HGCR Act 1996 - Pay when Paid

© Daniel Atkinson 2001 29 September 2001 Revised 17 January 2002

Summary

Section 113 prohibits "pay when paid" clauses except in cases of insolvency.  Since Section 109 allows payment on a "circumstance" it is suggested that Section 113 does not prevent "pay when certified" clauses. 

In Durabella Limited -v- J. Jarvis & Sons Limited (September 2001)  it was held that the 1996 Act clearly envisaged that pay-when-paid clauses which shared the risk of insolvency were not unreasonable.  
A contractor cannot rely on a “pay-when-paid” clause if the reason for non-payment is its own breach of contract or default.  A party cannot take an advantage from its own breach of contract.
A “pay-when-paid” could only be effective so long as the main contract machinery of payment was capable of being operated.  For the clause to be effective the contractor impliedly undertakes that it will pursue all means available to obtain payment, or it will not be able to rely on the clause to defeat the subcontractor’s claim for payment.
One interesting observation in Durabella was that Section 113(1) of the 1996 Act did not affect payment conditional on certificates under the main contract, the parties’ freedom to make such arrangements was stated to be legitimate and not unreasonable.

1. Statutory Prohibition - Section 113

Section 113(1) of the HGCR Act 1996 states that a provision which has the effect of making payment under a "construction contract" (as defined in the Act) 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.

Pay when paid clauses are therefore outlawed, unless the third party payer becomes insolvent. Accordingly if a main contractor includes a pay when paid clause in a subcontract he would only be able to operate it in the event of the insolvency of the employer.

Insolvency is defined in the Act at Section 113(2) as covering the whole range of procedures, for companies - administration, administrative receiver, a receiver or manager, voluntary winding-up without a declaration of solvency, the making of a winding-up order. The Act also covers the insolvency of partnerships and individuals under Sections 113(3) and (4) respectively.

The effect of the Act is to mitigate the effect of third party insolvency on the main contractor and make subcontractors share the risk and the loss in the event of the employers insolvency.

The implication of these provisions may cause problems to some members of the construction team, for example where a developer is relying on finance from a third party but the developer has the obligation to pay the main contractor, or where a main contractor's payments are "milestones" but his subcontractors are to be paid monthly.

2. The Scheme

Paragraph II.11 of the Scheme provides that where a contract payment provision is ineffective as mentioned in Section 113 of the Act, and the parties have not agreed other terms of payment then

"(a) paragraphs 2, 4, 5, 7, 8, 9 and 10 shall apply in case of relevant construction contract, and

(b) paragraphs 6, 7, 8, 9 and 10 shall apply in the case of any other construction contract."

3. CaseLaw

The recent decision in Durabella Limited -v- J. Jarvis & Sons Limited (September 2001) now establishes the position in English Law.  It was held that the 1996 Act clearly envisaged that pay-when-paid clauses which shared the risk of insolvency were not unreasonable. Such clauses would therefore be enforced. In my view, unless a contract falls under the 1996 Act, it will be difficult now to argue against enforcement of any pay-when-paid clauses on grounds of unreasonableness.

The decision does not open the floodgates for pay-when-paid clauses. There are a number of sensible legal safeguards identified in the decision.  First, it was held that a contractor cannot rely on a “pay-when-paid” clause if the reason for non-payment is its own breach of contract or default.  A party cannot take an advantage from its own breach of contract.  Second, it was held that a “pay-when-paid” could only be effective so long as the main contract machinery of payment was capable of being operated.  It was an implied condition for the operation of such a clause.  If the machinery breaks down as for instance where certificates are not or cannot be issued as they should be, then the contractor was best placed to remedy the situation.  For the clause to be effective the contractor impliedly undertakes that it will pursue all means available to obtain payment, or it will not be able to rely on the clause to defeat the subcontractor’s claim for payment.

The second safeguard was applied to the particular facts of the case in Durabella.  Termination of the contractor’s employment with the Employer prevented further payment.  The contractor had failed to pursue its remedies promptly and effectually.  It was held that the contractor could not rely on the “pay-when-paid” clause.

One interesting observation in Durabella was that Section 113(1) of the 1996 Act did not affect payment conditional on certificates under the main contract, whether by Architect or Engineer under the contract.  This confirms the view generally taken by legal commentators.  The parties’ freedom to make such arrangements was stated to be legitimate and not unreasonable.

PRACTICE NOTE

The approach to be taken by a subcontractor faced with non-payment and a pay-when-paid clause can be stated in summary as follows:
1.  Establish by legal advice whether the clause is an “if” clause i.e. conditional on payment, or a “when” clause i.e. setting the time for payment only;
2.  If the clause is an “if” clause, then establish
     (a) whether the non-payment is due to the contractor’s default – if so he may not be able to enforce the clause; or
     (b) whether the non-payment is due to the breakdown of the main contract administration – if so the contractor may not be able to enforce the clause if he has not take steps to enforce his right to payment.
3.   If the clause is an “if” clause, then establish whether your contract is caught by the Housing Grants Construction and Regeneration Act 1996 – if so “if” clauses are unenforceable except in situations of insolvency.