Drafting "pay when paid" clauses which are effective upon upstream insolvency

The Court of Appeal has handed down a judgment, agreeing with a decision in the Technology and Construction Court, which serves as a reminder that, to be effective, exclusion clauses need to be carefully and very clearly drafted, and that contracts should be reviewed following changes in legislation.

In William Hare Limited ("Hare") v Shepherd Construction Limited ("Shepherd") the Court of Appeal held that the main contractor’s "pay when paid" clause as drafted was ineffective when its upstream employer became insolvent. This exposed Shepherd to significant liabilities to pay its sub-contractors which could have been avoided with careful drafting.

Background

In 2009 a judgment of the Technology and Construction Court had held in favour of a subcontractor, Hare, that the main contractor Shepherd could not refuse payment of £996,683.35 in reliance on a "pay when paid clause" following the going into administration of the employer Trinity Wakefield Limited (Trinity). Shepherd appealed.

Section 113 (1) of the Housing Grants (Construction and Regeneration) Act 1996 (the 1996 Act) outlawed "Pay when paid" clauses in the construction industry unless it could be shown that the third party employer was insolvent. Subsection (2) provided "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", i.e. by order of the court. Subsection (2) also identified other processes by which a company became insolvent for the purposes of the1996 Act.

By the Enterprise Act 2002, the Insolvency Act 1986 (the 1986 Act) was amended, adding two types of administration without court order, conveniently labelled "self certifying options". That led to an amendment to section 113 of the 1996 Act to clearly include both administration through court order and "self certifying".

In about 1998, the former solicitors for Shepherd, had drafted a form of "pay when paid clause" for insertion into a standard form of subcontract which followed the then terms of section 113 of the 1996 Act. In 2008 Shepherd, as the main contractor for the employer, Trinity, used the same clause in the same terms without reflecting the amendment to section 113 in 2002, as clause 32, in their sub contracts with amongst others Hare and other sub-contractors.

Trinity went into administration by a self-certifying route. Shepherd sought to rely on clause 32 in refusing to pay the subcontractors the very substantial sums otherwise clearly due. Hare’s case was that Trinity was not insolvent within the meaning of clause 32, and that Shepherd could not therefore rely on section 113 of the 1996 Act.

Shepherd argued that any reasonable person would have appreciated that something had gone wrong with the drafting and that the intention was that the words of the amending legislation were intended to be inserted. Shepherd contended that the clause should be interpreted accordingly.

The Court of Appeal dismissed Shepherd’s appeal, making the following points:

• Pay when paid clauses were made ineffective unless the third party was insolvent and insolvency was defined by reference to the ways in which a company could become insolvent. If a main contractor wants to have a pay when paid provision in a subcontract he must, if it is to be effective, identify a way in which the third party employer becomes insolvent as defined in the legislation. If he chooses a way which is not in accordance with the legislation because he mis-drafted the provision, principles for construction of documents as used by the courts will be of no assistance
• If a main contractor has drafted his provision in a way which actually does work (as the clause in this case did), even if a reasonable person would guess that it was not intended to be so limited and that there has been an error, there is even less reason for the courts to come the rescue
• Clause 32 was effectively an exclusion clause intended to relieve Shepherd of a liability to pay which they otherwise had and it was for Shepherd to get a clause of this nature right if they wished to rely on it. The general rule is that, if a party otherwise liable is to exclude or limit his liability he must do so in clear words; unclear words do not suffice; any ambiguity or lack of clarity must be resolved against that party. It was not therefore open to Shepherd to argue that there was a lack of clarity in a provision that they drafted so as to relieve themselves from liability.

Lessons to be learned

• exclusion clauses need to be carefully and very clearly drafted
• parties should beware of using old, "template" contracts or contract clause
• contracts should be reviewed after changes in legislation
• contracts may be drafted in terms to incorporate amendments to legislation existing at the time the contract is made. However, this may not always be an attractive solution since the amending legislation might result in an allocation of risk that was not what the parties had bargained for or had expected