Contractual Risk in Construction Contracts: Practical Legal Guide

Construction projects involve complex relationships, long timelines, and significant financial exposure, making contractual risk almost unavoidable. Without clear and well-drafted construction contracts, these risks can quickly escalate into disputes, delays, and financial losses.

Legal Framework of Construction Contracts in Indonesia

Construction projects typically involve multiple parties, long timelines, and high transaction value. These characteristics make construction contracts highly exposed to legal and contractual risks. A construction contract serves an essential function as it legally regulates the rights and obligations of the party, including the project timeline, quality standards of the works, mechanisms for variations, payment terms, and others.

In Indonesia, construction contracts are governed by Law No. 2 of 2017 on Construction Service as amended by Law No. 6 of 2023 on Stipulation of Government Regulation in Lieu of Law No. 2 of 2022 on Job Creation into Law (“Construction Law”), Government Regulation No. 22 of 2020 on Implementing Regulation of Construction Law as amended by Government Regulation No. 14 of 2021, and the Indonesian Civil Code. Under Article 47 of Construction Law, construction contracts shall at least govern the identity of the parties, work description (scope of work, value of work, etc), rights and obligations of the parties, labour, payment system, dispute resolution, termination of contract, force majeure, and building failure provision. For government projects, additional rules apply under President Regulation Number 16 of 2018 on Procurement of Goods/Service as amended by President Regulation Number 12 of 2021.

Contractual Risks in Construction Contract

Contractual risk refers to potential problems arising from a contract that has already been agreed upon. These risks may arise from financial obligations, regulatory and contractual arrangements, or the performance of the construction works themselves. If not properly anticipated and managed, contractual risks may lead to disputes, project delays, cost overruns, or even contract termination. Based on common practice in construction projects, contractual risks can generally be categorized into financial aspects, regulatory aspects, and contractual performance aspects, as explained below.

Financial Risk of Construction Contract

In a financial aspect, contractual risks arise from payment arrangements, financial security, and potential monetary liabilities during or after the implementation of the construction contract. Some common examples of contractual risk in the financial aspect include:

1. Delay Damages
   Delay damages may be imposed when a contractor fails to complete the works or achieve agreed milestones within the contractual timeframe. Risks arise when the contract does not clearly regulate the daily penalty rate, the maximum cap of delay damages, or exceptions where delays are not caused by the contractor. Unclear or disproportionate delay damages clauses often lead to dispute.
   
   
2. Termination Cost
   In the event of contract termination, various financial obligations may arise, such as payment for completed works, reasonable demobilization costs, and compensation in cases of termination for convenience. The absence of clear provisions on termination consequences may result in uncertainty and financial disputes between the parties.
   
   
3. Bank Guarantee Liquidation
   Construction contracts commonly require performance security or advance payment guarantees. Financial risk arises when bank guarantee clauses are ambiguous or bank guarantee cannot be enforced because it has expired or because the claim submission procedure does not comply with the terms and conditions stipulated in the bank guarantee itself.

This risk can be mitigated by ensuring that the bank guarantee clause is drafted clearly and consistently, and that its terms are aligned with the relevant provisions in the construction contract.

Regulatory and Compliance Risk in Construction Contract

Contractual risks under the regulatory and contractual aspect arise from non-compliance with applicable laws and regulations, as well as from unclear or poorly drafted contractual provisions. Contractual provisions that violate laws and regulations may be deemed null and void and have no legal effect. Even when the parties intend to regulate certain rights and obligations, improper drafting or ambiguous language may create legal uncertainty and increase the risk of dispute. Common examples of contractual risk in the regulatory and contract aspect include:

1. Unilateral Termination
   Contractual provisions allowing one party to terminate the contract unilaterally (termination for convenience) may create legal risk if they are not clearly justified and proportionately regulated. Such clauses may violate the principles of balance under Indonesia law, especially when exercised without substantive grounds. Based on existing jurisprudence, namely in Decision 24/Pdt/2017/PT. DKI and Supreme Court Decision 600 K/Pdt/2018, the judge was of the opinion that the inclusion of a clause allowing one of the parties to terminate the agreement unilaterally violated the principle of balance so that the clause was declared invalid and had no legal force.
    

   Unilateral termination for convenience clause may be considered as invalid if they breach the principle of balance.

2. Intellectual Property Rights
   Construction projects often involve designs, software, technical documents, or reports. Contractual risks arise when ownership, licensing, or usage rights over such intellectual property are not clearly regulated in the contract, potentially leading to disputes over ownership and permitted use. To mitigate this risk, the construction contract should expressly regulate the transfer of intellectual property ownership for the final project deliverables. In addition, the contract should clearly regulate the ownership, use, and protection of all intellectual property related to the project to avoid future disputes. When there is a termination of contract, a clarity whether the project owner would retain the right to further use the design prepared by a contracted or consultant of which contract is already terminated, is crucial.
   
   
3. Unclear Dispute Settlement Clauses
   Contractual risk may arise when a construction contract does not clearly regulate the dispute resolution mechanism. The absence of clear provisions on dispute resolution may delay the settlement of disputes, and one party wishes to resolve the matter through arbitration, requiring a further arbitration agreement to be reached. In addition, the failure to specify key matters such as the seat of arbitration or the number of arbitrators may also delay the arbitration process.

Ambiguous dispute resolution clauses may result in uncertainty regarding the competent forum. For example, a contract may state that:

“if no agreement can be reached through deliberation, the parties agree to submit the dispute to the Indonesian National Arbitration Board (BANI), which shall decide based on the applicable law and be conducted in Jakarta, or through the South Jakarta District Court.”

This clause creates uncertainty because it provides both arbitration and court litigation as dispute resolution options. Under Article 11 of Law No. 30 of 1999 on Arbitration and Alternative Dispute Resolution, the existence of a written arbitration agreement removes the parties’ right to submit the dispute to the District Court. As a result, such wording makes the dispute resolution clause unclear and may lead to jurisdictional disputes.

Contractual Performance Risk in Construction Contract

Contractual performance risks relate to how the construction works are executed in practice and whether the parties fulfil their contractual obligations. Common examples of contractual risk in the contractual performance aspect include:

1. Delay in Project Completion
   Delays in project completion may arise from various causes, including delays caused by the contractor due to poor project management or poor quality of the works. In such circumstances, it is important for the contract to clearly stipulate that the contractor bears responsibility for the delay and may be subject to delay damages.
   
   Delays may also be caused by the employer, whether due to changes in design or specifications, late payment, failure to provide access to the site, or delays in issuing approvals that prevent the contractor from commencing or continuing the works. In these circumstances, the contract should clearly regulate the contractor’s entitlement to an extension of time and/or compensation for additional costs, depending on the situation.
   
   In addition, delays may occur as a result of force majeure events beyond the parties’ reasonable control. Provisions governing force majeure are essential to ensure that such events are not treated as a contractual default by either party, nor used as a justification for non-performance in situations that the event could have been prevented or reasonably mitigated. The contract should also clearly regulate the contractor’s entitlement to an extension of time in the event of force majeure.
   
   
2. Variation Orders
   Variation orders are changes to the scope of work, specifications, or construction methods agreed under the construction contract. Changes to the scope of work are common in construction projects. Contractual risk arises when variation orders are implemented without prior written approval or without clear agreement on additional costs and time extensions. This often leads to disputes over payment and project timelines.
   
   
3. Lack of Proper Documentation
   Lack of proper documentation is a common source of contractual risk in construction projects. Construction contracts generally require instructions, approvals, variation orders, and claims to be submitted in writing and within specified time limits. Failure to comply with these requirements may result in the loss of contractual rights, even when the underlying event has actually occurred. In practice, many issues are discussed informally without proper written records. Without documents such as formal notices, meeting minutes, or written approvals, it becomes difficult to prove the cause of delays, responsibility of the parties, or entitlement to additional time or costs, which often leads to disputes.

Conclusion

Contractual risks are a natural part of construction projects due to their complexity, long duration, and high transaction value. Such risks may arise from financial arrangements, regulatory and contractual structures, as well as the performance of the construction works, and may lead to disputes, delays, and financial losses if not properly anticipated and managed. Effective mitigation of contractual risks relies on clear and precise contract drafting, proper written documentation, and fair and balanced risk allocation. Key provisions on delay damages, variation orders, termination, bank guarantees, dispute resolution, and intellectual property rights must be drafted clearly and implemented consistently.

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Sources:

• ET-Asia Webinar on Procurement and Contract Administration in Practice by Dr. Eddy M. Leks;
• Indonesia Civil Code;
• Law No. 30 of 1999 on Arbitration and Alternative Dispute Resolution;
• Law No. 2 of 2017 on Construction Service as amended by Law No. 6 of 2023 on Stipulation of Government Regulation in Lieu of Law No. 2 of 2022 on Job Creation into Law;
• Government Regulation No. 22 of 2020 on Implementing Regulation of Construction Law as amended by Government Regulation No. 14 of 2021;
• President Regulation Number 16 of 2018 on Procurement of Goods/Service as amended by President Regulation Number 12 of 2021.