Security of payment legislation

5.4.1 Function of a security of payment legislation

One of the most disturbing situations that contractors and subcontractors may face is not getting paid on time the amount of money commensurate with the amount of works that they have done under the contracts or subcontracts. This can have serious impacts on the cash flow of the contractors and subcontractors and, in turn, on their ability to complete the contract or subcontract works for the project concerned, and possibly also for other projects that they are concurrently undertaking.

Generally, a contract or subcontract should have included payment terms that define the conditions for payments and the handling procedures to be observed by the contract parties.

These will typically include the timing for submission of interim payment claims, the substantiating information to be included in the claims, the methods and procedures for determining and certifying how much money is to be paid and when payments are to be made.

A deliberate refusal to making payment, be it just an interim payment, can amount to a repudiation of contract.

In the adverse situation where the client of a building construction project becomes insolvent, his inability to make any payments will lead to termination of the main contract and, in turn, termination of all associated nominated subcontracts and nominated supply contracts.

Otherwise, a project client will normally be keen to see construction works for his project are completed on time and, to ensure timely and satisfactory project completion, he will fulfil his contractual obligations, including making prompt payments according to the amounts certified by the architect.

However, the certified amounts that the client will pay may be less than what the contractor claimed for himself and on behalf of the nominated subcontractors. Payment deductions will happen if the quantities of works certified to be complete are less than the claimed quantities, or if the architect finds some of the works are unacceptable. As reviewed in Chapter 4, a main contractor will not pay a nominated subcontractor (and possibly also his domestic subcontractors) unless and until he is paid by the client the sum that the subcontractor entitles, i.e. the pay-when-paid practice, and may also set-off monies from payments due to a subcontractor. Disputes among the client, the contractor and the subcontractors could arise whenever payments are withheld or deducted.

A contract or subcontract may also include dispute resolution methods, which can be used to settle disputes on payments and, if necessary, the contractor or subcontractor may take legal actions to enforce payment. However, much time, effort and cost would need to be paid to obtain payments through such means, and payments, if any, may come too late by which time

the contractor or subcontractor might have suffered from other losses, e.g. lost of opportunities to win other contracts due to lack of cash flow, or run into bankruptcy.

As project clients predominate in setting terms and conditions in contracts and nominated subcontracts, such terms and conditions will be set to their favour. In turn, main contractors have control over payments to nominated subcontractors while domestic subcontracts are subject to terms and conditions that favour the main contractor. A client or a main contractor may also withhold payments to off-set monies the payee owns him under the current contract or other contracts (the latter is referred to as cross-contract set-off).

Compared to main contractors, subcontractors are subject to greater risks of having payments withheld due to the power of the main contractor to set-off and the pay-when-paid clause in the subcontracts. Legislative control over the obligation of a party to pay for goods or services rendered to him by another party under contract can override unfair payment terms in contracts and provide speedier and less costly means for enforcing payment.

In order to reduce the number of disputes and minimise costly and time consuming arbitrations or litigations on payment matters in the construction industry, regulatory control over security of payment has been enacted in some states or countries, such as UK, New South Wales of Australia and Singapore. Hong Kong does not yet have a security of payment legislation and little progress has been made on enacting such legislation, notwithstanding that the CIRC report (CIRC, 2001) did recommend the matter be looked into.

5.4.2 Essential features of a security of payment legislation

The purpose of enacting a security of payment legislation is to help contractors and subcontractors obtain payments to which they are entitled, and without undue delays. The legislation will make it a legal obligation to make prompt payment for goods or services delivered under a contract, which cannot be overridden by private agreements in contracts.

The legislation must define an appropriate set of procedures, including the time limits for the contract parties to take actions, such as the number of days from the payment claim submission date within which the amount of payment to be made must be determined and a certificate confirming the payment amount issued; the number of days thereafter by which payment must be made; and when the party suffering from unfair payment assessment or overdue payment can initiate actions to compel payment according to provisions made in the legislation.

Disputes would have already arisen when one contract party had to rely on the provisions in a security of payment legislation to obtain payment. Therefore, the means for settling disputes over payment matters must be defined in the legislation. Since adjudicating on such matters requires expert knowledge about construction contracts and other relevant laws, the legislation must define who can act as an adjudicator and who is to pay for the adjudicating service. A source of supply of suitably qualified adjudicators must also be established to ensure adjudicating services can be sourced whenever needed. The power of the adjudicator and his decision, whether the adjudicator’s decision would be final and, if not, means for appealing against the decision; and penalties for not complying with the decision must all be clearly defined.

In the security of payment legislations currently in force overseas, cross-claims and pay-when-paid or pay-if-paid practices are prohibited, and will be overturned even if such clauses appear in contracts. Some security of payment legislations apply only to written contracts (e.g.

Singapore) but some others cover also contracts that are not in written form (e.g. NSW, Australia).

Banning the set-off and pay-when-paid practices will allow subcontractors to enjoy more equitable treatment, and thus should become a legal requirement, even though this will increase the risks to parties employing subcontractors. However, to main contractors who are required by contract to enter into subcontracts with nominated subcontractors, this may not be considered to be entirely fair (see discussions below).

The argument in favour of insisting the existence of written contracts is about the concern that without a written contract, it would take much time and effort to establish genuine and unambiguous contract conditions during an adjudication process, which will paralyse the function of the legislation to provide speedy settlement of payment disputes. However, considering that the contracts used by lower tier subcontractors in the local construction industry are typically not well written or may even be oral contacts, insisting in basing adjudications on written contracts will render the security of payment legislation not being able to also protect the right of lower tier subcontractors. The requirement for written contracts is one important issue that must be carefully considered in drafting the legislation.

A security of payment legislation will still fail to ensure contractors or subcontractors will be paid for the works that they have done in case the project client becomes insolvent. In this case, the suffered parties may have to institute proceedings to wind up the insolvent party. To subcontractors, they will face a similar situation if the main contractor becomes insolvent, but provisions may be made in the legislation to allow the project client to make direct payments to them.

Greater protection for creditors of an insolvent party may be provided by implementing in parallel with the security of payment legislation a compulsory insurance legislation requiring each client, contractor or subcontractor who will contract out works to take out insurance for the benefit of those to whom they let out works. This policy, however, will increase the costs of construction projects and could be abused, leading to ethical players subsidising unethical players in the industry (similar to how the Protection of Wages on Insolvency Fund is often being criticised). Furthermore, the insurance companies could face unbearable burdens should a catastrophic situation arise, where many companies become insolvent at the same time. Appropriate means for guarding against abuse of the policy must be established and the benefit and cost of the policy must be carefully evaluated, before a decision is made on whether to implement a compulsory insurance legislation.

5.4.3 Problems with nominated subcontracts

A security of payment legislation will significantly increase the risk and financial burden that main contractors will have to bear due to their obligation to pay subcontractors for their works. For works that a main contractor sublets to his domestic subcontractors, it is reasonable to impose this obligation on the main contractor, as his responsibility to pay for the works of his domestic subcontractors is very much the same as the project client’s responsibility to pay for his works. Furthermore, the increase in financial burden on a main

contractor will be compensated by the greater certainty in obtaining payment on time from the project client. Although payment to a main contractor is subject to evaluation by the quantity surveyor and certification by the architect while a deduction in the payment amount will be made if some of the works are found unacceptable, this is not unfair to the main contractor as he is wholly responsible for the works of his domestic subcontractors.

As to nominated subcontract works, provided the evaluation and certification of the amount to be paid for the nominated subcontract works can be completed, and payment from the client of the certified amount can be made, within the period by which time the main contractor is obligated to pay the nominated subcontractors, the main contractor will have no difficulties in fulfilling his obligation to pay the nominated subcontractors. However, in the event that payment from the project client for the nominated subcontract works is delayed, the banning of the pay-when-paid practices implies that the main contractor will have to pay the nominated subcontractor upfront while he has to request for an adjudication to force the client to pay. Should the project client becomes insolvent, the main contractor will also be liable to pay the subcontractor any amounts due to him but he may not get the money back from the insolvent client. Since nominated subcontractors are hand-picked by the client, imposing this liability on the main contractor may not be considered entirely fair and reasonable.

In the UK Construction Act, pay-when-paid clauses are made ineffective but are invoked in case of an ‘up-steam’ party being subject to insolvency proceedings. In the recent review of this provision (DTI, 2005), no clear conclusion could be drawn if this exception to banning pay-when-paid clauses in contracts should be removed.

5.5 Summary remarks

Since the publication of the Construction Industry Review Committee’s report in January 2001, institutional arrangements established in Hong Kong for enhancing work quality standard and competitiveness of the construction industry, which are relevant to subcontracting, include the establishment of a voluntary subcontractor registration scheme (VSRS) and a mandatory construction workers registration scheme (CWRS). The enactment of a security of payment legislation, however, is still pending.

The VSRS can serve to provide information about the technical and financial capacity of individual registered subcontractor companies and their job records for reference of employers of subcontractors for building works. It can also serve as a launch-pad of new initiatives for improving the professionalism and upgrading the management training of subcontractors. However, because both public and private sector clients will select tenderers for subcontract works based on their own assessments of the tenderers, the value of being a registered subcontract under the scheme is limited, except for small size subcontractors provided that contract or subcontract conditions are included to require the contractor and subcontractor to sublet their works only to registered subcontractors. The scheme, however, will have limited effect on improving quality of construction works and on reducing burdens on subcontractors in respect of retention of payment, requirement for bond and provision of warranties.

The mandatory CWRS will help provide an integrated control over the identity of workers on construction sites, keep more accurate records of workers’ work hours on site, ensure workers

have had basic training on site safety measures and provide more reliable data on supply of skilled, semi-skilled and general construction workers. Its ability to enhance quality of works depends on the passing standards required for acquiring the qualifications for registration as construction workers at different skill levels but, being a mandatory scheme, such standards can only be set at levels that are not difficult to meet. Otherwise, the scheme could lead to shortage in labour supply in the construction industry and can paralyse the ability of the industry to cope with times with large increases in the volume of construction works.

Although work has been done to incorporate more equitable conditions in standard forms of contracts and nominated subcontracts (see Chapter 4), such conditions will fail to help contractors and subcontractors if they are modified or struck out from contracts and subcontracts. For ensuring that payment terms in contracts will be fair and equitable, regulatory control which cannot be overridden by terms in contracts is necessary, but little progress has been made yet on the enactment of a security of payment legislation in Hong Kong to help contractors and subcontractors obtain prompt payments. Admittedly, this is a rather complicated issue while international experience is still limited.

This chapter discussed the key issues that should be considered in the drafting of a security of payment legislation for Hong Kong, and the increased financial burden and risk to main contractors due to their obligations to make payments to subcontractors. In drafting the legislation, careful considerations should be given to whether the legislation will apply to unwritten contracts and to the situation where the project client or the main contractor becomes insolvent. Furthermore, it entails consideration to be given to whether a compulsory insurance policy needs to be implemented to ensure security of payment even in cases of insolvency of debtors.

5.6 References

CIRC, Construction for Excellence, Report of the Construction Industry Review Committee, Hong Kong Special Administrative Region Government, 2001.

DTI. Improving payment practices in the construction industry – Consultation on proposals to amend Part II of the Housing Grants, Construction and Regeneration Act 1996 and Scheme for Construction Contracts (England and Wales) Regulations 1998, UK: DTI, 22 March 2005.

PCICB. Operational framework of the Voluntary Subcontractor Registration Scheme, Provisional Construction Industry Co-ordination Board, March 2003.

PCICB. Rules and procedures for the primary register of the voluntary subcontractor registration scheme, Version 5, Provisional Construction Industry Co-ordination Board, 19 December 2005.