"Pay when paid" Legalised under PFI Construction -Frazer Wardhaugh

31st October 2011

But not for everyone. Most parties involved in the construction industry are familiar with the Construction Act which, among other things, affects payment terms under construction contracts in the UK. Many will, no doubt, be aware of the amendments which are expected to come into force in Scotland on the 1st November 2011, and which will have a significant impact on payment terms in construction contracts.

The existing Construction Act outlaws ‘pay when paid’ provisions and these rules have been further tightened in the proposed amendments. This means a contractor cannot set up a payment regime under a construction contract which only releases payment to a subcontractor when (or if) the main contractor is paid by the employer

Whilst this ban is almost universally accepted as being a good thing, it does present problems in certain situations. In PFI contracts it is the norm for the PFI project company, usually a Special Purpose Vehicle (SPV), to include such arrangements within its contracts with its construction and operating contractors. This is because, in simple terms, an SPV has no cash other than what it borrows from a bank to pay for construction of the relevant facility and whatever income it generates through the charge paid by the local authority. Consequently, those lending money to the SPV want to ensure it has maximum cash flow protection to safeguard their investment in the project or, in PFI speak, it must be “kept whole”.

This has always presented a problem for PFI investors. The contracts they enter into with their sub-contractors are invariably contracts that are subject to the Construction Act. This means any provisions which claim to make payment to the sub-contractors subject to receipt of payment from the authority are illegal. Indeed such provisions have been tested in the courts and have been held to be unenforceable.

The legality of ‘pay when paid’ provisions has led to much angst in the PFI industry as it underpins the philosophy of keeping the SPV whole. Whilst the commercial reality is that the supply chain will readily accept ‘pay when paid’ it is unfortunate that the contractual provisions will not stand up to legal challenges. This has led to some weird and wonderful drafting provisions to try and make them “legal”. We have seen:
• ‘pay when certified’
• parallel loan agreements where the contractor has to give the SPV an interest free loan to pay itself
• extended payment dates (of up to two years) for successful claims

All of these measures are intended to circumnavigate the law. Moreover the ‘pay when certified’ provisions will be expressly outlawed in the changes about to come into force.

The PFI investment community is, however, breathing a sigh of relief because the Scottish Ministers have decided to exercise their powers under the Construction Act (as amended) to exclude from the application of the Act provisions in contracts “whereby a project company in a PFI project sub-contracts any of its obligations under the principal contract with the authority."

The effect of this is to legalise ‘pay when paid’ provisions in PFI construction and operating contracts, which raises a number of issues.

Commercial reality of PFI
In reality, the exclusion of ‘pay when paid’ provisions was always required because the changes to the Construction Act would have tightened the rules on ‘pay when paid’ clauses and made PFI completely unworkable, so contractors are going to have to work around the problem.

Whilst they always signed up to these provisions, contractors did so in the knowledge that they were open to challenge in the event cash flow became an issue. They will now be legal in the contract with the SPV, but not in the contracts further down the chain. This means the SPV’s cash flow will be protected, but the sub-contractors’ cash flow will not and they will bear the brunt of the cash flow issues where payments are delayed up the line.

Efficient claims procedures
The quid pro quo of agreeing to ‘pay when paid’ in PFI contracts was that a lot of time and effort went into the contractual mechanics of dealing equivalent disputes up the line. For example, SPVs would be under a duty to progress claims with the authority promptly, contractors would be entitled to raise proceedings directly against the authority in the name of the SPV and timescales for dealing with disputes were kept to an absolute minimum. It is likely now that ‘pay when paid’ provisions are going to be enforceable, less time and effort will be spent in making sure that the claims procedures are as efficient.

It is imperative, therefore, that contractors entering into arrangements with SPVs scrutinise their contracts and ensure they provide for efficient management of claims for additional payment. The Construction Act will not protect contractors from their own supply chain.