【Haichuan EPC】Selection Models and Risk Allocation for Subcontractors in International Engineering Projects

I. Selection model for subcontractors: The legal relationship in subcontracting involves the main contractor assigning part of its work scope to a selected subcontractor. However, the legal relationship of the entire project is such that the general contractor occupies an intermediate position, between its obligations to the employer and those of the subcontractors to the general contractor. Although the subcontractor is directly liable to the general contractor, if the subcontractor fails, it is inevitably linked to the general contractor’s obligations to the employer. Therefore, selecting a subcontractor is undoubtedly a crucial step in a project. Traditionally, the selection of subcontractors can be determined before or after the main contract is signed. It depends on the employer – whether it’s before or after. (1) Selection prior to the signing of the main contract (direct designation by the employer): Direct designation by the employer usually occurs during the project bidding phase. If the employer specifies this directly in the tender documents, or even if they can negotiate the terms and prices for the work/materials directly with the subcontractors and impose those conditions on the general contractor, requiring the latter to choose the specified subcontractors once it wins the bid, the general contractor has no choice left. Of course, when bidding, the contractor can also recommend subcontractors, or submit the names of potential subcontractors for the employer’s evaluation. There are complex reasons why employers act in this way. Employers may worry that the general contractor will not be able to select subcontractors of their choice, or that the employer already has close ties with certain subcontractors. In any case, the employer’s direct appointment of subcontractors in advance poses risks to the general contractor, which requires special attention from the latter. It must be emphasized that even if the subcontractor is actually selected or appointed by the employer, any legal liability arising from the subcontractor’s performance of the contract remains with the main contractor. The greatest risk that employers directly appointing subcontractors to the general contractor pose is that the subcontractor is chosen due to their relationship with the employer, rather than based on their skills and experience. This will directly affect the progress and quality of the project, thereby posing significant and even fatal risks to the general contractor’s ability to fulfill the project contract properly. Although Clause 5.1 of the FIDIC Conditions of Contract provides that the main contractor has legitimate reasons to object to the use of nominated subcontractors, or in certain circumstances to be exempted from the contractual responsibilities arising from them, it still cannot completely eliminate the contractual risks posed to the main contractor by nominated subcontractors. Lack of experience and skills on the part of the subcontractor, or the subcontractor’s intentional breach of contract, can all serve as reasons for the main contractor to defend itself. But how can one prove that the subcontractor lacks experience and skills, or that they intentionally breached the contract? This is a very tricky issue that may increase the risk of repeated discussions and disputes between employers and main contractors regarding the performance of subcontractors. The more “dangerous” risk is that designated subcontractors, accepting contracts at a loss for various reasons, may eventually undermine the completion of the project. Furthermore, once a subcontractor is assigned, the general contractor loses the advantage of negotiating with potential subcontractors; it can no longer select the subcontractor it prefers through a bidding process. Of course, it is also beneficial for the owner to directly appoint subcontractors during the bidding phase and require the general contractor to sign subcontract agreements right after winning the bid. For example, it eliminates the need to spend time selecting subcontractors, which directly helps to speed up project progress and may help avoid potential delays. To avoid the uncertainties associated with choosing a subcontractor, it is common practice for the employer to include a short list of potential subcontractors in the tender documents. Then, the general contractor selects one from the list. Although this approach cannot completely eliminate the aforementioned risks, it is undoubtedly more attractive for main contractors and employers, as it provides them with more room to assess which subcontractor is better suited to carry out the work that must be done. However, it must be remembered that under this approach, the general contractor incurs additional costs when selecting subcontractors (selection fees), and these costs may be borne by the general contractor, resulting in higher prices for the employer. Regrettably, when assigning a subcontractor before signing a contract, the employer rarely gives full consideration to the subcontractor’s skills and capabilities. The general contractor often regards the subcontractor’s bid as the main factor to consider, ignoring elements such as the subcontractor’s track record, which undoubtedly affects the implementation and execution of the entire project. In the international engineering community, designated subcontracting has never been a good approach for project execution, yet it is still not condemned for that reason. Since the employer is willing to assign the project to a general contractor, why not trust that the general contractor has the ability to select a good subcontractor? The reasons behind this deserve consideration.

(II) After the main contract is signed, the assignment of subcontractors is generally completed during the bidding stage. But more often, the employer does not specify a subcontractor; instead, it leaves it up to the general contractor to make the choice, and this decision-making process usually takes place after the main contract is signed. On the one hand, the employer relies entirely on the proper assessment of the general contractor to select the most suitable subcontractor to carry out the work (for example, under an EPC contract); on the other hand, the employer retains the final decision-making power over the subcontractors chosen by the general contractor (for example, with its consent and/or approval). Therefore, during the bidding stage, the employer usually sets requirements for the selection of subcontractors, such as the need for the subcontract to include certain terms favorable to the employer. For example, employers usually try to explicitly exclude any liability during the selection process by including specific clauses, such as: the employment of any subcontractor shall in no way relieve the contractor of any losses incurred as a result of the subcontractor’s failure to fulfill its obligations. The FIDIC Conditions of Contract contain similar provisions; unless otherwise specified in the special conditions, the main contractor shall be liable for the negligence of any subcontractor involved in the work (see Clause 4.4 [Subcontractors]). This is different from the situation where the employer directly appoints subcontractors; in such cases, the employer’s direct appointment of subcontractors can, under certain circumstances, relieve the general contractor of some responsibilities, whereas no such provision applies to subcontractors chosen by the general contractor itself. Therefore, the consequence of the general contractor selecting subcontractors on its own is that the general contractor is liable to the employer for all legal consequences arising from any defects in the performance by the subcontractors. This places high demands on general contractors when selecting subcontractors. However, in practice, the employer does not fully delegate the authority to the general contractor to select subcontractors; the general contractor still has to go through approval procedures. The employer often takes advantage of these approval processes to serve their own interests. And the general contractor cannot claim rights against the owner afterwards regarding this. This is something that requires special attention when the general contractor selects subcontractors on its own. Whether it is designated subcontracting prior to the signing of the main contract, or the general contractor selecting subcontractors on its own after the contract is signed, it always leads to ongoing disputes between the employer and the general contractor. The main contract usually specifies the method for resolving disputes, allowing either party to submit the dispute to a dispute resolution body. However, the subcontracting of international engineering projects plays a decisive role in the smooth progress of the entire project. And reaching a decision on a dispute is another lengthy process. Neither the employer nor the general contractor can accept the idea of carrying out subcontracting after a dispute resolution has been reached; both parties need to avoid lengthy and destructive discussions, as such discussions and arguments only delay project progress. Therefore, we can see that the main contracts for international engineering projects generally include such provisions: disputes are set aside, and action is taken in accordance with the employer’s wishes first ； If the general contractor is not satisfied, they may apply to a dispute resolution body for a ruling later on. Obviously, these are very unfavorable terms for the general contractor. Such provisions have almost become standard practice in international engineering projects, and the general contractor has no choice but to accept them, unless it withdraws its bid during the bidding phase.

II. Risk Allocation: Whether the owner directly appoints subcontractors or the general contractor selects them on its own, the general contractor shall be liable to the employer for any breaches of contract by the subcontractors. There is no direct legal relationship between the employer and the subcontractor. This means that, in most cases, even if responsibility is attributed to the subcontractor, the main contractor will not be held liable for the subcontractor’s actions or omissions. Therefore, it is crucial to allocate risks reasonably and find an appropriate balance between the obligations of the general contractor to the owner and those of the subcontractors to the general contractor. The main contractor’s goal is to avoid any gaps or inconsistencies between the obligations it has toward the employer and those it has toward subcontractors. The general contractor needs to be able to claim from the subcontractor any compensation from the employer that can actually be attributed to the subcontractor. Undoubtedly, subcontracts will play a crucial role in risk allocation. In this regard, there are different methods to achieve such a result. (1) Customized subcontracts: In particularly complex projects, it is quite common for employers and general contractors to use customized contracts. In such a situation, when the general contractor subcontracts part of the work scope, the best approach is to carefully read each clause of the main contract and thoroughly assess whether (and how) the obligations under specific clauses are passed on to the subcontractors. After signing the contract, simply refer to the subcontract to avoid cross-referencing with the main contract. The downside is that a carefully drafted custom subcontract requires a lot of time, and if the main contract is modified, the subcontract must also be amended accordingly. (II) The parties to a formatted subcontract may also use standard contract forms, such as the FIDIC standard form contracts. These standard form contracts are widely used; the parties do not need to draft the contract from scratch and only need to modify specific terms. In such cases, the subcontract is either governed by specific standard subcontract clauses (such as the FIDIC Conditions of Subcontracting for Construction) or the terms of the main contract are appropriately modified. However, the parties may not pay sufficient attention to the specific conditions, and gaps may still exist in the legal relationships and risk allocation. (III) The third method for back-to-back contracts (widely used and often a source of many disputes) is to use back-to-back agreements and clauses, also known as “downstream clauses”. “A “downstream clause” is a contractual provision under which the parties incorporate some or all of the terms and conditions of the main contract into the subcontract by reference. All parties generally consider this approach to be a shortcut that indicates the intention of all parties (the main contractor and subcontractors) to hold the subcontractor liable to the main contractor with the same responsibilities as the main contractor holds toward the employer. However, both parties often fail to realize that, if drafted improperly, a back-to-back agreement may lead to future disputes, as it is inserted without a proper analysis of the terms of the main contract. Back-to-back agreements, although they save a lot of time in drafting, still require both parties to conduct thorough examination of the contract.

【Haichuan’s Grand Spending for National Day】No matter how high the mountains and far the distances, the moon over home remains full! https://bbs.hcbbs.com/thread-5702569-1-1.html (Source: Haichuan Chemical Industry Forum)

【Haichuan’s Grand Spending for National Day】Good news. There are only 132 days left until the next major holiday, the Spring Festival. https://bbs.hcbbs.com/thread-5702665-1-1.html (Source: Haichuan Chemical Industry Forum)

【Ten Years of Great Development in Chemical Engineering Equipment】2025–2035: From Black Shackles to Green Building Materials – A Transformation of Coal-Based Solid Waste https://bbs.hcbbs.com/thread-5702535-1-1.html (Source: Haichuan Chemical Industry Forum)