In our September 2009 updater we reported on the first instance case of William Hare v Shepherd Construction Limited and others which considered the effectiveness of a pay-when-paid clause. The court decided that main contractor (Shepherd Construction) could not refuse payment to the sub-contractor of approximately £1 million in reliance on a "pay when paid clause" following the administration of the employer, Trinity Wakefield Limited. The contractor appealed to the Court of Appeal.

William Hare v Shepherd Construction Limited and others [2010] EWCA Civ 283

Section 113 (1) of the Housing Grants (Construction and Regeneration) Act 1996 (the Construction Act) prohibited "pay when paid" clauses in the construction industry unless it could be shown that the third party employer was insolvent. Subsection (2) of the Construction Act set out four situations which could constitute insolvency. One of those grounds was “the making of an administration order against it under Part II of the Insolvency Act 1986”.

By the Enterprise Act 2002, the Insolvency Act 1986 (the 1986 Act) was amended, adding administration without court order, described as "self certifying” administration. That led to an amendment to section 113 of the Construction Act to clearly include both administration through court order and "self certifying" administrations.

The sub-contract between the parties drafted in 2008 contained an express pay-when-paid clause (clause 32) which had been drafted by the contractor and entitled the contractor to withhold sums of money otherwise due to the sub-contractor in the event of the employer’s insolvency. The sub-contract set out the grounds which would constitute insolvency. These grounds followed the grounds set out in the Construction Act but did not reflect the amendments made to section 113 in 2002.

The contractor withheld approximately £1million from the sub-contractor pursuant to the pay-when-paid clause in the sub-contract when the employer went into administration. The sub-contractor challenged the withholding on the basis that the employer was not insolvent within the meaning of clause 32 on the dates that the contractor issued its withholding notices because the employer had not had a court administrative order made against it.

The problem for the contractor was that the employer’s insolvency arose through as a result of a “self-certifying” administration (without the need for a court order). As set out above, self-certifying administrations were not referred to in clause 32.

Was the employer insolvent within the meaning of clause 32? The contractor’s arguments

The contractor argued before the Court of Appeal that it would be absurd if clause 32 of the sub-contract was construed without taking into account the subsequent amendments to the 1986 Act and that this was one of those cases where it was so clear that something had gone wrong with the drafting that the court should construe the clause as covering all routes to administration. In particular, the contractor relied on the Jolloy case:

  • The House of Lords decision in Investors Compensation Scheme v West Bromwich Building Society [1998] 1 WLR 896 - the interpretation of a contract depended on what a reasonable person having all the background knowledge which would have been available to the parties would have understood the words to mean.
  • Lord Diplock LJ in Antaios Compania Naviera SA v Salen Rederierna AB [1985] AC 191, 201:

“if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense.”

  • Chartbrook Limited and Another v Persimmon Homes Limited and Another [2009] 1 AC 1101 which demonstrated that the words themselves could be altered, if the court was compelled to the view that the parties simply could not have meant what the words said (Lord Hoffmann).

Was the employer insolvent within the meaning of clause 32? The Court of Appeal’s view

The Court of Appeal dismissed the contractor’s case and gave strong support to the first instance decision. Waller LJ said of the first instance decision that:

“… The judgment is a model of clarity and I would like at the outset to pay tribute to it, and indeed reveal a strong inclination simply to say that for the reasons the judge gives the appeal should be dismissed…”

His Lordship did, however, go on give his own reasons why the contractor’s appeal should be dismissed (with which the two other lord justices agreed). The Court of Appeal confirmed that:

  • The starting point for the principles of contract interpretation are those in Investors Compensation Scheme but that there must be a strong case to persuade the court that something must have gone wrong with the language used in a contract (it should not “… easily be accepted that people have made linguistic mistakes, particularly in formal documents ...”)

However, in cases of exclusion of liability, such as this case, the Court of Appeal was “very doubtful” that the usual principles set out above would apply at all. In the court’s view:

  • Pay-when-paid clauses were generally ineffective except in cases of third party insolvency as set out in section 113 of the Construction Act.
  • If the contractor wanted to rely on a pay-when-paid provision in a sub-contract, the pay-when-paid provision would need to cover an event of employer’s insolvency as defined in the legislation.
  • If the contractor mis-drafted the pay-when-pay provision so that the ground of insolvency was not in accordance with the legislation, there was no reason why, however obvious it was that the contractor had mis-drafted the provision, the court would come to the rescue.
  • If the contractor had drafted the pay-when-paid provision in a way which actually worked (as the clause did in this case), even if a reasonable person would guess that there had been an error, there was even less reason for the court to come the rescue. The clause as drafted was still workable but just not wide enough to cover the scenario the contractor would have wanted it to.

In this case, the pay-when-paid provision had the effect of relieving the contractor of a liability to pay and it was for the contractor to get a clause of this nature right if they wished to rely on it. The Court of Appeal considered that the dominant principle to be applied was that set out by Lord Bingham in Dairy Containers Ltd v Tasman Orient Line CV [2005] 1 WLR 215

“The general rule should be applied that, if a party otherwise liable is to exclude or limit his liability . . . he must do so in clear words; unclear words do not suffice; any ambiguity or lack of clarity must be resolved against that party”.

As a result, it was not open for the contractor to argue that there was a lack of clarity in a provision that they had drafted so as to relieve themselves from liability, and the court should not use the principles identified by Lord Hoffmann (above) to help the contractor. Clear words should have been used.

Accordingly, the Court of Appeal confirmed that the pay-when-paid provision was not effective.

Editors’ comments

Contract drafters should take note of the decision of the Court of Appeal. Had clause 32 of the sub-contract been amended to refer to any amendment re-enactment of the legislation which entitled an administrator to be appointed without a court order, then the result would have been different and the contractor could have relied on the pay-when-paid provision.

Bespoke amendments made to standard form contracts should be checked regularly to ensure that changes to legislation and indeed to judicial interpretation of contractual provisions are taken into account.

The decision also confirms that contract clauses which seek to exclude or limit liability are likely to be strictly enforced against the party seeking to rely on them.

View: William Hare v Shepherd Construction Limited and others [2010] EWCA Civ 283