Pay when paid clauses in construction contracts – are they ever acceptable?

17 October 2024

‘Pay when paid’ clauses seek to make payment to one party conditional on payment being received by another.

For example, a Contractor might want to include a term stating that the Sub-Contractor is only entitled to payment where the Contractor has received payment in respect of that work from the Employer.

Section 113 of the Construction Act prohibits pay when paid clauses – with one exception

Section 113 of the Housing Grants, Construction and Regeneration Act 1996 (“the Construction Act”) prohibits pay when paid clauses in construction contracts.

They are therefore unlawful and unenforceable except for one exception; upstream insolvency:

“(1) A provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective, unless that third person, or any other person payment by whom is under the contract (directly or indirectly) a condition of payment by that third person, is insolvent.”

A term in a contract which complies with that section is therefore likely to be enforceable.

If for example the Employer becomes insolvent and there is a pay when paid clause which is compliant with section 113(1) in the Sub-Contract, the Contractor can withhold payment to the Sub-Contractor unless it has been paid by the Employer.

What counts as insolvent?

Section 113 of the Construction Act then goes on to define what constitutes insolvency:

“(2) For the purposes of this section a company becomes insolvent—

(a)when it enters administration within the meaning of Schedule B1 to the Insolvency Act 1986,

(b) on the appointment of an administrative receiver or a receiver or manager of its property under Chapter I of Part III of that Act, or the appointment of a receiver under Chapter II of that Part,

(c) on the passing of a resolution for voluntary winding-up without a declaration of solvency under section 89 of that Act, or

(d) on the making of a winding-up order under Part IV or V of that Act.”

Relevant case law

The Court of Appeal decision in William Hare v Shepherd Construction [2010] EWCA Civ 283 concerned a pay when paid clause.

Hare was a sub-contractor to Shepherd. Shepherd’s client went into administration.

Shepherd’s sub-contract included a pay when paid clause and defined insolvency on the same basis as the Construction Act at the time it was drafted, which provided for administration where an administration order was made by the court (it said “on the making of an administration order against it under Part II of the Insolvency Act 1986”).

However, Shepherd’s client had gone into administration by way of a different route – an out of court appointment, per Schedule B1 of the Insolvency Act 1986. Shepherd therefore sought to hang on to £996,68.35 it owed Hare on the basis of its pay when paid clause.

Although the definition of insolvency in the Construction Act had been updated by subsequent legislation to include entering administration in that way, Shepherd’s sub-contract had not.

The first instance decision in the Technology and Construction Court held that the pay when paid clause should be construed narrowly; because the administration occurred because of a reason not stated in that clause, the clause did not apply. That meant that Shepherd could not rely on the clause and had to pay Hare.

The Court of Appeal upheld that finding. It decided:

  • The Construction Act meant that pay when paid clauses were ineffective unless the third party was insolvent which was defined by reference to the certain ways in which a company could become insolvent. If a main contractor wants to have an effective pay when paid provision it must identify a way in which the third party employer becomes insolvent as defined in the legislation. If it chooses a way which is not in accordance with the legislation because it mis-drafted the provision, principles for construction of documents as used by the courts will be of no assistance.
  • If a main contractor has drafted the provision in a way which does work, even if a reasonable person would think that it was not intended to be limited in that way and that there has been an error, there is even less reason for the courts to save the main contractor.
  • The pay when paid clause was effectively an exclusion clause. It was Shepherd’s responsibility to get a clause of this nature right if it wanted to rely on it. The general rule is that an exclusion or limitation on liability must be in clear words; any ambiguity or lack of clarity must be resolved against that party. Shepherd could not therefore argue that there was a lack of clarity in a provision that it drafted to relieve itself from liability.

What about downstream insolvency?

Section 111(1) of the Construction Act provides that the payer must pay the notified sum on or before the final date for payment. However, section 111(10) provides an exception to this where the payee (the party receiving the money) becomes insolvent:

“(10) Subsection (1) does not apply in relation to a payment provided for by a construction contract where—

(a) the contract provides that, if the payee becomes insolvent the payer need not pay any sum due in respect of the payment, and

(b) the payee has become insolvent after the prescribed period referred to in subsection (5)(a).”

So, section 111(10) says that the payer does not have to pay the notified sum where 1) the contract says it is not payable in the event of insolvency of the payee and 2) the payee has become insolvent after the last date for giving a pay less notice.

Even in that situation, per the explanatory notes to the Act which amended the Construction Act, Parliament’s intention appears to have been that where the insolvency happened while a pay less notice could still be issued, the paying party could just issue a pay less notice!

Key points

  • Pay when paid clauses in construction contracts are unlawful, with one exception: upstream insolvency.
  • Even then, pay when paid and other exclusion clauses must be carefully drafted.
  • Parties should be careful of using out of date template clauses and must make sure their contracts reflect changes in legislation.

How CCC can help you

Whatever stage your project is at, CCC can provide advice and assistance. This will ensure that practical steps are taken so that you achieve the best outcome when dealing with variations, just as we have helped many others. This includes:

Contact us for a free initial consultation.

 

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