Court Ruling Could Change the Status of Lump-Sum Contracts

The construction sector uses two main types of contracts. 

The first type, called a “measurement contract,” is a contract whose underlying principle is accuracy. In this type of contract, the contractor’s consideration is measured according to the work that was actually performed. The second type is called a “lump-sum” contract, and is aimed at increasing certainty for all parties. 

What is a Measurement Contract?

A measurement contract is an accurate and fair model. In this model, neither party is enriched at the expense of the other party. If the contractor ultimately has to perform more work than originally planned, it will receive payment for it. The reverse is also true. If the scope of work is reduced, the client will not pay for work not performed. This model has two disadvantages:

1. The parties need to invest significant inputs to prove what is work which was actually performed.
2. Neither the client nor the contractor have certainty at the outset about the sum that will eventually be paid.

What is a Lump-Sum Contract? 

A “lump-sum contract” is a model that does not accurately link the consideration to the work actually performed. According to this model, the parties agree in advance on the consideration to be paid for the work, based on particular assumptions and the scope of work, such as work plans and specifications. This model increases certainty, since each party knows, from the outset, what is the sum to be eventually paid. It also increases efficiency (since it does not require any precise measurement of the work actually performed). The disadvantage of this model is that it may impose risks that could be perceived as unfair to one of the parties in respect of unforeseen events.

Paper versus Reality

In practice, the reality lies somewhere in between. In many instances, the model of engagement uses the lump-sum model as a basis. It adds a mechanism allowing some deviation from the consideration under specific circumstances, which usually involve significant changes to the scope of work.

Up until now, the logic underpinning these contracts has been maintained even during disputes. The courts have tended to rule that the contractor is entitled to payment for additional work, even when discussing lump-sum contracts that did not include price adjustment mechanisms. The courts’ starting point in such rulings was the fact that the parties had agreed in advance on the inclusive consideration based on specific information and data: work methods, plans, technical specifications, etc. When determining that the baseline data substantially differed from the reality, the courts found a way to “open” the lump-sum price. In other words, from a risk allocation perspective, courts ensured that parties to lump-sum contracts bore the risks they assumed, no more and no less.

Recently, however, the court ruling in A. Arenson Ltd. v. T.A.N. Earthmoving Works Ltd. eliminated that baseline.

The Lawsuit

The case in question involved a contractor that won a tender to perform particular works, including installing drainage pipes under a road. Defects were later discovered in some of the works, which required repairs. The contractor proposed to repair the drainage pipes using the “sleeve” method in a way that would not require “opening” the road and would be relatively simple and inexpensive. The client rejected the contractor’s proposal and instructed it not to perform the repairs using this method. Ultimately, the parties agreed that a subcontractor on behalf of the contractor would perform the works by “opening” the road.

The contractor and the subcontractor then signed a contract with a pre-agreed consideration of ILS 11.5 million. The contract was defined as a “lump-sum contract (payment not according to measurable quantities).” The contract further stipulated that the contractor was to perform the works according to the plans and specifications attached thereto.

Ultimately, the subcontractor managed to change the client’s mind, and performed the works using the “sleeve” method. As a result, the contractor sued the subcontractor in respect of the sums it claimed it had overpaid. This was because the works ultimately performed differed drastically from those stipulated in the contract’s plans and specifications. Additionally, the works were nearly eight times less expensive than the lump-sum consideration of ILS 11.5 million (only about ILS 1.5 million).

The Ruling

The court analyzed the facts of the case and customary practices in lump-sum contracts. It mentioned that the contract stipulated works must adhere to the plans. Since the works were indisputably performed differently, prima facie, adjusting the consideration seemed justified. However, the court held other circumstances existed:

1. The signed contract included a clause that enabled adding additional plans in the future.
2. A representative on behalf of the contractor, who was present at the site, had tacitly “approved” changing the work method to the “sleeve” method.

In its summation, the court ruled that the subcontractor did not have to return the excess sums to the contractor.

The Ruling’s Implications

This court ruling creates a problematic outcome in principle with regard to several salient aspects:

1. Economic logic

The court ruling abruptly diverged from the economic logic and risk allocation model underpinning lump-sum contracts. As stated, in a lump-sum contract, the consideration is assessed in advance on the basis of objective data, such as plans and specifications or other data for which a correlation exists between the data and the consideration. When works diverge from contract data, the economic logic behind the contract is undermined, potentially leading to disputes. The court negated the initial risk allocation model between the parties. It retroactively intervened in how they assessed work, scope, and consideration.

2. Anticipated changes in contract

The second aspect relates to the court’s reliance on a clause in the contract that foresaw a scenario whereby the plans attached to the contract might change. However, this is a relatively standard clause in contracts in the construction sector, the purpose of which is to prevent a situation in which a contractor demands additional payments for relatively minor modifications in plans. Accepting a standard clause as justification for a drastic work method change strains credulity.

3. Conduct in real time

The third aspect relates to the parties’ conduct in real time and the weight that the court attributed to it. The court ruled that the presence of the contractor’s representative at the site constituted “tacit consent” to the change in the work method. It is incomprehensible why such presence, even if it could be construed as “tacit consent” to change the work method, constitutes an additional, separate agreement in relation to the consideration.

4. The principle of certainty

The fourth aspect is the court’s unraveling of the principle of certainty in lump-sum contracts. Until now, turnkey contract parties agreed on a set price for predetermined works, ensuring cost predictability. However, when the work content drastically changed, both parties knew the contractual consideration would change.

5. Unlawful enrichment

The fifth aspect (which may not be unique to the construction sector) is the court’s ruling that, under the circumstances of the case, the subcontractor did not benefit from enrichment at the contractor’s expense. However, paying ILS 11.5 million for ILS 1.5 million worth of work, and deeming it lawful enrichment, appears incomprehensible.

It will be interesting to see if of the contractor appeals this ruling to the Supreme Court and what the results will be. One way or another, though, this ruling significantly changes the status quo.

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Adv. Shai Avnieli is a partner at Barnea Jaffa Lande and leads the firm’s Infrastructure Dispute Resolution practice.