Direct payment or bust

As reported in Building (8 January, pages 22-24), the best hope for this year is 1% growth. At worst, output will shrink 1.5%. While keeping my fingers crossed that the industry does not head in this direction, my thoughts inevitably turn to the sort of legal problems that arise during or immediately after a period of recession. Rather like buses, a host of court decisions on the same topic tend to come along, late in the day and all at once. For example, in the early 1990s, we had a number of decisions on the status of retention funds in building contracts and, shortly after, a few cases on how performance bonds are supposed to operate.

Often, these cases arise against the background of the insolvency, or pending insolvency, of at least one of the parties to the contract. From the employer's perspective, one of the most pressing tasks in the event of a contractor's insolvency will be to keep the existing team in place, find a replacement contractor and get the job restarted as soon as possible with the least amount of disruption. Keeping existing subcontractors on board in such circumstances may involve the employer deciding whether it can pay them directly.

The problems that arise when employers pay subcontractors directly have plagued the industry for many years and, unfortunately, show no sign of being resolved. This is one of those areas where the principles established in one part of the law (construction) clash with the principles established in another (insolvency).

These difficulties arise out of the pari passu rule, the principle of "fair treatment" that operates in an insolvency situation. In a case of liquidation, for example, a trust is imposed over all the unsecured assets of a company, and the creditors' debts are converted to the right to claim in the proceeds of sale of those assets. If its claim is admitted by the liquidator, a creditor is entitled to a dividend, each creditor receiving the same percentage of its debt as all the others. Subcontractors will rank as unsecured creditors of contractors when they become insolvent. Consequently, a direct payment by an employer to a subcontractor in the event of a contractor's insolvency offends the pari passu rule and is therefore illegal. Even if the employer has already paid the subcontractor, it will have to pay the liquidator as well.

This issue has come before the courts on a number of occasions, but has yet to be resolved. Unfortunately, one of the leading English decisions in this area has confused matters further. British Eagle International Airlines Limited vs Compagnie Nationale Air France1 concerned an arrangement whereby the International Air Transport Association acted as a clearing house to settle mutual rights and liabilities between airlines.

The court had to decide whether a liquidator was bound by the clearing house arrangement. The House of Lords decided by three to two that the arrangement was void against the liquidator of British Eagle, notwithstanding the fact that the authority of the clearing house was stated to be "irrevocable".

• Contracts should allow for direct payments to subcontractors in insolvency cases

• Government must amend the Insolvency Act 1986 to reverse the effect of the British Eagle case

It seems that the British Eagle decision closed off the possibility of using a direct payment clause in the event of the liquidation of a company. However, in practice, companies very rarely, if ever, go straight into liquidation: they usually go into administration or receivership first.

Strictly speaking, the British Eagle decision does not apply to receiverships or administrations, although this is not entirely free from doubt. Is it possible to operate a direct payment provision if the contractor is in administration? This depends on the contract.

Notwithstanding the obvious merits of permitting direct payment to subcontractors in these circumstances, the JCT has attempted to remove the power to make a direct payment after termination for insolvency altogether2. Practice Note 24 does not explain why direct payment is no longer available where the contractor enters receivership or administration, even though it recognises that the pari passu rule does not apply in such circumstances. Instead, the note assumes (wrongly, I think) that since liquidation will inevitably follow administration or receivership, the end result will be the same.

  In addition, the contract is unclear and poorly drafted in places. The definition of the "insolvency events" in clause 27.3.1 of JCT98 does not tie in with the list of events in clause 27.6.2.2 (which deals with direct payment to subcontractors) and, even more damaging, the list of events in clause 27.6.2.2 appears to exclude receivership. Consequently, it may be possible to argue on the wording of 27.6.2.2 that you can pay subcontractors directly if a receiver is appointed.

What can employers do to address these difficulties? An appropriately worded provision could be included in the contract permitting direct payments in the event of insolvency, but it would be prudent to require an indemnity from subcontractors in such circumstances, preferably secured, for the return of any payment made in the event that the employer is forced to pay the same amount to the liquidator.

Ownership of materials may also need to be considered: if the value of any materials or equipment is included in any direct payment made, the subcontractor should be asked to give a warranty as to title and to agree that title will pass to the employer on payment (unless the goods have already been incorporated into the works).