‘Pay-when-paid’ clauses unenforceable, except on insolvency

07/06/2010

By Chris Kirby-Turner, Solicitor in Construction & Engineering.

Pay-when-paid clauses, favoured by contractors seeking to pass the risk of not being paid down the chain to their subcontractors, were effectively banned when section 113 of the Construction Act 1996 (the Act) came into force.

The Act provides that pay-when-paid clauses are unenforceable, unless they only apply where the paying party becomes 'insolvent’, by one of the insolvency routes defined in the Act. Any other pay-when-paid clause is rendered ineffective by virtue of the Act, whatever the parties may have signed up to. In other words, if the employer became insolvent before the contractor was paid, a pay-when-paid clause could, in theory, be valid and come to the contractor's rescue.

If a non-compliant clause is included in a contract, then not only is it ineffective but all of the payment provisions in the construction contract (and not just the offending pay-when-paid clause) will be replaced by the default provisions contained in the Scheme for Construction Contracts 1998. As well as being futile, non-compliant clauses therefore create great uncertainty and could significantly increase the commercial risk and likelihood of matters ending up in a formal dispute.

The fairly draconian effect of section 113, and the ban on pay-when-paid clauses, mean that disputes have very rarely got as far as the courts. However, the issue was given some detailed consideration by the Court of Appeal in the recent case of William Hare Ltd -v- Shepherd Construction Ltd [2010].

The main point in contention was whether the terms of the clause fell foul of the provisions of the Act, because of the way in which the employer's insolvency was defined. Essentially, the problem arose because the wording of the clause was quoted from the original version of the Insolvency Act (IA), whereas the IA was updated by the Enterprise Act 2002 (EA) to refer to various new, additional, statutory insolvency procedures (one of which the employer had used). The court held that it was not appropriate to imply the updated EA wording into the contract, as it was not the court's business to come to the rescue if a party has made a mistake and mis-drafted a pay-when-paid clause. The Court of Appeal, concurring with the initial judgment of the Technology & Construction Court, held that the withholding notices that were issued were invalid and that the amount should therefore be paid to the subcontractor.

The case therefore reemphasises that pay-when-pay clauses will only be allowed in the very limited circumstances permitted under the Act, and brings into sharp focus the need to ensure that such clauses are drafted with proper precision.