How builders could protect themselves from drastic changes in market conditions

Author: Georgi Vassilev, attorney at law firm "Benov, Vassilev and Natskov"

"Builders stop selling greenfield properties", "Greenfield property deals stop due to price spike", "Shock for the property market! Greenfield deals stop" - these and other similar headlines have abounded in the media space over the past few months. The reason for them is related to the drastic increase in the price of construction materials, energy sources and the already raging high inflation wave, which is why a large part of the construction business in our country, although continuing to build, has stopped concluding preliminary sales contracts until the construction process has reached a stage that allows builders to make an assessment of the cost price of the properties and their market prices.

Without underestimating the seriousness of the current economic situation in our country and internationally, such media noise and sharp turns in the business behavior of the construction industry are exaggerated, as the law has long provided mechanisms for dealing with such situations of economic uncertainty, in which, due to the constantly rising levels of prices of raw materials, labor or goods and services in general, the business is exposed to serious risk when concluding long-term contracts. What should a merchant do when he does not want to miss out on a secure client now for his future production or service, but is uncertain about how much it will actually cost him to provide this production/service in the future?

The answer is simple – by providing in customer contracts the so-called price determinability clause, also called price update clause or price indexation clause. Behind this terminology is actually the possibility provided in the law for concluding a contract at a price not initially determined, but at a determinable price. In order to meet the requirements for fairness, predictability and transparency of contractual relations, however, price determinability should not be made dependent on subjective criteria, but should be based on objective external factors that can be reasonably perceived as measures of changes in business and economic life and therefore can be relied on for the fair distribution between the trader and the customer of the risks of unpredictable market fluctuations.

There are cases known from practice where the clauses for price determination set out in contracts consist of very laconic formulations such as "the price set out in the contract changes accordingly to the change in the market index ..." Indeed, most often the clauses for price determination in practice tie the contract price to the changes in a certain market index, but setting this condition in the contract in such a blanket manner hides serious risks of future disputes with an unclear outcome. The introduction of contractual clauses for indexation/update of the price is a responsible task, the implementation of which should take into account a number of specifics. Here are some of them:

A BRIEF GUIDE TO WRITING THE PRICE INDEXATION/UPDATE CLAUSE

(1) Establish a base price subject to update.

The unit price of a product/service to be updated should be fixed as precisely as possible. Specify whether the base price is per unit or per quantity. Specify the specific month and year for which the base price is set; this point in time is often called the base point in time. If agreed, specify a period of time during which the base price will remain unchanged.

(2) Select an appropriate index or indices.

These are economic business indicators maintained by reliable bodies and institutions, which aim to objectively measure changes in price levels and the business climate over time. This information, in turn, can serve to update the base price initially provided for in the contract, so that in the future the trader can maintain his initially provided profit margin and not be forced to enter into expensive and uncertain cases for economic unsustainability of the contract. In the specific example of the construction industry, a suitable such index would be the official CCI index for new construction price trends maintained by Eurostat (the EU statistical office).

(3) Clearly indicate the chosen index and cite a reliable source of information about it.

The contract price update clause should identify the selected index or group of indices, providing information on its exact name and identification code. The clause should also refer to a specific official or other source of up-to-date index data.

(4) Specify whether indices with or without seasonal adjustments will be applied.

In general, seasonally adjusted indices are not suitable for a price update clause. Since this clause is usually intended to capture real price changes, contracting parties would in most cases not want to eliminate seasonality in price level changes for the purposes of their contract price calculations.

(5) Specify the price update frequency.

The price update clause should clarify how often the price will be updated – quarterly, semi-annually, annually or some other period. The price update should be calculated at specific time intervals, starting from the base point in time of the contract. As explained above, this is the time associated with the agreed base price. Problems could arise in contracts that do not provide for a specific frequency of price updates. The following paragraph and guideline (7) provide more details in this regard.

(6) Provide procedures for missing information or discontinuation of the selected index.

There are cases where statistical information from the selected index is not available, most often because the source information on price levels has not been provided to the statistical authority/institution by a significant number of respondents. Highly detailed indices are more susceptible to such a problem than indices with a higher level of generalization. For such cases, the price update clause should provide procedures for obtaining the missing information from the selected index. Sometimes it is possible to permanently discontinue the maintenance of a given index, if, for example, a given product suddenly loses its market importance. This is also the case when a given index does not meet the minimum standards for publication, in which case the contractual clause on price determinability should provide guidelines for replacement indices when the maintenance of the initially selected index is discontinued. If the institution maintaining the index makes a change to the name or code of the relevant index, it essentially continues to be the same index, therefore such a situation should not require renegotiation of the established price update clause.

(7) Please note that the most current version of the index information at the contractually agreed time of calculation of the price indexation should always be used for price indexation.

This rule requires the contracting parties to explicitly specify the base time point and subsequent months of the index that will be used to calculate the price, as well as the exact time point at which the calculation itself will be performed to establish the update. Compliance with this rule can save many future problems. Contracts that do not provide for such agreements should indicate which version of the index information should be used for the purposes of calculations, because:

(a) some indices update the information in them a certain period of time after their initial publication;

(b) sometimes these time periods change; and

(c) although in rare cases the information of an index may be subject to corrections.

For effective compliance with guideline (7), it is important not only to determine the frequency/intervals of the price update, but also the indicative date on which the update will be carried out.

The contracting parties' choice of a price update date should only be made after they have previously agreed on: (a) the month of the base time, (b) the time interval for the price update, and (c) whether the calculation will be based on the initially published or the final index values for the month selected for comparison in the price indexation. It is extremely important that these issues are clarified before signing the contract. Otherwise, disputes could arise if the initially published index information and its final values differ.

If the parties do not specify a specific date for the price update, the contract should at least stipulate whether the initially published index information or its final values will be used for the purposes of the calculations. Where possible, the use of the final values of the index information is preferable, because only the final values will be replaced retroactively when the initial base values of the index are changed by the institution maintaining it.

The contract should not refer to index values relative to the base price, but rather to the index values for the relevant month and year. For example, the following referencing could create problems in the future:

"Divide the current index value by 103.9 (this is the index value for the base time point January 2010) and then..."

Such an agreement should be written as follows:

"Divide the index value that corresponds to the month of the price update by the index value for January 2010, which represents the index value at the base time point, and then...."

(8) Do not tie the indices used for price update purposes to a specific base period on which the index is based, as this base period may be changed by the institution maintaining the index.

(9) Define the methods of price update.

(a) Simple percentage method.

In this method of price update, the base price changes by the same percentage as the corresponding index changes. Let us illustrate this with a concrete example – let us assume that the price update clause provides for the index “X”, without seasonal adjustments, and that its value for December 2010 was 178.4 and this is the base month for which the base price under the contract is set at 1000 euros per unit of production. Twelve months later, when the index information for December 2011 is released and when the first price update should be calculated, the index value for December 2011, published in mid-January 2012, was 187.7. The percentage change shows an increase of 5.2 percent in the index values and a corresponding increase of 52 euros in the base price per unit of production.

(b) Update of part of the price.

This method provides for only a portion of the base price to be updated against the selected index, while the rest of the price remains fixed.

(c) Composite indices.

Some contracts provide for the construction of a composite index based on different indices. The advantages of a composite index are that it can more accurately identify the appropriate price change in the base price, since it refers not to one, but to several of the costs associated with the production/provision of the relevant product/service. However, a composite index involves more calculations at the time of updating than the simpler methods described above. Although composite indices are based on official index values, they are not official indices themselves.

(d) Limiting price update.

Price adjustment clauses sometimes include a lower or upper threshold, or both, in order to set limits on price indexation for the duration of the contract. However, sometimes contracts stipulate that the adjusted price cannot fall below the base price, i.e. movement can only be in the upward direction. It is also possible to stipulate that price adjustment should only be activated above certain levels of change in the reference index values.

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