19th January 2018

Cash flow in the construction sector – the Insolvency Exception

A key objective of the terms of construction contracts is to allocate construction and other commercial risks, including cash flow risk in supply chains.

A key objective of the terms of construction contracts is to allocate construction and other commercial risks, including cash flow risk in supply chains.

Outside construction, commercial parties usually have freedom to contract on the terms agreed between the parties, including using ‘pay when paid’ clauses to allocate cash flow risk. This practice of employers and main contractors in the construction industry pushing that risk down the supply chain was historically commonplace until it was largely prohibited by the Housing Grants, Construction & Regeneration Act 1996 (“the Construction Act”), except in certain circumstances of insolvency.

Pay when paid clauses

Such a clause would usually mean that the payer is only obliged to pay the payee once the payer has been paid sums by a third party. Section 113 of the Housing Grants, Construction & Regeneration Act 1996 (as amended) (“the Act”) made ineffective and prevents the enforcement of "pay when paid" provisions - with one exception.

If the clause provides that a payment is conditional on payment being received by a third party, that clause will still be effective and enforceable where that third person is insolvent. This insolvency exception also applies where payment by a third person is, under the contract, itself conditional (directly or indirectly) on any other person making a payment and that other person is insolvent.

Whether this insolvency exception applies depends specifically on what the contract terms say. It is not automatic on insolvency occurring. Even if one of the Carillion companies that entered compulsory liquidation on Monday lies within a supply chain of construction contracts, it does not necessarily mean that no party should be paid whilst the insolvency process is concluded. It may be that a clause permitted by the Section 113 exception is not present or effective at all points in the supply chain.

This could have a material impact on the cash flow of all parties in the supply chain, depending on how payment terms have been agreed and documented. A timely review of payment provisions and careful compliance with notice requirements under the Act and contract can help protect the parties.

The idea that the rules may change on insolvency occurring may be seen as unfair, as the credit risk is re-allocated down the supply chain. Sub-contractors (and their own sub-sub-contractors) might be regarded as acting as credit insurers to the senior contractors on insolvency occurring.

There are also gaps in the provisions and how they may work where (as Carillion's Liquidators have stated they will) payments are made for services or payments are eventually made as dividends. How are these then to be shared, if at all in the supply chain?

There is similarly no obligation to provide information on any funds received from the Liquidator. If a main- or sub-contractor received 30p / £, may that be retained by the contractor or shared with the supply chain?

The Act provides the essential obligation that the payer must pay the sum notified (following the tightly prescribed rules under the Act) on or before the final date for payment. However, this provision does not apply where:

  • the contract provides that, if the payee becomes insolvent, the payer does not have to pay any sum due; and
  • the payee has become insolvent after the prescribed period for serving a pay less notice”.

Some standard form contracts, such as the JCT 2016 Design & Build Contract, include such a clause but assumptions should not be made. Careful drafting is needed with bespoke payment provisions. Care is required to control cash flow risks by the timely issue of the notices required by the Act.

Many cases come before adjudicators and the courts on these issues. The drafting and procedures adopted may need to accommodate changes in the law. Often, the way contracts are negotiated, the use of outdated terms or failure to incorporate properly the written terms that a party thinks are agreed causes uncertainty, so a “pay when paid” clause may not be enforceable. This occurred in William Hare v Shepherd Construction (2010) when the clause that the paying party sought to rely on had not taken account of changes in the law.

The interaction of contractual provisions, the Act and insolvency (including insolvency set-off in liquidation or administration) is not straightforward and timescales are short. Construction parties need to look lively.

For advice on specific insolvency-related issues, please contact Mark Cullingford.

For advice on reviewing construction contracts, please contact Eric Livingston.

For advice on insolvency and payment issues, please contact Steve McCombe.

 


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