A practical guide to the implications of the Housing Grants, Construction and Regeneration Act 1996 Part II: Construction Contracts

Frank Dufficy and Paul Smith consider the Housing Grants, Construction and Regeneration Act 1996 and its effect on the PFI

The Housing Grants, Construction and Regeneration Act 1996 (the "Act") is proving to have a fairly significant effect on the contractual arrangements under PFI projects in respect of payment and dispute resolution. This is despite the Construction Contracts (England and Wales) Exclusion Order 1998 (the "Order") which excludes PFI concession agreements, finance agreements and development agreements from the scope of the Act.

The project company bears considerable risk under a PFI arrangement, although due to its capital structure and the way it is funded, the majority of risk is transferred to its sub-contractors and only a relatively small amount of risk is actually retained. Therefore, to the extent that the Act generates additional risk, predominantly between the project company and its sub-contractors (where the sub-contract is a "construction contract" as defined under the Act), the project company must seek either to make provision under the concession agreement or the various sub-contracts to avoid or mitigate its effects.

The definition of a "construction contract'' under the Act relates to contracts for the carrying out of "construction operations". Such contracts include the construction contract itself (whether for a building or engineering project), the facilities management contract or operations contract for the provision of maintenance services and possibly, depending upon the scope of the services, the hotel services contract for an accommodation type project.

As the Act focuses on payment and dispute resolution, there are any number of scenarios in which a party may be exposed to a risk not considered before the Act came into force.

This article focuses on those material risks. It will then go on to consider how contracts under a PFI project are addressing such risks and then finally examine ways in which legislation could be amended to avoid or mitigate the risks.

The payment issues

Interim payments
The Act grants the payee under a construction contract the right to interim payments, the right to receive a notice of amounts to be paid and a further notice prior to the final date for payment of any amounts to be withheld and the reasons why.
Clearly, this arrangement cannot apply to a concession agreement where payment to the project company commences only after it has begun to provide services, hence concession agreements are excluded from the scope of the Act by virtue of the Order. Where a sub-contract does fall within the scope of the Act, then certain risks that were not previously considered by the project company arise.
During the construction phase of a PFI project, the project company does not receive any payment from the public sector and instead pays the building contractor from funds drawn down from a loan facility. The Act will apply to the building contract but not the funding agreement. Therefore, although certification of amounts due is made by a third party, where a dispute arises between the parties on the amounts due, the project company is in a position where:

• the dispute may be resolved under different procedures;
• it cannot itself rely on the protection provided by the payment provisions under the Act; and
• it cannot rely on "pay-when-paid" provisions.

A similar scenario may arise in respect of sub-contractors providing various services post completion of the building works. The project company may make deductions from amounts due (for poor performance for instance) which may arise out of similar deductions made from amounts due to the project company by the public sector. Notwithstanding the restrictions in respect of pay-when-paid (or conditional payments), in the event of a dispute regarding amounts due, the project company will be exposed to the same problems outlined above.

A sub-contractor (under a construction contract) has the statutory right to suspend performance of its obligations under its sub-contract in the event that payment of amounts due is not made by the final day for payment or is not made by the final date for payment having been given an ineffective notice of withholding payment. In the absence of any corresponding rights against its lenders or the

public sector, the consequences of suspension could delay payment from the public sector and thereby

the project company's ability to commence

repaying its debt and ultimately result in default

and possibly termination.

Conditional payments - "pay when paid"

As mentioned earlier, the Act has also outlawed conditional payments (i.e. pay when paid clauses).
Traditionally, where an entitlement to additional sums arises under one of the sub-contracts which also gives rise to an entitlement under the concession agreement, any amount so recovered by the project company from the public sector will be the amount that the sub-contractor is entitled to be paid by the project company. This arrangement may now be deemed to be a conditional payment.
Additionally, so as not to cause a cashflow deficit, it is often the case that the project company will only pay the sub-contractor after receipt of payment from the public sector. This is clearly a conditional payment.
The effects of outlawing conditional payments are therefore fairly significant when considering interim payments, payments of termination compensation or major variations. The project company is unnecessarily retaining a cashflow and funding risk as well as the risk that it pays out more than it recovers.

Statutory adjudication issues

Section 108 of the Act sets out the criteria for
statutory adjudication.
If a dispute arises under one of the sub-contracts which is also a matter for which the project company would raise a dispute with the public sector or its lenders, then where the dispute resolution procedure under the concession agreement or the funding agreement is not Act compliant, the project company is faced with the following:

• the decisions may be reached at different times;
• the decisions may be different;
• the sub-contractor has no obligation and has the statutory right not to join the project company in a dispute if the other procedure is not Act compliant;
• the Act compliant decision is binding until finally resolved by the courts;
• the dispute may be complex and therefore unsuitable for resolution within 28 days.

If the project company is faced with different decisions or with decisions that do not coincide, then

it does not have the financial means to "weather the storm" until the dispute is finally determined by the courts or is confirmed under the concession agreement procedure. This is particularly the case in payment related disputes which may arise in relation

to the completion of the works, commencement of services, payments themselves, termination and compensation. The following scenarios illustrate this point:

1.Over Completion of the works - if a dispute arises in respect of certifying completion, whilst a procedure may allow for an independent certification, where the building contractor challenges what could be a delay in certification he has the statutory right to refer the matter to adjudication, regardless of the terms of the contract. The adjudicator may determine (perhaps incorrectly) that the project company should grant an extension to the completion date of the works in which case it would lose its right to recover damages from the building contractor. If the same decision is not reached (perhaps at some later stage) under the concession agreement, the project company is unjustly left with no right to damages, no revenue from the public sector and therefore the risk of default,
insolvency or termination.

2. Performance monitoring and its effect on payment - if a dispute arises between the project company and the public sector in respect of performance of services, then the result of that dispute should impact directly on the sub-contractor providing that service. However, in accordance with the Act (and where the services contract is a construction contract for the purposes of the Act) the sub-contractor can require the dispute to be determined by adjudication. In this scenario, the adjudicator may incorrectly determine that the sub-contractor is not at fault and should be entitled to full payment. If the same decision is not reached under the concession agreement, then the project company will have to pay in excess of what it receives until the matter is perhaps resolved in the courts (assuming that it can sustain the effects of the shortfall until the matter is heard).

The same points arise on the results of benchmarking, compensation payments for a
variation, termination and compensation. The
problem is obviously compounded if the sums in question are high.
It is difficult to predict how parties will act in a
given situation, particularly if the sub-contractor is also a shareholder in the project company and would
not wish to see the project company suffer. However, whilst the risk exists that the above scenarios may
arise, then the project company must seek to avoid
the consequences.

The present solutions

The effectiveness of contracting out of the provisions of the Act are uncertain and either party may at such time seek to rely on its statutory rights. It is likely that a Court would uphold a party's statutory right, regardless of what was agreed to in the contract.
Therefore, other means of mitigating these significant risks must be considered.
The particular issues raised above have been dealt with in a number of ways on PFI projects that have been signed in the period since the Act came into force on 1st May 1998.

Payment

In respect of interim payments during the construction period, to attempt to avoid disputes arising between the lenders, project company and building contractor, it has generally been the case that the parties agree to abide by certification of amounts due by an independent expert. However, where a dispute does arise, then the building contractor will have the right to statutory adjudication. The project company must also establish new procedures so that the various notices required under the Act are complied with.
In respect of conditional payments, a procedure has in some cases been adopted whereby the determination of the amounts due involves negotiation between the public sector, project company and sub-contractor. The amount then agreed between the parties is the amount payable to the project company and thereafter the sub-contractor under the sub-contract. This may not be deemed a conditional payment. The sub-contractor's due date for payment of such sums agreed may then be a prescribed period after certification by the public sector rather than the date of receipt of payment from the public sector.
Alternatively, the payment terms for certain compensation may be such that the due date for payment of compensation is set at a period long enough to give the project company time to recover payment from the public sector before it has a corresponding obligation to pay the sub-contractor.

Adjudication

To avoid the risks associated with differing adjudication procedures, in some cases the concession agreement has set out an Act compliant dispute resolution procedure which would apply to any disputes in relation to "construction operations" as defined by the Act. Where this has been the case, provision has been made under the sub-contract whereby if a dispute arises between the sub-contractor and the project company which is also a dispute between the project company and the public sector, then the parties agree to be joined in an action against the public sector in accordance with the adjudication procedure set out under the concession agreement. This solution is not contrary to the Act as it does not deprive either party from its right to statutory adjudication.
However, the public sector may not wish to include an Act compliant dispute resolution procedure under the concession agreement. This is because the procedure would apply to any construction dispute, require the adjudicator to reach a decision in 28 days and for such decision to be binding until such time as it is finally determined. Given the reasons why statutory adjudication is not suitable for complex disputes (as discussed earlier), it is not surprising that in some cases the public sector are refusing to agree.

The way forward

The solutions considered above are by no means exhaustive as lawyers and their clients are continuing to develop ways of avoiding the Act. Whilst a model solution will eventually be found, unnecessary costs
are being incurred in the meantime. The solution may therefore be in the hands of the legislators and
could be found in extending the scope of the
Exclusion Order.
For instance, the Order could be extended to include the "first tier" sub-contracts (building contractor, operator, facilities manager, hotel services contractor etc.) entered into by the project company. Although this merely shifts the problems further down the contractual ladder, the first tier sub-contractors may be in a better position than the project company to manage the risks outlined above and more importantly survive the consequences.
Alternatively, the Order could be extended to include all construction contracts that are entered into in connection with the PFI. This however would prove difficult to define and may prove contrary to the original intention of the Act given the nature of some of the sub-sub-contracts and consultants' appointments and the protection that the Act has given them.
Other options may include amending the Act
itself so that it can apply to PFI arrangements. This however would prove difficult given the wholly different type of contractual arrangements (in respect of payment particularly) under the concession agreement and finance agreement as opposed to the various sub-contracts.
The effectiveness of the various solutions are in some instances uncertain. The way forward will not become clear until such time as the issues are resolved by legislation, addressed by the courts or a consistent approach, perhaps led by the Taskforce, is taken. What is clear, however, is that the Act is delaying finalisation of PFI deals through additional negotiation and drafting. This is inevitably increasing the development costs of a project. This was clearly not the intention of the Act and teething problems aside, the Act does not fit the PFI type contractual arrangements and must be addressed if the momentum of successful PFI deals is to continue.