Step 2: ensuring sums paid (promptly!) to the main contractor flow down quickly and undiluted to source

My previous perspective regarding strategies purchasers of construction and engineering services may adopt to mitigate exposure to main contractor insolvency risk advocates prompt payment and not messing around with payment periods included in standard form contracts.  Step 2 is to ensure payments made flow down to the supply chain as quickly as possible and are subject only to deductions properly applied and specific to the employer’s project.

Securing prompt payment to supply chains and protection of payment from the effects of main contractor insolvency are the central themes of Scottish Government policy relating to the use and availability/accessibility to subcontractors of project bank accounts (see CPN1/2019 and the restatement of that policy in CPN7/2020). The objectives behind those CPNs (supporting SME businesses in Scotland) are highly commendable, but the “hardnosed” benefits achieved for employers under construction and engineering contracts through implementing them are not as widely considered.  If a main contractor, insolvency event is experienced, in many cases the fastest and most cost effective route for the employer to build-out their project will be to appoint a replacement contractor to step-into and take over the existing supply chain.  Ensuring the main contractor does not retain payments intended to be flowed down to the supply chain for any longer than is strictly necessary is, therefore, very much in the employer’s commercial interests and operates as a practical protection in respect of insolvency risk. If payments to the supply chain are up to date at the point of main contractor insolvency, the build-out costs incurred by the employer will almost certainly be less.  In addition, the risk of the employer having to “pay twice” following step-in for works previously carried out by the supply chain, where the benefit of payments made has not been passed down, is mitigated.

Despite the above commercial benefits/protections, there is still resistance to the widespread adoption of project bank accounts in Scottish construction and engineering contracts.  While other public bodies are encouraged to adopt PBAs, use of them is still only mandatory in relation to building and civil engineering projects above the applicable threshold value procured directly by SG and bodies sponsored by SG.  The limited availability of banks willing to offer PBA facilities, complexities with and timescales involved in account opening, plus the related costs all operate as practical barriers to achieving more widespread use of the approach.  In the face of those challenges, HM has been actively considering alternatives to the PBA approach that will provide the above insolvency protections and (for clients who are contracting authorities but not subject to the mandatory PBA regime) also demonstrate compliance with the requirements of section 15(5)(d) of the Procurement Reform (Scotland) Act 2014.

In recent and live construction and engineering projects where HM provides contract negotiation services, we have encouraged clients to amend standard forms so that the main contractor is required to incorporate “compliant subcontract payment terms” in “relevant subcontracts”.  Imposing controls over payments made to all subcontractors would be impractical, so (consistent with the approach to identifying “Qualifying Sub-Contractors” used in SG template drafting for PBA projects), the focus is on larger value and sub-contract packages that are otherwise significant to the overall works.  Compliant subcontract payments terms focus on three key areas:

• requiring relevant subcontractors to submit applications for interim payment, invoices (or any equivalent) that are specific to works performed and/or goods, materials or services supplied under their relevant subcontract (and not single applications relating to multiple projects on which they may be working for the main contractor at the same time);
• prohibiting the main contractor from setting off sums due to relevant subcontractors under relevant subcontracts, against amounts assessed or claimed by the main contractor to be payable by that subcontractor in relation to subcontracts entered into between the parties relating to other projects; and
• obliging the main contractor to pay relevant subcontractors promptly (overall payment periods under relevant subcontracts not to exceed those applicable under the main contract by more than 14 days).

The first bullet is particularly important to a sub-set of relevant subcontracts in HM’s suggested approach, namely “significant subcontractors”.  Significant subcontractors are those who enter into the Bullet one is relevant to the highest value and most significant relevant subcontracts.  HM advises that such subcontractors (who are not design subcontractors, providing collateral warranties) are required to enter into step-in undertakings in favour of the employer.  The step-in undertakings prevent significant subcontractors from terminating their relevant subcontract (including on grounds of non-payment by the main contractor) without first affording an opportunity to the employer to step-in and remedy the main contractor’s breach.  They also provide for the employer stepping-in following a main contractor insolvency event and include a “whistleblowing clause” (notice by the significant subcontractor to the employer where the main contractor fails to comply with prompt payment requirements).  Requiring invoices to the main contractor to be specific to an individual project makes it much easier for the employer to verify the value of payments due to a significant subcontractor at the point of deciding whether to step-in.

Bullet two addresses a widely adopted practice, namely the main contractor reducing sums payable to a subcontractor on the grounds they consider that subcontractor owes them money in relation to another project.  The main contractor will view this as legitimate practice, based on their business relationship with a supply chain used regularly and across multiple projects.  It is, however, not in the employer’s interest to permit the main contractor to use funds paid to meet costs incurred on the employer’s project to resolve commercial differences with the supply chain on unrelated projects for different clients. 

Bullet three replicates the prompt payment requirement that underpins that PBA approach and should assist those employers who are contracting authorities to evidence compliance with the section 15(5)(d) obligations mentioned above.

“Policing” bullets 2 and 3 in SBCC based contracts involves the employer having more extensive rights to approve the main contractor’s sub-contract terms than has traditionally been the case (but that is quite normal in nec based contracts).  For bullet 3, we advise requiring the main contractor to evidence – at the point of applying for and as a condition of being entitled to claim interim payments from the employer – that no payments are outstanding to relevant subcontractors for longer than the permitted payment periods without due cause.

Changing practices that have been in place for a long time is never easy, but we believe seeking to do so is essential, especially as we enter a period when an enhanced risk of the occurrence of insolvency events may apply.  Purchasers of construction and engineering services cannot prevent the risk of main contractor insolvency from arising, but through strong and prudent contract negotiation, they can place themselves in a much better financial position to deal with the consequences of insolvency where it does occur.