In one of our previous articles, we discussed managing construction insolvency risk, and how to spot and minimise disruption in a supply chain. We also talked about how the construction industry experiences the highest number of insolvencies in England and Wales using the latest figures from the Insolvency Service. As a result, one of the issues that commonly arise in construction projects with multiple subcontractors is ensuring continued payment and cashflow so that works are not halted due to a contractor’s insolvency.

Closely tied to this topic is the issue of terminating a construction contract, and these rights exist in two folds; (1) terminating under the provisions of the construction contract; and (2) terminating under common law for repudiatory breach.  Unless specified in the contract, both options are available to the party seeking to terminate, but the best approach will depend on the circumstances and requires careful analysis.

When considering terminating a construction contract, it should be noted that under the Corporate Insolvency and Governance Act 2020 (CIGA 2020), the rule introducedwhich applies to suppliers of goods and services, prohibits the supplier from terminating because of insolvency (or similar events) of its client. However, once the client has gone insolvent you can still terminate if a further termination right arises after the relevant insolvency type event. This restriction does not apply where it is the client terminating because of the supplier’s insolvency.

It is therefore important to understand the best approach leading up to termination. The question that often arises is what alternatives are available to ensure that cash flows to the subcontractor and works continue? In this article we look at Direct Payment Agreements (DPA) and questions that arise in relation to this.

A Direct Payment Agreement is an agreement between the employer and subcontractor to pay the subcontractor directly for works performed.

A Direct Payment Agreement would be expected to cover the following:

1. Background of the project
2. The outstanding amount payable to the subcontractor
3. The payment mechanism setting out how it would be paid to the subcontractor (i.e. payment milestones or fee breakdown)
4. The reason for which payment is made.
5. Where there is an underlying subcontract for the works, reference to this should be made in the DPA.

Some of the key questions that may arise when considering a Direct Payment Agreement are as follows:

Do you need to obtain consent from the main contractor to enter a Direct Payment Agreement?

No, if the contract between the employer and the main contractor contains a direct payment provision, this allows for payment to be made directly from the employer to the subcontract with an equivalent provision that extinguishes any claim the main contractor may have in this regard. While these clauses are rarely included in the NEC or JCT contracts, they could be built in using bespoke schedule of amendments, and it is important to consider the risk associated with this approach as while it may be beneficial to the employer in a case where the main contractor becomes insolvent, the main contractor would want to consider the approach in terms of managing its relationship with the subcontractors.

In the absence of this provision, an alternative would be to see if there’s a collateral warranty in favour of the employer which contains step in rights. This would allow the employer to potentially step into the position of the main contractor and assume responsibility for payment to the subcontractor which could be formalised by a DPA.

Novation Agreement as an alternative

Alternatively, the employer may enter into a novation agreement with the main contractor and the subcontractor. This would effectively allow the employer to assume the position of the main contractor to the subcontractor. It is important to note that there are risks associated with this as it exposes the employer to the risk which the main contractor would otherwise have been liable for under the subcontract and vice versa.

Would this mean the obligation on the main contractor to pay is discharged?

This would depend on the circumstances of the case. However, where the employer has paid the main contractor an amount of money to be used towards the subcontractors which hasn’t been used because the main contractor has become insolvent, the employer may wish to recover this from the main contractor alongside any other monies owed. This would be addressed during the insolvency process.

Does entering a Direct Payment Agreement mean the employer now bears the responsibility of the main contractor in relation to ensuring the subcontractor works are carried out properly?

Whether this happens depends on the circumstances of the case. If the main contract between the employer and the main contractor provides for a direct payment provision, then the employer does not automatically become responsible for the main contractor’s obligation to supervise and ensure the quality of the subcontractor works under the subcontract. However, this would be different where the employer exercises its step in right under a collateral warranty or enters into a novation agreement in which case it would be responsible for this obligation.

Alternatively, where the employer is in the process of appointing a replacement contractor and novating the subcontract from the main contractor to the replacement contractor, then the replacement contractor could assume the obligation under the subcontracts.

Is there an overall benefit of Direct Payment Agreements?

As seen from above, the benefits of DPAs typically lies with the employer and the subcontractor. For the subcontractor this would mean having an improved cashflow and not been subject to the risk associated with the contractor’s insolvency.

For the employer this would mean that it can deal directly with the subcontractor to keep the project progressing and avoiding delays which could cause financial liabilities for the employer. For instance, where the project involves the development of a residential or commercial property and units have been sold under a purchase agreement which includes a projected completion and possession date, the employer would be mindful of defaulting and consequently incurring potential claims for delay.

In conclusion, DPAs are helpful in certain instance. However, it must be drafted efficiently to ensure it is enforceable, and it accomplishes the purpose for which it is made.

How we can help

If you need advice on any of the issues mentioned above or to consider what options are available to you in a project where the contractor is insolvent, our construction team at HC can help you with this. Please contact us.