Applicable law for construction and engineering contracts: constraints on freedom of choice

This, in turn, has practical and commercial implications for how the works are to be executed and for which payments are to be made, among a plethora of other contractual obligations and responsibilities for project risks.

The freedom to choose the applicable law varies across legal systems in ways that contracting parties need to understand. Also in most, if not all, territories, ‘local’ laws will govern the performance of the works and others’ contractual performance. These ‘mandatory laws’ must be considered too.

We have looked at the position, both as regards the interpretative implications and the operation of mandatory laws, in a diverse sample of four legal systems and jurisdictions – England & Wales, China, Saudi Arabia (KSA) and the United Arab Emirates (UAE). This comparative survey serves to highlight how in reality the freedom to choose the applicable law differs considerably around the world.

The freedom to choose the applicable law

An ‘applicable law’ clause specifies which set of laws the court, tribunal, or other decision maker – for example, an adjudicator – must use to interpret the terms of the relevant contract. In the context of contracts for significant construction and engineering projects, which very often involve parties coming from different countries with different legal backgrounds, there will ordinarily be a desire on both sides to select a ‘neutral but reliable’ applicable law; however, ultimately the applicable law is a commercial matter to be negotiated between the parties often on a partisan basis. Whatever set of laws is agreed to apply, the choice should be stated clearly – as regards the substantive contract, then distinctly as regards other aspects such as the ‘arbitration agreement’ and the ‘conflict of laws’ clause.

In the absence of mandatory controls in this area, the negotiated outcome will usually reflect the relative strengths of the parties’ respective negotiating positions and their perceptions as to whether the proposed applicable law will be more or less favourable to one or other party. Considerations as to whether the proposed applicable law is capable of providing a sufficiently clear and certain legal foundation should also be relevant during negotiations.

All parties will want to have some confidence as to the meaning and effect of the contractual provisions and how they would be interpreted and applied in the event that the parties end up in a dispute. It will therefore be important for the parties to have a comprehensive understanding of the implications of the proposed applicable law when entering into the contract. Invariably, ‘local’ law advice will be required.

English law as the baseline

The laws of England and Wales (English law) are a common choice of applicable law for large international construction and engineering projects around the world, primarily due to their sophistication, stability and respect for party autonomy.

There are, however, some limits on the extent to which English law features are exportable. In particular, there are some mandatory features of English law which apply to construction and engineering projects situated within England & Wales which would not automatically apply to a project situated abroad even though English law has been selected as the applicable law.

For example, the statutory adjudication scheme, which will be familiar to anyone who has undertaken a major project in the United Kingdom, does not extend in application to projects outside England. Consequently, parties negotiating the applicable law clause to a contract must consider whether there is a similarly mandatory statutory scheme which will apply to the parties with respect to the foreign project notwithstanding the choice of English law as the applicable law and, if not, whether the contract ought to cater for the attainment of the same commercial aims that underpin the statutory adjudication scheme.

Another example of the limits of English law as the appliable law in a foreign project arises from the implication of statutory terms under the Unfair Contract Terms Act. That act does not apply to a contract where English law is the applicable law only by reason of the choice of the parties. This statutory limitation gives effect to the principle of freedom of contract flowing through English law – especially in the context of international contracts – by relieving the parties of certain ‘local’ legislative requirements. The absence of those implied terms may well reflect the intention of the parties, and if that is so then it will be important to understand whether there are other mandatory provisions of the law where the project is being undertaken which will nonetheless affect the way the parties perform the contract and comply with their respective contractual obligations.

Unforeseen consequences – diverse limits on the adoption of a foreign law

Under Chinese contract law, parties may validly agree to the application of foreign laws to their contract only where:

• one of the parties is a foreigner – with the nationality of a corporate entity usually being decided by reference to its place of incorporation;
• the subject matter of the contract is abroad – such as where the project is to be built outside of China; or
• the occurrence of the events giving rise to an obligation to be discharged by one of the parties is outside China.

For instance, a domestic contractor and a domestic developer negotiating for the construction of a project to be situated in China may not validly select a foreign law as the applicable law of their contract. However, if the design of the project is to be produced by a foreign architecture firm, that firm would be free to choose a foreign law to govern its contract with its domestic Chinese peer.

In jurisdictions such as the UAE and the KSA, to varying extents principles of Sharia law underpin the entire legal system. Generally, parties are free to negotiate their own terms of contract, unless the activities to which the contracts pertain are prohibited under Sharia law, a body of religious law that that forms a part of the Islamic tradition. These are not negotiable principles.

For example, in the KSA, contracts involving excessive uncertainty (‘gharar’) or deception are prohibited. Further, they are unenforceable. Similarly, contractual provisions dealing with interest (‘riba’) are generally unenforceable. The position in the KSA is now subject to the operation of the Civil Transactions Law, Royal Decree No. M/199, dated 16 June 2023 – which will enter into force on 16 December but with retrospective effect. This statute reflects the KSA’s aim of providing clear guidelines and enhancing transparency and efficiency in civil transactions.

In the UAE, the local courts will not uphold an agreement giving jurisdiction to a foreign court where the UAE courts themselves would otherwise have jurisdiction to determine the matter before them. Examples include certain matters relating to property situated within the UAE, transactions made in the UAE, or events which occurred in the UAE. Further, clauses purporting to give jurisdiction to foreign courts in matters – including commercial agency, employment, and certain UAE real estate – will not be recognised. This is commercially important because once a UAE court is seized of jurisdiction, it will apply Emirati law to the subject matter of the dispute. Foreign law will be a matter of expert evidence, at best.

Constraints on the scope of law applying to the performance of a construction contract

Even if there are no restrictions on the ability of the parties to choose the applicable law, it is very likely that the laws of the country in which a contract is negotiated, or the project is constructed, will impose mandatory requirements on the parties to the relevant contract.

In China, the law prohibits parties from contracting out of the mandatory minimum warranty periods. The mandatory minimum warranty period for the structure of a building equals the design life of the building, is five years for waterproofing, and two years for mechanical, electrical, and plumbing works. For certain projects, such as public utility projects and residential clusters, it is also mandatory for the contractor to appoint a licenced firm to supervise the quality of the works. These mandatory requirements cannot be displaced through the parties’ selection of the applicable law.

In many civil law countries, including KSA and the UAE, the concept of good faith is imported into all contracts regardless of the applicable law – although, notably, both the UAE and the KSA’s Civil Transactions Law include provisions codifying the principle. According to Sharia law, ‘good faith’ equates largely to having good intentions. The requirement for good faith is implied into all contractual relations. Thus, parties owe an obligation to each other before and after the formation of their contract to act in good faith. Parties can rarely avoid a clear term of a contract and, on the contrary, must apply contractual terms in good faith.

The good faith obligations will likely impact upon matters such as the level of intervention in construction works that is allowed by an employer; a party’s discretion to terminate or suspend the contract; and the employer’s discretion to claim pre-agreed sums under the contract, such as liquidated damages for delay. The good faith obligations will be interpreted according to the surrounding facts of each case, with particular regard to the knowledge of each party. In addition, the principle known as ‘abuse of rights’ prevents a party from enforcing its contractual rights in certain situations, such as where the exercise of that right is intended to solely cause harm to another or to exercise that right would be unlawful.

Riba, in Arabic, refers to interest or “usury” – that is, unreasonably high interest rates. Riba is forbidden in Sharia law. In the KSA, the courts will not award interest even if the applicable law to the contract would otherwise allow it. This does not, however, mean that interest clauses are not found in some Saudi-law-governed contracts. Many contracts contain interest provisions, and these are not problematic so long as the parties are themselves voluntarily abiding by them. Issues only usually arise when there is a dispute in relation to interest, in which case the courts will usually determine the interest clause to be void and unenforceable. If such a determination is made, the interest clauses in contracts can be severed, so that the rest of the contract will remain valid and enforceable.

The approach taken by the UAE courts is usually less strict than that seen in the KSA, and the Emirati courts will enforce interest provisions up to a point. Compound interest, however, will not be awarded and clauses requiring compound interest will not be upheld.

Construction contracts relating to projects carried out in the UAE will be subject to certain mandatory provisions of the UAE Civil Code. These provisions cannot be contracted out of through the parties’ selection of the applicable law. Similar provisions are found in other civil code jurisdictions such as KSA and Qatar. Of particular note is the imposition of a period of decennial – ‘10 years’ – liability which imposes strict liability – that is, where no fault is required to be proven. Designers and works contractors are jointly liable to pay compensation for any total or partial collapse of a building, or any defects affecting the stability or safety of a structure for a period of ten years from delivery of the work.

General guidance

The choice of the applicable law of the contract is an important decision and bears directly upon the way in which the parties’ rights and obligations will be interpreted and determined and thus upon the manner in which the project will be performed. However, the choice of applicable law must also be considered by reference to the limits of ‘exportability’ and the potential role of other laws which may have mandatory effect and affect the manner of performance of the contract.

It is not safe to assume that all applicable laws are ‘about the same’ when applied in the commercial context of a major construction or engineering project. A prudent party will give careful consideration to both the applicable law, or laws, chosen by the parties, and to the other potentially applicable legal requirements, before entering into the contract.

Co-written by Adrian Elliott, Nesreen Osman, Kevin Zhou and Melissa McLaren of Pinsent Masons.