Vol 2 (2005) - Issue 3

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Insolvency: The Validity of "Pay When Paid" Terms

In this article we briefly outline the validity of ‘pay when paid’ provisions in construction contracts caught by the Housing Grants, Construction and Regeneration Act 1996, look at their potential in relation to insolvency and highlight some interesting case law.

‘Pay when paid’ clauses have always been a bone of contention in the construction industry. This is because the party lowest down the contractual chain, generally being the financially weakest party and the party least able to withstand delays in payment and the negative burdens placed on their cashflow, have in the past had to take the full brunt of these provisions, thereby putting at risk their own commercial viability. ‘Pay when paid’ provisions are commonly found in sub-contractors’ terms and conditions; however they have also been found in those of consultants and main contractors. The Housing Grants, Construction and Regeneration Act 1996 sought to partially redress this imbalance for construction contracts and provided in section 113(1) that

A provision making payment under a construction contract conditional on the payer receiving payment from a third party is ineffective ...

For a construction contract which comes within its ambit, this Act now renders ineffective any provision which makes payment conditional on receipt by the paying party of monies from a third party further up the contractual chain. Needless to say, this clause has brought to an end the practices of many main contractors taking advantage of their position to the detriment of their sub-contractors. There is a limited exception to the general principle under the Act which provides that such ‘pay when paid’ clauses will remain effective in the event

... 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.

This position therefore spreads the consequences of an employer’s insolvency amongst the remaining contractual parties including the main contractor, its sub-contractors and its suppliers. In addition section 113 goes on to provide at sub-section (6) that

Where a provision is rendered ineffective by subsection [113] (1), the parties are free to agree other terms for payment.
... In the absence of such agreement, the relevant provisions of the Scheme for Construction Contracts apply.

The importance of the insolvency exception under the Housing Grants, Construction and Regeneration Act 1996 is highlighted by the following cases:
In Aqua Design & Play International Limited (T/A Aqua Design) v Kier Regional Limited (T/A French Kier Anglia): Fenlock Hansen Limited (T/A Fendor Hansen) v Kier Regional Limited (T/A French Kier Anglia), Kier was engaged by Heathland (UK) Limited to undertake fitting out works at a health and fitness centre. Kier engaged its sub-contractors Aqua to supply and install the swimming pool, saunas and associated works and Fendor to supply and install glazed screens. Both sub-contractors carried out their sub-contract works. Heathland then became insolvent and did not pay Kier any monies due for either the swimming pool or the glazed screens. In turn, Kier asserted that they had no obligations to either Aqua or Fendor to pay to them such sums and sought to rely on a term they claimed had been incorporated into the sub-contracts. The term was condition 32.1 in the uncorrected version of the subcontract conditions for use with the Domestic Sub-Contract DOM/1 Articles of Agreement 1980 edition for use in conjunction with JCT form of main contract 1998 edition, namely

Notwithstanding anything to the contrary elsewhere in this Sub-Contract if the Employer is insolvent as defined in clauses 32.2, 32.3 and 32.4, the Contractor shall not be obliged to make any further payment to the Sub-Contractor of any amount which is due or may become due to the Sub-Contractor unless the Contractor has received payment in respect thereof from the Employer and then only to the extent of such receipt.

Both Aqua and Fendor contended that this term was not incorporated into their sub-contracts. At first instance the court supported this same view. As such upon the insolvency of Heathland and without the benefit of a properly drafted ‘pay when paid’ clause, Kier had no rights to withhold monies from either Aqua or Fendor even though they themselves had not received payment. Kier appealed.