Termination payments and costs “reasonably incurred”

A recent decision of one of the UK’s highest courts has considered the extent of a contractor’s entitlement to payment after the termination for convenience of a FIDIC 1st Edition contract. The terminology considered by the court is commonly found within the termination provisions of other standard form construction contacts, making the decision of wider interest in an area where there is little previous case law. In finding that the contractor’s costs in this case had not been reasonably incurred, the decision highlights the significance of such restrictions and the more generous approach taken by some standard forms.

Termination payments under the standard forms

Many common standard forms used for construction projects include a requirement that, in certain termination scenarios, the contractor is to be paid – among other things – the costs reasonably or properly incurred in anticipation of completing the works. For example, in the FIDIC 1st and 2nd Editions the contractor is entitled to recover, upon termination for convenience, employer default or Force Majeure / Exceptional Events, “any other Cost or liability which in the circumstances was reasonably incurred by the Contractor in the expectation of completing the Works” (clauses 19.6(c) and 18.5(c) respectively). The 2nd edition also permits the recovery of loss of profit.

In the NEC3 and NEC4 standard form, the contractor is entitled to recover, for any termination, “other Defined Cost reasonably incurred in expectation of completing the whole of the works” (clause 93.1, termination payment “A1”). In the Infrastructure Conditions of Contract (ICC) form, upon termination for employer default or frustration, the contractor is entitled to recover, “any cost reasonably incurred by the Contractor in the expectation of completing the whole of the Works …”.

The requirement under these forms for costs to be incurred reasonably contrasts with the more generous approach taken under the ENAA form where termination for convenience or employer default entitles the contractor to recover “any amounts” to be paid to subcontractors as a result of the termination, as well as the cost of other obligations undertaken to third parties “in good faith” (clause 42.1.3, Process Plant Construction).

A recent decision of the Privy Council (composed of members of the UK’s highest court) has considered the termination for convenience provisions of the FIDIC form and sheds light on when termination costs can be said to have been “reasonably incurred”.

Water and Sewerage Authority of Trinidad and Tobago v Waterworks Ltd

The Water and Sewerage Authority of Trinidad and Tobago (“WSATT”) entered into two FIDIC 1st Edition Yellow Book contracts with Waterworks Ltd (“Waterworks”)  for the design and construction of water treatment plants. The contracts were terminated for convenience before designs had been finalised with no construction work having taken place. Over a year prior to the contracts being terminated, Waterworks entered into contracts for the supply of equipment for the plants. Under those contracts, Waterworks was liable to pay cancellation charges calculated at 30% of the total price.

Waterworks claimed these cancellation charges were recoverable under clause 19.6 of its contracts with WSATT. This clause was unamended from the original quoted above, requiring that costs be “reasonably incurred” in the expectation of completing the Works. Waterworks claimed that it was common practice for contractors to seek to “lock in” prices quoted by suppliers once a main contract had been entered into – so as to avoid price increases which could not be passed on.

The trial judge considered it would have been unreasonable for Waterworks to have entered into unconditional supply contracts at a point in time when designs had not been approved by the Employer. However, the trial judge considered Waterworks’ supply contracts to be akin to an option, whereby Waterworks agreed to purchase equipment at some point in the future in return for the supplier holding its quoted prices, but subject to a 30% cancellation charge if the purchases were not ultimately made.

The Court of Appeal in Trinidad and Tobago disagreed with the trial judge, finding that Waterworks had entered into unconditional supply contracts and that this was unreasonably premature in the absence of approved designs. Waterworks appealed to the Privy Council in the UK.

Unreasonable supply contracts

The Privy Council agreed that Waterworks had entered into unconditional supply contracts. As to reasonableness:

• Reasonableness could not be inferred where the project was at an early stage. The fact that no steps had been taken to perform the supply contracts reinforced that impression. It was “prima facie unreasonable” for Waterworks to agree cancellation charges in relation to a period when the supplier was not incurring any costs or liabilities for which compensation was required.
   
• Evidence was required from Waterworks to displace this prima facie position. For example, any long-lead time activities the supplier was to undertake such as arranging export and import permissions or arranging its own sub-supply contracts.
   
• The only benefit properly evidenced by Waterworks was the protection said to be obtained against subsequent price increases. However, there was no evidence that this was actually the reason for the placing of the supply contracts. There were also contrary indications; for example, the supply contract was entered into almost 2 years after the contracts with WSATT.
   
• In any event, other means of protecting against price increases could have been explored, such as an agreement to hold prices for a given price. There was no explanation as to why such options had not been explored.

The meaning of “reasonably incurred”

The Privy Council also provided guidance as to the meaning of the term “reasonably incurred” in the context of a termination claim:

“… as a general rule under a contract of this kind the contractor is entitled to proceed and to incur costs and liabilities on the assumption that the contract will be performed. Arguments that, because the contractor knew or ought to have known that the employer was likely to exercise its right to terminate the contract early for its ‘convenience’, the contractor acted unreasonably in ordering materials or equipment required if the works were to be performed will not generally carry weight. … To hold back from expeditious performance because of an expectation that the contract was likely to be terminated before completion would … expose the Contractor to a risk of liability to pay liquidated damages and incurring other additional costs in the event that the contract was not terminated early for which it would not be entitled to any compensation from the employer. It is unreasonable to expect the Contractor to take such a risk.”

Accordingly, the fact that various problems arose after the contracts were signed which gave rise to a likelihood that WSATT would terminate for convenience were not relevant to whether Waterworks had acted unreasonably in placing the supply contracts when it did. However, the court was not able to agree with the full extent of Waterworks’ submission that it was sufficient for the purpose of clause 19.6(c) to show merely that costs had been incurred in “genuine expectation of completion of the works and that, had the works been completed, those costs or liabilities would have been no more than reasonably necessary to perform the contract”.

In the court’s view, the fact that a contractor was entitled to assume that the contract will be performed did not mean that “all questions of timing are irrelevant in applying the test of reasonableness. A prudent contractor would not generally commit itself to purchasing equipment before it is needed (taking into account delivery times) and before the designs to which the equipment must conform have been finalised.”

Conclusions and implications

This is a significant decision from one of the UK’s highest courts as to the meaning of termination clauses which permit a contractor to recover costs reasonably incurred at the point of termination. The court’s decision shows that a contractor need not pre-judge whether the contract will be terminated, but mere bona fides in committing itself to supply contracts and sub-contracts will not be sufficient to ensure recovery. Work or equipment ordered too far in advance of when it is needed may be subject to question.

The decision also highlights the significance of the more liberal drafting adopted by contracts such as the ENAA form, which permit any payments, or any bona fide payments, to sub-contractors or suppliers to be recovered.

It is notable that Waterworks’ claim failed entirely, even though other charges (for example, to hold the quoted prices for a certain period) may have been reasonable had Waterworks proceeded differently. It is unclear if an alternative claim for such charges would have been successful had Waterworks produced evidence to support them.

Many standard forms also entitle a contractor to claim more generally for losses incurred as a result of termination, in addition to costs “reasonably incurred” in anticipation of completing the works. This is the case in all of the forms quoted above in relation to employer default, and also in termination for convenience scenarios under the FIDIC 2nd Edition and NEC3. It is unclear whether these more general provisions would enable a contractor to avoid the need to show that costs had been reasonably incurred.

References:

Water and Sewerage Authority of Trinidad and Tobago v Waterworks Ltd (Trinidad and Tobago) [2025] UKPC 9