Direct payment clauses: Caught in the middle

Retailer John Lewis is reported to be considering the introduction of a clause into its contracts that would allow it to pay subcontractors direct if the main contractor does not do so (Building, 15 March). The intention behind such a clause is to avoid potential disputes downstream - in particular, where a subcontractor is threatening to suspend work for non-payment. The clause would then allow the employer to recoup the sum paid from money otherwise due to the contractor in the next interim application.

There are obviously commercial issues with this sort of arrangement. Many main contractors would be none too happy about what they would see as interference. They would regard the management of subcontractors and suppliers as their business, not the employer’s. But leaving aside these points, what are the legal issues with direct payment clauses?

Direct payment clauses were in vogue over 20 years ago. The law reports from those days are full of horror stories where employers got involved in costly three-way disputes

One problem for the employer is that it may have swapped one dispute for another. The main contractor may have valid reasons for not paying its subcontractor. It may believe that the subcontractor has carried out defective work or there may be valuation issues. Alternatively, the contractor may have some deductions to make by way of set-off - for example, for delay or disruption costs that it has incurred through the subcontractor’s breaches of contract.

Here the employer will have a decision to make. Is the main contractor merely trying to hang on to the cash? Or does it have a genuine reason for not transmitting the payment on? Such scenarios may be difficult for an employer to bottom out, even if the clause gives it the right to call for documents from themain contractor to assist. The danger is that if the employer misjudges the position, it may find itself on the receiving end of an adjudication from its contractor.

The employer could consider obtaining a separate indemnity from the subcontractor. This would require the subcontractor to repay if it turned out that the contractor was right all along not to have paid the money over. But this would require direct pre-contract negotiation with the subcontractor over and above requiring a standard collateral warranty or third party rights agreement. The employer might ask itself at this stage whether the control that it was getting over the subcontract was worth the potential downside of having to act as a referee between two warring parties.

One area where direct payment would not be possible is where the main contractor has gone into liquidation. It has been clear since a case in 1975 called British Eagle that a payment in such circumstances could be seen as an attempt to give a benefit to one unsecured creditor (the subcontractor) over others. In such a case, the liquidator could still claim the money from the employer, leaving it in the position of having paid out twice for the same work.

This could be avoided by the employer putting money in a separate trust account and using that account to make any required payments to the subcontractor. Since the contractor would have no claim on the account, the liquidator would not be able to get his hands on it.

However, that is moving away from the realm of simple direct payment clauses and into the area of project bank accounts.

Direct payment clauses were used in standard building contracts when nominated subcontracting was in vogue over 20 years ago. The law reports from those days are full of horror stories where employers used nominated subcontractors and then got involved in costly three-way disputes. As a result, that form of contracting is now rarely used and has disappeared from the JCT contracts, for example. Direct payment clauses themselves vanished from JCT in 2005.

Arguably, if an employer wants to control its subcontractor, it should consider construction management, whereby it has direct contracts with the various trade contractors, and engage a construction manager to do the management only. That needs a good construction manager, of course.

The commercial issues are also not to be underestimated. Main contractors augment their profit margins by making use of their cash holdings. If they have to give up the right to decide when to pay, they might want recompense by way of an increase in the contract price. And any clause that is intended to strongarm the main contractor into paying on time does not necessarily set the relationship off on the right footing.

Ian Yule is a partner in Weightmans