Practical Law

Managing and securing the cash flow of any business enterprise is of paramount importance, and contracting parties in the construction industry are no exception to this. If regular cashflow from the main contractor to its subcontractors and the supply chain is disrupted, parties to the project may soon find themselves in difficulty. The purpose of a conditional payment clause is to help a main contractor guard against a cash flow “crunch” by making the downstream payment obligation conditional on receipt of payment from the upstream party.

Conditional payment provisions, stipulating that payment can be made only “when” or even “if” the main contractor is paid or upon the occurrence of certain events or actions, are prohibited in the UK and various other jurisdictions around the world, including New Zealand, Malaysia, and certain provinces/states in Canada, Australia and the USA. However, in some jurisdictions, particularly in the Middle East, “pay when paid” and even “pay if paid” provisions play a significant part in allocating risk on construction projects. In the Middle East, such payment clauses remain enforceable, though parties need to be aware of how the respective Civil Codes in the region affect their operation.

Forms of conditional payment clauses

Conditional payment clauses can take many forms.

A “pay when paid” clause defers timing of the payment. However, the main contractor retains the risk of non-payment by the employer. Consequently, while a main contractor may invoke a “pay when paid” clause it is not able to do so indefinitely.

A “pay if paid” clause makes payment contingent on the main contractor receiving payment from the employer. The risk of non-payment by the employer is transferred to the subcontractor.

UK: prohibition on conditional payments

For construction contracts that fall within the ambit of the Construction Act 1996, section 113(1) provides that any term making payment under the contract conditional on the payer receiving payment from a third person is ineffective.

In addition, section 110 of the Construction Act 1996 provides that every construction contract is required to contain an “adequate mechanism” for determining what and when payments are due. In respect of conditional payment terms, section 110(1A), which took effect in England and Wales for construction contracts dated on or after 1 October 2011, provides:

“(1A)  The requirement… to provide an adequate mechanism for determining what payments become due under the contract, or when, is not satisfied where a construction contract makes payment conditional on

(a)        the performance of obligations under another contract, or

(b)        a decision by any person as to whether obligations under another contract have been  performed.”

This was intended to prohibit “pay-when-certified” clauses, which were being used as a way to avoid the prohibition on “pay-when-paid” provisions. An example of this type of clause is where payment to a sub-contractor under its sub-contract is conditional on the main contractor’s application for payment under the main contract having been certified for payment by the employer.

If or to the extent that a contract contains a non-compliant payment mechanism, the relevant provisions of Part II of the amended Scheme for Construction Contracts (England and Wales) Regulations 1998 will replace the offending payment terms (section 110(3)).

Main contractors are therefore prevented by statute in the UK from transferring the risk of non-payment from the employer onto a subcontractor. A notable exception from the prohibition on “pay when paid” provision is in respect of upstream insolvency.

The Middle East: conditional payment clauses

In contrast, main contractors in regions such as the Middle East are free to agree that the payment terms in their subcontracts operate “back to back” with the payment terms they have agreed with the employer, although the statutory codes of the different jurisdictions play an important role in supervising the operation of conditional payment clauses.

A cornerstone of all Civil Codes in the Middle East is that the contracting parties have an explicit obligation to conduct themselves in a manner that is consistent with principles of good faith in the performance of a contract.

Moreover, the subject matter of a contract must have a valid cause, in the sense of a purpose or motive, and must not conflict with public order, decency or laws passed for the public interest. Areas of public interest include marriage, inheritance and lineage, systems of government, freedom of trade, circulation of wealth, rules of private ownership and “the other rules and foundations upon which society is based”, as noted in Bahrain’s Civil Code.

Practical implications

Examining the mechanics of conditional payment clauses there are a number of aspects parties need to bear in mind:

Loss of protection

In the Middle East, the main contractor should be aware that if it fails to pursue payment on behalf of the subcontractor, it may lose back-to-back protection and leave itself open to a claim from the subcontractor. The main contractor may then find itself in the position of having to pay the subcontractor “from its own pocket” before pursuing the claim separately against the employer.

When is when?

According to Article 428 of the UAE Civil Code, a condition must be observed as far as is possible. However, a typical question in respect of “pay when paid” clauses is “when is ‘when'” under the subcontract? For example, is the subcontractor entitled to payment only upon project handover, or when the subcontract works are handed over?

Dubai Court of Cassation Case No. 281 of 1995 (dated 6 July 1996) considered the effect of a “back-to-back” conditional payment provision. Here, a main contractor resisted a subcontractor’s claim for the balance of the subcontract price, relying on a conditional payment clause which made payment conditional upon receipt of payment from the employer.

The Court found that the subcontractor was only entitled to a proportional payment during the “performance period” from any payment received by the main contractor. However, the position changed when the subcontractor completed all of its work and delivered the subcontract works to the main contractor. At this point all payments became due and the subcontractor did not have to wait for payment until such time that the main contractor was paid. The main contractor was not entitled to suspend payment indefinitely.

The Court affirmed that conditional payment clauses are subject to general principles of contract which require the court to have regard to the “meaning and intention, not mere words”. The Court further noted that the contract provisions have to be interpreted in such a way so as to achieve the common interests of the parties and not to give undue weight to the interest of one party over the other. To require the subcontractor to wait for payment beyond the handover of the project, or to be penalised for problems that it may not have caused, would be incompatible with these principles.

Possible remedies or solutions

In the event of non-payment, the subcontractor may have a right to suspend its works under local laws, for example, in the UAE pursuant to Article 247 of the UAE Civil Code. However, the subcontractor needs to ensure that it has complied with its performance obligations. If the employer’s payment obligations are “back to back” with the main contract, the subcontractor may still be dependent on the main contractor being in a similar position vis-à-vis the employer before a domestic court will consider the question of whether the subcontractor’s actions were proportionate in the circumstances.

Going forward

While prohibited in certain jurisdictions, conditional payment provisions continue to play an important part in allocating risk on construction projects around the world, particularly in regions such as the Middle East. This a commercial reality many are willing to agree to in order to do business. Yet all parties on a project need to be acutely aware of exactly how such provisions operate under the particular law governing the agreements they sign up to.

It was the famous English judge, Lord Denning who first coined the axiom that cash flow represents “the very lifeblood of the enterprise” and it remains a truism on construction projects the world over. Parties ignore conditional payment clauses at their peril.