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Are direct payment arrangements too risky?

Direct payment provisions can be found in some contracts – but do the risks of using them outweigh the benefits?

Employers sometimes ask lawyers to include clauses in contracts with main contractors known as direct payment provisions.

These allow them to pay subcontractors direct if the main contractor fails to pay, to ensure that work continues and to avoid subcontractors threatening to suspend work for non-payment. But are direct payment arrangements more trouble than they are worth?

The benefits

Direct payment provisions were included in the standard form building contracts when nominated subcontracting was in fashion many years ago, but the use of direct payment clauses is now relatively rare. Indeed, the NEC and JCT suites of contract no longer provide for them at all.

The provisions usually only benefit employers and subcontractors.

The employer may benefit from a lower price from the subcontractor in exchange for the improved cashflow, and the subcontractor gains a level of protection against the insolvency of the contractor.

“There is no real advantage to the main contractor and, if anything, direct payment arrangements may be detrimental to main contractors”

So far, so good – at least for employers and subcontractors. There is no real advantage to the main contractor and, if anything, they may be detrimental to main contractors, as an employer making a direct payment may indicate that the main contractor is in financial difficulty.

So what are the risks and do they outweigh the benefits?

For subcontractors, most direct payment provisions only permit, rather than require, direct payment. They do not create an express right for the subcontractor to demand payment from the employer.

For contractors, a direct payment may interfere with its commercial arrangements with the subcontractor, or payment may not have been made because of defective work or breach of contract.

Where are the risks?

Perhaps the biggest risks rest with the employer. Firstly, if the contractor had a genuine reason for withholding payment, the employer may find itself the subject of an adjudication claim from the contractor.

Secondly, if the employer makes a direct payment to the subcontractor and the main contractor is in or enters administration or liquidation, the employer may still be liable to pay the main contractor for that subcontractor’s works, even though it has already paid the subcontractor directly.

“There is a real risk of double payment with the use of direct payment provisions”

Why so? Because this type of arrangement is likely to offend one of the most fundamental principles of insolvency law: creditors’ equal right of payment, known as the ‘pari passu’ principle, which means that all unsecured creditors must share equally any available assets of the insolvent company.

Put another way, if the employer pays the subcontractor direct then the subcontractor is getting a windfall that would otherwise have been shared among the contractor’s creditors, something English insolvency law is keen to avoid.

Conflicting case law

The law in this area is not entirely satisfactory and there is conflicting case law on the topic.

Two old decisions (Re Wilkinson and Re Tout and Finch) upheld the effectiveness of direct payment clauses. But in 1975, the majority of the House of Lords in the British Eagle case confirmed that an agreement that an asset of an insolvent estate would not be made available for the insolvent company’s creditors would be struck down.

The Northern Irish Court of Appeal in McLaughlin and Harvey plc agreed and held that direct payment arrangements were completely inconsistent with the insolvency regime.

More recently, Tate Building Services Ltd considered a contractor’s attempt to pay a supplier direct (circumventing the subcontractor due to its financial difficulties). In that case, the main contractor had to pay twice for the same works.

As can be seen, there is a real risk of double payment with the use of direct payment provisions. Without a change in the law, given the uncertain economic times ahead following the Brexit vote and the increased risk of contractor insolvency, it seems very unlikely that direct payment arrangements will increase in popularity any time soon.

Jessica Walker and James Morris are senior associates at Mayer Brown International

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