Tricks with contracts: PFI and the Construction Act

The Construction Act does not affect PFI contracts – right? A “contract entered into under the private finance initiative” is excluded from the definition of a construction contract and therefore not subject to the Construction Act. So why are PFI lawyers getting in such a fuss about the draft Construction Contracts Bill, which will amend the 1996 legislation?

The reason is that to say PFI contracts are not affected by the new bill is a dangerous oversimplification. Most contracts that PFI lawyers deal with are not, in fact, PFI contracts at all. The contract between the procuring authority and the special purpose vehicle (SPV) for the provision of the school, hospital or prison is certainly a PFI contract. But the contracts between the SPV company and the building contractor and all the others actually doing the work are not PFI contracts and are therefore subject to the legislation.

The real problem is clause six of the bill, which will outlaw “pay when certified” clauses. The 1996 act made “pay when paid” clauses ineffective in most situations. That meant that main contractors could not refuse to pay subcontractors on the basis that they hadn’t been paid themselves. Contractors have tried to get round that provision by including a term in the subcontract that says that payment will only become due when a relevant certificate is issued under the main contract, in other words, a “pay when certified” clause. In that way they hope to ensure that, before they pay out to the subcontractor, they will have a certificate for payment, if not payment itself, from the employer.

There has always been some doubt about whether that arrangement complies with the requirement under section 110 of the Construction Act, which says every construction contract have an adequate mechanism for determining when payments become due. The change to the act being introduced by clause six of the Construction Contracts Bill makes it clear that reliance on a decision under a different contract is not an adequate mechanism. It will not be possible to provide that the main contractor only has to pay the subcontractor when it receives a certificate under the main contract.

This is a particular problem for PFI lawyers. As the name suggests, the SPV is there for one purpose – the project. It only receives money for that purpose, and is therefore reliant on payment from the bank or procuring authority in relation to the project. It doesn’t have any other money. It has to ensure that if money has to be paid out on the project, it can be sure that money will be coming in first. This is a simple principle, typically known as equivalent project relief (EPR). “Pay when certified” provisions have been an important part of the mechanism.

In the current financial climate, we can anticipate increasingly energetic scrutiny by banks to ensure that the EPR system works. PFI lawyers will also need to consider ways of ensuring that the EPR system functions effectively. Other clever tricks that are being tried to replace the “pay when certified” provisions include:

If the contractor is awarded money in advance of the SPV obtaining an equivalent sum, the contractor is obliged to ‘loan’ the amount of its award back.

 

• Providing for as long a period as possible between the due dates and the final dates for payments of sums to the building contractor, sometimes as long as 24 months. The SPV hopes that will be long enough to be certain of getting cash in before it has to be paid out

• Using a “parallel loan” agreement. This will provide that if the contractor is awarded a sum of money in advance of the SPV obtaining an equivalent sum from the procuring body, the contractor is obliged to “loan” the amount of its award back to the employer until the matter is finally resolved under the dispute resolution procedures in the project agreement

• Inserting clawback provisions into the building contract. Under these, the contractor simply agrees to pay back to the employer any money it receives under the building contract that exceeds the amounts received by the employer under the project agreement. This applies to both time and money

• Limiting the remedies that a contractor would otherwise have against the SPV. The contractor may be required to waive its right to bring insolvency or other enforcement proceedings.

Of course, it might make more sense for the SPV to be well capitalised in the first place so that it has more working capital to hedge against mismatched cash flows. However, in the face of fierce competitive dialogue procurements this is unlikely to happen.