Payment to subcontractors: The direct approach

In his column at the end of last year (Building 6 December 2013, page 47) Ian Yule pointed out that one of the major difficulties with contractual provisions allowing for direct payment is that they could fall foul of the 1986 Insolvency Act. Insolvency law requires all creditors to be treated equally (the pari passu rule).

Where a lead contractor has failed to make payment because he has gone into insolvency (this would also extend to administration even though the administrator may ultimately save the company), direct payment could be regarded as treating the subcontractor as a preferred creditor, thus breaching the pari passu principle.

The above concern was prompted by a majority decision of the [then] House of Lords in the British Eagle case in 1975. This was not a construction case but it has always been assumed to be applicable to construction. Almost 20 years ago in his report for both government and industry SirMichael Latham recommended that there should be legislation making clear that the British Eagle decision did not apply to construction. This recommendation can now – finally – be actioned.

Article 71(3) of the revised EU Public Procurement Directive gives member states the option to provide in the transposed law that contracting authorities pay subcontractors directly where the subcontractor requests this.

Furthermore Article 71(7) gives member states the option to require contracting authorities to pay subcontractors directly without them having to request this.

The Cabinet Office has been consulting on whether to take up one of these options and make direct payments mandatory.

Where a lead contractor has gone into insolvency, direct payment could be regarded as treating the subcontractor as a preferred creditor, thus breaching the pari passu principle

The 1975 French Law of Sub-Contracting introduced an obligation upon both public and private sector clients to make direct payments to subcontractors. This law places a limit on the extent of the employer’s obligation of “the amount he still owes to the main contractor at the date of receipt of a copy of the form of notification.”

The position is slightly different where the contracts involved are in connection with public sector procurement. Here the direct payment obligation allows the employer to pay the subcontractor directly and, in the process, exempt the main contractor from his payment obligations to the supply chain.

Legislation enabling direct payments from clients to subcontractors can also be found elsewhere.

The Miller Acts in the United States require that lead contractors working on federal, state and local public sector projects provide bonds to their subcontractors to guarantee payments. Liens legislation in North America also have provisions for direct payments.

The issue with direct payments relates to the amount that the client should pay the subcontractor. For those public sector works coming within the scope of the Construction Act the solution is fairly straightforward.

In the absence of a pay less notice the amount to be paid must be that in the notice issued by the payer or payee or in a payee’s default notice.

If the paying party has issued a pay less notice the amount in that pay less notice must be paid by the final date for payment.

Providing that the relevant notice is valid under the act then the contracting authority is able to make a direct payment of the amount stated in the notice.

This notice procedure does not, of course, apply to contracts outside the scope of the act. Such contracts could include projects in the utilities sector such as nuclear plant construction. The option for direct payments can be taken up in respect of utilities contracts.

In this situation the direct payments could be activated in the event that an invoice is outstanding and there has been no response from the paying party justifying his failure to make payment or the payer does not provide a legitimate reason for not discharging full payment.

Direct payments will have the added benefit of ensuring that greater care is taken in appointing lead contractors. A history of poor payment performance or solvency issues are likely to exclude some from public sector procurement.

Rudi Klein is chief executive of the Specialist Engineering Contractors Group