In January this year, construction giant Carillion entered into liquidation. In a sense its demise was sudden – the firm entered straight into liquidation rather than the more familiar administration procedure, meaning it had no meaningful assets that gave any prospect of the business, or any part of it, continuing as a going concern. But in another sense it was expected: a large failure of this type had been expected by industry watchers for some time.

Many of the reams of column inches devoted to Carillion’s failure - which rarely for the construction industry (despite its importance to the economy) saw it make (unfortunate) front page news - considered how the public sector would be affected. That is understandable given their scale and the wider public interest. But this article considers a different angle, and one which is, perhaps, more relevant to the industry in the long-term: the impact of a large scale failure such as Carillion further down the supply chain.

Small and medium sized business 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 be whether they will still get paid and whether they have to pay third parties when a main contractor, or any party above them in the supply chain, hits financial difficulties.

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 with 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.

This 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…”.

When companies start to see financial difficulties, they inevitably limit their outgoings, and that means stopping payments downstream as far as possible. If that happens, 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, or for any other reason (for example continued ‘promises’ to pay ‘soon’), 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.

Unfortunately, it is easy to be wise after the event – and for many businesses that are reliant on work flowing from big contractors or large sub-contractors, it can be difficult to do anything but wait for payment to come. But being clear about payment terms, and not allowing improper payment practices, is essential from the off to avoid becoming the next victim of the insolvency trap.