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Breaking up is never easy to do

LAWS - Parts of the standard form that allow for the withholding of payment on termination may be invalid, according to a recent ruling by the Court of Appeal. Lindy Patterson reports

WHEN an employer chooses to terminate a contract, its main concern is likely to be to get the work back on track.

An aggrieved contractor's concern may simply be to extract as much in the way of value as possible.

A recent decision of the Scottish Appeal Court ? Melville Dundas (in Receivership) v George Wimpey & Norwich Union Insurance ? illustrates the difficulties the various parties can have.

It also shows how far reaching the Construction Act's influence can be.

Most standard forms of contract give parties the right to terminate the agreement in specific circumstances ? for example, if the contractor fails to proceed regularly and diligently with the work, if the employer fails to make payment, or in the event of the insolvency of either party.

The clauses in question set out how parties' rights are to be regulated following termination.

Most are stated to be without prejudice to the parties' rights in common law ? meaning that other rights may exist but the written contract terms will usually apply.

Take, for example, a contractor employed under JCT '05.

Under the terms of clause 8, if a contractor's employment is terminated ? whether by reason of insolvency or a breach of the contract ? the contractor's rights to payment change.

The employer is not obliged to make any further payment until the work is completed.

An accounting then takes place whereby any additional costs of completion are deducted from money otherwise due to the contractor.

Often the result is that any sums owed to the contractor are wiped out by the completion costs of the employer. This is a form of contractual set-off.

So, on termination, JCT'05 purports to allow the employer to withhold any further payment, at least until the work is complete.

There is an exception to this in JCT'98 in that the employer may not withhold payments that were due more than 28 days before termination.

But section 111 of the Construction Act provides that no payment can be withheld after the final date for payment without a valid withholding notice first being issued.

It had been generally accepted in the industry that this section did not affect contract termination provisions as the latter were simply changing the basis of payment post-termination.

No withholding notices were required as different due dates arose postponing payment.

That approach made sense, especially where the reason for termination of the contract was the contractor's insolvency.

Set-off on insolvency is of particular importance as, unless it can be achieved, the employer will simply rank as an ordinary creditor in respect of any increased costs incurred by having others complete work.

The extent of set-off on insolvency is wider by virtue of both statute and, in Scotland at least, the common law. The standard contractual termination provisions effectively enshrine this wider right of set-off.

The view taken by Lord Clarke in the Melville Dundas case supported this.

Melville Dundas, which Wimpey had employed under a JCT 'with design' contract, went into receivership on May 22, 2003.

A valuation of its work had been issued with a final date for payment of May 16, 2003, several days prior to appointment of the receivers. No withholding notice was issued.

On May 30, Wimpey terminated the contract on the basis of Melville Dundas' insolvency and Melville Dundas responded by suing for payment of the valuation.

Wimpey relied on clause 27 ? now clause 8 ? which provided that sums due less than 28 days following termination were not due until the overall accounting was done.

Melville Dundas argued that this amounted to a withholding of payment and, in the absence of a withholding notice, was contrary to section 111 of the Construction Act.

Lord Clarke rejected this argument, finding that clause 27 set a new date for payment post-termination. Melville Dundas appealed against this decision and the Appeal Court found in its favour, ordering payment of the valuation.

Section 111 of the Act is about cash f low, declared the Appeal Court judges, and it applies even after termination.

As it was impossible to discover from clause 27 what the final date for payment would be, the final date for payment was not thereby amended.

The final date for payment of the sum sued for under the contract had passed without any effective notice of intention to withhold payment.

The court stated: 'Where a contractor becomes insolvent, there will not be enough money to go round and losses will have to be borne. In our opinion Parliament has provided quite clearly that, in circumstances such as the present, losses should be borne by the defenders as the employer under the contract, hence the provisions of section 111 (1).' Although the contractor's insolvency was critical to the issue, arguments about different rules applying to insolvency were not advanced. The judges acknowledged this.

If the decision in Melville Dundas stands then it may interfere with the law of insolvency and extend the ambit of the Construction Act into areas beyond its intended scope.

KEY POINTS

On termination, most standard forms of contract allow the employer to withhold any further payment due to the contractor until the work is complete and a balancing of accounts takes place.

These termination provisions are a form of contractual set-off.

Applying the Melville Dundas decision, these provisions may be contrary to section 111 of the Construction Act, where they do not clearly alter the final date for payment and/or no effective notice of withholding has been issued.