The insolvency exception to the pay-when-paid ban

Five years ago, the overwhelming majority of respondents to a government consultation requested the removal of the insolvency exception to the ban on pay-when-paid clauses. The government refused to act.

The exception in section 113 of the Construction Act applies where a third-party payer up the supply chain has gone bust and your payer uses a pay-when-paid provision to deny payment of outstanding amounts.

This exception was inserted at the last minute in the draft bill after lobbying by some large main contractor organisations.

But it is fundamentally unfair. It requires subcontractors to act as insurers of both main contractor and client insolvency. Assuming you still have access to credit insurance, a debt owed by a third party to your own payer is not an insurable interest.

In addition, the exception is unworkable:

• If a main contractor receives money from the administrator of an insolvent client, there is no mechanism in section 113 for allocating the money among the different subcontractors
• There is no statutory obligation on the main contractor to inform its subcontractors of any funds it has received from the administrator.

So, are subcontractors powerless to do anything if their payer denies payment because of the insolvency of a third-party payer? The Court of Appeal decision in Hare vs Shepherd Construction points us towards a possible answer.

Hare was a subcontractor to Shepherd. The client went into administration. Clause 32 of the subcontract contained a pay-when-paid clause to apply if the client went into administration. Section 113 originally defined an administration order as one made by the court.

This definition of administration was repeated in clause 32 of Hare’s subcontract drafted in 1998. But the Enterprise Act 2002 (Insolvency) Order 2003 had amended section 113 to include out-of-court appointments (for example, by creditors of the insolvent company). This amendment applied to contracts made after 15 September 2003.

Hare’s subcontract with Shepherd was entered into in December 2008, but clause 32 had not been amended. Hare had issued two applications for payment for just under £1m.

Shepherd had issued withholding notices freezing the payment on the basis that no money had been received from the employer. Previously, the client’s board of directors had decided to appoint an administrator. Shepherd argued that clause 32 must now be read so as to include the situation where the administrator is appointed out of court.

Mr Justice Coulson held that clause 32 clearly stated that the pay-when-paid clause could operate only in the event of the court appointing an administrator.

Since ignorance of the law is no excuse, the parties were deemed to be aware that, five years before December 2008, the Enterprise Act had amended the Construction Act. Therefore, Shepherd should have amended clause 32 so it could operate pay-when-paid arrangements where an administrator had been appointed out of court.

The Court of Appeal approved the judgment of Mr Justice Coulson, who said pay-when-paid clauses were “a form of exclusion clause”.

Lord Justice Waller in the Court of Appeal added: “[The pay-when-paid] clause was not truly sharing the risk of insolvency, it was relieving Shepherd of a liability to pay which they otherwise had.”

Now we have a judicial “nod and a wink” that pay-when-paid clauses in this context are exclusion clauses, we can attack them using the Unfair Contract Terms Act 1977. The fact that the Construction Act permits this limited use of pay-when-paid clauses does not make them immune from such attacks.

The onus will be on the main contractor to demonstrate that the clause was reasonable. Section 11 of the 1977 act requires that the clause should have been “a fair and reasonable one”, having regard to the circumstances in contemplation of the parties when the contract was made.

The case law on the act suggests that a total exclusion of liability would generally be regarded as unreasonable, especially when the party who objects to the clause does not have the means to accommodate the risk.

The advice to subcontractors wishing to challenge a pay-when-paid provision in these circumstances is to obtain a quick decision from an adjudicator that, by virtue of the Unfair Contract Terms Act, the clause is not reasonable and, therefore, not valid. Alternatively, a final decision can be obtained from the court.

Professor Rudi Klein is a barrister and chief executive of the Specialist Engineering Contractors’ Group

Original print headline: A new weapon in an old battle