Problems with payment provisions

You may already know ‘pay when paid’ provisions in construction contracts (that we have all seen!) are prohibited under the Housing Grants, Construction and Regeneration Act 1996 (as amended) (the “Construction Act”). However, did you know that the position changes if another party upstream is insolvent?

When a party involved in a construction project becomes insolvent, whether through liquidation, administration, or other insolvency proceedings, it can have significant implications on payment for those downstream. Every party in a construction project wants to protect themselves from these implications. But what is the best way to do that? Well one effective way is to take advantage of the insolvency exception on the prohibition of pay when paid clauses.

Section 113 of the Construction Act tells us that “A provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective, unless that third person, or any other person payment by whom is under the contract (directly or indirectly) a condition of payment by that third person, is insolvent”.

But be warned – this does not mean that any time a party upstream becomes insolvent you do not have to pay downstream! Firstly (and most importantly) you have to have a pay when paid on insolvency clause in your downstream contract. You will not be able to rely on the section 113 insolvency exception without it! Including this clause in your sub-contracts may sound unfair on the other party – but it’s important to remember you may not have to rely on it, and the clause will only be relevant if the employer (or maybe the contractor) goes bust. Think of it as an insurance policy. If you choose not to include the clause in your sub-contract, and the employer becomes insolvent, you could be liable for your subbie’s large bill while being paid very little (if anything) yourself.

The other factor to consider is the validity of your pay when paid on insolvency clause. One of the leading cases on this point is William Hare Limited v. Shepherd Construction Limited [2009], which was upheld in the Court of Appeal. Hare was Shepherd’s sub-contractor on a large development in Wakefield. Hare had a valid claim for works completed under the sub-contract. However, Shepherd withheld the money owed to Hare when the employer went into administration by relying on a pay when paid on insolvency clause in the sub-contract.

The clause incorporated the four specific insolvency scenarios set out in the Construction Act. However, Shepherd failed to take into account a change in the law when drafting the sub-contract: five years before the parties entered into the sub-contract, the Insolvency Act 1986 was amended to include two additional ways a party could enter into administration, including the ‘out of court’ route.

Unfortunately for Shepherd, the employer had used this out of court route to enter administration. The court therefore held that the pay when paid on insolvency clause was not effective, as Shepherd had not specifically included a provision for this type of administration in the clause that was within the contract.

The moral of the story is that you should always be including a pay when paid on insolvency clause in your sub-contracts – or at least giving it serious thought. It’s always better to have the clause and not rely on it, rather than be on the end of an upstream insolvency without it, and generally they are accepted in most cases. The protection these clauses offer are particularly important when we are seeing construction insolvencies left right and centre.

You should also bear in mind the cautionary tale of Hare v. Shepherd when drafting your sub-contracts. It’s not enough to only have the clause, you need to make sure it is accurate and effective for the type of insolvency events that may arise. If you are concerned about any pay when paid on insolvency clauses in your sub-contracts, or want to discuss introducing them, you know where we are…