Construction contractors beware – common clauses may now be unenforceable after Maxcon Constructions v Vadasz

By Owen Hayford and Hannah Stewart-Weeks
Senior Fellow in the Melbourne Law Masters and Partner, PwC Legal and Senior Associate, PwC Legal

Probuild and Maxcon Case Page

If you’re a construction lawyer or construction industry professional, by now you’ve probably heard about the recent High Court decision in Maxcon Constructions Pty Ltd v Vadasz [2018] HCA 5 (‘Maxcon’) (handed down at the same time as the decision in Probuild Constructions (Aust) Pty Ltd v Shade Systems Pty Ltd [2018] HCA 4). Most commentators have focused on the judicial review issue which arose in both of those cases. However, the High Court in Maxcon also determined that a provision in a construction agreement which allowed a head contractor to withhold retention moneys under a subcontract until certain events had occurred under the head contract was a ‘pay when paid’ provision, and was therefore not legally enforceable under the security of payment (SOP) legislation. (See Kiefel CJ, Bell, Keane, Nettle and Gordon JJ at [16]–[29]. Gageler J at [32] and Edelman J at [41] agreed with the conclusions of the plurality regarding the operation of the SOP legislation, but did not consider the issue determinative of the appeal).

In this instance, the relevant SOP legislation was the Building and Construction Industry Security of Payment Act 2009 (SA) (‘SA SOP Act’), but most other States apart from Western Australia and the Northern Territory have similar provisions to the SA SOP Act. Thus, the decision has potentially broad implications for head contractors, not only in relation to retention provisions, but also in relation to other provisions which attempt to make a payment under a subcontract contingent upon an event occurring under the head contract. Head contractors may need to review their subcontracts to ensure that they don’t inadvertently contain ‘pay when paid’ provisions as a result of this decision.

What is a ‘pay when paid’ provision?

Prior to the enactment of the SOP legislation, head contractors commonly included a clause in their subcontracts which provided that payment to the subcontractor was either determined by the date on which the head contractor received payment from the principal (‘pay when paid’); or dependent on the head contractor receiving payment from the principal (‘pay if paid’).

By including these types of clauses, head contractors were attempting to share the cash flow risk of projects with their subcontractors. The problem was, subcontractors typically had much smaller balance sheets than head contractors, and were less able to manage the effects of poor cash flow – leading to a high rate of subcontractor insolvency.

The purpose of the SOP legislation is to help ensure security of payment for subcontractors and reduce the high levels of insolvency. One of the ways it does this is by prohibiting both ‘pay when paid’ and ‘pay if paid’ provisions, as well as a third, broader, type of provision which ‘makes the liability to pay money owing, or the due date for payment of money owing, contingent or dependent on the operation of another contract.’ (See eg, s 12 of the SA SOP Act) Importantly for the following analysis, ‘money owing’ is defined as money owing for construction work carried out or undertaken to be carried out…under the contractas  in s 12(2) of the SA SOP Act.

Since the enactment of the SOP legislation, head contractors have generally tried to avoid drafting direct ‘pay when paid’ or ‘pay if paid’ provisions into their subcontracts. However, the Maxcon case highlights the potential for other common clauses to inadvertently fall foul of the prohibition on ‘pay when paid’ provisions.

How did the case arise?

The case involved a subcontract for piling work, which included a standard form retention clause. This clause allowed the head contractor to retain by way of security 10% of each progress payment due to the subcontractor until the head contractor had retained a total of 5% of the contract sum.

The release of the retention money was contingent upon the issue of a certificate of occupancy for the entire project. The High Court held that the retention clause in the subcontract was in fact a ‘pay when paid’ provision. This was because the dates for release of the retention money under the subcontract were dependent on the issue of a certificate of occupancy, and such a certificate could not be issued until completion of the whole project in accordance with the head contract. The release/payment of the retention money was therefore ‘contingent or dependent on the operation of another contract as prohibited in s 12(2)(a) of the SA SOP Act, and so the whole of the retention monies clause, including the provision allowing the head contractor to retain retention monies from the progress payment otherwise payable to the subcontractor, was unenforceable.

What does this mean for subcontracting arrangements in construction?

This decision has significant implications for subcontracting arrangements, particularly as the High Court’s analysis is likely to apply to the SOP legislation in most states (other than Western Australia and the Northern Territory where the legislation does not prohibit the broader restriction on provisions that make liability to make a payment under one contract ‘contingent or dependent on the operation of another contract’).

Retention money

Most obviously, head contractors will need to consider their subcontract retention provisions to ensure that they do not contravene the ‘pay when paid’ prohibition by making the release of retention money dependent on practical completion (or some other event) occurring under the head contract for the project.

Instead, release of retention money needs to be tied to operation of the subcontract itself, eg, practical completion and/or the expiry of the defects liability period under that subcontract. The problem for head contractors is that in a large project there may be a large number of subcontracts, each with different dates for practical completion that may be earlier (sometimes significantly so) than the date for practical completion under the head contract.

Two main issues arise if release of retention money is tied to the defects liability periods under each separate subcontract. First, this adds to the administrative burden for the head contractor, who must now manage the release of many retention amounts at different times. More significantly, there may be complications where an important piece of subcontracted work is completed early in the project (such the piling subcontract – which was the relevant subcontract in Maxcon). If the release of retention money under the subcontract is tied to the expiry of the defects liability period under that subcontract, the time for release of retention money is likely to arrive before the expiry of the defects liability period under the head contract. And if there are issues with that subcontractor’s work which only become apparent after the release of the retention money, it may be difficult to get the subcontractor to come back and fix the problem – even though the defects liability period under the head contract is still on foot.

One potential solution is for head contractors to require bank guarantees or insurance bonds instead of retention money. Unlike retention money, a bank guarantee is not ‘money owing’ in relation to work under the subcontract, but rather a security requirement which is separate to the contract sum. This means the ‘pay when paid’ provisions won’t apply. However, a subcontractor must pay to take out bank guarantees or insurance bonds, so this kind of requirement is likely to translate to higher subcontract prices, and therefore higher overall project cost.

Milestone payments

Another common provision which is likely to be affected is a provision which provides for milestone payments under a subcontract which are linked to events occurring under a head contract. For example, a head contractor may want to tie a subcontractor’s final payment to practical completion under the head contract. Like withholding security, the idea is to ensure the head contractor has some leverage in circumstances where the principal does not consider that the works under the head contract have reached practical completion due to some issue with the subcontractor’s work.

It now seems fairly likely that this kind of provision is a ‘pay when paid’ provision and is therefore not enforceable – as it makes payment to the subcontractor contingent on an event occur under the head contract, over which it has no control.

Linked claims/linked disputes provisions in pass through subcontracts

The High Court’s decision also reinforces the potential issues with common ‘linked claims and linked disputes’ type provisions.

As an example of this, the standard AS4903 ‘pass through design and construct’ subcontract contains a provision which allows the head contractor to require a subcontract dispute which affects the head contract to be resolved as part of the head contract dispute resolution process – and the subcontractor is required to accept the outcome of that dispute process.

Similar provisions are common in the core subcontracts on Public Private Partnership (‘PPP’) projects, which typically contain a provision which attempts to limit the liability of the Project Company to its contractors by reference to the Project Company’s entitlements against the State under the PPP Contract. In essence, if the contractor makes a claim against the Project Company and that claim is one that can be brought by the Project Company against the State under the PPP Contract, the contractor’s entitlement is limited to the amount recovered by (or other relief granted to) the Project Company under the PPP Contract. Typically, the clause will also provide that it does not apply to the extent that it would have the effect of making the clause a ‘pay when paid provision’ within the meaning of the SOP legislation.

The decision of the High Court in Maxcon indicates that these types of provisions may be largely ineffective as, in many cases, they will in fact operate as ‘pay when paid’ provisions.

This is because it is relatively clear that a linked claims/linked disputes provision attempts to make an entitlement under one contract ‘contingent or dependent on the operation of another contract’. The entitlement under the subcontract is contingent on the success of the head contractor’s claim or dispute under the head contract. The analysis therefore turns on the term ‘money owing’, defined as money owing for construction work carried out or undertaken to be carried out…’  (see eg s 12(2) of the SA SOP Act (emphasis added)).

It may be asked whether a linked claim/linked dispute provision operates to make payment of money owing under the subcontract contingent on the operation of the head contract. The answer is that it depends on what kind of claim is involved.

In our view, most claims that a subcontractor brings against a head contractor which the head contractor in turn brings against the principal are likely to be claims for ‘money owing’. For example, variation claims, claims for costs incurred in dealing with latent conditions, and claims for acceleration costs (and potentially delay costs as well) are all claims for money that relate to the carrying out of construction work. In those circumstances, a linked claims/linked disputes provision is unlikely to be effective to limit the subcontractor’s entitlements to the extent of the head contractor’s recovery against the principal. The head contractor can try to protect itself from a potential gap between the amount recovered from the principal and the amount payable to a subcontractor by ensuring that all relevant contractual and technical provisions are passed through to the subcontractor. But even then, there is no guarantee that a claim or dispute will be determined the same way under both the contracts.

However, on the other hand, some claims by the subcontractor against the head contractor will not be claims for ‘money owing’, and so the prohibition on ‘pay when paid’ provisions will not apply. For example, a claim for an extension of time is not a claim for money at all, and a claim for breach of contract is a claim for damages in respect of loss suffered, and not a claim for money owing in relation to construction work carried out.

Pass through of determinations

Finally, many ‘pass through contracts’ attempt to ‘pass through’ determinations and decisions of the superintendent, principal, or independent certifier under the head contract to the subcontractor to the extent they relate to the same issue (unless disputed). Like the linked claims/linked disputes provisions, these types of provisions are also likely to be unenforceable to the extent they are linked to payment of ‘money owing’ to the subcontractor.

Consider the following example: under the head contract, the head contractor is required to pass a certain prototype test before proceeding to full production. One of the head contractor’s payment milestones is linked to passing this test. The head contractor has subcontracted the work relating to the production and testing of the prototype, and has also included a payment milestone under the subcontract linked to passing the test. The superintendent under the head contract determines that the test had not been passed. The head contractor will then want to ‘pass through’ that same determination to the subcontractor. However, this provision has the effect of making payment to the subcontractor (the payment milestone for completion of the test) contingent on the operation of the head contract (whether or not the head contract superintendent considers that the test was passed) – and so is likely to offend the ‘pay when paid’ provisions of the SOP legislation.

To contrast: another example might be where the head contract superintendent has determined that a design document produced by the subcontractor (and submitted by the head contractor under the head contract) does not comply with the contract. Provided that this determination is not linked to payment or withholding of the subcontract price, the ‘pay when paid’ provisions will not apply.

Conclusion

It has long been understood that ‘pay when paid’ and ‘pay if paid’ provisions are prohibited under SOP legislation.  However, it has not been well understood that provisions allowing a head contractor to withhold payment under a subcontract until certain events have occurred under the head contract will also fall foul of the prohibition in most states (other than WA and the NT). This has potentially broad implications for head contractors both for retention provisions, and for other provisions which attempt to make a payment under a subcontract contingent on an event occurring under the head contract.

Consequently, head contractors should review their subcontracts to ensure they don’t inadvertently contain ‘pay when paid’ provisions.

AGLC3 Citation: Owen Hayford and Hannah Stewart-Weeks, ‘Construction contractors beware – common clauses may now be unenforceable after Maxcon Constructions v Vadasz’ on Opinions on High (1 March 2018) <http://blogs.unimelb.edu.au/opinionsonhigh/2018/03/01/hayford-and-stewart-weeks-maxcon/>.

Owen Hayford is a Senior Fellow in the Melbourne Law Masters and a partner at PwC Legal specialising in infrastructure. Hannah Stewart-Weeks is a Senior Associate at PwC Legal. They have provided advice on many of Australia’s most significant Public Private Partnerships.