High Court finds clauses commonly found in construction contracts are unenforceable

By Owen Hayford and Hannah Stewart-Weeks, PwC Legal

Head contractors should review their subcontracts to ensure they don’t inadvertently contain “pay when paid” provisions, following the High Court’s decision in the 2018 Maxcon Constructions versus Vadasz (Maxcon) case. 

If you’re a construction lawyer or other construction industry professional, by now you’ve probably heard about the recent High Court decision in Maxcon (handed down at the same time as in Probuild Constructions (Aust) versus Shade Systems.

Most commentators have focused on the judicial review issue which arose in both of those cases. However, the High Court in Maxcon also considered a separate issue.

The court held that a provision allowing a head contractor to withhold retention moneys under a subcontract until certain events had occurred under the head contract was a “pay when paid” provision, and was therefore not legally enforceable under the security of payment (SOP) legislation.

This has potentially broad implications for head contractors – for retention provisions, but also other provisions which attempt to make a payment under a subcontract contingent on an event occurring under a the head contract.

“Pay when paid” provisions

Prior to the enactment of the SOP legislation, it was common for head contractors to include a clause in their subcontracts which provided that payment to the subcontractor was either determined by the date on which the head contractor received payment from the principal (“pay when paid”); or dependent on the head contractor receiving payment from the principal (“pay if paid”).

By including these types of clauses, head contractors were attempting to share the cash flow risk of projects with their subcontractors.

The problem was, subcontractors typically had much smaller balance sheets than head contractors, and were less able to manage the effects of poor cash flow – leading to a high rate of subcontractor insolvency.

The purpose of the SOP legislation is to help ensure security of payment for subcontractors and reduce the high levels of insolvency.

One of the ways it does this is by prohibiting both “pay when paid” and “pay if paid” provisions, as well as a third, broader, type of provision which “makes the liability to pay money owing, or the due date for payment of money owing, contingent or dependent on the operation of another contract”.

Importantly for the following analysis, money owing” is defined as “money owing for construction work carried out or undertaken to be carried out…under the contract.”

Since the enactment of the SOP legislation, head contractors have generally tried to avoid drafting direct ‘pay when paid’ or ‘pay if paid’ provisions into their subcontracts.

However, the Maxcon case highlights the potential for other common clauses to inadvertently fall foul of the prohibition on pay when paid provisions.

The High Court’s decision

The subcontract was for piling work, and included a standard form retention clause.  

This clause allowed the head contractor to retain by way of security 10 per cent of each progress payment due to the subcontractor until the head contractor had retained a total of 5 per cent of the contract sum.

The release of security the retention money was tied to the issue of a certificate of occupancy for the entire project.  

The High Court held that the retention clause in the subcontract was in fact a “pay when paid” provision.

This was because the dates for release of the retention money under the subcontract were dependent on the issue of a certificate of occupancy, and such a certificate could not be issued until completion of the whole project in accordance with the head contract.

The release/payment of the retention money was therefore “contingent or dependent on the operation of another contract”, and so the whole of the retention monies clause, including the provision allowing the head contractor to retain retention monies from the progress payment otherwise payable to the subcontractor, was unenforceable.

Implications

This decision has significant implications for subcontracting arrangements, particularly as the High Court’s analysis is likely to apply to the SOP legislation in most states (other than WA and the NT where the legislation does not prohibit the broader restriction on provisions that make liability to make a payment under one contract “contingent or dependent on the operation of another contract”).

Retention money

Most obviously, head contractors will need to consider their subcontract retention provisions to ensure that they do not contravene the “pay when paid” prohibition by making the release of retention money dependent on practical completion (or some other event) occurring under the head contract for the project.

Instead, release of retention money needs to be tied to operation of the subcontract itself, e.g. practical completion and/or the expiry of the defects liability period under that subcontract.

The problem for head contractors of course is that in a large project there may be a large number of subcontracts, each with different dates for practical completion that may be earlier (sometimes significantly so) than the date for practical completion under the head contract.

Two main issues arise if release of retention money is tied to the defects liability periods under each separate subcontract.

First, this adds to the administrative burden for the head contractor, who now has to manage the release of many retention amounts at different times.

More significantly, there may be complications where an important piece of subcontracted work is completed early in the project (such the piling subcontract – which was the relevant subcontract in the Maxcon case).

If the release of retention money under the subcontract is tied to the expiry of the defects liability period under that subcontract, the time for release of retention money is likely to arrive before the expiry of the defects liability period under the head contract.

And if there are issues with that subcontractor’s work which only become apparent after the release of the retention money, it may be difficult to get the subcontractor to come back and fix the problem – even though the defects liability period under the head contract is still on foot.

One potential solution is for head contractors to require bank guarantees or insurance bonds instead of retention money.

Unlike retention money, a bank guarantee is not “money owing” in relation to work under the subcontract, but rather a security requirement which is separate to the contract sum.

This means the “pay when paid” provisions won’t apply.

However, a subcontractor has to pay to take out bank guarantees or insurance bonds, so this kind of requirement is likely to translate to higher subcontract prices, and therefore higher overall project cost.

Milestone payments

Another common type of provision which is likely to be affected is milestone payments under a subcontract which are linked to events occurring under a head contract.

For example, a head contractor may want to tie a subcontractor’s final payment to practical completion under the head contract. Similar to withholding security, the idea behind this is to ensure the head contractor has some leverage in circumstances where the principal does not consider that the works under the head contract have reached practical completion due to some issue with the subcontractor’s work.

It now seems fairly likely that this kind of provision is a “pay when paid” provision and is therefore not enforceable – as it makes payment to the subcontractor contingent on an event occur under the head contract, over which it has no control.

Linked claims/linked disputes provisions in pass through subcontracts

The High Court’s decision also reinforces the potential issues with common “linked claims and linked disputes” type provisions.

The standard AS4903 pass through design and construct subcontract contains a provision which allows the head contractor to require a subcontract dispute which affects the head contract to be resolved as part of the head contract dispute resolution process – and the subcontractor is required to accept the outcome of that dispute process.

Similar provisions are common in the core subcontracts on PPP projects, which typically contain a provision which attempts to limit the liability of the Project Company to its contractors by reference to the Project Company’s entitlements against the State under the PPP Contract.

In essence – if the contractor makes a claim against the Project Company and that claim is one that can be brought by the Project Company against the state under the PPP Contract, the contractor’s entitlement is limited to the amount recovered by (or other relief granted to) the Project Company under the PPP Contract.

Typically, the clause will also provide that it does not apply to the extent that it would have the effect of making the clause a “pay when paid provision” within the meaning of the SOP legislation.

The decision of the High Court in Maxcon reinforces that these types of provisions may be largely ineffective as, in many cases, they will in fact operate as “pay when paid” provisions.

It is relatively clear that a linked claims/linked disputes provision does attempt to make an entitlement under one contract “contingent or dependent on the operation of another contract”.

The entitlement under the subcontract is contingent on the success of the head contractor’s claim or dispute under the head contract.

The analysis therefore turns on the term “money owing”, defined as “money owing for construction work carried out or undertaken to be carried out…”

The question is whether a linked claim/linked dispute provision operates to make payment of money owing under the subcontract contingent on the operation of the head contract.

The answer is – it depends on what kind of claim we’re talking about

In my view, most claims that a subcontractor would bring against a head contractor which the head contractor would in turn bring against the principal are likely to be claims for “money owing”.

For example, variation claims, claims for costs incurred in dealing with latent conditions, and claims for acceleration costs (and potentially delay costs as well), are all claims for money that relate to the carrying out of construction work.

In those circumstances, a linked claims/linked disputes provision is unlikely to be effective to limit the subcontractor’s entitlements to the extent of the head contractor’s recovery against the principal.

The head contractor can try to protect itself from a potential gap between the amount recovered from the principal and the amount payable to a subcontractor by ensuring that all relevant contractual and technical provisions are passed through to the subcontractor.

But even then there is no guarantee that a claim or dispute will be determined the same way under both the contracts.

However, on the other hand, some claims by the subcontractor against the head contractor will not be claims for “money owing”, and so the prohibition on “pay when paid” provisions will not apply.

For example, a claim for an extension of time is not a claim for money at all, and a claim for breach of contract is a claim for damages in respect of loss suffered, and not a claim for money owing in relation to construction work carried out.

Pass through of determinations

Finally, many pass through contracts attempt to ‘pass through’ determinations and decisions of the superintendent, principal, or independent certifier under the head contract to the subcontractor to the extent they relate to the same issue (unless disputed).

Similar to the linked claims/linked disputes provisions, these types of provisions are also likely to be unenforceable to the extent they are linked to payment of “money owing” to the subcontractor.

Consider the following example: under the head contract, the head contractor is required to pass a certain prototype test before proceeding to full production.

One of the head contractor’s payment milestones is linked to passing this test.

The head contractor has subcontracted the work relating to the production and testing of the prototype, and has also included a payment milestone under the subcontract linked to passing the test.

The superintendent under the head contract determines that the test had not been passed.

The head contractor will then want to ‘pass through’ that same determination to the subcontractor.

However, this provision has the effect of making payment to the subcontractor (the payment milestone for completion of the test) contingent on the operation of the head contract (whether or not the head contract superintendent considers that the test was passed) – and so is likely to offend the “pay when paid” provisions of the SOP legislation.

To contrast: another example might be where the head contract superintendent has determined that a design document produced by the subcontractor (and submitted by the head contractor under the head contract) does not comply with the contract.

Provided that this determination is not linked to payment or withholding of the subcontract price, the “pay when paid” provisions will not apply.

Take-away

It has long been understood that “pay when paid” and “pay if paid” provisions are prohibited under security of payment legislation.  

What was not well understood is that provisions allowing a head contractor to withhold payment under a subcontract until certain events have occurred under the head contract will also fall foul of the prohibition in most states (other than WA and the NT).

This has potentially broad implications for head contractors – for retention provisions, but also other provisions which attempt to make a payment under a subcontract contingent on an event occurring under a the head contract.

Head contractors should review their subcontracts to ensure they don’t inadvertently contain “pay when paid” provisions. 

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