Risk Allocation: The Pentagon Renovation Project
Summary of a Presentation by Andrew Blumenfeld
Chief Counsel, Pentagon Renovation Project
Conceptually, the renovation of the Pentagon is best viewed as urban renewal in a decayed rust belt city. This particular city has three defining characteristics: its size; the diversity of purposes it serves; and the extent of deterioration.
The Pentagon is a fairly self-sufficient complex that houses everything from bagel kiosks to extremely sensitive military command centers and everything in between. There is a fire department, a police department, shopping, and myriad other spaces and functions (Figure 7.1).
Prior to 1998, the renovation of the Pentagon was being overseen by 5 separate organizations in 2 agencies. No one entity was in charge of the overall success of the project, although different agencies were responsible for individual elements, creating an environment of fragmented authority and decision making, leading to ineffective project execution. As a result, there was an inability to control changes to the project scope of work. There were numerous modifications very late in the design and construction process, which prevented the general contractor from operating efficiently. Projects were coming in 50, 60, or 70 percent over budget and well behind schedule. The entire renovation was on the verge of being cancelled.
Department of Defense decision makers recognized these problems and restructured program responsibility, in both function and reporting. A single program manager was given the authority and resources to manage the project.
The program manager initiated significant changes in job management and operations. A switch was made from a design/bid/build to a design/build project delivery system. Concurrently, the solicitation approach was changed from a low bid to a best value process. The use of prescriptive, detailed specification contracts was abandoned in favor of performance requirements-based contracts. The staff was reorganized from a “stove piped” or individual discipline approach to an integrated project team. More communication with senior leaders in the Pentagon was instituted. As a result, the situation improved significantly and projects are routinely under budget and ahead of schedule.
The Pentagon, more than 60 years old, is only now being renovated. All major building systems are well beyond their design lifetimes and are beyond repair. The building has hazardous materials present throughout, does not meet modern building code requirements, and is far from being energy efficient (Figure 7.2).
PENTAGON RENOVATION ACQUISITION SYSTEM
The Pentagon moved away from using a low bid process for several reasons. First, low bid is inappropriate in situations with many unknowns, certainly the case at the Pentagon. Second, market forces inherent in the low bid process drive the contract price to the cost of performance or below it. The contractors enter the process driven to find ways to make a profit. A common practice is for
contractors to identify problems that will result in change orders and claims in order to drive additional work over the original contract. Thus, turmoil, confusion, problems, and time delays can serve to increase profits for the contractors. In this type of operating environment, contractors enter the process as adversaries. Employing this practice is not necessarily how the contractors would like to work, but is seen as a way to make a profit in a project with a low bid process. Third, the low bid method deters some of the best firms from competing for the work, particularly given associated federal reporting requirements, cost accounting standards, and other issues.
The new Pentagon renovation acquisition system is a two-phased, best value process. In the first phase (initial down-select), any interested firm can respond to the request for proposals (RFP) by submitting a summary of their experience with similar work and sufficient information to allow for extensive reference verification for both design and construction work. This phase progresses quickly and allows contractors to respond to an RFP with minimal expense. The two to four most qualified firms then emerge from the pool of responders.
The second phase, or final selection, is very different. Pentagon project owners and managers meet with the most qualified firms to review contract specifications and drawings in detail. They solicit and receive suggestions from the firms on how the Pentagon can modify its bid packages. The Pentagon representatives ask the most qualified firms to submit a priced offer with a conceptual design. This phase is costly for the contractors, so the Pentagon offers stipends ranging from $20,000 to $100,000, depending on how much work is involved in responding. Phase Two results in a conceptual design, competition that benefits the owner, best value, and a realistic budget.
The resulting contract has only one major objective: to align the interests of the general contractor with those of the owner. The contract is structured as a fixed-price incentive (firm target) with an award fee. The first source of profit for the contractors is the award fee, which ranges up to approximately 10 percent of the contract price and is based on performance. This is a subjective evaluation by the owner, typically conducted every 90 days. The owner scores the contractor and provides a fee in regular intervals. Firms receive payment within two to four days of their evaluations.
The second source of profit is the traditional guaranteed maximum price (GMP) sharing of under run. The government and the contractor share any savings. The share line is adjusted based on the particulars of individual projects, but it has ranged from 50/50 to 70 percent for the government and 30 percent for the contractor. To be eligible for sharing in the under run, the contractor must perform well on the award fee evaluation. We also split overruns 50/50, up to 120 percent of the contract price.
From the owner’s perspective, the principal benefit of the award fee is that it provides an opportunity every 3 months to reward contractor behaviors that are cooperative and helpful. It also provides an opportunity to “send a message” by withholding some award fees when behaviors are counterproductive.
The Pentagon has also dramatically reduced the size of the specification and drawing packages. The traditional specification package for the first phase of the Pentagon renovation (before 1998) included about 3,500 pages. Massive specifications are cumbersome and almost ensure conflict. Contracts have since been reduced to approximately 16 pages of broadly defined performance objectives and thresholds that must be met. The intent is to tell the contractor what is needed, not how to achieve the desired product. Contractors are given broad leeway to design the job in an efficient manner.
EQUITABLE RISK ALLOCATION
The core principle that the Pentagon has reorganized around is that dispute minimization begins well before the contract is awarded. The single most important element of dispute minimization is the equitable distribution of risk.
One of the principle functions of a contract is to allocate risk and doing it well is critically important. In my view, no form of alternative dispute resolution (ADR), partnering, or other good dispute minimization techniques can overcome a fundamentally flawed allocation of risk. There must be an
allocation of risk which reflects the commercial reality of the project, not merely the relative bargaining power of the owner in relation to the general contractor.
There are two principle methods of allocating risk. One is the active method, which is most appropriate for large, complex projects. This is a project-specific plan where the owner develops a detailed understanding of his risk profile. Active risk allocation typically requires substantial planning, time, and cost. There is an up-front cost the owner must be able to bear.
Active risk allocation is suitable for large projects that involve renovation of an existing structure, which is always risky, and projects with unknown factors that are beyond the control of either party. Such factors include geotechnical or environmental conditions, restricted site access, permitting, historic preservation, political issues, hidden conditions, and market/inflation risk in a multiyear contract. Rather than write a contract that puts all of the risk on the contractor, the owner can write a contract with a common baseline. If the actual situation turns out significantly different from the baseline, the contract price can be adjusted (Figure 7.3).
The second useful risk allocation procedure is pre-price general conditions cost. If the project is likely have some delays, as the owner I want the general contractors who are bidding on the project to tell me how much it is going to cost for each day the project is delayed. Then, as exigencies arise, I can have a fairly good estimate of potential delay costs.
With multi-year projects such as the Pentagon, inflation of materials costs is a significant cost driver. The Pentagon hired a cost estimating firm to create a custom inflation index of the materials used on the project. Every three years the base price is adjusted to reflect changing market conditions.
For multi-year projects, it is also in the owner’s interest to have a bilateral exercise of options. A bilateral option exercise gives both the owner and the general contractor the ability to “opt out” of future work by giving timely notice to the other party. First, as an owner, I don’t want to work with a contractor who doesn’t want to be there. Second, bilateral option exercise dramatically reduces risk for a general contractor and, as a result, the initial bids will be somewhat lower.
Establishing limitations on markups in projects employing a large number of specialty contractors is also a useful practice for an owner. I am reluctant to permit markups on work performed by others beyond a certain cap.
Active risk allocation also includes contract type, of which there is a range: from hard money lump sum, to guaranteed maximum price, cost, incentive, time and materials; or a hybrid combination of any of these.
Passive risk allocation is the standard package of clauses found in government contracts or the American Institute of Architects standard form contract. These are allocations of general purpose for items such as differing site conditions, site investigations, unusually severe weather, permits and responsibilities, changes, and the like. Passive risk allocation is appropriate for vertical construction on a previously undeveloped or “green” site, smaller projects with manageable unknowns, standard commercial office spaces, and most federal construction projects.
USING LEVERAGE WISELY
It is not uncommon for owners to attempt to shift the project risk to the contractor up-front because of their leverage at this point in the process. Owners do this by adding clauses that impose no damages for delay, shifting the risk of defects in specifications and drawings to the general contractor. However, commercially unreasonable allocation of risk almost always fails. First, it drives away the top firms, who will choose not to bid on the project. Second, it creates an atmosphere of distrust. Third, it requires contractors to include in their proposals large risk contingencies that may not be realized. Fourth, is the phenomenon called “balloon theory.” This is where the owner uses the contract or a regulation, or other leverage to attempt to squeeze costs out of one area. However, these costs will pop up in another area. The courts disapprove of these risk-shifting provisions.
The key is using leverage wisely. Leverage in a construction project, particularly a big construction project, shifts between three principle parties: the owner, the general contractor, and the subcontractors.
In the solicitation and award phase, owners have all the leverage. They can dictate the contract type, the specifications, and the project delivery method, as well as who can bid (based on past performance, bonding or other factors), award criteria (low bid, best value), and allocation of risk through specific contract clauses.
When the owner awards the contract, leverage is shifted to the general contractor. When selecting subcontractors, the general contractor can choose whether or not to honor the subcontractors’ pre-award bids, or may “shop” the bids, or adjust significant terms and conditions. In many cases, the subcontractors are relatively powerless at this point and faced with a take-it-or-leave-it contract.
At the mobilization and construction phases of the project, the leverage shifts from the general contractor to the subcontractors, who are responsible for delivering a significant portion of the job. Some subcontractors may feel the need to recover losses through change orders and claims if the general contractor has used them badly. In short, what goes around comes around. If the situation has reached this point, partnering, or other ADR techniques will not work. Effective partnering requires fairness from the beginning.
Another good reason that owners and general contractors should use their leverage gently is the time factor. Phase 1, where the owner has the leverage is very brief, probably 1-3 months. Phase 2, award to the general contractor, may last 1-3 months. For the remainder of the project, which may take several years, the subcontractors have the leverage. No one should be surprised if subcontractors who have been treat unfairly in Phase 2 “return the favor” in Phase 3.
ADR, partnering, and other hybrid methods of dispute minimization begin with equitable allocation of risk where leverage is used to create an atmosphere of trust. Complex projects require active risk allocation and careful planning. To help create trust and foster communication in the Pentagon renovation project, the owner’s representatives, the general contractor, and the subcontractors, all work closely in the same space or trailer. Maximizing communication is critical, but trust cannot be achieved if the allocation of cost and risk is fundamentally flawed.
A number of best practices that emerged during the course of the Pentagon renovation are listed below.
Best Practices for General Contractors
Manage and coordinate subcontractors proactively.
Maintain project continuity by (1) involving the project manager in bid preparation and (2) avoiding staff reassignments before substantial completion.
Avoid frivolous changes by carefully screening subcontractors’ proposed changes and their costs; establish a minimum change value; control indirect costs (general conditions, home office overhead, cumulative markups).
Offer solutions, not just descriptions, when unexpected problems arise on the critical path.
Hold separate meetings to discuss solutions and “who pays” when resolving issues on the critical path.
Best Practices for Project Owners
Develop concise specifications and drawings based on national codes.
Use commercial standards to the extent possible; unique requirements discourage firms from bidding on the project.
Pay invoices in a timely manner to avoid friction at the job site.
Provide adequate authority at the job site so that decisions can be made quickly when something unexpected happens.
Speak with one voice.
Safeguard the critical path by (1) providing clear and timely direction to the general contractor, (2) providing timely responses to requests for information, and (3) clearly acknowledging changes in the contract scope in writing.
Hold separate meetings to discuss solutions and “who pays” when resolving issues on the critical path.
Finally, contract clauses that allow contractors to “match existing” or to use a brand name “or equal” product have proven to be one of the leading causes of claims and disputes. If you are the owner and you have no intention of accepting other than the cited product, just say so. And general contractors should resolve any questions they have about matching existing materials when preparing their bids.
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