Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News.

. Engineering, Procurement, Construction (EPC) Bonds

RISKS UNIQUE TO EPC CONTRACTS: A NORTH AMERICAN* SURETY PERSPECTIVE

Background Beginning in the 1990s, the construction industry moved to better understand and support the Engineering, Procurement and Construction (EPC)** system of project delivery, particularly on contracts being project financed. This has resulted in many public and private projects being performed on an EPC basis. The project sizes vary from the routine to the largest and most complex engineering contracts (e.g., power plants and private toll roads). EPC, a fixed price, lump sum, turnkey system, is now established as a viable construction project delivery system used by both public and private owners. It is also one of the several delivery systems used in public-private partnership (PPP) projects and other project financed infrastructure projects. Prior to the 1990s, the traditional approach to project delivery contemplated the design service would be performed by a design professional directly retained by and contracted with the owner, and construction would be performed by a general contractor who is also directly retained by and contracted with the owner. This form of delivery system has been known as Design-Bid-Build. It contemplates that design, procurement and construction of the project will proceed sequentially, with award of the construction contract delivered to the lowest responsible bidder based upon completed plans and specifications. Some of the principal advantages of this traditional design-bid-build system include checks and balances between independent members of the team with no conflicts of interest, advantage or price competition and the benefit of a large body of judicial precedent that allocates liability among parties. Potential drawbacks of this system include: (a) the assumption the owner has the time and ability to coordinate the design and construction process; (b) since each phase of the process must be
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Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

sequential, the design-bid-build process requires a significant amount of time from design inception to start of construction on to final completion of the project; and (c) the significant potential for conflict, claims and litigation between the various parties. In contrast, the EPC system of project delivery is an integration of design, engineering, procurement and construction in one contract characterized by a single entity providing all the services necessary to design, engineer and construct the project based upon the requirements established by the owner. This system of project delivery has experienced steady growth in the United States and Canada. The advantages to this project delivery method include: (a) placing all responsibility on a single source, providing faster delivery of the project to the owner and creating one point of contact for the owner making it easier to monitor and coordinate; (b) setting a fixed or maximum cost for the entire project, subject to limited adjustments, which results in protecting the owner from market rise and defining the investment figure from the start; (c) assuring there will be few or minimal changes and conflicts between the parties; (d) a fixed completion date; (e) the potential for multiple disputes between the owner and the EPC entity can be resolved in a single forum (due to a single contract); and (f) the EPC entity takes full responsibility for the quality of the design, work and achievement of performance guarantees (subject to any exclusion). The rationale for this last point is that the EPC entity accepts both the project risk for design, engineering and construction, which limits other parties it may blame should problems arise. In addition, growing owner frustration with constant requests for change orders, time extensions and other issues has made the concept of a single source of responsibility for a project very attractive to owners. The EPC entity The EPC entity usually falls into one of the following four categories: 1. A joint venture, partnership or consortium consisting of a general contractor with one or more other construction firms and/or design (engineering) firms; 2. A sole venture general contractor who subcontracts the design services; 3. A sole venture design firm that subcontracts the constructions services; or 4. A sole venture company that has the internal capabilities to perform both the construction and the design services. The two most common entities seen in our experience are: (a) the joint venture of a general contractor and design firm and (b) the general contractor who subcontracts the design services to a design firm. When creating these types of relationships, the key is to be comfortable that the
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Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

combination of these firms for a particular project makes sense. It is critical that partners share a common approach to the execution of their respective roles within a joint venture as well as share a similar risk-reward philosophy towards construction. The key skill of an EPC entity is generally not its actual construction quality but its risk management capabilities. The design/engineering risk In the EPC system, the design professional can be part of the EPC entity, an independent firm retained by the EPC entity as a joint venture, or an independent firm hired by the EPC entity as a subcontractor. The choice may be driven by the professional licensing laws of the particular state or province where the project is located. The EPC entity, pursuant to its contract, will have primary responsibility and liability to the owner for the design risk. For the typical general contractor, this provides a much higher standard of care than a traditional design-bid-build contract where the design firm is independently responsible for the design risk. This increased risk and standard of care will also increase the suretys corresponding risk as North American* performance bonds typically incorporate by reference the terms of the underlying contract. This is particularly relevant to the surety where the performance bond either requires or permits the surety to procure completion in the event of contractor termination for default or gives the owner the option to demand that the surety do so. A key goal of the general contractor that is part of the EPC team should be to properly allocate the design liability to the party that is responsible for actual performance of the work. Regardless of whether the EPC entity that executed the contract with the owner is any of the four entities previously listed, the EPC entity assumes all the design risk and must manage it responsibly. After selection of the preferred design firm, the two most common approaches to manage the design risk are through either (a) an indemnification or hold harmless clause or (b) insurance transfer. The surety, during its underwriting process, will want to confirm that one is in place. Indemnification or hold harmless clauses contained within any contract are a common way to distribute the risk of loss to the contracting party who may be more culpable or who has the ability to insure for such a risk. When the EPC entity subcontracts the design services to a professional engineering firm, or one is part of a joint venture, it is essential to have proper indemnification language in the contract for the services provided by the engineering firm. Though the indemnity clause should clearly establish the design firm as being primarily responsible for this obligation, it is not a foolproof solution. Indemnity or hold harmless clauses
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Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

are only effective if the party providing the indemnification has the necessary financial resources to address the liability, if required. If these resources prove to be inadequate, it does not change the EPC entitys primary responsibility for this exposure to the owner. Since the liability tail for EPC contracts is often quite long, combining indemnification and hold harmless clauses with professional liability insurance to address this risk exposure will be something the surety will want to explore. Design errors and omissions exposures are often covered by professional Errors & Omissions (E&O) insurance policies which generally protect the insured against liability arising from negligence, errors and omissions in rendering professional services. Care should be used when evaluating this coverage as E&O policies may vary significantly between insurance carriers and insureds. Many such policies have limitations that may affect claims periods, tail coverage and potential claimants. A complete review of the E&O policy by the surety may be necessary. Additionally, many EPC entities purchase project-specific E&O coverage. These policies provide coverage dedicated to a specific project and may be available with extended reporting periods. For larger, more complex EPC contracts, it is important to verify the financial stability of the insurance carrier. When the EPC entity subcontracts the design work, the entity should have the design firm, as subcontractor, purchase the professional liability insurance coverage for the project and then name the EPC entity as an additional insured. This may provide protection from owner and third party claims but may not allow the EPC entity to make direct claims under the policy due to insured versus insured exclusions. The EPC entity should work with the insurance agent to ensure that the coverage provided protects the EPC entity in the broadest manner possible. On large contracts, it is not uncommon to see Owner Controlled Insurance Programs (OCIPs) and Contractor Controlled Insurance Programs (CCIPs) that require a specific E&O policy be purchased to protect the entire project. It is critical with this form of coverage that the limits be adequate and that the tail period be sufficient to cover any long tail exposures. Often, there may be a gap between the tail coverage available in the marketplace and the time period under statutory law in which a design E&O claim can be perfected. If no insurance coverage remains available from the project-specific policy, the primary responsibility will shift back to the EPC entity and the indemnification language of the contract and/or any practice policies that are in force. The advantage of this approach is that blanket policy limits are subject to reduction by losses on other projects.

Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

The project risk The risk the EPC entityand its suretyassumes will vary significantly according to the type, size and complexity of the contract being executed. For example: 1. Buildings, apartments and retail complexes typically impose nominal risk provided the owner does not require specialized mechanical, electrical or other systems. Risk will increase proportionately to the uniqueness of the design. 2. For highways, roads and bridge contracts, many federal, state, provincial, local and quasi governmental entities are now utilizing the EPC delivery system. The risk here is somewhat reduced as these contracts typically must conform to governmental or local design standards. Using proven designs, the remaining risk arises primarily from planning, scheduling and configuration issues. 3. Power, industrial or treatment plant process type projects are among the most risky. These often require complex mechanical systems or new technology with each plant being unique. Additionally, owners typically have specific demands and requirements for the services the plant produces and are often subject to financial penalties for delayed operation of the plant or the inability of the plant to produce at the desired level. A common reason for owners to use the EPC method is to assist in meeting tight time deadlines. For example in the United States, the I-15 highway project in Salt Lake City, Utah, which was structured as a large EPC contract, allowed the State Department of Transportation to perform over USD 1,000,000,000 worth of highway construction in order to prepare the City for the Winter Olympic Games within four years. The traditional design-bid-build system would likely have taken much longer. EPC was the States only practical solution in that case. An important factor for the EPC entity to consider is the owner. The owners responsibilities are not eliminated with an EPC contract. Those responsibilities do, however, undergo a change which requires a shift in focus, mind set and internal resources. In other words, the owner must trust the EPC entity to deliver a quality turnkey product on time and within budget. It is critical that the owner communicate a clear statement of project requirements, designate responsible representatives and make timely decisions during the contract period, in order to avoid potentially significant problems. Finally, the owner must demonstrate to the EPC entity and its surety or cosureties they have sufficient funds available to finance the project and to pay the EPC entity in a timely manner.

Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

Penalties that may be imposed on the EPC entity that its surety will want to closely review include: 1. Liquidated damages penalties: These may be linked to the performance guarantees and are generally to be limited to 25% of the contract amount or less; 2. Performance guarantees: While these differ based upon the specific output requirements, each item typically has a stated penalty and a cap of typically 10% of the contract amount. There is also an overall cap of all performance guarantee exposure that is not to exceed 25% of the contract amount, generally; 3. Most EPC entities will not enter into contracts with unlimited liability. As such, EPC contracts, particularly those for oil and gas projects, will cap the entitys liability, for all liquidated damages and performance guarantees, at no more than 100% of the contract amount. A thorough review of the contract documents, including all terms and conditions, is recommended. Key provisions to review include the scope of work, default provisions, performance guarantees (if any), warranties, liquidated damages, delay, differing site conditions and pricing and payment provisions. Each owner may have its own preferred EPC contract and the EPC entity may find itself reviewing significantly different documents on each project. As the EPC delivery system has grown over the years, however, demand has increased for a comprehensive set of well-written, integrated contract documents. A number of industry associations have published such a set of contract documents including, but not limited to, the Associated General Contractors of America, Inc. (AGC and its various design-build guides and documents), The Design Builders Institute of America (DBIA), the Canadian Construction Associations (CCA) Design-Build Institute (CDBI and its design-build practice manual), The International Federation of Consulting Engineers (FIDIC and its Silver Book), The European Engineering Industries Association (Orgalimes Legal Committees turnkey contract) and The International Chamber of Commerce (ICC and its model turnkey contract). These documents provide the contractual tools for assembling the project team and establishing the legal relationships between the owner, design/builder, architect/engineer and construction trade subcontractors, through a consistent statement of each partys rights and obligations. Owners may choose not to use these forms and public owners often tend to have their own preferred documents. An EPC entity should review its subcontracts and subcontract surety bond forms to ensure that exposures assumed under the EPC contract are contractually allocated to the
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Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

subcontractor or supplier responsible for that portion of the work. The same goes for risk they will assume under the surety bond(s) they provide to the owner on an EPC contract. Finally, the EPC entity should have a sound risk management program in place. This requires a thorough understanding of the current available insurance products and the ability of insurance to absorb certain risks that are inherent in an EPC contract. The EPC contract will have certain insurance requirements listed therein. There are others which the EPC entity may consider purchasing on its own, including but not limited to the following: 1. 2. 3. 4. 5. Workers compensation (where applicable) and employers liability insurance covering injury to workers; Commercial general liability (CGL) insurance covering third party bodily injury and property damage, faulty construction and workmanship; Professional E&O insurance covering faulty design (including project-specific policies); Contractors pollution liability covering third party environmental bodily injury and property damage and cleanup; and Builders risk insurance covering first party damage to property of the owner, contractor and suppliers during construction.

Other forms of risk transfer or security include letters of credit, bank guarantees and third party guarantees.

*All references to North America and North American in this paper refer solely to Canada and the United States, the primary focus of this paper, as performance bonds there operate differently than those in other North American countries. **Also commonly referred to as design-build.

Panamerican Surety Association - XXII GENERAL ASSEMBLY BEIJING - Tuesday, May 25 Panel: Industry News. Engineering, Procurement, Construction (EPC) Bonds

The author is senior vice president for international surety at The Travelers Companies, Inc., Hartford, Connecticut, U.S.A.

The Travelers Companies, Inc. (NYSE: TRV) is a leading provider of property casualty insurance for auto, home and business. A component of the Dow Jones Industrial Average, Travelers has more than 30,000 employees and generated revenues of approximately USD 25 billion in 2009.

Sources Based upon: 1. Design/Build, Travelers White Paper, 2009. With support from: 2. Worlds Apart: EPC and EPCM Contracts: Risk issues and allocation, Phil Loots and Nick Henchie, Mayer Brown, November, 2007. 3. EPC contracts in the oil & gas sector, Mallesons Stephen Jacques, August, 2004. 4. Project Finance, EPC contracts and the brave new world for Chinese contractors, Minter Ellison, October 2009. 5. Bonding the Public-Private Partnership Project: Perspectives from the Surety, Blake Wilcox, Bruce Cliff, Vivian Katsantonis, Christopher Brasco, Elizabeth Dorman, American Bar Association Tort, Trial & Insurance Practice Section, Fidelity & Surety Law Committee, Mid-Winter Meeting, January 2009.

This paper contains the views and comments of the author only and not those of The Travelers Companies, Inc. or any of its subsidiary insurance companies. This paper is for general informational purposes only. None of it constitutes legal advice, nor is it intended to create any attorney-client relationship between you and the author.