Where the main contractor ceases trading, one option is for the client to make direct payments to subcontractors. This is attractive for both parties. The subcontractor gets paid for the work it has done and the project keeps moving.
The main forms of JCT contract allow clients to make payment direct to subcontractors in two situations. First, payment may be made direct to nominated subcontractors at any time if the main contractor fails to pass on payments received from the client. Second, in the event that the main contract is terminated, the client may pay direct to any subcontractor for work carried out or goods supplied for which payment has not been received from the main contractor.
However, even where the client has the contractual right to make payment direct, care needs to be taken not to fall foul of the law that governs parties affected by insolvency. It is a fundamental principle of insolvency law that unsecured creditors should be treated equally and that, with limited exceptions, no creditor should receive preferential treatment. The consequences of this rule were considered in the important case of British Eagle International Airlines vs Air France (1975). The action was a test case brought by the liquidator of British Eagle against Air France. After two appeals, the House of Lords decided that a contractual provision that ran counter to the principle of equal treatment between creditors was unlawful and would not be enforced. In that case, the parties had agreed that any debts between them would be dealt with through an independent clearing house rather than directly between the parties. The court decided that, although this was a sensible commercial arrangement, it could not be allowed to interfere with the principle of equal treatment and should be disregarded in any liquidation.
This meant that the liquidator of British Eagle was able to recover from Air France any sums owing to the insolvent company regardless of the sums that were owed to the clearing house.
Although British Eagle was not a construction case, the implications were far reaching. Subcontractors are treated as ordinary unsecured creditors. The decision had the effect of making unlawful any provision in a construction contract that allowed the employer to make payment direct to subcontractors if the main contractor was in liquidation. As a result, the JCT amended its standard forms to exclude a client's right to make direct payments in such cases. This may seem to fly in the face of common sense with direct payments prohibited precisely when they are most needed. But the policy of the law is that contractual arrangements, however sensible, must not override the principles of insolvency law.
Nevertheless, direct payments may be permissible in some circumstances. The JCT provisions do not prevent payments being made direct to subcontractors in the event that the main contractor is in administrative receivership or subject to an administration order. This situation is likely to be more common than liquidation following the Enterprise Act 2002, which promotes the making of administration orders in cases of insolvency.
Unfortunately, it is unclear whether the principle laid down in British Eagle applies to receivership and administration. If payments are to be made direct to subcontractors, great care needs to be taken to ensure that the client is able to set off any sums paid against amounts otherwise due to the main contractor from the client. Any client that wishes to make direct payments to subcontractors should ensure that, if the payment is later found to be unlawful, it is agreed to be repayable by the subcontractor. Otherwise, the client could find itself paying twice.
The problems caused by the British Eagle case were considered in the Latham report, which recommended the establishment of compulsory trust accounts for retentions and interim payments in order to protect subcontractors.
The government declined to act and the position remains unchanged. The aftermath of the Ballast collapse shows that subcontractors continue to suffer as a result.
Paul Thwaite is a partner at Stephenson Harwood, which is acting for clients on projects where Ballast is the contractor.