar circumstances existing case law may suffice instead. If tender documents and correspondence between the employer and NSC are sufficiently clear, there is every likelihood that a court will identify a warranty for some aspects of performance. As a fall-back position where comprehensive collateral warranties have not been obtained, this outcome would be a relief to developers.

A third alternative?

Developers in Hong Kong can choose between these two alternatives – the comprehensive and certain terms of a collateral warranty, or the less costly yet let ultimately more risky fall-back position of the Rotegear case law. A third approach appears to have ended on a Hong Kong cutting-room floor. Contrary to earlier consultative drafts, the 2005 private domestic form of building contract was issued in Hong Kong without this third category, called 'named' subcontractors.

In the UK the use of named subcontracts is popular with developers, particularly on smaller projects using the JCT intermediate standard form contracts. Here the main contractor is required to choose from a list of sub-contractors that the developer has pre-approved. Sometimes the developer will have already obtained quotations from the short listed candidates, which helps transparency, but it is not mandatory for the main contractor to use this quotation. The relationship between main contractor and subcontractor is otherwise akin to a domestic subcontract.

Why is this approach popular? Under a nominated subcontract the main contractor may claim an extension of time for delay caused by a nominated subcontractor, which the main contractor has taken all reasonable measures to prevent (e.g. in the HK standard form at clause 29.13). These claims are easy to make but far more difficult to refute. Yet, under a named subcontract arrangement, the risk of appointing the sub-contractor, and its performance, lies with the main contractor. The 'naming' procedure allows clients to retain some control on sub-contractor selection without having to take responsibility for performance.

In circumstances where the subcontractor cannot or will not provide the employer with a collateral warranty, and where there is an absence of correspondence such as that described in Rotegear, some parties may find the 'third way' of naming particular subcontractors an attractive approach to procurement.

Minter Ellison, Construction Law Update
October 2009

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