The following case raises important issues in relation to the “pass through” of availability and performance deductions in PFI sub-contracts. The outcome of the case - decided by the Outer House of the Court of Session in Scotland - will be of interest to all involved in the field of PFI.
Before considering the issues, we will briefly examine a typical contractual chain in a PFI contract.
PFI contracts - the typical contractual chain
Parties to PFI transactions - principally the project company, the construction contractor and the facilities management (or FM) contractor - enter into contracts, relying on the ability to “pass down” their respective obligations, duties and liabilities through the contractual chain. This is particularly so in the case of availability and/or performance deductions levied by the authority on the project company (as a result of the project company’s default under the terms of the project agreement).
The interface agreement
In reality, there is a great deal of interface between works being carried out by the construction contractor and the FM contractor. The FM contractor may well be in breach of the FM contract and incur deductions (under the FM contract) as a result of a breach by the construction contractor (and vice versa).
The project company, construction contractor and the FM contractor therefore often enter into an interface agreement. Amongst other things, the interface agreement governs the right of the construction contractor and FM contractor to recover (from each other) any deductions levied by the project company against either one of them which arise due to a failure by the other to perform its obligations under the main contract or FM contract (as applicable).
In the following case the court analysed the terms of the various project contracts to determine:
- whether a construction contractor was entitled to pass down to its sub-contractor certain deductions which the project company had passed on to it?
- whether the project company was able to choose which of its sub-contractors it thought was appropriate to pass on the deductions which had been levied against it on the basis that the sub-contractors could battle it out under the terms of their interface agreement to correct any incorrect deductions?
Kent County Council v Robertson Construction Northern Ltd  ScotCS CSOH 41
The diagram here illustrates the contractual chain.
The relevant facts were:
- The authority entered into a project agreement with the project company for a project comprising the design, construction/refurbishment, financing and operation of six schools and associated services.
- The project company sub-contracted the project under two separate contracts:
- The main contract with the construction contractor for the design, construction and fitting out of new school buildings; and
- The facilities maintenance contract with the FM contractor for the provision of services within those schools once they were in operation.
- The project company, the construction contractor and the FM contractor entered into an interface agreement to regulate the relationship between these three parties as regards certain liabilities and payments and the recovery of certain sums.
- The construction contractor entered into a sub-contract with a sub-contractor (the sub-contractor) for the design, supply and installation of loose furniture at the schools. The tables supplied by the sub-contractor (as part of the loose furniture) did not conform to the contract specification.
- An Acceptance Certificate was issued under the project agreement in respect of the schools. One of the items listed as a snagging item (to be remedied under the terms of the project agreement) were the non-compliant tables.
- The issue of the Acceptance Certificate triggered commencement of the services period and the FM contractor became responsible for providing the services under the FM contract.
- The authority deducted certain amounts (deductions) from the monthly payments to the project company as a result of the unavailability of the schools caused by or attributable to the problems of the non-compliant tables.
- The project company passed on these deductions to the construction contractor who, in turn, sought to pass them on to the sub-contractor. The construction contractor did so on the basis that having supplied the non-compliant tables, the sub-contractor was primarily responsible for the deductions levied by the project company under the project agreement (and passed on to the construction contractor under the main contract).
- The sub-contractor claimed that the construction contractor was not entitled to “pass down” the deductions to it under the sub-contract.
The court had to consider whether the construction contractor was entitled to pass down to the sub-contractor the deductions which the project company had suffered and passed down to the construction contractor under the main contract.
The first issue: Was the construction contractor entitled to pass down deductions levied against it to the sub-contractor?
The sub-contractor argued that the construction contractor was not entitled to pass down the deductions on the basis that:
- The project company’s right to make deductions arose from failures in performance which related to the operational services under the project agreement and not the design and construction (which was the subject of the main contract).
- The deductions could only be passed on by the project company to the FM contractor under the FM contract and not to the construction contractor under the main contract.
- The construction contractor’s liability for the non-compliant tables under the main contract was to remedy the default listed as a snagging item. The failures in the non-compliant tables did not lead to any contractual right for the project company to make deductions from the construction contractor under the main contract.
The court analysed the various contracts.
Scope of the Project Agreement
The court held that the project involved two stages:
- The design and construction stage (Part 3 of the project agreement);
- The provision of operational services (Part 4 of the project agreement);
- Part 3 did not extend beyond the design and construction stage (i.e. it did not include the provision of any operational services).
- The project company’s primary obligations under Part 3 had been completed when the Acceptance Certificate was issued, subject to a continuing obligation to carry out the snagging works.
- The project company’s obligations in respect of the provision of operational services covered by Part 4 of the project agreement commenced from the date when the Acceptance Certificate was issued.
The project company’s liability for deductions
The court held that:
- Clause 21.5.2 in the project agreement provided that: “The issue of an Acceptance Certificate and any identification of any Snagging Works shall not relieve the [Project Company] of liability for Deductions in terms of Schedule Part 7 (Payment Mechanism) …”
- Clause 21.5.2 meant that the project company could not avoid liability for deductions - because in terms of the relationship between the authority and the project company - the project company was responsible for both Parts 3 and Part 4.
- The project company’s liability for deductions arose from failures in achieving the required performance and availability standards forming part of the provision of operational services under Part 4, and not in respect of its design and construction obligations under Part 3.
- The splitting of the project company’s obligations between Parts 3 and 4 was crucial when the project company sub-contracted the work under the project agreement.
The crucial question therefore was whether the project company had passed down its liabilities to pay deductions under Part 4 to the construction contractor.
Did the Project Company correctly pass on to the construction contractor its liability for performance and availability deductions?
The court found that the project company had not correctly passed on to the construction contractor its liability for deductions.
It was plain to the court that:
- The main contract covered the design and construction of the work covered by Part 3 of the project agreement (not Part 4).
- Subject to a residual obligation to carry out the snagging works, the obligations of the construction contractor under the main contract were satisfied when the design and construction stage of the works was completed.
- The failures on the part of the main contractor did not directly result in the project company suffering deductions because the deductions under the project agreement related to failures in the provision of the operational services under Part 4 (not Part 3) of the project agreement. Part 4 only came into being once the design and construction stage had been completed.
- Although the project company had passed through the deductions to the construction contractor, who in turn had passed on the deductions to the sub-contractor under the sub-contract, there was no entitlement to do this.
In short, the court found that:
- The construction contractor was not liable for the deductions under the main contract and had no right to pass such deductions down to the sub-contractor under the terms of the sub-contract.
- The project company had sub-contracted its liability for performance and availability deductions in respect of Part 4 to the FM contractor under the FM contract.
The court noted that the Construction Contractor did not plead a relevant case for it being able to pass on to the sub-contractor any deductions which may have been made against it.
The second question: was the Project Company permitted to pass down deductions upon whichever of its sub-contractors it chose under the Interface Agreement?
The construction contractor, in addition to its primary case set out above, sought to argue that the project company had applied the deductions not against the construction contractor but against the FM contractor, which in turn had claimed against the construction contractor under the interface agreement.
Although this argument was inconsistent with the construction contractor’s primary case, the court did, however, consider the interface agreement in the light of this argument.
Clause 3.3.1 of the interface agreement provided:
“Project Co shall be entitled to claim or deduct or claim an amount equal to any such Deductions or other claim ,,, from the FM Contractor and/or [the construction contractor] as appropriate whether by deduction from monies due or from any retention under the FM Agreement or Building Contract;”
The construction contractor argued that the words “as appropriate” meant that if the authority applied deductions against the project company, the project company was entitled to choose which party was the appropriate party against which to pass on the deduction.
The court rejected the construction contractor’s argument. The court held that:
- The purpose of the interface agreement was clear. If either the FM contractor or the construction contractor was in breach of their obligations under their respective sub-contracts causing the project company to suffer a deduction, the project company would be able to claim a like amount from whichever party had caused the project company to incur that liability or deduction.
- It was impossible to see how it could be appropriate, in circumstances where it was the breach by sub-contractor A that has caused the project company to incur a liability, for the project company to pass that liability to sub-contractor B.
- It would not make commercial sense nor would it give effect to the concept of “appropriateness” for the project company to choose which of its sub-contractors it thought was appropriate to pass on the liability or deduction.
- As between the construction contractor and the FM contractor, if the construction contractor was in breach of the main contract which caused the FM contractor to suffer deductions under the FM contract, then the construction contractor would be obliged to make payment to the FM contractor.
Here, the construction contractor did not plead a case to the effect that its failures caused the FM contractor to be in breach of the FM contract and to suffer deductions. The court declined to comment as to whether it would be able to make out such a case.
This decision is a warning to those who draft PFI and PPP contracts that it is crucial to allocate carefully the project company’s liabilities for deductions between the construction contractor and the FM contractor.
Despite the fact that, in this case, the construction contractor was responsible under the main contract for the deductions caused by the construction contractor or by defects in the construction works, the construction contractor was unable to pass deductions levied against it to the sub-contractor.
That outcome arose:
- because of the division under the construction contract and the FM contract respectively of the obligations of the construction contractor and the FM contractor in relation to deductions under the project agreement, with the result the construction contractor had no primary responsibility for the deductions; and
- because the construction contractor had not pleaded - and the court had not therefore considered - argument that the construction contractor was liable to the project company under the construction contract on the basis that its failures caused the project company to be in breach of the project agreement and to suffer deductions; or that the construction contractor was liable for the deductions under the interface agreement (as opposed to the main contract) because the construction contractor’s failures caused the FM contractor to be in breach of the FM contract.
Parties should ensure that the main contract is clear that if a construction contractor is not primarily liable for deductions levied under the project agreement it will be liable for sums equivalent to the deductions levied on the project company which have been caused by a breach under the main contract (including failure to remedy snagging items and latent defects).
An alternative solution to this issue might be to set up a deductions-specific retention following the issue of an Acceptance Certificate (or equivalent) for the purpose of compensating the project company in the event that the authority levies performance and/or availability deductions against the project company for failures in the construction works which cause a performance or availability issue in the operational services stage.
We note that this is an Outer House decision which might yet be subject to appeal.