‘Direct payments and construction insolvency’
Main contractor Carillion’s entry into liquidation has resulted in many employers seeking to establish relationships with subcontractors, under which they will be paid directly in order to stay on site and finish the relevant project. On the face of it, this seems like an attractive solution, and may leave some employers wondering why they didn’t procure their projects by construction management in the first place. However, establishing direct relations is not without risks, and requires safeguards for employers and subcontractors alike. Those are set out in the last section of this article, but it is important to understand the pitfalls, particularly of direct payment, first.
It is a familiar scenario: a main contractor goes into liquidation, and the project works are suspended. No further interim payments are due to it, sometimes even in respect of work which has been certified for payment. The contractor’s extended payment terms mean it has not yet paid certain subcontractors, who are unsecured creditors in the liquidation and the law expects them to wait to receive their dividend from it (if any). In response to overtures from the employer, who wishes to restart the project, the subcontractors say they will return to site only if they are paid for all the work they’ve done to date. Commercially, acceding to the subcontractors’ demands seems simple enough. However, in law it isn’t, because there may still be sums due from the employer to the contractor, which the contractor’s liquidator will seek to recover for the benefit of its creditors.
As maddening as it may seem, there is every risk that the employer faces paying twice (i.e. to contractor and subcontractor) for the same work. In Tate Building Services Ltd v B & M McHugh Limited [2014] EWHC 2971, McHugh were the main contractor to Network Rail for the refurbishment of the toilets at Liverpool Street station. Tate were McHugh’s subcontractors, and Washroom Limited were sub-subcontractors which manufactured and installed bespoke cubicles on site, and were regarded as crucial to the refurbishment. Tate got into financial difficulty. McHugh therefore removed the cubicles from the scope of Tate’s subcontract works and paid Washroom £145,000 directly. McHugh maintained that occurred with Tate’s agreement. Tate then went into a CVA and made a referral to adjudication in respect of the full amount it considered due, including work done by Washroom and paid for directly by McHugh. Tate contended that it had not agreed to the change in scope, and the adjudicator awarded the sum Tate sought. McHugh promptly issued proceedings to have the dispute dealt with in court. Tate counterclaimed and sought summary judgment for payment of the adjudicator’s award. McHugh knew it would not succeed in resisting that, so instead asked the court to use its discretion to stay enforcement of the summary judgment order because Tate’s CVA meant it may not be able to repay the adjudicator’s award if it lost the substantive dispute.
The court decided that while the adjudicator’s award was valid, it used its discretion to say that the first £150,000 should not be enforced; that covered McHugh’s direct payment to Washroom. In respect of that £150,000, McHugh had to pay £75,000 into court pending the outcome of the substantive dispute. My observations are that the adjudicator had no compunction in ordering McHugh to pay Tate in full regardless of the position with Washroom and that award was enforceable, and while the court partially stayed enforcement, that was at its discretion. Payment of £75,000 into court was more than McHugh bargained for when it paid Washroom direct; although safer, it would still have hit McHugh’s bottom line.
The warning signs of contractor insolvency include the withdrawal of credit facilities, or unpaid subcontractors threatening to suspend work, which can result in direct payments to subcontractors and suppliers before any formal insolvency process begins. Subcontractors may regard the employer as a guarantor of the contractor’s payment obligations, yet without proper formalities there is no enforceable right to payment. The case of Actionstrength Ltd (t/a Vital Resources) v International Glass Engineering IN.GL.EN SpA (‘Inglen’) (1) St Gobain Glass UK Limited (2) [2003] UKHL 17 illustrates why. St Gobain contracted with Inglen for the construction of its factory. Inglen subcontracted labour to Actionstrength, but after a while, stopped paying them. Actionstrength maintained that St Gobain undertook to deduct sums in respect of subcontract labour from payments to Inglen and pay them direct to Actionstrength instead if Actionstrength kept its labour on site. Actionstrength remained on site but the money did not come through. Actionstrength sued both Inglen and St Gobain, getting summary judgment against Inglen which then went into liquidation.
St Gobain, anticipating that Actionstrength would turn their fire on them, made a defendant’s application for summary judgment. They denied Actionstrength’s version, saying it had agreed to assist if it could but would not pay a subcontractor direct in the way Actionstrength alleged and moreover, as a matter of principle, an oral guarantee was unenforceable thanks to section 4 of the Statute of Frauds 1677. This requires any guarantee by one party of another’s obligations (surety) to be in writing, as a safeguard against false guarantee claims. This legal point went all the way up to the House of Lords, which held that since section 4 of the 1677 had been re-enacted as recently as 1989, Parliament’s intent that oral guarantees were unenforceable was quite clear. Actionstrength’s claim therefore failed. It may sound like St Gobain won on a technicality, but the requirement for certainty through written guarantees is understandable. It also means subcontractors have no recourse against employers who might ‘make the right noises’ but do not back it up in writing.
Tate and Actionstrength illustrate the danger for employers and subcontractors in resorting to direct payments. Look before you leap; you have to regularise the position in writing before you work or pay! The tripartite arrangements which can facilitate that are set out in the last section of this article.
Most standard forms of construction contract already have a wide definition of insolvency, and provide that the employer need not make any further payment to the contractor following its insolvency until the works are complete, and allow it to complete the works using an alternative contractor, with the cost of doing so being offset against sums owed to the original contractor.
Is a clause in the main contract, allowing direct payments to subcontractors, suppliers and professional consultants engaged by the contractor, permissible? The short answer is ‘Yes’, but such clauses cannot prevent the risk of having to pay twice, due to the “Pari-passu” (equal right to payment) rule in insolvency law; all unsecured creditors must share any available assets of the insolvent entity equally, in proportion to the debts due to each creditor. Linked to this is the “Anti-deprivation principle”; to ensure the distribution of assets on a pari passu basis, the court has the power to strike down any provision in a contract that causes the assets of a company to transfer to a creditor upon that company's insolvency (see British Eagle International Ltd v Compagnie Nationale Air France [1975] All ER 390). The contractor’s entitlement to be paid is an asset and the liquidator is charged with maximising the return for all creditors generally. Therefore, any payments direct to subcontractor etc., and corresponding deduction from payments to the contractor are highly likely to offend either rule.
Strangely, the only case where the British Eagle principles have been properly applied in the context of direct payment clauses is in the Court of Appeal of Northern Ireland, in B Mullan & Sons Contractors Ltd v Ross aka Re McLaughlin & Harvey Plc (In Liquidation) [1996] N.I. 618; 86 B.L.R. 1; 54 Con. L.R. 163, concerning the redevelopment of Londonderry Harbour. Direct payment clause 27.4.3.2 in JCT Standard with Contractors Design 1981 was held to offend article 93 of the Insolvency (Northern Ireland) Order 1989, which concerned the pari passu rule and the British Eagle principles. The judgment prevented further payments to subcontractor Mullan & Sons, and the employer port authority had to pay main contractor McLaughlin & Harvey’s liquidator instead. In a comprehensive judgment, two English decisions which endorsed direct payment clauses and rejected insolvency-based challenges, Wilkinson Ex parte Fowler [1905] 2 K.B. 713 and Tout and Finch Ltd [1954] 1 W.L.R. 178, were shown to have been wrongly decided, and of course they predated British Eagle. Direct payments clauses therefore come with a significant health warning.
Other options for employers faced with an impecunious contractor include terminating its employment on grounds other than insolvency, because, for example, its performance is already inadequate or delayed. NEC3 clause 91.2 permits termination if the contractor has "substantially failed to comply with his obligations", and JCT DB 2016 clause 8.4.1.2 also allows termination where the contractor fails to proceed "regularly and diligently" with the works. It may be tempting to omit certain work then place them elsewhere, but remember that contract clauses which permit omissions are intended for situations where the employer does not wish to have the work carried out at all, and cannot be used to take work from one contractor only to award it to another. Care needs to be taken in these situations, because wrongful termination or placing work with others is highly likely to be a repudiatory breach that entitles the contractor to damages.
What does this mean for you or your business?
It can therefore be seen that the law does not give employers much freedom to redirect payments or reallocate work when a contractor gets into financial difficulty. It is very much an ‘all or nothing’ situation, because new contractual relationships are predicated on the termination of existing ones, whether due to contractor insolvency or other breach. Careful thought needs to be given from the start concerning how the project is procured, and is supported financially. Too many employers fail to consider whether, if they did things differently, they might have more options when the going gets tough.
What do you need to be doing now?
Consider using a different contract structure in future, such as construction management, where the employer, assisted by a professional construction project manager, enters in to direct contracts with various trades, who take direction from the construction manager. The repercussions of contractor insolvency are therefore avoided. If a traditional structure must be used, supplement it with safeguards and schemes to improve cash flow, such as reducing or eliminating the retention (using a retention bond for equivalent security) to improve cash flow, or making an advance payment (secured by a bond, as necessary) to reduce the burden on a contractor having to fund a significant portion of the works. Parent company guarantees confer some comfort that the contractor’s parent will ensure the main contract is performed, or you are compensated. Alternatively, use a project bank account, from which agreed payments are made to the contractor, key sub-contractors and suppliers who are a party to that arrangement. All parties agree that the contents of that account will create a trust in the event of insolvency, so they do not fall in the main contractor’s insolvent estate.
Steps can be taken prior to work commencing which will regularise the position with subcontractors in the event of contractor insolvency. Collateral warranties from subcontractors in favour of an employer in respect of the subcontractors’ duty of care are not uncommon, but in order to confer meaningful control for the employer they should also include step-in rights. Such a collateral warranty will require the subcontractor to give notice to the employer if it intends to terminate its subcontract and, at the employer’s election, continue the subcontract under the employer’s direction, and even provide for novation of the subcontract to the employer. Typically, the employer then performs the functions formerly undertaken by the main contractor, including payment of sums outstanding to the subcontractor. The main contractor will need to be a party to that warranty to ensure that it is bound if the worst case scenario does transpire. This is quicker and more certain than negotiating with the contractor’s insolvency practitioner for the assignment or novation of subcontracts to the employer.
These notes have been prepared for the purpose of articles only. They should not be regarded as a substitute for taking legal advice.