Administration through an out of court method not caught by “pay when paid” clause

“Pay when paid” clauses (where payment from B to C is said to be conditional on payment from A to B) were effectively outlawed by section 113 of the Construction Act 1996, except where A is insolvent. The Court of Appeal last week upheld a TCC judgment that said that B could not refuse payment to C following A entering administration through an out of court method. The affirmation of the decision is an important win for subcontractors and reinforces the importance of careful drafting of pay when paid clauses.

The brief facts of the case are as follows:

· C was engaged by B in 2008 to fabricate and erect steelwork as part of a large development for A.

· The subcontract between B and C included a pay when paid clause which was in similar terms to section 113 and which defined the employer’s insolvency by reference to four alternative situations: “on the making of an administration order against it” by the court; the appointment of an administrative receiver; insolvent liquidation; and the making of a winding-up order by the court.

· Party A entered administration by an out-of-court filing, a route that was introduced by the Enterprise Act 2002 i.e. after the Construction Act was implemented but before B and C entered into their subcontract.

· B issued various withholding notices in respect of the applications received from C in reliance on the pay when paid provision.

· C argued that because there was no administration order against A by the court and none of the other three insolvency events identified in the pay when paid clause had occurred, A was not insolvent within the meaning of the clause. This argument was rejected by B, who said that it would be absurd for the clause to be construed as ignoring the subsequent amendments implemented by the Enterprise Act 2002 i.e. that a company could enter administration by a means other than an order of the court.

In rejecting B’s argument and deciding that the withholding notices were therefore invalid, the judge at first instance said that there was no reason to depart from the plain meaning of the words used. He said that where the effect of the clause was that C could do a considerable amount of work and then not be paid for it, it was important that the parties stuck to what they had agreed and that the clause was not re-written to expand the circumstances in which C would find themselves out of pocket.

The Court of Appeal agreed with this rationale. Lord Justice Waller said that if B wanted to include a pay when paid clause the onus was on it to ensure that if the clause were to be effective it identified a way in which A would become insolvent as defined in the legislation. There was no reason to depart from the words of the clause that the parties had agreed just because B had mis-drafted the clause so as not to apply to the changes implemented by the Enterprise Act 2002. He stated that “the clause as worded does work although, as we were told, the number of court orders are miniscule compared with self-certified administrations; this clause was not truly “sharing” the risk of insolvency, it was relieving [B] of a liability to pay [C] which they otherwise had and it was for [B] to get a clause of this nature right if they wished to rely on it.”

Where insolvency in the construction industry is continuing to rise, this judgment serves as a useful reminder to ensure that the insolvency exceptions to pay when paid clauses are drafted properly and, more broadly, that the effects of changing legislation are carefully considered when negotiating contracts.

The ban on pay when paid clauses only applies to construction contracts (as defined by the Construction Act 1996). Whilst it does not therefore apply in the PFI/PPP context to project agreements, it does apply to some PFI/PPP subcontracts. Attempts to get around this through the introduction of pay when certified clauses will be scuppered if the proposed changes to the Construction Act are implemented. However, it is hoped that there will be a last minute change to the amendments to allow the proposed ban on pay when certified clauses to be disapplied to PFI/PPP subcontracts given that equivalent project relief clauses are vital aspect of PFI/PPP arrangements.