Financial Safeguards in Construction Contracts
1.0 Introduction
1.1 Clients normally provide for clauses in the contractual documentation pertaining to construction of works [buildings & infrastructure including maintenance] for financial safeguards to ensure against possible losses that may arise from claims due to poor performance of contractors and / or accidents resulting in injuries and damages caused to works/workmen and any third parties at the work sites or during construction.
2.0 Types of Financial Safeguards
2.1 The financial safeguards can generally be divided into two categories:
[a] Mandatory safeguards as required by laws of the country and local
authority; and
[b] Optional safeguards that are imposed by the owners of the works.
A - Mandatory Safeguards
2.2 Mandatory safeguards normally cover protection for workers involved in the implementation of works. The prescribed mandatory safeguards include the following:
[a] Safety working conditions;
[b] Compensatory payments against loss of income due to injuries or to
dependents due to death; and
[c] Compulsory insurance
2.3 The responsibility for implementing the relevant prescribed safeguards in Malaysia is assigned to several agencies/authorities. These are as follows:
[a] Ministry of Human Resources [Government];
[b] National Institute of Safety and Health [NIOSH]; and
[c] Construction Industry Development Board [CIDB].
2.3 All the above relevant authorities have authority to take legal action against those found to be responsible for any negligent action causing unsafe working conditions that may result in work site injuries or deaths.
2.4 The primary emphasis is on prevention of accidents at construction sites and other work places. This objective is implemented by several programs which include the provision of following:
[a] Guidelines on safe working conditions;
[b] Training on safe working methods;
[c] Monitoring the compliance of prescribed safe working conditions and
working methods; and
[d] Disciplinary and legal action where necessary.
2.5 In addition, the CIDB also has the added responsibility to develop the construction industry. The law provides for CIDB to collect a levy to finance its programs. The funds are also used for the following purposes:
[a] Registration of Contractors;
[b] Training or workers together; and
[c] Providing trained workers with limited insurance cover.
[Note: It is emphasized that different countries have different laws. These laws are generally very comprehensive in the developed countries with effective monitoring and enforcement with prompt revisions whenever it is realized that the existing laws/procedures/penalties do not achieve the objective of zero accidents. This level of importance to safety is a major contributing factor to absence of any major disasters in the developed countries. Unfortunately, the relevant authorities in developing and under-developed countries do not provide the same level of commitment to safety, thereby resulting in accidents on a regular basis that cause multi-million dollar losses. The media regularly reports construction site and work area accidents.
Readers are requested to obtain the prescribed legislation to obtain full details of the requirements in the country where the construction works may be located and in some cases also where they reside as is relevant to companies or individuals involved in overseas projects, either as owners or workers respectively.
B - Optional safeguards
2.6 The optional safeguards are those that are normally practiced in the construction industry. The main safeguards are as follows:
[a] Earnest Moneys - The objective is to ensure that the prospective bidders are genuinely interested and are bona fide in participating in the implementation of the works. The payment format can be in cash, bank draft/order, cashiers check or any other mode prescribed as acceptable to the client. The quantum can be from a few hundred to several hundred thousands and are commensurate with the administrative costs of the tender invitation. The moneys are refundable to the unsuccessful bidders who have submitted bona fide bids after the successful bidder is selected and has accepted the offer but are forfeited if the selected successful bidder fails to accept the bid for whatever reason.
[b] Performance Bonds - Successful bidders are requited to provide a bond/guarantee in the form of cash, or bond/guarantee issued by a licensed bank/insurance company operating locally. The standard quantum in Malaysia is 10% of the contract value which may be reduced to 5% if part of the progress payments is subject to any deduction of part referred to as retention moneys.
[c] Insurance Policies - Construction contracts terms & conditions generally provide for three types of insurances policies. These are:
- [i] Insurance of Works that provides for cover during construction and continues to include the defects liability period. The cover is for known and some anticipated risks. The quantum of coverage should be the estimated value of works that are at risk.
- [ii] Workmen Compensation Insurance Policy is intended to provide for financial compensation for workers involved in the implementation of the works who may be involved in accidents during construction. This insurance policy is supplemental to the policy provided by CIDB in the registration of workers. However Clients may take the coverage provided by CIDB Group Insurance Policy when specifying the scope of coverage in the WCI Policy.
- [iii] Public Liability or Third Party Insurance Policy is taken to cover possible claims from members of public or property owned by third parties who may suffer losses that can be attributed to the works being implemented.
- [Note: An article explaining in detail various aspects pertaining to the above referenced insurance policies has been provided in the Auditnet.org web site and published in the Monthly Newsletter Section in mid 2006. Readers can request an updated revised article by e-mailing the writer at his e-mail address: gursharan38@gmail.com]
- [iv] Professional Indemnity Policy - The objective of this policy is to cover risks of failure/damages to the works due to design failures. However this is rarely taken as the premium quantum that is to be borne by the Client can be very high as it is dependent on the value of the works to be constructed at risk. Further it may be almost impossible to prove negligence on the part of the designer in the event it occurs. Further legal action would be very high and any judgment, if received, may not have financial value as the professional/firm may declare bankruptcy and cease to exist. In some countries a cap is provided on the financial awards that may be made by the courts on certain professions but no such capping may be possible in respect of construction projects where the cost may be in billions. Insurance companies may not be willing to provide the cover due to the many unknowns and ‘gray’ areas.
3.0 Responsibility of Management
3.1 Management should provide for comprehensive and relevant procedures and internal controls to ensure that the prescribed safeguards are in place and all involved are aware of their existence and objective and legal/financial implications. Further, it is the primary responsibility of management to ensure that the contractual documents provide for and ensure that all the above and any other safeguard that may be relevant to the scope of works or method of implementation are complied with by line managers. The existence, relevancy and effectiveness should be monitored on a regular basis and prompt remedial action taken in the event of any observed weakness or shortcomings.
4.0 Role of Board of Directors
4.1 It has been observed that the responsibility of ensuring that the safeguards are existing, relevant and complied is deemed to be with the management with the Board of Directors having negligible role and responsibility in this respect. However, it is observed that in the developed countries, such as UK, Directors are beginning to realize the importance of these safeguards as is advised by the Institute of Directors and Health and Safety Commission. The Directors have realized the substantial direct and indirect gains that can be archived through increase in productivity and reduction in lost man-hours from sickness, medical costs, absenteeism, etc, by ensuring safe working conditions that can also result in insurance premium reductions. It is about time that the Directors give due importance to the aspect of financial safeguards and safe working conditions as it has direct effect on the successful completion of construction projects and profitability of the companies on which they have directorships.
5.0 Role of Auditors
5.1 It is the responsibility of the auditors, especially the Internal Auditors, to ensure that the safeguards that are prescribed are relevant, comprehensive, in line with current industry practices and most important are complied by those responsible. This should be done on a regular basis and should be part of the normal audit functions. Auditors should always keep abreast with the latest knowledge. Knowledge can be acquired by reading, browsing the Internet and also through continuous training by attendance of seminars that are relevant to the core activities of the client and their own scope of duties that should be compatible with the core activities.
6.0 Implications of Neglect
6.1 The adverse financial and legal implications of not providing or insufficient quantum of compliance of the above referred safeguards can have significant negative effect on the financial bottom-line of the Client in the event the works were to face implementation problems, accidents and damages including effect on third parties’ projects and individuals or by other parties on the Client’s works progress. Neglect can result in losses may also not be recoverable if caused by disruption of works from whatever reasons. With the advent of mega projects and advance of engineering knowledge in building and infrastructure construction projects costs may be in billions. Further, working conditions can be very challenging such as skyscrapers whose height can be several hundreds of meters, sites that are located in difficult site conditions such as hillsides, in the sea, or others where the conditions may not be known.
7.0 Recommendations
7.1 The best recommendation is for Management to take appropriate
relevant action by ensuring compliance of the prescribed safeguards.
Board of Directors should also be committed and ensure that management
members discharge their responsibilities. The last internal control is
the Auditor who should periodically confirm compliance of the
safeguards. The financial benefits can be substantial. Another
intangible benefit is the good reputation that can be gained when the
works are completed in time, at optimum costs and without any
disruptions. Goodwill that is gained can be a major contribute to future
advancement of the company.
Effective & Comprehensive Safeguard Provisions
Contribute to Increased Profits.
GSK/Dec 07
E-mail: gursharan38@gmail.com sharwant38@yahoo.com
The opinions, beliefs and viewpoints expressed by the various authors and forum participants on this web site do not necessarily reflect the opinions, beliefs and viewpoints of AuditNet®