There is growing acceptance across the construction industry, particularly among financiers and owners, that payments need to flow down the contract chain to those actually doing the work.  This has seen a growth in construction contracts requiring head contractors to prove payment of their subcontractors, if cashflow is to continue; and in financiers also requiring proof of such payment.  Similarly, head contractors are seeking direct payment obligations from project financiers to protect themselves against developer default.

The difficulty with these arrangements is that, in the event of insolvency, preferring one subcontractor over other unsecured creditors (for the obvious reason that they are needed on site), thereby diverting those payments out of the creditor pool, runs the risk of being voidable insolvent transactions in terms of s292 of the Companies Act 1993.

The recent decision of the Court of Appeal in Ebert Construction v Sanson clarifies that position.  The attached article was published in the September edition of LawTalk and has been submitted to the International Bar Association’s publication Construction Law International.

While it is clear that a direct payment agreement, creating a freestanding and enforceable obligation on owners and financiers to make such direct payments would survive s292, where a direct payment is made on the owner’s or contractor’s behalf, it would be caught.  As this scenario is most likely to arise in the event of insolvency, this risk cannot be understated.

The lesson to be learned is that as currently drafted most direct payment obligations, whether in the head contract (in relation to subcontractors) or in direct payment agreements (in relation to head contractor payments) will almost certainly fall foul of s292, as voidable insolvent transactions.  In that case, the payments will be reversed, and will be paid into the creditor pool for distribution pari passu.

Conversely, if the beneficiary of the direct payment obligation can enforce the right to payment directly (independently of any rights they may have under the insolvency), whether against project financiers or against owners, then the Court of Appeal decision would suggest that the payments will not be caught.

In practical terms, this means that owners and their financiers need to reconsider the structure of their contractual arrangements.  While a single point of responsibility for contractual performance has historically been the norm, such arrangements may have passed their use by date.  It should be recognised that all project participants have a fundamental right to be paid for the work they carried out; especially as owners and their financiers get the benefit of their work; to require them to ensure that such project participants get paid is surely not too much to ask.

Hopefully, the Supreme Court will agree with Kós P.

The full text of the article is here – Direct payment obligations

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