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the issue with late payments

1 March 2014

A recent cross party parliamentary report concluded that "the problem of late payments is getting worse" and that the construction industry was particularly bad.

Whilst some parties have been trying to improve payment terms for those they work with (e.g., John Lewis is considering direct payment to subcontractors and Mears revealed that it was using a "credit card" system to make prompt payments to its subcontractors), Carillion recently implemented a (widely criticised) payment system of up to 120 days with "reverse factoring", a financial mechanism that allows suppliers to be paid early if they pay a charge to the bank. We consider some questions that can arise in respect of payment below.

Why do parties withhold payment?

There is considerable anecdotal evidence that withholding of payment is part of a culture of "bullying and intimidation" in the industry. However, it is important to remember that parties may have good reasons for not paying, for example because of defective works or culpable delay. Take care to ensure that you have all relevant information before you challenge any withholding.

What can I do to improve my cash flow during the course of a project?

The obvious starting point is to check your rights as set out in your contract. You should also check whether the contract complies with relevant legislation. Most obviously, (assuming that it applies) the Construction Act requires an "adequate payment mechanism", staged payments (if the works are to be in excess of 45 days) and prohibits a party making payment conditional upon performance under another contract. Also important are the requirements of the Late Payment of Commercial Debts (Interest) Act 1998. Changes to this Act made on 16 March 2013 altered the date on which interest on debts will run from: where a purchaser is a public authority the payment period cannot exceed 30 days; where the purchaser is a private sector business, the payment period cannot exceed 60 days unless agreed and not "grossly unfair" to the creditor. The amendments also now expressly allow a payee to claim "reasonable" costs of recovering a debt.

Sadly, breaches (either a party not complying with the contract or the contract not complying with relevant legislation) can be difficult to remedy. If a counter party is regularly withholding small but significant money on spurious grounds, even the (usually non-recoverable) costs of adjudication can present an insurmountable barrier to a cash-strapped business recovering its debts. In such circumstances, parties might agree to one "precedent setting" adjudication, but if a party is prepared to withhold payment as set out above, this might be unlikely. Ideally therefore you need to address the underlying issue.

Can I alter my contracts to improve cash flow?

Yes - and in numerous ways. An obvious starting point is simply to extend or reduce (as appropriate) the period from when the works are undertaken to when payment becomes finally due. However, this somewhat crude way of improving cash flow is likely to be unpopular with a partys client or supply chain.

A more progressive alternative for a paying party is to amend the level of retention or vary the common release dates of practical completion / the defects liability period. Whilst unusual, companies might prefer being paid a slightly smaller, but certain, sum more regularly than having arbitrary deductions made.

What can employers do to make sure that their subcontractors get paid?

Employers have a few options, including: (1) direct payment clauses, (2) project bank accounts and (3) escrow arrangements.

Havent direct payment clauses disappeared?

Not quite. Direct payment clauses (within a main contract to allow an employer to make direct payments to the project subcontractors) were popular when the use of nominated sub-contractors was also common in standard form contracts. However because of the three way issues created by nominating subcontractors modern JCT contracts have done away with nominated sub-contractors and direct payment clauses also disappeared. A party should ensure it understands the risks of this three way relationship and approach direct payment clauses with caution.

What are project bank accounts?

These are accounts set up jointly by the parties with the purpose of making payments out to the relevant parties. The primary benefit of project bank accounts is the security of payment given to sub-contractors and suppliers, both in respect of when they will be paid and in the event of main contractor insolvency. The bank account is normally provided for by the underlying building contract which also provides a mechanism for calculating the sum the Employer is to pay into the project bank account. Thereafter the bank is given instructions to make payment direct to the contractor, sub-contractors and / or suppliers.

The primary drawback is that charges on the accounts and the administration required can make them prohibitive for smaller projects. Both the NEC and the JCT forms have project bank account options for those that are interested.

What is an escrow account?

In a construction setting an escrow account will usually involve the employer paying a sum of money into a joint account with sums released from the account upon the joint instructions of the parties (or more commonly their agents). The parties will need to decide whether the money held in the escrow is to be paid out in respect of each payment application made or more typically if a single sum of money will be held to draw down upon in the event the employer fails to make a payment that is due.

An escrow account can provide payees with security of payment and protection in the event of employer insolvency (depending upon the account it could also be used to protect sub-contractors in the event of main contractor insolvency).

Whilst an escrow account can be tailored to the parties needs, the drawbacks include the administration of the account, the costs and the fact the employer will usually have to deposit a significant sum of money that it is then unable to use in the operation of its business.

How can I protect myself against insolvency of a counter-party?

Bonds and guarantees provide additional protection from a third party in the event of default and / or insolvency of the primary party.

Guarantees (such as parent company guarantees) are most commonly used to protect an employer against default or insolvency of the main contractor- although remember these will not always be available and are only as good as the entity providing the guarantee.

Bonds can be used in a variety of ways. The most typical example in UK construction is the performance bond where the bondsman will guarantee performance of a main contractor (up to the financial limit of the bond). However, bonds can also be used to serve other purposes: tender bonds are frequently used in North America to provide security for tender costs or maintenance bonds can be used as an alternative to retention being held.

This article was first published in The Structural Engineer

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