by Omar Al Saadoon

The title of this article does not suggest the fear of stakeholders in the construction industry in the UAE or any other country affected by the global downturn is wholly irrational. No, on the contrary, the fact the UAE is currently experiencing a dramatic and unprecedented slowdown in its construction industry (which apparently accounts in part for Dubai’s first budget deficit in 2009) is symptomatic of the global fear of the instability of global financial markets and the ability of banks to lend to the public and each other. It is difficult to guage the actual effect of the downturn on the local construction industry given the UAE does not publish its GDP date on a quarterly basis.



The title however seeks to put this fear into proper local perspective given the current and perhaps global attitude of stakeholders adopting a “wait and see” approach pending the increased circulation of liquidity and lending restrictions being eased.

Current Industry Trends

“Dubai Inc” projects are either being dramatically scaled down in scope or major stages are being re-sequenced but proceeding nonetheless. Furthermore the trend in Dubai is that projects which are at the foundations or ground excavation stage or where ten percent or more have been paid to the contractor are more than likely to proceed to completion albeit at a reduced pace and provided there is close consultation between the developer and the Real Estate Regulatory Authority (RERA) at key stages of the project.

It is worth noting the Emirate of Ajman has recently followed the example of the establishment of RERA by establishing the Ajman Real Estate Regulatory Establishment (ARER) which, we believe, will serve to better regulate and safeguard the property market and construction industry in Ajman.

However, projects which are at the feasibility or concept design stage or where less than 10% of a residential development is sold off-plan are unlikely to proceed given the chronic problem of the circulation of liquidity, the current high rate of interest set by the UAE central bank and the psychological fear of some speculative investors who for now may not be willing to change their attitude to risk.

RERA has recently restricted sub developers from receiving more than 20% of the cost of the property from purchasers if construction of the property has not commenced. RERA is also due to implement regulations soon designed to increase the confidence of property investors. The regulations if implemented are likely to put intense pressure on sub-developers by ensuring that at least 20% of a project will have to be completed before developers are permitted to sell their plots. Another measure being discussed is for sub developers to own title to the land in which a project is situated before they can sell. These practical measures are likely to increase investor confidence but cause many sub developers to either cancel projects or become insolvent for lack of funding.

In light of tight liquidity conditions, contracting parties may have to agree alternative forms of payment or related security in order for projects (already under construction) to be completed without too much delay. We therefore anticipate an increase in use in letters of Credit, promissory notes or even the transfer of legal title to units of property (either completed or off plan). Such forms of security should not only serve as an incentive to the contractors to lower their prices but may also be used by contractors to secure credit facilities to finance the construction itself.

Developer’s Accountability in Dubai

A law was passed last year in Dubai which obliges developers to open an escrow or project account (or escrow accounts) in connection with any off-plan sales for a development.

The main purpose of this law is to provide legislative protection and greater comfort to purchasers involved in off-plan transactions and contractors in the developer having to prove they have the financial resources to build and complete their projects. Some economic advantages of project accounts include:

• Protection from the insolvency of the contractor for the employer and sub-contractors.

• Ability of the employer to effectively make direct payments to sub-contractors.

It is recommended that contractors (preferably at the outset of a project) check and continue to check the financial status of their employer and make regular enquiries with the escrow agent for each development to ensure there are sufficient funds at all relevant stages of a project they will be involved in. Consultants, subcontractors and suppliers are advised to do the same.

FIDIC Rights/Obligations

Due to the present adverse conditions of the property market and the number of project suspensions and cancellations, there is a heightened need for those who are parties to a construction contract to revisit their contractual rights and obligations given the current ‘squeeze’ on liquidity is likely to increase the spectre of disputes.

Given the pervasive use of the FIDIC forms of contract (for Civil Engineering Construction) in the UAE if not the Gulf region, we set out below a brief overview of certain provisions based on the standard FIDIC forms which may be relevant to contracting parties in light of the current downturn.

Notice to proceed

Based on recent market news, many projects have either been delayed or scaled back. Therefore it is not surprising to find a contractor who has been issued with a valid letter of acceptance (of the Contractor’s tender) by the employer to find the employer delaying to issue a contractual notice to commence to the contractor to formally activate (under the contract) commencement of works and a corresponding obligation for payment with all the liabilities that will accrue.

Security

It is common practice for contractors to provide contractual security to an employer to guarantee its performance under the contract.

Typically in the UAE, an employer would require the contractor to furnish an unconditional (on demand) bond to be issued by a reputable bank. Generally the terms of an unconditional on demand bonds are designed such that the bank will have to pay to the employers upon its demand without the need for the employer to prove that the contractor has defaulted or is in breach of its obligations under the contract.

In circumstances where an employer (as sub developer) may face serious issues of liquidity, it may very well be the case that the demand made by the employer was not bona fide but with the ulterior motive of cashing on whatever funds that is readily available for its disposal. Another possible scenario in which an employer may call upon a performance bond is when the contractor becomes insolvent or bankrupt or is the subject of a company administration or receivership.

Of course there are repercussions the employer will have to bear if it resorts to calling upon a bond in bad faith. However, in the mean time, the contractor will be out of pocket as the issuing bank may by then have liquidated the fund or property that was pledged to the bank as security for issuance of the bond.

It is due to such extreme scenarios set out above that we consider contractors should try and negotiate with their employers to include certain conditions precedent before the issuing bank or the surety is obliged to pay. However in light of current market conditions it is highly likely banks will insist on keeping the nature of performance bonds unconditional to improve their security (recourse to funds) in the event of contractor default.

Vetting Nominated Subcontractors

It is not uncommon for employers to nominate a particular subcontractor to be engaged by the main contractor to carry out part of the works.

A main contractor’s performance under the contract with its employer is inevitably dependent on the individual and collective performance of its subcontractors. Irrespective of whether an employer agrees or not with its main contractor that a particular subcontractor is performing badly or otherwise, ultimately the main contractor remains wholly liable to the employer for the performance of its subcontractors.

Given current market conditions and the increased attention parties are giving to their contracts, main contractors must negotiate the right to vet all proposed nominated subcontractors from a financial and capability point of view as failure to do may render the main contractor liable for issues including delays and poor performance.

With respect to nominated subcontractors, main contractors need to be mindful that there is a provision in some of the standard FIDIC forms which entitle the main contractor to object to the nomination of any subcontractor if it considers or believes a particular subcontractor does not possess sufficient financial ability to carry out the proposed subcontract work.

Delayed payments and overdue payments

During this period of downturn, the likelihood of an employer delaying or defaulting on its obligation to make payment is high. There are provisions in the FIDIC forms of contract which address such situations. For instance, there are provisions which allow a contractor to receive financing charges on those amounts outstanding from its employer.

The contractor’s right to financing interest does not take away its right to suspend work or terminate the contract pursuant to the conditions of the contract for non-payment of either the interim or final amount duly certified under the contract.

Suspension of work

Under most standard forms of FIDIC the engineer who administers the contract may at any time instruct the contractor to suspend part or all the works. The contractor is then obliged to protect and secure the suspended works from deterioration, loss or damage. It is not mandatory for the engineer to notify the contractor the reason for the suspension. Therefore, it seems that an employer can instruct its engineer to temporarily suspend work until such time that the employer can sort out its financial arrangement or, perhaps, to negotiate with the contractor regarding its financial obligations and the costs payable to the contractor.

Tricky issues may ensue following suspension in relation to the quantification of additional time and costs. An important question is the issue of ownership of “float” if it is not addressed by the terms of the contract. In other words, can the employer utilise the available float time within the contractor’s program for its benefit leaving the contactor with a reduced period of time extension?

Further, the employer needs to be aware that if the suspension exceeds a certain period of time the contractor would be in the position to either treat part of the work which has been suspended as an omission or if the whole of the works has since been suspended, then to terminate the contract and claim any loss and damage arising from the termination (including loss of profits).

Termination for convenience

The conditions of the 1999 FIDIC standard form entitle an employer to terminate a contract at any time for its convenience. There is no need for the employer to notify the contractor for the reason for the termination. Therefore, an employer may (in theory) raise an argument to terminate a contract for reasons of financial difficulties i.e. not being able to make payment by virtue of circumstances not foreseeable at the time of entering into a contract.

Parties Finances

There are also conditions which entitle a contractor to go one step further beyond suspension in that it may lawfully terminate the contract arguably in times of financial crises. The right of the contractor would however only be exercisable under limited circumstances and the contractor could potentially claim various costs and expenses including loss of profit.

The increasingly popular 1999 FIDIC standard form allows the contractor to request and obtain from the employer, reasonable evidence that the employer is maintaining a financial arrangement that will enable it to meet its financial obligations under the contract. The contractor may invoke its right to suspend work if the employer fails to supply such evidence within a prescribed period from its receipt of the contractor’s request. Further failure on the part of the employer may cause the contractor to terminate the contract.

The practical effect of the aforementioned provision allows the contractor to monitor the financial health of the project during the course of the contract period to help forward plan and mitigate the risk of non payment by the employer which could potentially expose the contractor to claims from its subcontractors.

This particular standard form provides added protection to the contractor in that it imposes an obligation on the employer to notify the contractor with detailed particulars if it intends to make any material change to its financial arrangements.

It would be interesting to consider the type and extent of damages that a contractor can recover (at least in theory) as a result of an employer’s breach of this particular obligation.

The UAE Civil Code and Financial Crisis

In conjunction with the express terms of a contract, the Federal UAE Civil Code also provides certain remedies to contracting parties in times of financial crises. Under the Civil Code either party may suspend the performance of its obligation should the other party fails to carry out its side of the bargain.

As to a more drastic measure, either party may also apply to the courts to compel the defaulting party to perform its obligation or for an order to affirm the cancellation of a contract. Unlike the contractual suspension or termination route, the outcome of such application would solely be dependent on the discretion of the courts who will take into consideration the fairness and justice of the case as a whole. In practice, the courts will consider issues regarding the stage of construction, the prevailing financial viability of the project and the financial interests of the parties. An employer should be cautious of invoking a right to terminate at will in order for it to engage other contractor to continue with the works. It may do so on the basis of persistent material breaches on the part of the contractor but may face difficulties if trying to terminate on the grounds it will save the employer money.

Reality Check

Whilst stakeholders in the construction industry are increasingly nervous about the dramatic shift in economic conditions, most seasoned practitioners would comment that a reality check was long overdue. Contractors and employers are attempting to cut their losses on cancelled projects by settling disputes through commercial negotiation which has always been the preferred way of doing business. Indeed the current fear factor is pressuring parties to negotiate in order to strengthen their balance sheets given the reluctance to “throw stones at glass houses” and the general uncertainty in the global economic climate.

However, disputes will increasingly become a sign of the times, the scale of which it is submitted, will depend on the rate of circulation of liquidity and the financial resources of those involved notwithstanding the appetite of contracting parties to claw back whatever monies are rightfully owed to them.

What has not been publicised so much in the local press is the recent dramatic softening of the price of steel and concrete which has caused developers to incur substantial financial losses given developers locked contractors to abnormally high prices for those materials not too long ago. The sums involved could arguably affect the solvency of those involved in projects and the existence of the projects themselves. Furthermore, it is guessed that in the next 18-24 months, the UAE is likely to witness a large number of insolvencies of contractors and developers given their financial status was precarious even if before the onset of the global downturn.

Reasons for Hope

The reduction or scaling down of projects, will also mean there is likely to be a growing trend of competitive tendering as sub developers and master developers (pressured by the requirements of debt funders) will seek to cut costs and gain increased added value to projects. This can only be a good thing for stakeholders in the industry.

The UAE property market despite the sharp correction remains a lucrative property market compared to its neighbours in the region though authorities should re-assess the current level of interest rates as being ultimately harmful to investors (home owners) and banks. RERA are also due to implement regulations which will protect investors by obliging them to pay 70% of the purchase price of a plot once the particular development is complete.

Briefly given our established reputation, experience and contacts in the local construction industry and if we are to take a broader and long term view of the industry, we remain confident and notwithstanding the uncertainty of the extent of the global downturn and its real impact on the local construction industry, the current downturn is not likely to be felt as acutely as economies in the West for the following reasons:

• The availability of world class facilities and infrastructure associated with mixed use projects completed in the UAE over the past 10 years;

• Official declarations of the combined amounts of sovereign wealth funds in the UAE as opposed to the debt allegedly owed by government owned entities coupled with the authorities’ commitment to continue and complete their ambitious strategic master plans for Abu Dhabi and Dubai;

• The UAE’s pre-eminence in the Gulf region as an innovator in the construction and property industry with its large pool of skilled resident expatriates;

• The important and far reaching regulations due to be implemented by Dubai’s RERA to mitigate against the risk of a meltdown in the property and construction industries;

• Substantial oil proceeds generated over the last three years which the UAE Government has prudently invested will further increase its ability to further withstand the effect of the global downturn. OPEC’s ability to monitor and adjust its oil prices to reflect market conditions should also further assist the UAE in sustaining the development of its construction industry.

Conclusion

Developers will have to be pro-active, diligent and creative if they are to survive. They will have to carefully cultivate their relationships with RERA and banks.Key stages of projects may have to be suspended in consultation with master developers and RERA pending market conditions. Additional incentives by way of discounts for “early bird” or bulk purchasers on plot sales with preferential or flexible plans should be considered as well as alternative forms of contractual security by developers in consultation with banks.

The undeniable reality is the UAE construction market is an important one in the MENA region. Banks in the UAE will resume their lending (albeit on stricter terms) given lending is their raison d’être.

Let us not forget the UAE government is a federation with long standing ties between the ruling families of all seven emirates. The authorities have officially committed to supporting local banks to support the major economic industries of the UAE, fulfilling the objectives of their master plans to redevelop Abu Dhabi and Dubai and to continue pursuing their united long term objective of being leaders in the construction and property industries in the Gulf region if not the Middle East.

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