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Avoiding payment to an insolvent payee under the amended Construction Act

Continuing on the theme of commenting on the drafting of the amendments made to Part II of the Housing Grants, Construction and Regeneration Act 1996 (Construction Act 1996) by the Local Democracy, Economic Development and Construction Act 2009 (LDEDC Act 2009), this blog considers new section 111 of the Construction Act 1996. Specifically, it looks at how section 111 operates in the event of payee insolvency.

Section 111

Section 111 of the Construction Act 1996 (as amended) provides:

111 Requirement to pay notified sum

(1) Subject as follows, where a payment is provided for by a construction contract, the payer must pay the notified sum (to the extent not already paid) on or before the final date for payment…

(5) A notice under subsection (3)-

(a) must be given not later than the prescribed period before the final date for payment…

(10) Subsection (1) does not apply in relation to a payment provided for by a construction contract where-

(a) the contract provides that, if the payee becomes insolvent the payer need not pay any sum due in respect of the payment, and

(b) the payee has become insolvent after the prescribed period referred to in subsection (5)(a).”

Therefore, subsection 111(10) says that the requirement to pay the “notified sum” may not apply in the event that the payee has become insolvent. “Insolvent” has the meaning given in section 113 of the Construction Act 1996. The two criteria (on contract terms and the timing of the insolvency) to be met before the payer can withhold payment under this section are set out in subsections (10)(a) and (b), above.

The prescribed period

The “prescribed period referred to in subsection (5)(a)” must be interpreted as the period of time falling before the final date for payment (even if not immediately before), during which a payer may serve a notice of its intention to pay less than the notified sum (a pay less notice) in respect of a payment. If the parties do not agree the prescribed period, it is set as the period “not later than seven days before the final date for payment”, by paragraph 10 of part II of the Scheme for Construction Contracts 1998 (as amended).

It might have been better for the words “not later than” in subsection 111(5)(a) to read “during”, instead, to avoid the suggestion that the “prescribed period” is simply an agreed number of days between the last date the pay less notice may be served and the final date for payment. On this reading, the Scheme would provide a “prescribed period” of “seven days”.

However, that interpretation must be incorrect because it would mean that the wording in subsection 111(10)(b) could not operate as intended, as “after the prescribed period” would, in effect, be the same as saying “after the final date for payment”.

Timing of the insolvency

The intention of subsection 111(10) appears to be that the payer should deal with the insolvency of the payee by issuing a pay less notice, where the insolvency occurs before the expiry of the prescribed period. The government’s explanatory notes to the LDEDC Act 2009 say:

“[Subsection (10)] provides that the subsection (1) requirement to pay the ‘notified sum’ does not apply where the contract allows the payer to withhold moneys upon the payee’s insolvency and the payee becomes insolvent after the expiry of the period for giving a notice of intention to pay less than this sum (pursuant to subsection (3)).”

Therefore, in the event of payee insolvency occurring before the end of the prescribed period, the payer should issue a pay less notice (where the contract allows) if it wishes to withhold payment. If the insolvency occurs after the expiry of the prescribed period, the payer should seek to rely on the provisions of subsection 111(10).

Contract terms in practice

Where does that leave the payer drafting its contract? To take advantage of the protection offered by subsection 111(10) in situations where payee insolvency occurs after the expiry of the prescribed period, paying parties should certainly consider inserting a clause to the effect that “if the payee becomes insolvent the payer need not pay any sum due in respect of the payment”. Make sure that “insolvent” has the meaning given to it in section 113 of the Construction Act 1996, rather than using any other definition of insolvency that might be provided for elsewhere in the contract.

Also remember that, for a payer to be able to use a pay less notice to withhold payment on the insolvency of the payee, where that occurs prior to the end of the prescribed period, there must be adequate provision in the contract. Section 111(4)(a) of the Construction Act 1996 requires that a pay less notice specifies “the sum that the payer considers to be due on the date the notice is served”, and the amount specified must then be paid (though it may be zero). In other words, the contract must provide that no payment is due upon the insolvency of the payee, in order for the payer to be able to specify a sum of “zero” in the pay less notice and consequently pay nothing to the payee.

One point this blog does not consider is whether section 111(10) would apply to an insolvency that occurs after the final date for payment (which, arguably, still falls within subsection 111(10)(b)) in order to relieve the payer from the obligation to make a payment that should have been, but was not paid on or before the final date for payment.

4 thoughts on “Avoiding payment to an insolvent payee under the amended Construction Act

  1. Thanks for this James,

    I have to say these provisions have left some people I know scratching their heads.

    Just to be clear, is it the case that:

    1. Where the insolvency occurs prior to the last date for giving a Pay Less Notice, a Pay Less Notice is still required;

    2. Where the insolvency occurs after the last date for giving a Pay Less Notice BUT before the final date for payment, NO Pay Less Notice is required, i.e. it doesn’t matter if you haven’t served one as no payment is required;

    3. Where the insolvency occurs after the final date for payment, you have to pay the notified sum (so if you haven’t served a Pay Less Notice it is tough) OR the situation also falls within s.111(10) and no payment is required [i.e. your final paragraph].

    If correct:

    In the first scenario, and in order to protect your position, presumably your Pay Less Notice should include a deduction for the anticipated cost of completing the works with an replacement contractor.

    The difficulty is whether the Act does in fact differenciate between scenarios 2 and 3.

    The question I have been asked is whether there is anything Employers can do in terms of payment periods to gain maximum protection?

  2. You’re welcome, ConstructionJim.

    In relation to your numbered points, I believe 1 is correct, as is 2 (bearing in mind that the contract must make provision for this, as noted in s111(10)(a)).

    Point 3 is more difficult. The message from the final paragraph above is that the Act doesn’t make it clear what would happen in this situation. As far as the Act is concerned, you should have already paid the notified sum by the final date for payment. If, in breach of s111(1), you fail to make that payment, there is no express direction in the Act as to the relevance of s111(10).

    From a purely linguistic perspective, the wording of s111(10) would appear to encompass this situation, as the insolvency still occurs “after the prescribed period”. However, there are arguments against this literal interpretation which are summarised on this site (see Insolvency and new section 111).

    As for your other comments, while you would want to include such a deduction in your Pay Less Notice, remember that your contract must make provision for this in relation to determining the amount due, as the Pay Less Notice must state “the sum that the payer considers to be due on the date the notice is served”, as I’ve noted above.

    Finally, I think all Employers can do to protect themselves from contractor insolvency, is to set the final date for payment far enough in the future to reduce the risk of having to pay a contractor before he goes insolvent. On the other hand, Employers holding off payment as long as commercially possible may push more contractors into insolvency, so you might say it’s a double-edged sword!

  3. The law is a mess on this point thanks to Lord Hoffman’s judgment in Melville Dundas.

    The contract the court considered in Melville Dundas stated that the payer did not have to pay amounts which had become due, if the contract was determined. The contract stated that the contract could be determined if the payee entered into administration.

    In this case the payer had not issued a withholding notice by the final date for payment. A week later the payee had an administrative receiver appointed and the payer determined the contract.

    Lord Hoffman held that the payer did not have to pay in spite of not having issued a withholding notice by the final date for payment. In reaching his conclusion, Lord Hoffman made 3 observations:

    1. He did not consider that it was Parliament’s intention for the payment rules of the 1996 Act to apply where the payee had entered into an insolvency procedure (paragraph 12).

    2. That the 1996 Act did not prevent parties agreeing that an amount could cease to be due upon the occurance of specified events (paragraph 9).

    3. The law did not require parties to do the impossible – in this case issue a withholding notice before the relevant facts has arisen relating to the right to issue a notice) (paragraph 22).

    Lord Hoffman was apparently not concerned by the fact that that there would have been a period (between the final date for payment and the date of the determination of the contractor’s employemnt) when the amount which subsequently become ‘undue’ was overdue.

    Coulson J considered in the case of Pearce Design International v Johnston that it can not have been the House of Lords’ view that the clause which was relied on in Melville Dundas could be relied on where the determination of the contractor’s employment had occurred as a result of the payee entering into administration, but that it could not be relied on if the determination has occurred for other reasons.

    It is likely that in reaching this conclusion, Coulson J considered that if the court had thought that factual circumstances could arise which would mean that the clause did not operate as a part of an “adequate mechanism” then the court would have held that the clause was not effective (regardless of whether such facts had actually transpired) and would not have allowed the payer to rely upon it.

    Coulson J effectively therefore held in Pearce Design that the ratio of Melville Dundas was that parties are free to agree that an amount which has become due can cease to be due, and that in such circumstances a withholding notice does not have to be issued. It could be argued that this effectively defeats the whole purpose of the 1996 Act.

    The fact that under the new Act s111(10) is introduced to expressly permit parties to agree that the payer need not pay if the payee becomes insolvent after the expiry of the prescribed period, presumably means that it is Parliament’s intention under this new Act, that the parties may not agree that the amount due may become undue (other than in relation to insolvency), thus thankfully rendering Melville Dundas and Pearce Design largely obsolete where the new Act applies.

    In the circumstances though where a payee becomes insolvent after the final date for payment and the payer hasn’t paid, one school of thought would be that Lord Hoffman’s ‘logic’ still applies (albeit to the notified sum/pay less notice) and that a subsequent insolvency gets the payer off the hook.

  4. Jamie,

    Some excellent points here, I would very much appreciate your opinion on the following scenario:-

    (1) Under a standard design and build contract, with the usual provisions regarding further payment after insolvency.

    (2) The Main Contractor is required to make an application on a payment due date, the Employer is supposed to give notice of what the payment will be 5 days after receipt and final date for payment is 14 days after contractor’s application is received.

    (3) Contractor issues no application at the payment due date, then becomes insolvent and has an administator appointed.

    (4) Weeks later, the Administrator then issues a valuation of work, then attempts to enforce payment as no “pay less” notice is given. The contract obviously states no further payments are due till the works are completed and all defects made good.

    Do you think the Administrator is wrong in this?

    Thanks

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