Taken on trust

Supply chain interdependencies and thin margins make for a perfect storm should payment disruptions transpire. Of course, the Housing Grants, Construction and Regeneration Act 1996 sought to smooth cash-flow. It made it illegal for a party to avoid paying an amount due if it hadn’t issued the correct notices. Even if it had, the other person could adjudicate if it disputed the grounds for non-payment.

Nonetheless, the act can function only to the extent that contractors resolve to flex their muscles. Everyone knows a J. Wellington Wimpy (“I’ll gladly pay you Tuesday for a hamburger today”) – the customer who, like the Popeye cartoon character, pays late or not at all. Too often such conduct is tolerated in the belief that recovery will eventually materialise. However, restraint widens one’s exposure – firstly because an upstream insolvency may occur before payment is made but also because one can be bound to recompense subcontractors without money in the pocket, except within the limited circumstances of Section 113(1).

The evident answer is payment security. Yet rarely do contractors pursue this even as they readily furnish guarantees and retentions to underpin their own performance. Given that the revenues of some contractors outstrip their employers’, the reluctance appears odd.

Everyone knows that customer who pays late or not at all. Too often such conduct is tolerated in the belief that recovery will eventually materialise

Perhaps employers are mindful as they often use debt and external advice, which attract fresh levels of scrutiny. Perhaps contractors are loath to kick up a fuss in competitive tenders. Or it could be that they feel credit insurance and annual turnover are sufficient for them to swallow the occasional difficult project.

Such disdain can be dangerous, as we saw in the recession. Employer insolvency means contractors’ chances of salvaging unpaid sums are slim. A vigilant policy would be to only commit to a development where each party is certain the other can honour its responsibilities.

There has been one area, however, where contractors have routinely taken exception. That’s when they are unsure about an employer’s covenant strength. Offshore entities, special purpose vehicles (SPVs), trusts or other types of unincorporated association usually set alarm bells ringing. They should contemplate casting their cynical eye more widely, though.

Businesses with manifold internal controls before invoices can be paid, those lacking experienced personnel or advisers, or those saddled with reputations as problem payers are equally hazardous. It’s fair for contractors to regularly investigate clients’ ability to pay but no UK-specific standard form contract enables this.

It’s vital that the construction contract prescribes remedies in case the employer fails to comply with its escrow duties

So what collateral works best? Project bank accounts can be ignored since the current market has done just that. Obtaining a guarantee from the employer’s holding company or development lender isn’t always practical; the employer may be an SPV for its backers to profit from limited liability. Similarly, banks prefer not being on the hook to their borrowers’ project team, although they may settle for representing that there exist sufficient loan facilities.

By the process of elimination, the favoured measure is an escrow. This is an instrument between the contract parties and an independent escrow agent. The employer typically subscribes to put into escrow monies to cover two to three months’ cash-flow, which the agent then holds on trust. In the event the employer breaches the construction contract by failing to pay the contractor, the latter may call upon these sums.

Given the importance of the security offered by an escrow, it’s vital that the construction contract prescribes remedies in case the employer fails to comply with its escrow duties – for instance, permitting the contractor to suspend its obligations if the account is not topped-up following a pay-out. While the fine workings of escrow agreements, which are naturally legalistic, remain a mystery to some, the imminent arrival of a standard form should alleviate this.

Regardless, payment security alone may not be enough. It’s imperative that contractors follow the construction contract’s terms where clients may be in default. For prudence, they should further consider payment periods and protecting retentions through stakeholder arrangements or by offering bonds instead. It is not uncommon for contractors to reduce or withhold work where payments are late without issuing a formal notice to suspend. Such omissions risk muddying the contractual waters.

Contractors should remember that they have privileges and negotiating positions open to them. Exercising these is the most fruitful strategy to ensure they are paid in full and on time.

Francis Ho is a partner in Penningtons Manches