REUTERS | Toby Melville

Direct payments to suppliers on a construction project

A client who is building a large mixed use development called me yesterday with a dilemma. He had received a letter from a local equipment supplier, who was on the verge of bankruptcy because the sub-contractor who had engaged him had gone into administration after the hire period had come to an end. He was pleading with my client to help him recover some £20,000 of hire fees still owed to him.

The supplier had already approached the main contractor (appointed by my client) who had refused to pay the outstanding hire fees, because it had already paid the (now insolvent) sub-contractor. The supplier suggested that my client surely must have a guarantee, bond or retention monies available to ensure that small local traders (like him) would get paid in circumstances like this? Why couldn’t my client pay the supplier and recover this from the main contractor?

Could the performance security provided under the building contract be used to protect or reimburse a supplier in these circumstances?

While a main contractor may have provided performance security to an employer in the form of a performance bond or parent company guarantee, typically this can only be called in the event of a breach or insolvency of the main contractor, not a sub-contractor. This was the position in my client’s case.

Similarly any retention held by an employer is for its own benefit opposite the main contractor, as security for making good defects, and to be released in accordance with the terms of the building contract. The main contractor usually has similar obligations to release any retention owed to the sub-contractor in accordance with its sub-contract.

In our case, we had no visibility of the sub-contract arrangements. Nor had we seen the sub-contractor’s contract with the supplier. However, there were no provisions in the building contract entitling my client to make direct payments out of the retention monies to sub-contractors (or indeed sub-sub-contractors such as the supplier). If my client decided to pay the supplier, it would still be liable to pay the main contractor the whole of the retention, without deduction for any such payment to the supplier.

So, in what circumstances can an employer make a direct payment to a supplier?

Can the employer make a direct payment to the supplier where the main contractor is insolvent?

An employer is neither obliged nor entitled to make direct payments to sub-contractors or suppliers on the insolvency of a main contractor. Historically the JCT forms permitted direct payment in these circumstances, but that is no longer the case. The position between a main contractor and its sub-contractors is the same.

Can the employer make a direct payment if a main contractor fails to pay a sub-contractor (or, as in this case, a sub-contractor fails to pay sub-sub-contractors or suppliers)? 

Generally, an employer (or main contractor) is neither obliged nor entitled to remedy this failure, whether or not they have already made a payment that includes amounts owed to a sub-contractor (or a sub-sub-contractor or supplier). The only exception is where the contract expressly permits it to do so. Some employers include clauses to this effect in the main contract. Such provisions typically include a right for the contract administrator to request proof that amounts included in any previous interim certificate in respect of work, materials, goods or services supplied by any sub-contractor or supplier have been paid. If the main contractor is unable to provide this proof, the employer may pay the amount in question direct to the sub-contractor or supplier and deduct it from any future payment due to the main contractor under the building contract.

Additionally, some contracts allow  for direct payments to be made in certain other circumstances, for example where there is a perceived risk of insolvency. This is usually effected by including a clause allowing the employer to specify the amount due to a sub-contractor in an interim certificate under the building contract, but then to make an equivalent deduction from that amount and pay it direct to the sub-contractor or supplier, as the case may be.

This must be expressly stated to extinguish any claim that the main contractor would otherwise have against the employer for that sum.

Some of our clients who have ongoing relationships with key sub-contractors include these provisions in their contracts to protect their supply chain, but they are far from standard.

Are there any other options?

Unfortunately in my client’s case, there wasn’t a great deal it could do to facilitate payment to the supplier, other than encouraging it to pursue a claim with the sub-contractor’s administrators. If my client chose to pay the supplier direct, it would have been unable to reclaim that money from the main contractor or to rank in the administration/liquidation of the sub-contractor, so it would have ended up paying twice for the same service.

One possible solution to this problem could be to use a project bank account (PBA). The Government Construction Board proposed the use of PBAs back in 2009, and said that they should be used on central government construction contracts unless there was a compelling reason not to do so. Contracts such as NEC3, the project partnering contract (PPC 2000) and the JCT contracts provide for PBAs, and many banks are prepared to offer them. They can provide security and certainty of payment to the supply chain, and have been extensively (and successfully) used by major public sector employers such as Highways England and Crossrail.

Final thoughts

PBAs are viewed by some as complicated, time consuming to set up and expensive to operate. They are also seen by some main contractors as an unwarranted fetter on their ability to control the flow of cash to their supply chain. Conversely, suppliers regard them as a significant benefit and are prepared to offer lower prices (in effect, a prompt payment discount) where they are used.

PBAs are not widely used in the private sector, but maybe it is time that this changed? As Francis Maude said a few years ago, when talking about the government’s use of PBAs:

“To win the global race, we must support the smaller suppliers which are the lifeblood of our economy.”

Berwin Leighton Paisner LLP Geraldine Laing

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