In JB Leadbitter & Co Ltd v Hygrove Holdings Ltd the Technology and Construction Court (TCC) found a payment clause in an escrow agreement to be ineffective because it was a pay-when-paid clause. Such clauses are outlawed by the Housing Grants, Construction and Regeneration Act 1996 (Construction Act) because they make payment conditional on payment from a third party. This contravenes the principle behind the Construction Act that 'cash (flow) is king'.  

The outcome of this case saw the main contractor ordered to pay the sum of money owed to the sub-contractor. The court held this view even though the employer had responsibility for maintaining sufficient funds in the escrow account to pay the sub-contractor.

Pay-when-paid clauses

It is unusual to encounter disputes concerning "pay-when-paid" (or "pay-if-paid") clauses in the TCC. This is because they are prohibited pursuant to section 113(1) of the Housing Grants, Construction and Regeneration Act 1996 which provides that:

"A provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective, unless that third person, or any other person payment by whom is under the contract (directly or indirectly) a condition of payment by that third person, is insolvent."

There are two exceptions when pay-when-paid clauses are permitted by the Construction Act. The first one is in the case of "upstream insolvency" as provided by section 111(3) of the Construction Act, set out above. Upstream insolvency occurs where the third party who is due to make a payment becomes insolvent. In the usual scenario a contractor is relieved from having to pay his sub-contractor where the employer has become insolvent. However, the parties must provide for this exception in their contract.  

The second exception relates to PFI contracts. The top tier of PFI contracts are not subject to the payment and adjudication provisions (Part II) of the Construction Act . This is because the Act specifically excludes them (by virtue of an Exemption Order) from the definition of "construction contracts". The Construction Act only applies to construction contracts.

Escrow accounts

The essential nature of an escrow account is that monies are paid into an account by the ultimate paying party (usually the employer) and the account is administered by a third party (for example, the employer's solicitors). Payments from the account are then distributed to the parties down the contractual chain directly. This mechanism is aimed at speeding up the payment process. It should also avoid the situation where a sub-contractor is not paid because the main contractor has become insolvent but has nevertheless received payment for the sub-contractor's works from the employer.

Background

This was a summary judgment application by Leadbitter, the sub-contractor, for monies due to it from the contractor, Hygrove. The dispute arose in relation to a residential development near Swansea commissioned by Coastal Housing Group Ltd (Coastal). Leadbitter and Hygrove entered into a contract under the provisions of the JCT Design and Build 2005 edition, in or around 2009. In addition to the contract between Leadbitter and Hygrove there was a second contract between Hygrove and Coastal (the JCT contracts)  

There was also a tripartite Supplemental Agreement under which an escrow account was set up to be administered by solicitors. The Supplemental Agreement provided that Coastal would make payments to the escrow account and payments would then be made to Leadbitter after Hygrove had deducted its profit share from the payments. The Supplemental Agreement expressly stated that it varied and supplemented the JCT contracts.  

The dispute

The dispute between Leadbitter and Hygrove related to payment of two certificates which totalled £196,267.00 and in relation to which no withholding notices had been served by Hygrove. Hygrove admitted that in the absence of a withholding notice, the sums in the certificates became due and payable on the final dates for payment pursuant to the contract. This was undisputed on the basis of previous case law and pursuant to the provisions of the Construction Act. Accordingly, Leadbitter commenced proceedings in the TCC for summary judgment in the amount of the two unpaid certificates.

Hygrove's defence

No obligation to pay unless sufficient funds

Hygrove argued that the obligation to make payment under the two certificates had not yet arisen, or alternatively had been postponed because of the provisions of the Supplemental Agreement. This argument was based on clause 2.12 of the Supplemental Agreement, which set out that provided sufficient funds existed in the escrow account (failing which payments to Hygrove and Leadbitter would be reduced proportionately), the administrators of the account would pay Hygrove and Leadbitter the sums due to them under the JCT contracts. It also specified that the amount would be required by no later than the final dates for payment under the contract, or "as soon as practicable thereafter".  

Hygrove submitted by way of defence that Coastal was due to make further payments into the escrow account, and therefore Hygrove was as entitled to be paid further sums from the escrow account as was Leadbitter. In conclusion, Hygrove's argument was that it could not be liable for the sums claimed by Leadbitter if Coastal had failed to pay sufficient money into the escrow account to enable Hygrove to pay Leadbitter. According to the Supplemental Agreement, Hygrove argued it was not obliged to pay Leadbitter until it was "practicable" to do so; that is, until funds became available.  

Incorrect operation of the escrow account and over-retention of monies

Hygrove also alleged that there were two anomalies in the way in which the escrow account had been administered. The first alleged anomaly was based on Coastal's assertion that it paid more into the account than had been acknowledged by the administrators. Hygrove also alleged that the administrators had retained, in a separate fund outside the escrow account, more retention monies under the Hygrove account than should have been retained. Therefore, Hygrove argued, there was a sum of money which ought to be paid to Leadbitter in any event.

The judge, HHJ Havelock-Allan QC, quickly rejected the first alleged anomaly due to lack of evidence. As to the second alleged anomaly, Hygrove subsequently admitted that the administrators of the escrow account had erroneously retained £28,331 more than they should have done. Consequently, Leadbitter argued there should be a stay on the judgment to the extent of £28,331 pending a joint instruction by Hygrove and Leadbitter to pay the sum of £28,331 to Leadbitter.

Leadbitter's response

Leadbitter submitted that the only defence to Leadbitter's claim was that the effect of clause 2.12 of the Supplemental Agreement was to remove or postpone Leadbitter's entitlement to payment arising under the Hygrove contract. However, Leadbitter argued that clause 2.12 was not lawful because of the prohibition against pay-when-paid clauses set out in section 113(1) of the Construction Act.

The decision

Firstly, the judge highlighted that the over-retention of monies by the administrators was no defence to Leadbitter's claim. The judge then concluded that the two exceptions relating to pay-when-paid clauses (upstream insolvency and PFI contracts) did not apply in this case.

He also decided that section 113(1) of the Construction Act applied to the Supplemental Agreement, which itself was to be treated as if it were part of the JCT contracts. It took this view on the basis that both the JCT contracts were construction contracts and therefore governed by the provisions of the Construction Act. Accordingly, the judge found that clause 2.12 was void on the basis that it was in effect, a pay-when-paid clause. The judge therefore granted judgment in favour of Leadbitter, as there was no defence to its claim which would have a real prospect of success at trial; despite the fact that Coastal had not yet paid sufficient monies into the escrow account to cover the payment.  

The judge highlighted that his "sympathy" for Hygrove was tempered by two factors. Firstly, the fact that Hygrove had had sufficient time in which to resolve the payment issue with Coastal and could have commenced adjudication proceedings if necessary. Secondly, Hygrove admitted it had made sufficient profit from the project and had available funds with which to pay Leadbitter.  

The judge then considered the issue of a stay for a short period in order for Hygrove to resolve the accounting and payment position with Coastal. Leadbitter sought to persuade the judge that the stay should not be allowed on the basis that the information provided by Hygrove on the accounting position was inadequate. Furthermore, Hygrove had admitted it had funds with which it could pay Leadbitter immediately.  

While the judge acknowledged the aim of the Construction Act was to maintain cash flow and that the imposition of a stay should be avoided, he still ordered that judgement (aside from the sum of £28,331(over-retention of monies)) should not be enforceable until 21 days from the date of the judgment. In relation to the sum of £28,331, the judge ordered that there should be a general stay.  

Comment

There are various interesting aspects to this case. The most significant is the relationship between the JCT contracts and the Supplemental Agreement, as well as the fact that the Construction Act applied to the Supplemental Agreement. Construction professionals need to carefully consider situations where there are related documents (and specifically financial documents) which may fall within the definition of construction contracts and therefore be caught by the Construction Act. Similarly, the parties must carefully consider whether or not any contractual payment mechanism is in fact a pay-when-paid clause, or has a similar effect.  

The decision also serves as a reminder that there are a number of dispute resolution options open to claimants. However, the decision over which route to take will depend on the nature of the case and the extent to which the factual and legal issues are disputed. This case concerned a narrow point on contractual interpretation which was suitable for a summary judgment application.

The commercial aspect to this decision is that the courts will expect parties to seek to resolve issues before they escalate. Had Coastal and Hygrove attempted to resolve the payment issue (which remained unresolved), using adjudication proceedings if necessary, Leadbitter would not have been forced to commence legal proceedings. Undoubtedly, Hygrove will have to pay Leadbitter's legal costs as well as its own - an expense which could have been avoided.