Legal Briefing

‘Pay when paid’ or not? Lessons in commercial contract drafting

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Corporate & Commercial | 01 September 2011

Originally, the purpose of a ‘pay when paid’ clause as used in the construction industry was to absolve the contractor from liability to pay the subcontractor until it had been paid by the employer. The effect of such a clause was to allow the contractor to pass the risk of default by the employer to its subcontractors further down the construction chain. The use of these clauses created havoc in the construction sector in the late 1980s and early 1990s and as a result the law was changed to drastically reduce their lawful scope.

The change to the law was achieved by the effective prohibition of pay when paid clauses by s113 of the Housing Grants, Construction and Regeneration (HGCR) Act 1996. The only exception to this prohibition is a pay when paid clause applying in the event that there is an ‘upstream’ insolvency in a construction contract. Section 113(1) of the HGCR Act provides:

‘A provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective, unless that third person, or any other person payment by whom is under the contract (directly or indirectly) a condition of payment by that third person, is insolvent.’

This means that if the employer is solvent, a pay when paid clause in a contract between contractor and subcontractor will not enable the contractor to withhold payment from the subcontractor.

WILLIAM HARE LTD V SHEPHERD CONSTRUCTION LTD [2009]

The leading case on the validity of pay when paid clauses is the decision of Mr Justice Coulson in William Hare Ltd v Shepherd Construction Ltd [2009] in the Technology and Construction Court which was subsequently upheld in the Court of Appeal.

William Hare Ltd (Hare) was the subcontractor retained by Shepherd Construction Ltd (Shepherd) as contractor. Hare was subcontracted to fabricate and erect steelwork at a large development in Wakefield. Hare had a valid claim for £996,683.35 for work completed under the contract with Shepherd. Shepherd withheld this payment relying on the pay when paid clause in the contract when the employer, Trinity Walk Wakefield Ltd (Trinity), went into administration. The pay when paid clause of the subcontract between Shepherd and Hare was drafted so as to incorporate the four specific insolvency events originally contained in s113 (2) of the HGCR Act, which were as follows:

‘For the purposes of this section a company becomes insolvent:

a) on the making of an administration order against it under Part II of the Insolvency Act 1986;
b) on the appointment of an administrative receiver…;
c) on the passing of a resolution for voluntary winding-up without a declaration of solvency…;
d) on the making of a winding-up order…’

It will be noted that the clause refers to ‘the making of an administration order’. However, the subcontract between Shepherd and Hare was entered into in 2008, some five years after the Enterprise Act introduced amendments to the Insolvency Act by the introduction of Schedule B1, which permitted two new ways for a company to go into administration.

Instead of applying to court for an administration order, a qualifying floating charge holder (by paragraph 14 of Schedule B1) or the company or its directors (by paragraph 22 of Schedule B1) are entitled to appoint an administrator by filing notices at court. Usually known as ‘out of court appointments’, the court referred to these new methods of placing a company into administration, not requiring a court order, as ‘self-certifying’ options. The court also noted that the effect of the Enterprise Act amendments was to replace the provisions relating to administration in the original Part II of the Insolvency Act 1986 by the provisions of a ‘new Part II’ in Schedule B1 including the self-certifying procedures. The court noted that in fact the original Part II has not been abolished but is retained and applies to certain special types of company such as water utilities and railway companies. For the vast majority of companies the provisions in Schedule B1 apply. In addition, a statutory instrument was introduced to amend the terms of s113(2) of the HGCR Act to reflect the provisions of Schedule B1 as to administrations, including the self-certifying options for placing companies into administration.

Shepherd’s employer was placed into administration, not by court order, but by the company and its directors by way of a self-certifying option under the provisions of Schedule B1. Therefore the employer did not become insolvent by reference to one of the four insolvency events set out in the pay when paid clause in the subcontract between Hare and Shepherd. The clause had not been updated to refer to Schedule B1 of the Insolvency Act and in particular the type of self-certifying administration entered into by the employer.

On these facts, the judge had no difficulty in holding that the pay when paid clause in the subcontract was not effective to allow Shepherd to withhold the sum of almost £1m from Hare on the basis of the employer’s administration. The judge noted that there may have been a different result had the subcontract been put in place before the statutory amendments. In turn the Court of Appeal upheld the first instance decision in favour of Hare, describing Mr Justice Coulson’s judgment as a model of clarity.

DRAFTING POINTS TO NOTE

The first instance judgment of Mr Justice Coulson contains a number of lessons for those drafting commercial contracts.

Effect of changing legislation

Counsel for Shepherd had put forward the argument that it would be an absurd result if the pay when paid clause, which referred to what was originally the only method of a company entering into administration, was to be held as excluding the more recently introduced self-certifying administration brought in by the Enterprise Act. He argued that the pay when paid clause should be read as if the words were amended to say ‘on the appointment of an administrator under Schedule B1 of the Insolvency Act 1986’.

Against that, Hare successfully argued that none of the insolvency events under the pay when paid clause had occurred and therefore the clause had not been invoked. Hare made the point that in fact the reference to administration orders in the pay when paid clause still had meaning, as the provisions of Part II Schedule B1 also allowed for the making of a court order to place a company into administration. It would therefore be difficult to argue that the clause should be treated as referring to self-certifying options. The judge agreed.

The lesson here is that the courts will not treat references to legislation in contracts as incorporating amendments and revisions to legislation introduced before the date of the contract. Although it failed to deal with the effect of the amendments to the Insolvency Act, the court held that the pay when paid clause was both cogent and clear in its drafting. It could not therefore be amended by the court and there was no suggestion of a claim for rectification and no suggestion of mistake.

The court referred to another clause of the subcontract, which dealt with the practical consequences of Hare’s insolvency. This clause used the words ‘under the Insolvency Act 1986 or any amendment or re-enactment thereof.’ The judge noted that these words were sufficient to cover the different methods of appointing an administrator under Schedule B1. Crucially, the pay when paid clause did not contain these words.

The words used

The judge applied Ellse v Hill-Pickford [2006], which decided that in any dispute about the meaning and effect of a contractual provision the starting point is the natural and ordinary meaning of the words used. In explaining that he preferred Hare’s interpretation of the words in the clause as it was based on the plain meaning of the words used, he referred to Lord Hoffmann’s comment inInvestors Compensation Scheme Ltd v West Bromwich Building Society [1998] that ‘we do not easily accept that people have made linguistic mistakes particularly in formal documents.’ The judge also noted that the courts must take care to ensure that the words are not interpreted too literally at the expense of business common sense and that the law generally favours a commercially sensible construction.

The nature of the clause

In considering the nature of the pay when paid clause the judge explained that it was endeavouring to identify the circumstances in which Hare could do a considerable amount of work for Shepherd under the subcontract and then be paid not a penny. He noted that Shepherd wanted to pass on the risk of the employer’s default to Hare without Hare having a contract with the employer or the opportunity to do due diligence on the employer in contrast with Shepherd who did. He described the clause as a form of exclusion clause. The judge went on to note that traditionally pay when paid clauses were construed narrowly against those seeking to rely on them.

The contra proferentum rule

The court judge said that in view of his firm conclusion as to the proper construction of the clause, the contra proferentem rule (as set out in Lexi Holdings Plc v Stainforth [2006] EWCA Civ 988) was not really of significance in this case. However, it could be applied to the effect that since Shepherd was the party putting forward the relevant words in the pay when paid clause and was the party benefiting from those words, to the extent that there was any doubt over their meaning, the words would be construed against the drafting and benefiting party, and therefore it followed that they should be construed against Shepherd.

The Interpretation Act and Schedule 17 to the Enterprise Act

Shepherd had relied on provisions of Schedule 17 to the Enterprise Act, which state that, in a contract made before the Act, references to an administration order:

‘… shall be treated as including the reference to the appointment of an administrator under paragraphs 14 and 22 of Schedule B1.’

Shepherd was obliged to accept that this was of no relevance to the case because the subcontract was made years after the Enterprise Act introduced the new Schedule B1 regime. A similar point made in relation to the Interpretation Act also failed for the same reason.

Alternative view

The judge made a final comment to the effect that if, contrary to his primary view, there was a case to read the pay when paid clause as if the words were amended to reflect subsequent legislation, he was firmly of the view that the only change that would be warranted would be a change from ‘on the making of an administration order against it under Part II of the Insolvency Act 1986’ to ‘on the making of an order against it under Schedule B1 of the Insolvency Act 1986.’ Clearly, such a change would not have altered the outcome of the case.

The appeal

The Court of Appeal had no more sympathy for Shepherd’s case than the judge at first instance. Shepherd’s counsel expanded his argument, maintaining that the pay when paid clause was not an exclusion clause but a clause sharing the risk between subcontractor and contractor of the employer becoming insolvent. He argued that the court had discretion to amend the words of the clause if it could be demonstrated that a reasonable person would conclude that something had gone wrong with the drafting. Lord Justice Waller said that a contractor relying on a pay when paid clause could not expect the court to apply principles available to the court in interpreting the meaning of the clause to come to its rescue where the clause was misdrafted in a way that did not work. If the clause was misdrafted in a way that actually did work, as in this case, he saw even less reason for the courts to come to the rescue.

SUMMARY

It should be pointed out that the solicitors who drafted the construction contract for Shepherd had not been negligent in any way. The precedent contract had been created for Shepherd in 1998 when the contents of the pay when paid clause were in line with then current legislation. As Shepherd had not updated the contract since 1998, the pay when paid clause became out of date and failed to protect them.

It is worth noting that the use of the phrase ‘under the Act or any amendment or re-enactment thereof’ was approved by the court as an effective means of ensuring subsequent legislative change is covered. However, for those using standard contracts, whether in the construction industry or otherwise, it is wise to ensure that they are checked for legislative references and updated on a regular basis, in order to ensure they continue to provide the protection for which they were originally drafted.