10.1 The cascade system of payment in the industry - normally client to main contractor, main contractor to subcontractor, and so on down the chains - makes the exposure of different parts of the process to the insolvency of one participant particularly serious. The chain may begin above the client, with the banks or other funders who are financing the project. If a main contractor fails, subcontractors will be treated as unsecured creditors in respect of work which they have already carried out (or purchased equipment), whether on or off site. Even their retention monies will be at risk, since domestic subcontracts make no provision for secure trust funds. In theory, nominated subcontractors are protected in respect of their retention monies because the employer is supposed to hold the money in a fiduciary capacity. Also protected in theory is the main contractor's retention, in the event of the failure of the employer (c/f JCT 80, Clause 30.5). But:
1. Some forms of contract do not keep retention as "trust monies", either for the contractor or for nominated subcontractors. Even some Standard Forms do not, (e.g. ICE 6th edition).
2. Some employers delete these provisions - including public sector clients, on the grounds that they will not become insolvent.
3. The onus of establishing if the trust accounts have been set up rests in practice on the contractor or nominated subcontractor.
10.2 The normal interim payments for work performed are also insecure. The case of British Eagle International Airlines versus Compagnie Nationale Air France (1975) - which led to changes to JCT 80 from the previous limited protection in JCT 63 - removed the right of the employer to pay nominated subcontractors directly if the main contractor failed. The practical reality now, if the main contractor becomes insolvent, is that the primary or secured creditors of the main contractor will receive some monies which are intended for and owing to the subcontractor for work carried out. If the client fails, the main contractor and potentially also the subcontractors will be disadvantaged.
10.3 It is absolutely fundamental to trust within the construction industry that participants should be paid for the work which they have undertaken. It may be argued that there is no need for any action because:
1. Clients may exercise responsible prequalification procedures to ensure that work is only awarded to stable firms. They can also insist upon knowing who the subcontractors are, or they can nominate or "name" them, so as to prevent disruption of the work through failure there.
2. Equally, contractors (or subcontractors) can decline to work for a client (or main contractor) or can require prepayment or bonds/indemnities from them.
3. All businesses in all industries are at risk if insolvency affects their clients. Bad debt is not only a problem in construction and it is possible to insure against it.
10.4 Such arguments ignore the practical realities of construction. However diligently clients, contractors or subcontractors check on each other, the causes of the failure of any participant may be unrelated to the particular contract, or even to work in this country. In a difficult trading climate for construction, firms will undertake work for low (or no) margins, and will not endanger their chances of being selected by demanding prepayment or indemnities, even if they are aware that there might be a payment problem. Bad debt insurance is possible, but it is another cost overhead at a time when most firms are cutting their overheads in order to reduce their quotations for "preliminaries" and remain competitive.
10.5 The construction industry has a unique characteristic. Its goods and services become part of the land once incorporated within the building, and thus the property of the landowner. Any "retention of title" clause devised by suppliers or contractors who are delivering materials to site ceases to protect them once the materials are incorporated within the works. In construction, the contractor is likely to be well down the queue for payment if the employer fails, behind the funders or others who have charges on the land. There is specific construction industry legislation in a number of countries to deal with this potential injustice. The most comprehensive is the Ontario Construction Lien Act 1983, but there are others even more recent.
10.6 An effective way to deal with this problem is by setting up trust accounts for interim payments (and also retentions, if the latter system continues). I have already recommended such trust accounts as a necessary Core Clause to the New Engineering Contract. They should also be built into other construction contract conditions and should be underpinned by legislation.
10.7 Action was taken in Germany last year. The previous arrangement under the German Civil Code (Section 648) was that a contractor or trade contractor was able to demand a mortgage on land on which work was being carried out by the firm. This was, in effect, a Builder's Lien system. However, it proved an unsatisfactory remedy because a charge did little to help subcontractors, and was usually displaced by a prior charge registered by a bank or financial institution. The 1993 Contractors Security Law provides that German contractors can demand from their employers "adequate security" for the balance of any money payable to them under the contract. These rights also extend to consultants and subcontractors, but not suppliers. Public authorities are exempt. The right to demand secure payment is statutory and cannot be excluded by contract. It is in practice to be achieved through bank guarantees or surety bonds, (but not on-demand bonds) with a maximum cost to the beneficiary of 2% per annum of the value of the surety. (Any excess cost is to be met by the provider.) Failure by the employer or the main contractor to provide adequate security allows the main contractor or the subcontractor the right to suspend the works immediately, or, ultimately, to terminate. Most of the larger German contractors have close links with banks and so have no difficulty in providing security. Smaller companies have sought alternative solutions, including parent company guarantees, letters of comfort, advance payments or separate bank accounts89.
10.8 If the client is required to set up a trust account and pay into it at the beginning of each payment period the amount due for the next activity schedule or milestone, payment must be released at the appropriate time in an effective manner. The new approach set out in the NEC should lead the industry away from the process of monthly valuations and certification of interim payments. But if a contract does follow a Bill of Quantities route and monthly measurement, the employer, advised by the client's representative and/or professional quantity surveyor, must place an appropriate amount of money at the beginning of each month in the trust account. The sum allocated should correspond to a pre-agreed programme. The contractor and the subcontractors should be advised by the client's representative of the amount so deposited. If any of them consider the sum to be inadequate, they should have a right to approach the adjudicator for a ruling on whether this sum should be increased. Failure to increase it after decision by the adjudicator should entitle an aggrieved participant to suspend the work (a right not usually available under existing main contract documentation90) until the sum in the trust account is increased.
10.9 I have considered whether the trust funds should make separate payments to the main contractor and to subcontractors, or even if there should be separate accounts. The subcontractors favour such a system. The SEACC91 procurement system provides for main contractors and subcontractors to be identified separately. However, some clients may not be prepared to accept such a process, and may only be willing to set up one single trust account and make one payment out of it for each milestone/interim period. Whilst the subcontractors' concerns are understandable under the current system, they should no longer have reason to feel threatened in the future because:
1. Money must be deposited by the client in advance, at the beginning of each payment period. The client will also have been notified who the first line subcontractors are.
2. There is a suitably drawn up trust account, so they know that their payment will be safe even if the main contractor fails. Legislation will be needed to ensure that, in the event of the failure of the main contractor, trustees will have the duty of making due payments out of the trust account to subcontractors for work done and materials supplied. If the client fails, the trustees will pay the contractor, who will be contractually required to pay the subcontractors.
3. The contract and subcontract documents will involve a specific duty to trade fairly and to build up team work. New legislation relating to unfair terms will be introduced.
4. A comprehensive adjudication process will be in place, and the procedures relating to set off will have been regulated.
5. Clear and specific payment times will have been established and mandatory payment of interest if they are not honoured.
| 10.10 Although I do not feel able to recommend that subcontractors' payments should normally be made directly to them out of trust funds rather than through the main contractor (other than in cases of insolvency), some clients may wish to have this option It would be possible for the model in the SEACC system to be incorporated as a special condition or option within the NEC or other Standard Forms. That would require discussions with the Electrical Contractors Association, as holders of the copyright of SEACC. |
10.11 A suggestion made to the Review by the CIEC is that there should be a cut-off point in value of contract below which the trust fund arrangements should be unnecessary, either because the timescale of the contract is too short or the value of the work too low to justify it. (It suggested £1/4 million.) Alternatively, certain classes of contract should be excluded, such as consumer contracts. While I can see the logic in such suggestions, I am doubtful about them. Any cut-off point runs the risk of the contract being divided into small sections to avoid trust funds. But the amount of money involved in a small contract, though not great, may be very significant to those involved. If there are to be any exclusions at all I would suggest that they be limited to projects which are excluded from the CDM Regulations. Trust funds do not need to be set up for ordinary domestic work carried out without a formal contract document. Householders tend to pay for such work after it is completed in any case, or by stage payments informally agreed with the contractor.
10.12 Any interest accrued in the trust account should be entirely payable to the client. If the client wishes to make a charge to the contractor for the cost of operating a trust account, the charge should be agreed at tender stage and be included within the contract document. If necessary, a "cap" should be fixed to it, as in the German law. But it would be better if this could be resolved amicably between the parties in an atmosphere of cooperation. If the contractor decides to apportion some of the cost to the subcontractors, they should be told the cost which is being incurred by the contractor and how it is to be shared. It would be wrong for the contractor to seek to apportion the total cost to each of the subcontractors as, in effect, a "handling charge". If the main contractor wishes to impose some administration charge for passing on money to subcontractors, it should be explicitly identified as such in the contract documentation rather than being described as a "prompt payment discount". There is no longer any justification for such ''discounts". Payment should be on time.
10.13 The introduction of a right of suspension of work in the main contract should not be limited to the failure of the employer to place money in the trust account. It should also be available if the employer fails to release it from the trust fund or if the architect or engineer fails to issue a payment certificate on time without good cause. However, suspension should only become available if the adjudicator has first been involved and has issued a decision, which the employer has then failed to honour with immediate effect.
10.14 These trust funds must also be mandatory for public sector clients. While main contractors expect to be paid by a public sector client, who is unlikely to become insolvent, such funds will be a crucial source of reassurance for subcontractors if the main contractor fails during the course of the job.
10.15 Some evidence to the Review has pressed strongly for a Builders Lien Act similar to that in the United States or some Provinces of Canada. This is a complex legislative procedure. I believe that mandatory trust accounts and the other safeguards set out in the report will provide protection for payment due to main and specialist contractors. A lien is a weak defence. Funders may have established prior charges on the property, which dilute the potential equity available to be released to other creditors in the event of a forced sale.
10.16 Some participants have pressed for wider reforms of the insolvency laws. In its final report, the CIEC advocates:
1. A statutory right of the contractor to information about the charges and other rights over the site and of the covenants in the funding agreement (as in all provinces in Canada except Newfoundland).
2. Failing such a right, an amendment to the Insolvency Act 1986 to deny any added value on site to a funder who has delayed terminating the funding agreement beyond the period when that funder knew that the client was in financial difficulties. The funder's fixed charge would lose its priority in such circumstances.
3. Alternatively, alteration to the law of retention of title so as to prevent the transfer of ownership of materials/goods already fixed in the project until payment has been made to the contractor (or else giving the contractor the right to detach materials, where feasible). The Building Structures Group makes a similar recommendation.
10.17 I feel that these three proposals need further debate before a recommendation can be made. There will be time for the Implementation Forum to consider them while the Construction Contracts Bill is being drafted.
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88 The Building Employers Confederation have identified a site with nine layers of subcontractors!
89 I am particularly indebted to Ms Ann Minogue of McKenna 6 Co. for this information (see also her article in "Building" magazine on 25 February 1994) and for her helpful advice on this Chapter and others.
90
91 / wish to record special thanks to Mr Giles Dixon of Turner Kenneth Brown for his helpful advice and briefing throughout the Review, and especially about the SEACC system and adjudication and conciliation/mediation procedures generally.