Construction giant Carillion is headed into liquidation, putting billions of pounds worth of contracts into potential chaos.

The fallout from the failure of the UK’s second largest construction firm will affect many and generate many column inches asking the fundamental question: how could it happen? The truth is, the construction sector remains extremely difficult, and a large failure of this type had been expected by industry watchers for some time.

This article looks at the impact of a large scale failure such as Carillion further down the supply chain – the companies that make up by volume the overwhelming majority of the industry. The most immediate questions for those businesses, often micro businesses or the self-employed, will often be whether they will still get paid and whether they have to pay third parties.

Scenario

Party A has contracted with an employer to design and build commercial units. Party A enters into a sub-contract with Party B for the roofing of the units. Party B contracts with Party C to supply roofing materials under "the Contract". The Contract includes a conditional payment clause stating Party B does not have to pay Party C if Party A goes insolvent and Party B does not get paid. During the course of the project, Party A enters into administration. As a result, Party B does not get paid for certain works performed, but Party C still expects payment from Party B.

There are three questions to answer:

  1. Does the conditional payment clause apply even though Party C has not directly contracted with Party A?
  2. Can Party B resist paying Party C?
  3. What happens if there is a fourth party in the supply chain (Party D)?

The Housing Grants, Construction and Regeneration Act 1996 – more commonly known in the industry as the Construction Act – provides the answer. That Act renders conditional payment or "pay when paid" clauses invalid. However, crucially in this scenario, the exception to this is where the third party that payment is conditional on is insolvent. This is potentially bad news for sub-contractors who have entered into contracts where such clauses are included, as it means that a direct contractual link between the sub-contractor and the insolvent party is not required for the clause to remain valid.

In the above scenario, this means a conditional payment clause can still apply even though Party C has not directly contracted with Party A (the insolvency party). Party B can therefore resist paying Party C if it has not been paid in respect of Party C’s works by Party A.

If there was a Party D in the scenario, if the contract between Parties C and D provided a similar "pay when paid" clause to the Contract then Party D would be in the same position as Party C: Party C would be able to resist making further payment to Party D. However, without a contractual right to withhold payment to Party D, Party C may find itself between a rock and a hard place – not receiving payment in but being obliged to make payment out.

The importance of clarity

As with all contracts, the clarity of the contractual provisions is absolutely key. That is particularly the case in cases of insolvency where entirely 'innocent' parties - in the scenario above, Parties C and D - could end up out of pocket because of the failure of a party they have no control over.

This was demonstrated in the case of William Hare v. Shepherd Construction [2009]. There, Hare entered into a sub-contract with Shepherd to fabricate and erect steelwork at the employer’s development. The sub-contract prohibited payment being made conditional on Shepherd being paid by the employer, unless the employer was insolvent, with a definition of what amounted to ‘insolvency’. When the employer entered into a form of insolvency but not one specifically defined in the sub-contract, Shepherd attempted to withhold payment but Hare said it could not as the particular form of insolvency was not named in the sub-contract.

The court agreed with the sub-contractor. It said that the sub-contract set out the forms of insolvency and the fact that the one employed by Shepherd’s employer was not in the sub-contract definition was fatal. The court noted that the “pay when paid" provision was “endeavouring to identify circumstances in which Hare can do a considerable amount of work for Shepherd under the sub-contract and then not be paid a penny for that work” in which circumstances “the court is required to ensure that Shepherd are kept to the four corners of their bargain with Hare and that a clause of this nature is not rewritten…”.

There are reports that the government and other parties may step in to take over at least some of Carillion’s work, which may limit the effect of its insolvency. However, the industry can expect a volatile time with further large companies potentially facing difficulties as a knock-on effect.

It may be too late for some of the supply chain in Carillion’s case – contractual bargains that are already in place cannot be re-written simply because of a major insolvency and so where valid “pay when paid” clauses exist, there is little the unpaid party can do (subject to employing any commercial sway they might have).

Sub-contractors and the supply chain as a whole are well-advised to review contracts and see if "pay when paid" clauses are included. If they are, they must be limited to cases of insolvency to be valid. If payment is withheld on the basis of (non-)payment under another contract without a valid “pay when paid” clause, immediate action should be taken to preserve contractual rights and, pragmatically, to get to the front of the queue in chasing payment in circumstances when money might be tight following an upstream insolvency.

The content of this article is for general information only. The situation with Carillion is developing quickly – legal advice on any specific issue is advised.