The Construction Act and its amendment – payment issues

Part 8 of the Local Democracy, Economic Development and Construction Act substantially amends the Construction Act. It affects all "construction contracts" in England, Wales and Scotland. The amendments to the Construction Act came into force in relation to construction contracts entered into on or after 1 October 2011 in England and Wales, and 1 November 2011 in Scotland.

The aims of the amendments are:

• to increase clarity and certainty as to payment in construction contracts;
• to introduce a 'fairer' payment regime, and improve rights for contractors to suspend their work in non-payment circumstances; and
• to make adjudication more accessible  for the resolution of disputes.

This guide considers changes to payment rules under the Construction Act in relation to construction contracts entered into on or after 1 October 2011 in England and Wales, and 1 November 2011 in Scotland. For information about changes to the adjudication system, see our separate Out-Law guide.

What is a 'construction contract'?

The Construction Act defines construction contracts. All design and construction contracts, including professional appointments, are likely to be construction contracts as long as they relate to "construction operations".

Construction operations includes a very wide range of construction operations and the most common forms of engineering operation - for example, civil engineering projects. However, some engineering projects such as mining, nuclear and power generation are expressly excluded, as are contracts with residential occupiers.

What is the Scheme?

The Scheme for Construction Contracts (England and Wales) Regulations, known as 'the Scheme', supplements the Construction Act in England and Wales and provides  fall-back provisions where the contract itself does not include the necessary payment and adjudication provisions. A similar Scheme exists in Scotland through the Scheme for Construction Contracts (Scotland) Regulations.

If a construction contract:

• does not contain any payment rules, the entire payment provisions of the Scheme will be implied into the contract;
• complies in part with the payment rules required by the Act, then:
• the payment provisions that comply with the Construction Act will continue to take effect;
• any missing payment provisions will be implied into the contract by the Scheme; and
• any non-compliant payment provisions will be replaced by the relevant payment provisions in the Scheme;
• contains a so-called 'pay when paid' clause, then that clause is ineffective and – unless the parties have agreed other terms of payment – the payment provisions will be replaced by the payment provisions in the Scheme to the extent they are non-compliant.

A revised Scheme applies to all construction contracts entered into on or after 1 October 2011 in England and Wales, and 1 November 2011 in Scotland. The revised Schemes take effect at the same time as the changes to the Construction Act. The Scheme will continue to provide a fall-back position where a construction contract does not include the necessary payment provisions.

Contracts in writing

The first and most significant change to the Construction Act is the abolition of the requirement for construction contracts to be in writing. The Construction Act will now apply to all construction contracts - those which are wholly in writing, partly in writing or wholly oral.

This is an issue which affects adjudication in particular. Although the new legislation gets rid of the requirement for contracts to be in writing, some provisions ()such as the provisions for adjudication, costs and the 'slip rule' must still be in writing and if they are not then the Scheme will apply.

This change is likely to have an impact where there are letters of intent and where contracts are based on standard terms and conditions, but supplemented by oral agreements. Previously a party could not adjudicate on those sorts of agreement unless the written part contained a provision for adjudication but this will now be possible. Hearings are more likely to take place so that adjudicators can determine what the contract actually consists of,

This will make it even more important to ensure that agreements are fully recorded in writing. A good way to avoid arguments as to verbal agreements is to have entire agreement clauses which make it clear that formal agreement between the parties is limited to the contents of the document. These clauses will not always prevent arguments, but they will improve the position of a party arguing against an oral agreement.

Main changes to the payment regime

The main changes to the payment regime include:

• changes to the notice regime, including a requirement for the paying party to pay the notified sum and introducing new rules on payment and withholding notices;
• allowing clauses which permit an employer to withhold payments without notice in the event of a contractor's insolvency;
• new rights for a contractor who suspends performance for non-payment; and
• the abolition of conditional payment clauses.

Payment notices

The previous law: the Construction Act says that construction contracts have to provide an 'adequate mechanism' for determining what payments become due and when – generally known as the 'due date'. The Act also says that the payer has to give notice, not later than 5 days after the due date, specifying:

• the amount of the payment made or proposed to be made; and
• the basis on which the amount is calculated.

However, there is no effective sanction for failing to comply with this notice requirement and it is unclear what happens if no payment notice is provided because there is no certainty as to what sum is due under the contract. It is only the employer who can issue such notices and often the notice is considered unnecessary as it duplicates what is already contained in the certificate under the contract.

The amendment: construction contracts will have to require a payment notice to be given for every payment provided for by the contract, not later than five days after the payment due date. This is now defined in the Act as "the date provided for by the contract as the date on which the payment is due".

A construction contract must provide for the payment notice to be given by the payer, a "specified person" specified in or determined in accordance with the contract or by the payee itself. The notice must specify:

• the sum that the person giving the notice considers to be due or to have been due at the payment due date in respect of the payment; and
• the basis on which that sum is calculated.

Even if the sum considered due is zero, a payment notice must still be given in the required form.

This is not very different from the current regime where the employer has to issue a payment notice not later than five days after the due date, however there are some key changes:

• the payment notice does not only have to be issued by the employer – it can be issued by specified persons such as the architect or engineer, or the payee may be required to issue the notice;
• the notice must now simply state the sum which is "considered" to be due and the basis of the calculation. In this way the notice prevents duplication and takes into account any set off, abatement or any other deductions which may be withheld; and
• there is now a sanction for failure to issue a payment notice and a greater risk faced by parties that fail to issue payment notices – the risk is that the payee may now issue a notice in default stating the amount considered to be due and the basis for calculation.

If the deadline has passed and a payment notice has not been given, the payee may give the payer a payment notice – known as a 'payee's notice in default' – at any time, stating the amount it considers due and the basis for calculation. If the contract provides for an application for payment and the application is made, that will automatically be regarded as a payee's notice in default.

If a payee's notice in default is issued, the final date for payment will be postponed by the length of time between when the payer or specified person should have given the payment notice and the date the payee gave its notice in default.

These changes are important because there is now a positive obligation to pay the notified sum, which may be the value of an application under the contract. However, it is not clear what the position will be if no party issues a notice before the final date for payment.

Requirement to pay notified sum or less

The previous law: a party to a construction contract may not withhold payment after the final date for payment of a sum due unless it has given an effective notice of intention to withhold payment (a 'withholding notice'). In order to be effective, a withholding notice must specify:

• the amount to be withheld and the ground for withholding payment; or
• (if there is more than one ground) each ground and the amount attributable to it.

The withholding notice must be given not later than the 'prescribed period' before the final date for payment, as agreed by the parties. If the parties do not agree, the Scheme will apply, making the period seven days. A payment notice can operate as a withholding notice, as long as it meets the requirements above.

The amendment: creates a positive obligation on the payer to pay the 'notified sum', to the extent not already paid, on or before the final date for payment. The old form of withholding notices have been abolished.  The 'notified sum' is now a key concept. As outlined above, this sum is the sum stated in the payment notice, which can be issued by the paying party, the specified third party or the payee. This notice can also be the notice in default and in almost all cases this will be the application for payment. If no payment notice is issued, there is a positive requirement to pay the sums set out in the application if the contract allows or requires the making of an application.

This change allows the paying party (or a specified person) to issue what used to be a withholding notice and is now a 'notice of intention to pay less' or a 'pay less notice' before the final date for payment. The new notice of intention to pay less must specifiy:

• the sum that the person giving the notice considers to be due on the date the notice is served; and
• the basis on which that sum is calculated.

As is currently the case with the withholding notice, this notice must be given not later than the prescribed period before the final date for payment, specified in the contract or the Scheme. Insolvency exception

Another change to the Construction Act means that payment of the notified sum need not be made in insolvency situations where:

• the contract allows withholding of sums due in cases of insolvency: and
• the insolvency occurs after the expiry of the time for giving the counter notice.

This is not an automatic right and the contract must contain an appropriate clause to benefit from this provision.

Suspension for non-payment

The previous law: gives a party who is entitled to payment the right to suspend performance of its obligations under the contract if

• the sum due is not paid in full by the final date for payment; and
• no effective notice to withhold payment has been given.

The party wishing to use this right has to give the other party at least seven days' notice of its intention to suspend stating the ground or grounds for suspension. The right to suspend comes to an end when the other party pays the amount due in full. There is no entitlement in the Act itself which allows you to recover your loss and expense if you suspend for non-payment, although many contracts are amended to allow for this.

Any period of suspension under this right is disregarded when calculating the amount of time taken to complete the contract for the purposes of delay damages.

The amendment: the right of suspension now arises where there is a requirement to pay the notified sum and that requirement has not been complied with. The party wishing to suspend will now be able to suspend performance of any or all of its contractual obligations. This new entitlement to partial suspension of contractual obligations means that suspension is not limited to the actual construction obligations, but can go beyond it to - for example - suspension of the right to insure the works or suspension of works on only crucial areas or with certain sub-contractors.

Where the right to suspend is exercised, the other party will be liable to pay a reasonable amount in respect of the costs and expenses reasonably incurred by the suspending party as a result of exercising this right. This is now an entitlement set out in the Act itself.

The time period to be disregarded when computing the time to complete work is any period during which performance is suspended in pursuance of or in consequence of exercising the right of statutory suspension.

Conditional payment clauses

The previous law: provisions which make payment conditional upon receipt of payment from a third party ('pay when paid' clauses) are ineffective, unless that third party is insolvent. The Construction Act does not prohibit clauses which make payment conditional on other events, such as 'pay when certified' clauses - where payment is conditional on a certificate being issued under another contract.

The amendment: a clause will be invalid if it makes payment conditional on:

• performance of obligations under another contract; or
• a decision by any person as to whether obligations under another contract have been performed.

This is to prevent a party up the line from relying on circumstances relating to its own contract to delay payment under a separate contract - for example, the fact that an employer has not complied with its certification obligations to a main contractor cannot be used by the main contractor to deny payment to a subcontractor.

Exceptions: this amendment has a direct impact on management contracting or equivalent project relief arrangements, where the main contractor simply acts as a conduit - for example, under Private Finance Initiative (PFI) or Public Private Partnership (PPP) contracts, where the special purpose vehicle company created for the sole purpose of procuring the project has no assets and is not intended to have any liability unless it is first paid. For more on this see our separate Out-Law guide to PPP.

Exclusion Orders

Due to concerns that these amendments to the Construction Act will outlaw equivalent project relief provisions in subcontracts in PFI/PPP projects, Orders have been made which seek to protect certain EPR arrangements in respect of contracts entered into on or after the date that the amendments to the Construction Act come into force (1 October 2011 in England/Wales and 1 November 2011 in Scotland).

The Construction Contracts (England) Exclusion Order 2011 comes into force in England on 1 October 2011 - at the same time as the changes to the Construction Act. Similar Orders have been published in respect of Wales and Scotland.

The Orders means that provisions in first tier PFI sub-contracts which make payments in such contracts conditional upon obligations being performed in other contracts (such as providing certificates and 'pay when paid' clauses) will be effective.  However, 'pay when paid' clauses will, generally speaking, continue to be ineffective in accordance with the Construction Act.

Conclusion

For construction contracts entered into in England and Wales on or after 1 October 2011 (1 November 2011 in Scotland), it is important to bear in mind the following:

• notices are crucial, bearing in mind that if there is no payment notice the other party can serve a notice of default or rely on its own application for payment;
• the paying party will then have to pay whatever has been notified unless a valid notice of the intention to pay less has been served; and
• payment clauses will need to be redrafted to reflect these changes, and those operating on the construction site must be made aware of the importance of sending the correct notice on time and with the correct information.