Since it came into force on 1 May 1998, the Housing Grants, Construction and Regeneration Act, introduced with the intention of reducing disputes in a claims-stricken industry, has spawned a substantial body of case law. However, only recently has the Act been considered by the UK’s ultimate court, the House of Lords.

As most in the construction industry are aware, the Act outlawed the “pay when paid” clause, previously much relied on, particularly at the subcontracting end of the contractual chain. Under the Act, conditional payment is prohibited except in circumstances of insolvency. The underlying principle of the Act is that building and engineering contracts are to be arranged so that a contractor shall be entitled to submit regular applications for payment and the employer is obliged to make regular payments on receipt of those applications. Cashflow is the lifeblood of the construction industry and the Act is there to ensure it keeps flowing. An employer is only entitled to withhold payment from a contractor where a notice is served within a specified timescale, stating the grounds for withholding payment in accordance with s111 of the Act (often referred to as a withholding notice). Where no withholding notice is served, the contractor is entitled to the full amount of its application.

However, where a contractor is insolvent, an employer does not have to pay sums that are due. Instead, the employer is able to offset losses suffered as a result of the contractor’s insolvency against any outstanding payment due to the contractor. This provision is incorporated into many standard form contracts, including JCT 2005 and NEC 3. Is this contrary to the provisions of the Act? And what happens when an employer only becomes aware of a contractor’s insolvency after the final date for serving a valid withholding notice? Will the contractor be entitled to payment in spite of its insolvency, by relying on the absence of a withholding notice?

The Melville Dundas case

These questions were considered in the recent case of Melville Dundas Ltd (in receivership) v George Wimpey UK Ltd 1. The contract in question was a JCT with Contractor’s Design 1998. It allowed the employer to terminate the contract on the insolvency of the contractor. It also allowed the employer to set off any sum due to the contractor against losses resulting from insolvency. On 2 May 2003, the contractor submitted an interim invoice for £396,630. The final date for payment by the employer was 16 May 2003. The employer did not pay the contractor by that date and on 22 May administrative receivers were appointed for the contractor. The employer subsequently terminated the contract and refused to make payment, relying on clause of the contract, which allows set off in relation to losses resulting from insolvency.

The contractor argued that Clause was contrary to the provisions of the Act, because no valid withholding notice had been served. The employer relied on the fact that it was impossible to serve a notice in time because it only became aware of the relevant circumstances after the period for serving a withholding notice had expired.

An appeal to the Inner House, the Scottish equivalent of the English Court of Appeal, agreed with the administrative receiver that the contractor was entitled to payment in the absence of a valid withholding notice. It held that the clause upon which the employer sought to rely was contrary to the Act and was therefore unenforceable as against the contractor. The employer took the case to the House of Lords.

The decision - protection from insolvency more important than cashflow

The House of Lords were split in deciding the case, but a majority ruled that an employer should be entitled to rely on a contractual provision allowing it to set off losses incurred as result of a contractor’s insolvency against any sums due to that contractor.

What about the absence of a valid withholding notice? The Lords concluded that, when approving the legislation, Parliament had probably not considered a situation in which the circumstances of the insolvency only became known after the time for service of a valid withholding notice had expired. They therefore decided that s111 was not intended to apply to situations of insolvency.

Implications for the industry

The initial view of the legal profession following this decision was that it was only likely to apply in cases of insolvency and not otherwise. However, following a decision by the TCC in the case of Pierce Design International Limited v Johnston 2, it would appear that the decision in the Melville Dundas case has much wider application, although an unreasonable failure to pay will still be penalised.

The Pierce Design case

In this case, Pierce entered into a contract with Mr and Mrs Johnston to carry out construction works at their property. The form of contract was a standard form JCT 1998 with Contractor’s Design, with amendments. During the contract, the Johnstons underpaid interim valuations 4, 8, 9, 10 and 12, leaving a total of £93,460.33 unpaid. The Johnstons failed to served any withholding notices pursuant to s111 in relation to these underpayments. Pierce sought payment of the outstanding sums, together with interest. However, the works were not completed by the contract completion date and the Johnstons raised complaints about defects and incomplete works and served a notice of default on Pierce. The Johnstons subsequently determined the employment of Pierce, alleging the defects had not been remedied.

Clause of the contract prevented the Johnstons from deferring payment of any sums which had unreasonably not been paid and which had accrued 28 days or more prior to the determination. The TCC therefore had to consider:

  1. whether Clause is contrary to s111 of the Act, because it seeks to allow sums to be withheld in the absence of a withholding notice and
  2. assuming Clause does comply with s111, whether the operation of the clause entitled Pierce to payment of the outstanding sums on the basis that they had been unreasonably withheld.

Coulson J held that he was bound by the majority House of Lords decision in the Melville Dundas case, so that Clause was not contrary to s111 of the Act. It therefore fell to the court to consider whether the sums claimed were amounts properly due to be paid to Pierce, whether the right to the sums had accrued more than 28 days prior to determination and whether the Johnstons had unreasonably withheld the unpaid sums.

The judge decided that the sums were properly due under the contract and had accrued more than 28 days prior to determination. The question of whether the sums had unreasonably been withheld depended on whether a valid withholding notice had been served. In the absence of any notice, the court found that the Johnstons had acted unreasonably in failing to pay the full amounts certified and Pierce was awarded the sums claimed plus interest.

Looking to the future

Since Melville Dundas, the Department for Business, Enterprise and Regulatory Reform has issued its consultation paper on proposed reforms to the Act, including a proposal that the Melville Dundas decision should be confined to cases of insolvency.

It should be remembered that the decision is only to be applied in cases where Clause of the JCT 1998 form of contract is relied on. The clause does not appear in the more recent JCT 2005 form of contract. In the absence of this clause, the employer could have retained the outstanding sums until the final account had been agreed.

Currently, the Pierce decision is likely to benefit paying parties, since they will typically be able to retain a month’s payment otherwise due. If the proposed reforms are adopted, then this decision may well be reversed by legislation. However, the reforms are unlikely adversely to affect the paying party in circumstances of insolvency, where the principle of Melville Dundas will still hold good.