Construction Law in Saudi Arabia – a Snapshot of Current Trends and Developments
Saudi Vision 2030 is a strategic framework that has three key pillars – to make the Kingdom of Saudi Arabia (the KSA):
At the heart of this hugely impressive objective is the intention to reduce the dependency of the KSA on oil, diversify the KSA’s economy and to develop the public services sector, including in respect of health, education, infrastructure, entertainment and tourism.
Saudi Vision 2030 has inevitably resulted in the KSA entering a period of rapid and dramatic transformation and has triggered the inception and development of many multibillion-dollar and highly complicated projects. These projects supplement the various oil and oil-related projects that continue to be procured with regularity, particularly in the eastern provinces.
While the booming construction market in the KSA offers many opportunities and rewards, there are inevitably accompanying risks and challenges.
Al Tamimi & Company has been advising participants from all sectors of the construction industry in the KSA for many years. In this article, the authors provide a snapshot of the legal framework in the KSA and discuss some key, and often interconnected issues in respect of which stakeholders in this incredibly exciting chapter of the KSA’s development should be aware. For convenience, these have been broadly characterised under the following headings: (i) liquidity; (ii) risk allocation; (iii) COVID-19; (iv) contract administration; and (v) dispute resolution.
The KSA legal framework
The KSA legal system is uncodified.
Islamic sharia is the main source of law, supplemented by laws enacted from time to time, including by the king and government departments.
Although the courts are not bound by precedent, decisions of the higher courts tend to be followed.
From a contractual perspective, the principle of freedom of contract prevails and, as such, parties are fundamentally bound by their contractual bargains, provided that the agreed contractual provisions do not offend sharia principles or any relevant legislation.
A topical piece of legislation is the Government Tenders and Procurement Law (the “Procurement Law”).
The Procurement Law applies to procurement activities by government bodies (as well as by companies that are majority-owned by the government). It is particularly significant given that the overwhelming majority of projects that comprise Saudi Vision 2030 are government sponsored and the Procurement Law was enacted with this in mind.
Although construction projects in the KSA have, until now, mostly been procured on a traditional construction-only basis, procurement is becoming increasingly diverse.
For example, several significant commercial developments as well as infrastructure projects are being procured on a design-build basis. Additionally, engineering, procurement and construction (EPC) (as well as engineering, procurement and construction management or EPCM) contracting is prevalent in the context of industrial facilities, while PPPs (public-private partnerships) continue to gain momentum, particularly in the areas of health, education, water and transport.
Although the discussion below is of general application, the majority of the issues raised probably resonate most strongly with "traditional"/design and build forms of procurement.
Key Issues and Risks
Despite the buoyant construction market in the KSA, many participants in the construction sector are experiencing significant financial difficulties, particularly in the form of restricted cash flow.
While such liquidity issues are often most acutely experienced at a contractor and subcontractor level, employers (especially commercial developers) are certainly not immune from having financial difficulties.
Although in the authors' experience this action is seldom taken, they strongly recommend that contractors take proactive steps to satisfy themselves as to the financial arrangements that the employer has in place to ensure that it can pay for the works that are being performed (this point is amplified as works are invariably paid for in arrears). Contracting with a financially unstable employer is a recipe for disaster and the authors are aware of several major players in the industry that have been left financially scarred due to the failure by employers to comply with their payment obligations.
However, a further (and perhaps the predominant) cause of liquidity issues in the market originates from the prevalence of "back-to-back" contracting and specifically "pay-when-paid" payment terms, which are legal and enforceable in the KSA.
This issue can be magnified as payment terms (even in respect of major projects) can be extended under main contracts.
For example, it is not unusual for a main construction contract to provide for certification periods of 30 days and for payment of the certified amount to be made up to 60 days from the date of certification, thus giving rise to payment cycles of 90 days.
Payment terms of this nature can place considerable strain on the contractual chain, particularly as the main contractor is likely to build in a buffer in respect of the timing of its own payment obligations to its supply chain (and this will cascade down the supply chain).
This strain can be further exacerbated by the fact that advance payments (if actually available) do not always fully cover mobilisation/set-up costs, while payment terms under the main contract (as well as subcontracts) are usually incompatible with the typical costs necessarily incurred under a construction contract (such as payroll and preliminaries). An additional significant issue is that conditional payment regimes are often opaquely drafted and can therefore be abused. For example, it is relatively straightforward for an unscrupulous main contractor to contend that it has not received any payment under the main contract (or payment for a particular subcontractor’s scope) and to therefore stall on its obligation to make payment to its supply chain.
The main contractor’s position in this regard can be strengthened as subcontracts often contain a prohibition against subcontractors liaising with the employer, meaning that the subcontractor is unlikely to have any certainty regarding whether or not the employer has actually paid the main contractor. Even if such a prohibition has been omitted, it is unusual for employers to concern themselves with supply chain issues (other than when it is in their interest to do so).
An added risk to a subcontractor engaged on a pay-when-paid basis is that the employer may not be making payments to the main contractor on account of a dispute that has nothing to do with the subcontracted works or services in question.
Notwithstanding the competitive contracting environment (and while the authors accept that such mitigants can be challenging to negotiate), the authors nevertheless recommend that stakeholders who are subject to conditional payment regimes seek to qualify the absolute nature of this risk allocation by building in certain safeguards.
Such safeguards may include such things as requiring the main contractor to (i) substantiate its position regarding receipt of payments from the employer under the main contract, and (ii) demonstrate the actions that the main contractor has actually deployed in an effort to recover payment.
Further approaches may include seeking to implement certain thresholds that apply to the pay-when-paid mechanism. For example, it could be commercially agreed that payments of less than (or over) a certain threshold amount will fall outside of a pay-when-paid mechanism or that the pay-when-paid structure shall be subject to a longstop date. In other words, it could be agreed that outstanding payments shall become due (even if they have not been received by the main contractor) by a certain date.
Another issue encountered with increasing frequency in the KSA construction market is that of payments made by the employer to the main contractor being diverted by the main contractor from the project in question and allocated to other purposes that are not connected with the project in respect of which the payment was made.
This situation typically manifests itself in subcontractors and suppliers not being properly paid and, in turn, sub-subcontractors (and so on) not being paid.
This creates fertile ground for disputes, as it is highly likely that a project that is starved of liquidity will experience significant delays and that the work performed will be substandard.
As a partial solution to this situation, the employer can include a clearly drafted right of audit in the main construction contract that provides transparency regarding how payments from the employer have been distributed by the main contractor.
Allied to this, the employer may also wish to reserve the right (but not the obligation) to make direct payments to subcontractors, if the employer reasonably considers that amounts due have not been paid by the main contractor to its subcontractors.
It should be clearly documented that any such direct payments are made on the basis of necessity (and without creating any contractual relationship between the employer and the subcontractor), while the employer should reserve the right to set-off such direct payments from future payments that are due to the main contractor.
Agreed risk allocation under a construction contract also directly interfaces with liquidity issues, particularly as the materialisation of a particular risk can have profound consequences in terms of cost (as well as time).
As in other markets, the dual principles that risk should be (i) accepted by those who are best placed to manage the risk in question and (ii) adequately priced are generally accepted in theory in the KSA. However, the highly competitive tendering environment in the KSA (in respect of which price is often the decisive factor), as well as the general reluctance of employers to meaningfully negotiate can result in contractors being unable to properly price risk, thus leaving them exposed.
Although whether or not to execute a particular contract is ultimately a commercial decision, willingness to accept onerous contractual terms can constitute a de facto condition to entering the KSA construction market, while commercial requirements to fill order books can be compelling.
In terms of examples of onerous risk allocations, the authors are aware of situations where contractors have accepted the entire risk of ground conditions in respect of major developments even though it was not possible for the site conditions to be properly evaluated during the tender phase. In another similar example, the contractor, without any recourse, relied on inaccurate geotechnical data that was provided to it on the basis that the contractor would independently verify the accuracy of such information.
These incidences resulted in contractors – at their own risk – having to blast rock and deal with significant ground-water issues, both of which had significant time and cost consequences.
A further risk that is often encountered (and that is underestimated) concerns the design approval process, which frequently requires direct interface and collaboration with key stakeholders.
It sometimes happens that designers (particularly from an international background) are unfamiliar with the nuances and the particular requirements of the Saudi regulatory and design approval environment.
Obtaining approvals can be a time-consuming, repetitive and intricate process and its complexities can easily be underestimated.
It is therefore recommended that design teams that are experienced in the KSA construction market (including engineers of record) are engaged from the outset and both the employer and the contractor co-operate and collaborate with the intention of procuring the required approvals from the necessary stakeholders.
While onerous contracts and one-sided risk allocation can quickly result in contractual rights accruing in favour of the employer, it is often prudent for employers to carefully consider whether it is actually beneficial to the project for it to strictly enforce its contractual entitlements.
For example, a delay may have been caused on account of the occurrence of a contractor risk event. However, the deduction of delay damages may be counter-productive as this step is likely to create an adversarial relationship and also deprive the contractor of much-needed cash flow. This may further inhibit the contractor’s ability to perform the works.
Indeed, any deduction of delay damages from the contractor (i) may mean that the contractor is no longer incentivised to complete the works as expeditiously as possible (particularly if the agreed cap has been exhausted) and (ii) is likely to result in the contractor deducting delay damages from its subcontractors. As above, this may have a detrimental impact on performance (including in terms of quality) and hinder the completion of the project (thus delaying the inception of a revenue-generating asset).
Although each situation needs to be considered on its individual merits, it may be advisable for the employer to collaborate with the contractor and to potentially defer enforcing entitlements until at least the completion of the project or perhaps to waive some or all of that entitlement. Another option (which is relatively unusual) is for employers to consider offering "positive" incentives to the contractor, including in the form of early completion bonuses.
As is the case in all other jurisdictions, the onset of the COVID-19 pandemic has affected the construction sector in the KSA.
Construction sites in the KSA largely remained open despite lockdowns and as a result, the impact of COVID-19 has typically manifested itself in the form of cost escalations and supply chain issues.
For example, some projects were severely disrupted by prohibitions and restrictions regarding the delivery of long-lead items from overseas (including on account of the closure of manufacturing facilities and transport interchanges).
While the allocation of risk in respect of COVID-19-related issues may have been addressed contractually, any contractually agreed risk allocation is potentially "trumped" by a Supreme Court decision which characterised the COVID-19 pandemic as an “emergency circumstance”.
As a consequence, the Supreme Court decided that a contractor should be entitled to an extension of time as well as to additional costs to the extent to which it can be established that any delay or increase in cost is attributable to COVID-19.
However, it is important to highlight that the mere existence of COVID-19 does not necessarily give rise to relief. It is incumbent upon the contractor seeking relief to establish how it was impacted by COVID-19 and the authors note that this fundamental requirement is not always understood by contractors (some of whom regard the mere existence of COVID-19 as carte blanche to demand relief).
As in other jurisdictions, concerns have been expressed regarding the adequacy of the administration of some projects in the KSA.
If a FIDIC-based construction contract is being used, it is likely to be administered by the engineer appointed by the employer.
Although the engineer is required to act “fairly” when making determinations, allegations of bias towards the employer have been raised on a number of occasions. Typical examples of such alleged bias include broadly interpreting the scope to deny variation claims and ignoring "acts of prevention" by the employer that have caused or contributed to delays and/or cost overruns.
Perceptions of bias can create an adversarial contracting environment which is in neither party’s interest and it is therefore important that employers impress on the engineer the need for the contract to be administered fairly, if the engineer is under the incorrect impression that one-sided administration of the contract is beneficial to the employer.
If the contractor considers that an engineer has erred in making a decision, it is important that the contractor strictly follows the prescribed procedure for challenging the decisions that it disagrees with. This point is made all the more significant as construction contracts frequently state that a determination becomes binding unless it is challenged within a prescribed timeframe.
Aside from the determination of contractor claims, it is imperative that the engineer diligently and proactively supervises the contractor’s performance, particularly by measuring actual performance against the requirements set out in the programme and/or the method statement.
If issues of non-performance can be identified early, it is invariably far easier to address incidences of non-compliance at their outset by ensuring that appropriate rectification measures are put in place, while the implementation of such rectification measures needs to be closely monitored.
Additionally, close monitoring of the project typically unearths the root causes of non-performance (ie, the main contractor’s failure to pay its supply chain) and the smooth completion of the works will be facilitated if the causes of non-performance can be addressed from the outset.
Alternatively, if confidence is lost in the contractor’s ability to actually complete the works (ie, on account of liquidity issues, including if the contractor has under-priced the works), it may well be prudent for the employer to take decisive action.
Among other things, a well-drafted construction contract will provide for clear grounds for termination and also outline the consequences of this action. In particular, the employer should have sufficient security in place that can be called upon to cover the upfront costs arising out of termination for cause (such as the cost of engaging a replacement contractor), while the employer should also have a clear basis upon which to recover any other cost and expense arising out of the termination (including any additional cost to complete).
However, a construction contract should not be terminated without a coherent and "stress-tested" contingency plan being put in place, which addresses the appointment of a replacement contractor (as well as obtaining the necessary licences and approvals for the replacement contractor to proceed with the works) and also anticipates the terminated contractor’s likely combative response to its termination.
In the authors' experience, decisive action regarding the replacement of a non-performing contractor should be taken as early as possible. Indeed, once the works are relatively well advanced (but are not nearing completion) the "balance of power" can easily swing in favour of the non-performing contractor, thus making termination an unappealing option.
This is primarily because few contractors in the market are willing to take on unfinished projects (including on account of supply chain issues), while the employer may well be concerned about losing "single point responsibility", as it is unlikely that a replacement contractor will accept responsibility for works performed by a terminated contractor (particularly as it will be virtually impossible to verify the adequacy of such works).
In this situation, the employer’s lost leverage may result in the employer electing to make concessions to the contractor on a commercial basis – such as making account payments (usually against the satisfaction of pre-defined milestones) or waiving entitlements – in order to facilitate the completion of the works.
As in many other jurisdictions, participants in construction projects in the KSA typically want disputes to be resolved as quickly and as cost-effectively as possible.
While construction contracts contain a range of dispute resolution mechanisms, commercial settlement discussions are invariably a first step.
Although such discussions need to be conducted on a frank and candid basis in order to be meaningful, parties should be aware that the principle of "without prejudice" is not officially recognised under KSA law and, as such, appropriate protections need to be put in place.
Dispute adjudication boards (DABs) remain relatively unusual in the KSA market, but there has been an increase in the use of expert determination procedures, particularly in respect of disputes of a "technical" nature.
While such mechanisms can certainly be effective in resolving disputes, care is required to carefully define the disputes that fall under the jurisdiction of the expert, as what is meant by "technical" can be highly subjective.
This could result in disputes that have a significant legal (as well as technical) component being determined by an expert who may have insufficient legal knowledge. Furthermore, this position can be exacerbated if, as is frequently the case, it is stated that the expert’s determination is "final and binding, save in respect of fraud or manifest error".
Mediation is also gaining popularity, in respect of which the Saudi Centre for Commercial Arbitration has produced comprehensive rules that will apply in default if the parties have failed to agree on any alternative mediation rules. On 5 May 2020, the KSA ratified the United Nations Convention on International Settlement Agreements Resulting from Mediation (Singapore Convention), which provides for the reciprocal enforcement of valid settlement agreements in signatory states.
Arbitration is frequently used to finally determine disputes under construction contracts, particularly on the basis that arbitrators with expert knowledge of the construction industry can be selected and the Procurement Law permits disputes concerning government entities to be determined by arbitration.
Furthermore, the popularity of arbitration has increased following the enactment of the Arbitration Law (which is inspired by the UNCITRAL Model Law and applies to all arbitral proceedings seated in the KSA), while the KSA is also a signatory to the New York Convention.
However, court litigation also remains a frequent mode of final dispute resolution in respect of which the Commercial Court is the competent court to hear disputes between private parties, while the Administrative Court has jurisdiction over disputes that involve government entities. The Riyadh Convention generally allows for the reciprocal enforcement of court judgments in various Arab nations.
The above discussion provides a brief overview of some of the prevailing issues in the buoyant KSA construction market.
In conclusion, it is recommended that all project participants carefully consider and negotiate risk allocation under the contracts they are contemplating executing.
Once executed, contracts should be carefully administered so that all potential issues and bases for contention are proactively addressed from the outset.