UK: Insolvency And Payment Under The Construction Act: The House Of Lords Finally Decides

Last Updated: 17 April 2008
Article by Anna Rabin

The Facts

Melville Dundas Limited (in Receivership) v George Wimpey UK Limited and Norwich Union Insurance Limited [2007] UKHL 18 is a case about a contractor, (MD), which was employed by housebuilder George Wimpey UK Limited (GWUK) in respect of a housing development in Glasgow.  The contractor entered into a construction contract valued at approximately £700,000 on 20 March 2002. The contract incorporated the terms of the JCT Standard Form of Building Contract With Contractor's Design 1998 Edition, amended to suit use in Scotland.  Although the contract was governed by Scottish law, the relevant provisions argued in this case were JCT provisions which were unaffected by the Scottish Supplement to the contract, so the decision in this case does not turn on peculiarly Scottish provisions of contract.

The Housing, Grants, Construction and Regeneration Act 1996, commonly known as the Construction Act, applies to Scottish construction contracts. Therefore, the contract provided for monthly applications for interim payments and specified a final date for payment in respect of each interim amount due of 14 days after receipt by GWUK of the application.

On 2 May 2003, MD lodged an interim application for payment. GWUK should have paid MD the amount due on or before 16 May 2003. It didn't. Nor did GWUK serve a withholding notice to MD in accordance with section 111 of the Construction Act, identifying the sum being withheld from payment. On 22 May 2003, MD went into administrative receivership.

The JCT provisions provided that GWUK could terminate MD's employment under the contract if an administrative receiver was appointed. GWUK exercised this right on 30 May 2003. Termination brought into effect clause 27.6.5.1 of the contract which provided as follows:

"Subject to clauses 27.5.3 and 27.6.5.2 the provisions of this Contract which require any further payment or any release or further release of Retention to the Contractor shall not apply; provided that clause 27.6.5.1 shall not be construed so as to prevent the enforcement by the Contractor of any rights under this Contract in respect of amounts properly due to be paid by the Employer to the Contractor which the Employer has unreasonably not paid and which, where clause 27.3.4 applies, have accrued 28 days or more before the date when under clause 27.3.4 the Employer could first give notice to determine the employment of the Contractor or, where clause 27.3.4 does not apply, which have accrued 28 days or more before the date of determination of the employment of the Contractor".

The administrative receivers made a demand for payment to GWUK for £396,630.00. GWUK refused to pay on the grounds that, they argued, clause 27.6.5.1 provided that following termination of MD's employment, the provisions of the contract requiring further payments to be made no longer applied, with the exception of amounts accrued 28 days or more before the date the employer could have first given notice of determination or the date of determination itself (as applicable).  GWUK argued that as the payment claimed was inside of the 28 days period, clause 27.6.5.1 prevented MD from demanding payment. It was further argued that where the contractor's employment was determined, a balancing exercise would be carried out to arrive at sums due to the contractor by the employer or to the employer by the contractor, as the case may be, following the employer's right to pay others to purchase materials and goods necessary to complete the works, physically complete the works and make good defects.

MD argued that the effect of the statutory provisions in the Construction Act altered that position in favour of MD's claim. As a result, clause 27 operated as a suspension of payment until the balancing exercise and setting off of cross-claims had been undertaken.  Thus a scheme for withholding payment was, in effect, provided.  As GWUK had not served the requisite notice of its intention to withhold payment under section 111 of the Construction Act, it could not withhold the payment in question.

GWUK argued in response that the critical words in section 111 (italicised below) for the purposes of the present dispute were that a party could not withhold payment after "the final date for payment of a sum due under the contract" unless he had served an effective withholding notice.  As has been said, the parties are free under the Construction Act to determine what sums are due and when and in this case GWUK argued that the parties had agreed that even if a sum was due before a receiver was appointed by the contractor, then if the employer determined the contract as a result of that appointment, the only sums due and payable on termination were those provided for under clause 27.6.5.1.

The issues in this case concerned the meaning of the words "require any further payment" in clause 27.6.5.1 and whether the effect of that clause was invalidated by the statutory payment provisions in the Construction Act.

The Construction Act Payment Provisions

I summarise the payment position under the Construction Act in respect of construction contracts to which it applies as follows:

  1. a party to a construction contract is entitled to payment by instalments, stage payments or other periodic payments for work carried out unless certain circumstances apply and the parties are free to agree the amounts of the payments and the times at which they become due (section 109);
  2. every construction contract must provide an adequate mechanism for determining what payments become due under the Contract and when and a final date for payment in respect of every amount which becomes due and the parties are free to decide how long the period is between when the sum becomes due and the final date for its payment (section 110); and
  3. a party to a construction contract may not withhold payment after the final date for payment of an amount due under the contract unless he has given an effective notice of intention to withhold payment and the parties are free to agree in their contract how long before the final date for payment any withholding notice under the Construction Act must be given (section 111). 

If the parties do not agree the matters listed in the bullet points above, the relevant aspects of the Scheme for Construction Contracts apply.

The Decision Of The Court Of Session, Outer Session

On 22 October 2004, the Lord Ordinary, Lord Clarke, decided that clause 27.6.5.1 did allow GWUK to withhold payment, even of certified sums, where the final date for payment had passed and MD's claim was dismissed.

Lord Clarke took the view that the Construction Act's provisions were intended to deal with cash-flow questions arising out of continuing, non-determined construction contracts and the contract's provisions at clause 30 dealing with interim payments satisfied the Construction Act's requirements. However, clause 27 dealt with an entirely different situation and the Construction Act did not attempt to deal with this. This was a matter on which the parties were free to reach agreement and did reach agreement, the effect of which was that the final date for payment was altered and as such had not yet arrived. Any questions of further payment would have to be dealt with after the post-completion accounting exercise had been carried out.

MD appealed.

The Decision Of The Court Of Session, Inner Session

The Appeal was decided on 15 December 2005 by Lords Nimmo Smith, Mackay of Drumadoon and MacLean. The parties' arguments at appeal are summarised as follows.

MD claimed that the final date for payment of 16 May 2003 had passed without any withholding notice being served, the amount due was overdue on and from 17 May 2003 and nothing which happened (including the appointment of administrative receivers and subsequent determination of MD's employment under the contract) after that date could affect its right to receive payment or entitle GWUK to withhold payment. 

GWUK contended that the payment sought by MD had accrued within the 28 days period prior to the appointment of a receiver and by virtue of clause 27.6.5.1, the sum was not due for payment at all. GWUK had proceeded with the works following termination and an account was to be drawn up post-completion.  The sum sued for fell to be included in that account and the final date for payment in respect of that sum changed to become the date when a positive balance was found to be due to MD following the completion of that accounting exercise. 

Norwich Union (NU), the surety under the Performance Bond taken out at the outset of the Contract, argued that Lord Clarke had been correct in his assessment that the Construction Act only applied to on-going contracts. Denying the employer the right to withhold payment in circumstances such as those in the present case meant NU were denied the protection afforded by clause 27 of balancing what would probably end up being additional costs to complete the works against sums otherwise due to the contractor, leaving the employer to foot the whole increased bill. NU were a party to the case because if GWUK were held liable to make the payment, GWUK was likely to make a claim under the bond.

Their Lords stated that the sum claimed for became overdue for payment on 17 May 2003 and MD could have taken immediate steps to enforce payment. If NU and GWUK were correct in their arguments then this would deprive MD of a right it had already gained to enforce payment by retrospectively altering the final date for payment. Their Lords found no clear contractual provision in the contract to this effect. They further agreed that clause 27.6.5.1 did not contain any provisions which would allow the parties to ascertain a final date for payment and, as such, a final date may never even arise. The clause went no further than to provide for the preparation of a final account.

It was held that the contract did not alter retrospectively the final date for payment but allowed GWUK to withhold, in certain circumstances, an amount due after the final date for payment thereof.  The correct interpretation of the contract provisions read with the Construction Act's provisions, which continued to apply even after MD's employment was terminated, was that section 111 applied to prevent GWUK from relying on clause 27.6.5.1 to MD's detriment.

GWUK appealed.

The House Of Lords Decision

The House of Lords gave a three to two majority decision, allowing GWUK's appeal, on 25 April 2007.  Lords Hoffman, Hope of Craighead and Walker of Gestingthorpe formed the majority opinion. It was held as follows.

  1. Clause 27.6.5.1 enabled GWUK to withhold the interim payment and the words "require any further payment" meant require the employer to pay any more money.
  2. (Lord Mance and Lord Neuberger of Abbotsbury dissenting.)
    • There was no conflict between clause 27.6.5.1 and the requirements under the Construction Act as to the terms which the contract should contain. The object of sections 109 and 110(1) was to introduce clarity and certainty as to the terms of a construction contract rather than to dictate to the industry what those terms should be. The only substantive requirement was that the contractor should be "entitled to payment by instalments" and that there should be an adequate mechanism for determining what he was entitled to be paid and when. Instalment payments were provisional liabilities; they provided the cash-flow for the contractor to enable him to perform his duties under the contract. When the contractor's employment had been determined in consequence of the appointment of a receiver, the contractor no longer had any duties to perform and the liability to make interim payments was no longer provisional.  While the employer retained money, he could set it off against his cross-claim for non-completion against the contract but once the employer had paid the money to the contractor, it would be swept up by the bank's floating charge and the employer would have to prove in the liquidation for his cross-claim. Upon insolvency, liability to make an interim payment became a matter which related to the substantive rights of the employer and the contractor's secured or unsecured creditors; it was no longer a matter which related to cash flow.
    • A provision such as clause 27.6.5.1, which gave the employer a limited right to retain funds by way of security for his cross-claims, was a reasonable compromise between discouraging employers from retaining interim payments against the possibility that a contractor who was performing the contract might become insolvent at some future date and allowing the interim payments system to be used for a purpose for which it was never intended, namely to improve the position of an insolvent contractor's secured or unsecured creditors against the employer.
    • Section 111(1) of the Construction Act should be construed as not applying to a lawful ground for withholding payment of which it was in the nature of things not possible for notice to have been given within the statutory time frame. In the instant case the final date for payment of the interim payment was 16 May 2003. It would not have been possible for the employer to serve a notice under s 111(1) by 11 May (the date by which a withholding notice should have been served in normal circumstances) as the earliest that the employer would have known that it was entitled to withhold the interim payment was when the receivers were appointed on 22 May.

Accordingly, GWUK's appeal was allowed.

Comment

I find the decision of the majority of the House of Lords strange.  Whilst I can see the points their Lords are making have some logic in circumstances where the contractor is insolvent, I am disturbed by the fact that their comments are made with the benefit of hindsight in relation to the fact of MD's insolvency. Without any knowledge of MD's insolvency, which would have been the case during the first two weeks of May 2003, GWUK was either obliged by statute to serve a valid withholding notice under section 111 or make the payment of the amount applied for by interim application by 16 May 2003, the final date for payment. 

What I find particularly hard to understand is how their Lords have come to a finding that it would not have been possible for the employer to serve a withholding notice by 11 May 2003 (the date by which a withholding notice should have been served in normal circumstances) as, they say, the earliest that the employer would have known that it was entitled to withhold the interim payment was when the receivers were appointed on 22 May.  Not so, if the fact of the insolvency is taken out if the equation altogether.

This decision effectively condones the employer's action, or inaction, of not serving a withholding notice within the prescribed time limits in the contract, and as a result of the subsequent insolvency of the contractor, getting out of its obligation to pay the whole amount due. 

The effect of the House of Lords' judgments in this case should be applied in the future in limited circumstances, namely contractor insolvency allowing termination. It is difficult to see how circumstances other than insolvency might cause their Lordships to reach such a decision.

With this judgment in mind, though, it should be remembered that if a contractor is in difficult financial circumstances, a payment delay by an employer may be the final straw which leads to insolvency. In these circumstances, employers may "cause" insolvency and then benefit from it, by withholding an interim payment. If a contractor is in financial difficulties and a payment is not made, the contractor should consider resorting to its right to suspend performance of obligations under a construction contract for non-payment, which is permitted under section 112 of the Construction Act 1996. Properly suspending performance, then seeking payment in an adjudication, could allow the recovery of interim payments.

The decision has created an element of uncertainty in that if one party to a construction contract is able to demonstrate a real injustice caused by the Construction Act 1996, which was not considered expressly by Parliament when enacting the Act, there may be room for argument. The differences between the judgments, including the arguments put forward by the two dissenting Lords, will no doubt have to a part to play in future actions brought in reliance of the judgment made in this instance. Identifying exactly what the ratio of the decision is, and whether it would apply in slightly different circumstances, will take more than a passing reference in correspondence during an adjudication or prior to an adjudication.

The judgments in this case cannot be easily condensed, but the final effect of the decision is clear: the employer was able, in these circumstances, to withhold monies, despite not serving a withholding notice before the final date for payment. Not so in the subsequent case of Pierce Design International Ltd v Johnston and another [2007] EWHC 1691 (TCC) which was decided on 17 July 2007. The determination of a JCT Standard Form of Building Contract With Contractor's Design 1998 Edition by the employer in that case did not allow the employer to escape the consequences of its failure to serve the withholding notices required by the Construction Act 1996 and the building contract. Some distinguishing features in that case from Melville Dundas are that:

  • termination did not arise as a result of contractor insolvency;
  • the proviso of clause 27.6.5.1 was relevant which said,

    "provided that clause 27.6.5.1 shall not be construed so as to prevent the enforcement by the Contractor of any rights under this Contract in respect of amounts properly due to be paid by the Employer to the Contractor which the Employer has unreasonably not paid...."
    and the court found that the employer had unreasonably not paid several interim payments properly due to be paid by the employer to the contractor by virtue of the fact that no withholding notices had been issued; and

  • the unreasonably not paid payments fell outside of the 28 days period referred to in clause 27.6.5.1.

The contractor in Pierce Design won its claim for payment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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