Very few construction cases reach the House of Lords. In a rare decision on the Housing Grants Construction and Regeneration Act 1996, the House of Lords was split as to whether a clause in a construction contract permitting set off in an insolvency situation contravened the Act.

Many of the standard form construction contracts (including JCT 2005 and NEC3) provide that sums which have become due to a contractor (and therefore payable under the Act) are nevertheless not payable if the contractor has gone into administrative receivership. These clauses allow the employer breathing space to assess his losses arising from the insolvency. He can then set these losses against sums due to the contractor. But is such a clause contrary to the Act?

Facts of the case

On 2 May 2003 the contractor submitted an interim invoice for £396,630. The final date for payment was 16 May. Under section 111 of the Act, the employer can only withhold payment of a sum due under the contract if it has served a valid withholding notice no later than the prescribed period before the final date for payment set out in the contract. No withholding notice was served because there was no dispute that the contractor was entitled to be paid the amount invoiced. However, the employer failed to pay the contractor by the final date for payment and on 22 May administrative receivers of the contractor were appointed. On 30 May the employer terminated the contract (it was a JCT Standard Form of Building Contract with Contractor’s Design 1998 edition) and refused to make the payment, relying on clause 27.6.5.1. This is the clause that permits the employer to set off from any sum due to the contractor his losses resulting from the insolvency. The administrator, acting on behalf of the contractor, argued that clause 27.6.5.1 was invalid because it was contrary to the Construction Act. Any amount which has become due can only be withheld if a valid withholding notice has been served. In this case, it had not. The employer argued that it was impossible to serve a withholding notice in time because it only became aware of relevant circumstances after the period for serving the withholding notice had expired and that the contractor should be bound by clause 27.6.5.1, which set out the agreed procedure should insolvency occur.

The Scottish Inner House (which is a Scottish appeal court) agreed with the administrator that the withholding of payment is permissible only if a valid withholding notice has been served and held that clause 27.6.5.1 was contrary to the Construction Act, so unenforceable. The employer took the case to the House of Lords.

Cashflow v Protection against insolvency:The decision

The House of Lords was split. However, the majority decided that an employer should be allowed to rely on a contractual provision, like clause 27.6.5.1, to set off against any sum due to the contractor the costs incurred as a result of the insolvency of the contractor. The Lords said that Parliament, when passing the legislation, had probably not considered the sort of situation envisaged by clause 27.6.5.1 (where an employer cannot serve a withholding notice in time, because no grounds for serving such a notice exist at that time). Nevertheless, Parliament had surely not intended to outlaw this sort of clause, so the only solution was to hold that section 111 did not apply to it.

Comment

It is difficult to think how this exception to the requirement to serve a withholding notice could be extended in the future beyond an insolvency situation, but it leaves the door open for future attempts. Although the decision upholds what is a fairly standard sort of clause, it does mean that although the employer was in breach of contract, by failing to make payment by the final date for payment, it was rewarded with the right not to pay that sum at all because of the subsequent appointment of administrative receivers for the contractor. Perhaps this case will in the future encourage employers to refrain from making payment by the final date for payment if they believe the contractor’s financial difficulties are so serious that an administrator is about to be appointed.