Construction contracts: the cost of mistrust

Ramy Zaghloul*, Francis Hartman

Project Management Specialization, Department of Civil Engineering, University of Calgary,

2500 University Dr. NW, Calgary, Alberta, Canada, T2N 1N4

Received 12 February 2002; received in revised form 20 September 2002; accepted 19 November 2002

Abstract

Current contractual relationships are mainly based on confrontational situations that reflect the level of trust (or mistrust) in thecontract documents. This can be the driver to increase the total cost of a specific project and affect the overall relationship betweenthe contracting parties. This has been tested in the construction industry in Canada, and appears to be generalizable across NorthAmerica. Based on two independent surveys (including the one presented in this paper) of Owners, Consultants and Contractors

across Canada, the assessed premium associated with the five most commonly used exculpatory clauses in construction is between 8and 20% in a seller’s market. It should be obvious that trust and contracting methods are related and that this relationship is ofvital importance to effective project management and contract administration. To date, little work has been done to explore the

advantages of this relationship. This paper presents some of the results of a survey conducted across the Canadian constructionindustry that identifies some opportunities for better risk allocation mechanism and contracting strategies that are based on a trustrelationship between the contracting parties. These opportunities are based on a trust relationship that can be the root cause for a

significant saving in the annual bill for construction.# 2003 Elsevier Ltd and IPMA. All rights reserved.

Keywords: Risk allocation; Trust relationships; Transaction costs; Contracting strategies

1. Introduction

The construction industry in both Canada and theUnited States is the single largest non-governmentalemployer. In 1997, the industry was estimated inCanada to have a value of about $90 billion, represent-ing 15% of the gross domestic product and employingmore than 872,386 workers directly [1]. However, withinthe last 20 years considerable cost wastage has beenidentified by the Construction Industry Institute [2]. Asignificant portion of this cost wastage may be attrib-uted to inappropriate risk allocation in contracts, ascited in various examples analysing risk allocation in theconstruction industry and the underlying causes of dis-putes conducted in Canada and the United States[3,4,30].Meanwhile, construction risks are a major element

that can significantly affects the final cost of any project.

Specifically, how these risks are allocated has a directbearing on the final total cost. The cost of these risks iscarried by the owner, contractor, or both, as determinedby the type of the construction contract [5]. Risk allo-cation always occurs in any situation where more thanone party (owner, contractor, consultant, etc.) isresponsible for the execution of a project. Making surethat as many risks as possible are recognised and man-aged is good practice in any project. This activity is animportant step in that this allocation can significantlyinfluence the behaviour of the project participants andhence impact both project performance and final cost.

2. Construction contracts and risk allocation

Construction contracts are the written agreements signedby the contracting parties (mainly an owner and a con-tractor), which bind them, defining relationships and obli-gations [6]. In any certain project, the owner’s goal can bestbe achieved by selecting the contract type that will mosteffectively motivate the contractor to the desired end. Thisstep is also dependent on completeness of information for

0263-7863/03/$30.00 # 2003 Elsevier Ltd and IPMA. All rights reserved.

doi:10.1016/S0263-7863(02)00082-0

International Journal of Project Management 21 (2003) 419–424

www.elsevier.com/locate/ijproman

* Corresponding author. Tel.: +1-403-220-6185; fax: +1-403-282-

7026.

E-mail addresses: rszmoham@ucalgary.ca (R. Zaghloul),

fhartman@ucalgary.ca (F. Hartman).

the bidder(s) at tender time and the extent that the ownerwishes to take specific risk. In this context, contract riskcan be divided into performance risks and cost risks [5].Regarding risk allocation, the concept of ‘‘limitation

of liability’’ dates back more than three hundred years,when the British Parliament declared, as part of Mar-itime Law, that a ship’s owner should not bear greaterliability than the value of the ship’s hull [7]. In thiscontext, every contract allocates risk. Not all contractsallocate risk equitably or such that the power andauthority to manage the risk is allocated along with therisk itself. Given the opportunity, an owner shouldfavour efficient allocation of risk between parties to aproject that simultaneously reduces risk and improvesproject performance. This appropriate risk allocation isa significant contributor to low transaction cost of anyspecific project and vital issue in the success of the con-tracting process. However, in an owner–contractorrelationship at least, a common aim of owners appearsto be to avoid risk as far as possible by allocating asmany risks as it can to the contractor [8].

3. Risk allocation through disclaimer clauses

Any construction project involves risk and there is nopossibility to eliminate all the risks associated with aspecific project. All that can be done is to regulate therisk allocated to different parties and then to properlymanage the risk. This can be done through the languageof the construction contract. The decisions regardingrisk sharing or risk shifting are made within the contextof an owner’s contracting policy [9]. One of the objec-tives of the contract is to serve as a framework betweenthe parties to establish which one has assumed whichrisk.One way in which the contracting parties attempt to

address the right and responsibilities for risk is throughdealing directly with the issue of legal liability by includ-ing provisions that exclude liability arising from certaincauses. Disclaimer (exculpatory) clauses are examples ofsuch provisions. Such clauses attempt to transfer oneparty’s risk (which may be a legal liability) to another bycontractual terms [5]. In other words, these clauses areintended to exclude an owner’s liability in contract andoften in tort for cost incurred by a contractor [10].Using disclaimer clauses to allocate risk has been

identified by recent studies and industry–practice as amain reason to increase the overall cost of a project[2,4,11,13,14,31]. When a risk is shifted to the con-tractor and the contractor has no means by which tocontrol the occurrence or outcome of the risk, the con-tractor must either insure against it or add a con-tingency to the bid price [16]. Two recent studies(including the one presented in this paper) indicate thatusing disclaimer clauses in Canadian contracts carries a

premium of between 8 and 20%, depending on whetherbusiness conditions were favourable (low need for work,low technical complexity, fair contract administration,negotiated and suitable contract type, and completedesign work) or adverse (high need for work, hightechnical complexity, unfair contract administration, unnegotiated and un suitable contract type, and un com-plete design work) [11,12,17,18]. Contractors add theserisk premiums to each disclaimer clause in their contractwith the owner based on some main criteria.The most important of these criteria are their business

relationship with the owner, work conditions, and con-tract type and fairness. On multimillion-dollar projects,such an increase to the project cost can obviously bevery significant. An additional but less visible, cost ofshifting risk to the contractor through disclaimer clausespresents a number of hidden costs including restrictedbid competition, increased potential for claims and dis-putes and above all, more adversial owner–contractorrelationships [19–21]. Exhibit 1 illustrates the generaloutcomes for using exculpatory clauses in contracts.There is a significant amount of literature that dis-

cusses possible options for improved contracting meth-ods and better risk allocation processes. These studiespresent new ways for doing business such as partnering/alliances, risk sharing/reward systems, incentive-basedcontracts and others. However, these new contractingstrategies between owners and contractors are stillfounded largely on the self-interest of each participant.Motivation for performance under these strategies hasfocused largely on retribution for non-performance. Inmost cases, the relationships of the contracting partiesare still defensive and, in some cases, adversarial. Theatmosphere spawned by these relationships has not beenconducive to innovation or cooperation between parties[5,22]. With all of these solutions, owners are generallyunwilling to carry project risks and where possible,transfer them contractually to contractors through dis-

Exhibit 1. General outcomes of risk allocation through disclaimer

clauses.

420 R. Zaghloul, F. Hartman / International Journal of Project Management 21 (2003) 419–424

claimer clauses in order to have a control system overthese risks in what we call contract documents[17,23,24].

4. Why trust

With the absence of trust in business relationships,there is a significant need for good and powerful controlsystem to manage and administrate the contractingprocess. However, even with the existence of this pow-erful control system (the contract documents), with theabsence of trust, the success of any project or businessrelationship is always questionable. Trust should be atthe heart of how people do and think about risks.Meanwhile, these risks vary as the form of a relationshipbetween the contracting parties varies. Risks that thetrusting contracting parties assume and the mechanismsfor mitigating those risks emerge as a function of theform of the relationship between those parties.Trust influences almost every aspect of the project

management process, which affect the execution, andthe cost of any specific project. However, The conceptof trust is very complex and multidimensional and therehas been much debate within academic circles regardinga common definition or model [25–27]. In an attempt toadvance the conceptual understanding of the topic oftrust, Hartman [5,27] developed a model of trust thatenables a more simplified understanding of the concept.This model has been adapted for the purpose of thisresearch.

5. The colour of trust model

The colour of trust model specifies three colours (ortypes) of trust: Blue, Yellow, and Red trust. These typesare identified as follows:

� Blue (or competence) trust is all about ability andcompetence, which is based on the perception ofthe other’s capacity to perform what is required.It is simply the answer for the question ‘‘Can youdo the job?’’.

� Yellow (or Integrity) trust is based on integrity,which is founded upon the perception of theother’s attitude to act ethically, to adhere tovalues that we hold important, and to be moti-vated to not take advantage of the other party. Itis simply answer the question ‘‘Will you con-sistently take care of my interests?’’.

� Red (or intuitive) trust is based on intuition,which is the result of a combination of emotionalresponse and rapid processing of informationand may be described as the instincts or ‘‘gutfeelings’’ that one person has about the other, a

situation, or an artefact. It simply answers thequestion ‘‘Does this relationship feel right?’’

In this paper, the authors present some of the findingsof a study conducted across the Canadian constructionindustry including owners, contractors, and consultantsand appear to be generalizable to the United Statesconstruction industry.These findings identify the relationship between trust

and risk allocation practices in construction contractsand how a strong trust relationship through the Coloursof Trust Model can reduce the final cost of any specificproject by improving the risk allocation methodbetween the contracting parties.

6. The industry survey

In order to collect the data for this study, an industrysurvey was conducted in the Canadian and the UnitedStates construction industries. A self-administered mail-out was considered as the data-gathering method inorder to overlap the problems of bias, cost, and geo-graphic barriers [28]. The questionnaire included open-ended questions for identifying the respondent andidentifying suitable information for the research, andscales, assumption with yes/no answers, and multiple-choice questions to identify respondents’ professionaljudgment and experience on certain aspects concerningrisk allocation practice in the industry.The survey also solicited qualitative and quantitative

information on individuals’ perception of the mostcommon disclaimer clauses, the premiums associatedwith these clauses, and the rationale behind this beha-viour of allocating risk in the North American contractsidentified in recent research and studies. These clausesinclude:

� Uncertainty of work conditions� Delaying events� Indemnification� Liquidated damages� Sufficiency of contract documents

The results of the study are based on more than 300respondents to the survey. The study sample includesowners, contractors, and consultants from both privateand public industry sectors, working in different typesof projects; civil, industrial, commercial, residential, andothers such as oil and gas pipelines.

7. Results and discussion

Based on the survey results, it is noted that most of thecontracts used in the construction industry are prepared

R. Zaghloul, F. Hartman / International Journal of Project Management 21 (2003) 419–424 421

contracts that have been written by one of the con-tracting parties, normally the owner. In other words,more than 74% of construction contracts are preparedby the owner and not negotiated. Table 1 indicates theseresults.The study shows that these contracts, whether nego-

tiated or prepared, typically include one or more of thefive disclaimer clauses mentioned before. Actually theseclauses exist in more than 75% of the survey respon-dents’ contracts. Table 2 illustrates the frequency ofdisclaimer clauses usage in construction contracts.The study reports that under all circumstances, with

the existence of disclaimer clauses, contractors attachedrisk premiums to the total cost of a project in order toprotect themselves against these clauses. To a greatextent, the findings validate the work of Hartman andKhan reported by Hartman [12].These premiums fall into a range of 8–20% of the

total cost of a project based on whether the businesssituation is favourable (low need for work, low technicalcomplexity, fair contract administration, negotiated andsuitable contract type, and complete design work) oradverse (high need for work, high technical complexity,unfair contract administration, un negotiated and unsuitable contract type, and un complete design work).What interesting is that these clauses continue to beused in some of the newer contractual agreementsbetween owners and contractors such as partnering/alliances.

8. Trust, risk behaviour, and cost reduction

In the construction industry, risk behaviour has beengrouped into three general classifications: risk averse,risk neutral, and risk taker [15]. Each of these beha-viours will affect how an individual or organizationwould react to a specific contractual agreement. The

results of this research report that in most cases, industryowners are risk averse or risk neutral based on projectcomplexity and size. Industry contractors however, aretypically risk takers, neutral or risk averse based on pro-ject complexity, size, and market conditions. Resultsform this study show that the amount of the premium isbased on the contractor’s perception of the disclaimerclause risk. Which means that if the contractor’s per-ception of the disclaimer clause risk is high, the pre-mium will be large. One of the most important findingof this study is that a significant relationship existsbetween the amount of the premiums associated withthe disclaimer clauses and the level of trust between thecontracting parties, specifically between owners andcontractors.In other words, under a high trust relationship with

owners, contractors tend to lower the risk premiumsassociated with disclaimer clauses because their percep-tion of the disclaimer clauses risk is low. Meanwhile,under low trust relationship with owners, contractorstend to associate what we can call a normal level of riskpremiums (8–20%) with disclaimer clauses risks becausetheir perception of the risk is high. The perception ofdisclaimer clauses’ risk under low trust relationships isvery high (average of 4.4 out of 5 point scale). The per-ception of disclaimer clauses’ risk under high trust rela-tionships is very low (average of 2.3 out of 5 pointscale). Table 3 shows these averages (based on 5 pointscale).Another interesting finding of this study is that the

trust level that generally exists in the constructionindustry contracts between contracting parties is low(average 2.3 out of 5 point scale), which reflects the levelof mistrust in the industry contracting practice. As theresults report, owners and contractors risk allocationcontracting practice is mainly a function of their trust(or mistrust) relationship between each other. If theowner–contractor contract is based on a strong trustrelationship, the amount of the premiums associatedwith disclaimer clauses is very low, or even better; thedisclaimer clauses would not exist on the contract fromthe outset.The results also show that owners and contractors are

willing to change their risk allocation practice regarding

Table 1

Percentage distribution of contract type; negotiated vs. prepared

Contract type

Percentage

Negotiated

25.2

Prepared

74.3

Other

0.20

Table 2

Frequency of disclaimer clauses usage in construction contracts

Disclaimer clause types

Percentage

Uncertainty of work conditions

92.0

Delaying events

72.0

Indemnification

77.0

Liquidated damages

61.0

Sufficiency of contract documents

67.0

Table 3

Perception of disclaimer clauses risks under low and high trust rela-

tionships (averages out of 5 point scale)

Disclaimer clause

Low trust

relationship

High trust

relationship

Uncertainty of work conditions

4.5 2.4

Delaying events

4.5 2.4

Indemnification

4.4 2.2

Liquidated damages

4.3 2.1

Sufficiency of contract documents

4.5 2.1

422 R. Zaghloul, F. Hartman / International Journal of Project Management 21 (2003) 419–424

these clauses (use a different mechanism for risk alloca-tion) when contracting parties have previous workingexperience with each other, which can be related to trustrelationship. As a result, contracting parties are willingto have another method of risk allocation when:

� A contracting party has evidence that other partywill protect his interests;

� A contracting party has an industry or practicalevidence that other party is knowledgeableenough to manage the risk; and

� A contracting party has a good industryreputation.

It is the authors’ belief that most of these criteria canbe met through a trust-based relationship between thecontracting parties. Such a relationship can be built atthe front-end of a project and can be a significant con-tributor to cost reduction. To a great extent, these find-ings are consistent with the CII Cost–Trust relationship[29].The participants report that an owner–contractor

trust-based relationship enables them to commandstructure and authority systems, incentive systems,administrated pricing systems (cost, qualities, and pri-ces), good communication, and team working environ-ment in order to reduce the total cost of a project. Inother words, owners and contractors under a trust-based relationship are likely try to manage and mitigaterisk primarily for their own benefit and not to the dis-advantage of the other party. The converse is moretypical in most of today’s contractual relationship in theconstruction industry.

9. Conclusion and recommendations

Recent research and industry experts have indicatedthat inappropriate risk allocation through disclaimerclauses in contracts is a significant reason for increasingthe total cost of a project. Any improvement in theprocess would result in significant savings for the con-struction industry.This study indicates that using disclaimer clauses to

shift project risks to the other contracting party is stillthe general traditional practice in the constructionindustry. It also indicates that there is a significantrelationship between trust and risk allocation throughdisclaimer clauses that can result in cost saving in theconstruction industry. The survey respondents reportthat to reach a better risk allocation process, a trustrelationship between the contracting parties should existfirst. This can be done through certain stages as follow:

� a clear understanding of the risks being born byeach party and who owns or can manage the risk;

� more time and effort in the front-end of a projectand sufficient experience to manage or mitigatethe risks and administrate the contract;

� a negotiation phase prior to the start of thecontract should exist, this phase is required tobuilt a trust relationship between the contractingparties, then this negotiation phase can be part ofthe contract itself; and

� adequate risk-sharing or risk-reward systemshould exist to share the benefits if the risk doesnot occur during the project lifecycle.

The rationale for better risk allocation between own-ers and contractors ought to be based on meeting theseconditions as far as possible. Missing one of these cri-teria is very likely to trigger inappropriate risk alloca-tion process for any given project and hence bringadditional cost for the contracting parties.

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