A sub-contractor who has entered into a contract with the main contractor to which the employer is not a party has no cause of action against the employer for the price of the work done or goods supplied under its contract, unless it sues under a valid assignment.[1]
Introduction
The majority of physical work carried out in construction projects has been carried out by subcontractors for many years; particularly in specialist trades and supplies; and yet, owners have few direct rights against subcontractors, and vice versa. The starting point under the common law is that while a head contractor may delegate its obligations under a construction contract to subcontractors, it cannot transfer those obligations without the consent of the owner.[2]
In the overall contractual matrix:
- the owner provides the site and the design; generally procures consents and all rights necessary to carry out the work; pays for the work; and owns and has the benefit of the work carried out on the site;
- the head contractor is responsible for all work carried out under the head contract; ensures compliance with building consents; engages all labour, procures materials, including subcontractors; and is paid for all work, including for subcontractors; and
- the subcontractors carry out those parts of the work assigned to them under a contract with the head contractor; and is paid by the head contractor.
The unfortunate consequences of this traditional approach are that the owner gets the benefit of the subcontractors’ work, but pays the head contractor; the subcontractor gets no surety of payment; and if the head contractor defaults, the owner has no rights to secure the continued performance of the subcontract works and the subcontractor has no right to be paid by the owner.
For the owner and its financiers, the payment is for the project, not for the head contractor to disburse as it pleases (other than its margin); and for the subcontractor, its work and services have been provided for the direct benefit of the project. Yet, these two have always remained unconnected at law.
That position may be changing, with the Construction Sector Accord noting that its plan “focuses on building procurement skills, promoting clearer contracts, and a better deal for subcontractors”. Similarly, our most frequently used standard form, NZS3910,[3] is currently under review. Hopefully, these changes will better reflect the realities of the construction industry and will offer better protection for essential subcontractors and suppliers.
What is required across the industry is a better recognition of the role of subcontractors and suppliers, greater involvement by owners and more inclusion of subcontractors in project decisions. A standard form subcontract, aligned to a revised NZS3910 which recognises the specific obligations relating to the subcontract works and owners’ obligations to subcontractors and vice versa, would be a significant step in the right direction.
What is a subcontractor?
The definition in NZS3910:2013 is unhelpfully broad, referring simply to any person who contracts with the head contractor to design, carry out or supply part of the works. The definition makes no distinction between the permanent works, for which the owner has a long term interest; and the temporary works, for which the owner’s interest is transitory.
It should also be noted that the definition in NZS3910:2013, and the constraints in clause 4.1 under which the owner’s approval is required for subcontracting, apply only to direct subcontracts with the head contractor. Subsequent subcontracting, for example by a lead subcontractor for electrical and mechanical systems to HVAC designers, suppliers and installers or lift installers, are not caught. The definition of “Subcontractor” and all provisions relating to subcontracting the work only apply to that first tier, entered into directly by the head contractor.[4]
Typically, subcontracting also includes supply contracts; named subcontractors identified by the contractor in the tender; nominated subcontractors, required by the owner;[5] and approved subcontractors, tendered by the contractor and approved for the works by the owner.[6] Each provides a different means of securing delivery and installation of elements of the works of critical importance to the owner; and each provides for varying levels of engagement by the owner.
As a matter of practice, though frequently not specifically provided for, contracts for the supply of off the shelf items, for the supply of labour and the hire of contractor’s equipment are not caught by the consent requirements of the contract.
For all practical purposes, however, subcontractors carry out significant and important elements of the permanent and temporary works; they rely on project cashflows; and in the event of default by head contractors (a tragically common occurrence), they are left in a precarious position. In the context where they provide goods and services directly to the benefit of the project, and it follows to the owner, this is an issue which needs to be addressed.
For the temporary works, the subcontracts can be reasonably generic (eg, the supply of scaffolding), where others can be more critical. For example, in a major tunnelling project, the supply, commissioning, operation and removal of an earth pressure balance tunnel boring machine will be an issue in which the owner will have a very direct interest; or the supply of purpose built 200 ton dump trucks and the tip face design in a significant reclamation project may be critical to completion of the works, and health and safety at the site. The owner’s interest in the temporary works is typically in ensuring that the works can be completed; it is a question of securing performance by all, and not just the head contractor.
The position in relation to the permanent work is subtly different. In the purest sense, the owner’s interest in the permanent works arises only after practical completion. That, however, is overly simplistic. The owner has a direct interest in ensuring that all work is carried out to the required standard and in a timely manner. Where subcontractors are concerned, this includes access to the site and off-site places of fabrication; ensuring that the subcontractor remains available to complete their work, in the event of default by the head contractor; and securing warranties and other obligations following practical completion.
Contractual Provisions
In a previous era, subcontractors and employees were protected by the provisions of the Wages Protection and Contractors Liens Act 1939, under which a statutory lien was imposed on owners’ properties to ensure payment for workers and contractors. Purchasers had to ensure that no payments were outstanding before settling a property transaction. It is, perhaps, unfortunate that the Act was repealed in July 1988.
Unlike other international standard forms, notably the NEC suite of contracts, there is no standard form of subcontract provided with NZS3910. Some industries have developed their own forms (Master Builders and Civil Contractors stand out), many subcontractors have their own forms and most large head contractors have also developed their own.
This disparate approach has its drawbacks, with some simply describing the subcontract works, providing the payment terms and otherwise including the head contract terms by extension;[7] others rather optimistically providing that the subcontractor is only entitled to payment, claims and extensions of time which the head contractor can itself claim under the head contract. Neither approach is ideal.
When the inevitable ambiguity or outright omission in the drafting comes under the arbitral microscope, filling the gap becomes difficult. The Construction Contracts Act 2002 deals with pay-when-paid/pay-if-paid clauses; the common law deals with time at large claims; but the more difficult issues are not so easily disposed of.
For example, the owner may procure a performance design for an HVAC system from its consultants; the head contract may specify particular equipment, using the phrase “or similar” in relation to specified items; and the head contractor simply passes on those obligations by reference. For the HVAC subcontractor, there will be significant residual design obligations, supply constraints and installation complications. All too often a dispute breaks out between the owner, who argues that the performance specification has not been met; the head contractor, who alternately argues that the owner’s design was at fault and that the subcontractor is to blame; and the subcontractor who says that it simply installed what was specified.
In reality, little of the head contract is relevant to subcontracts. A standard subcontract which has terms consistent with the head contract terms in relation to access to the site; health and safety; suspension, with and without cause; quality of work, time and access; liaising with other subcontractors; intellectual property; insurance; assistance to the head contractor to enable it to meet its obligations under the head contract, where required;[8] an indemnity; and dispute resolution should suffice. The description of the subcontract works and payment terms can then be dealt with as items specific to the subcontract.
Quality/Time
Quality should not be an issue of particular concern for subcontract work. The quality of the works as a whole is already dealt with reasonably comprehensively in most standard form contracts, with rights of inspection and testing, and certification of quality assurance included.
With increasingly diverse and globally dispersed supply chains, ensuring the required levels of quality can be more complex, as shown with the recent controversy over steel supplied from the Peoples’ Republic of China. In many cases, subcontracts are approved with apparently reputable suppliers, but the goods supplied fall short of contract requirements, and they are inconsistent with the quality assurance documentation provided with them.
Ultimately, the ability to take legal action to enforce contractual rights is not as effective as simply ensuring that the goods meet the owners’ requirements through proper inspection and testing at the time of fabrication.
Similarly, it is not sufficient from a project management perspective to wait for the delivery or completion date to ensure compliance with the project programme. This is particularly problematic with international supplies. A product with a lead time of some months will create significant problems for owners and head contractors if it is late or defective.
All too often, subcontracts contain provisions to the effect that the subcontractor is entitled to extensions of time only to the extent that the head contractor is awarded extensions under the head contract. This will almost certainly result in time under the subcontract being “at large”[9] and any indemnity claims failing.[10]
The first issue turns on the prevention principle, under which an employer under a contract (in this case the head contractor) cannot insist on performance by the other party (the subcontractor) where the employer has prevented such performance. In a subcontract, the cause of the delay may have been by the head contractor insisting on meeting the head contract time for completion where it has caused the delay to the subcontractor by changing access arrangements or programming requirements. In such a case, the head contractor would not be entitled to an extension of time under the head contract, but must grant an extension under the subcontract if it is to keep any programming requirements alive.
A failure to grant such an extension of time to the subcontractor would result in the subcontractor being entitled to a reasonable time to complete and any stricture around subcontract liquidated damages failing away.
Most subcontracts will contain indemnities in favour of the head contractor for any liability arising under the head contract. Such indemnities would clearly be ineffective where the head contractor is responsible for or contributed to such liability.
Payment
The now famous statement by Lord Denning MR, that “There must be a 'cashflow' in the building trade. It is the very lifeblood of the enterprise”[11] was never more apposite than in relation to subcontractors.
Most owners and their financiers assume that instalment payments will flow through the contract chain to subcontractors, on the not unreasonable assumption that such payments have been included in the payment claims. Sadly, this has proven not to be the case. All too often, the first indication that the owner has that a head contractor is in financial trouble is when subcontractors either leave the site or complain that they have not been paid for some time.
The issue typically arises in three specific situations – (1) the timing of progress payments; (2) application of progress payments by the head contractor to other more pressing projects; and (3) retentions.
In most standard form contracts, payment is made on the 20th day of the month following submission of the payment claim (in NZS3910, it’s 17 working days). In ideal world, this would mean that subcontractors are paid in the following month. It has been standard practice in the construction industry to push the payment period for subcontractors out beyond this period to provide for a cashflow buffer.
For example, where a subcontractor becomes entitled to payment and makes a claim, say, in early April, the head contractor will include that subcontract payment in its payment claim submitted in late April and will be paid by the owner in late May. That payment will then be passed on to the subcontractor either in late May or early June; at least 60 days after it first claimed the payment. Increasingly, owners and their financiers are not unreasonably insisting on proof of payment of subcontractors to ensure continued payment of progress claims, and direct payment clauses, under which owners can pay subcontractors directly, at the cost of the head contractor.[12] Such clauses do not give rise to any rights on the part of subcontractors against owners to require direct payment,[13] nor is it enough to imply a trust in favour of the subcontractor.
There has been some discussion that the most effective means of ensuring that progress payments flow down the contract chain is to establish an express trust in the head contract for the benefit of subcontractors.[14] The requirements for such a trust to be established are (1) expression of the intention to create such a trust; (2) certainty as to the subject matter of the trust; and (3) certainty as to the beneficiaries of the trust. Arguably, the trust would only come into effect with the separation of trust funds into a designated account.
Over a number of projects, the cashflow buffer referred to above can create a sizeable cashflow surplus for head contractors. In a growing market, there is little cause for concern. However, in a shrinking market, or where the head contractor becomes liable for a significant claim under an unrelated project, the temptation to use the cashflow for one project to deal with more pressing needs on another project can be too great to resist.[15] There is nothing in most standard form contracts to counter such behaviour – contracts have tended to assume that the payments to contractors are their's to disburse. Where the value of projects has increased significantly, and margins have tightened, reliance on head contractors’ own balance sheets and available funding has proven to be ineffective.
Most contracts provide for retentions. The Construction Contracts Act provides for such retentions to be held on a trust, and only to be applied to the cost of rectifying defects.[16] Unusually, however, there is no obligation to set such funds aside in a separate designated account, though many owners do.
This creates an unusual situation for most subcontractors. Under the head contract, retentions will be set at a percentage of progress payments (typically less than 5%, and under NZS3910 up to an agreed cap). Retentions are then released half on practical completion of the project and the balance on expiry of a defects notification period of 30 days, 90 days or a year. In more complex projects this can be extended to two years to ensure performance through two complete annual seasonal variations.
This creates two problems for subcontractors. First, head contractors will often seek to pass on the entire retention cashflow to subcontractors, increasing the percentages retained to ensure that, effectively, all retentions for the project are covered by subcontractors. Second, the timing of the release of retentions is linked to project completion, rather than to the completion of the subcontract works. This causes considerable cashflow issues for subcontractors.
The clearest illustration of this is in the failure of Mainzeal Property and Construction Ltd in 2013. While Mainzeal had $11 million owed to it for retentions across a number of projects, it was liable for subcontractor retentions of $18 million, resulting in a $7 million hole in retentions. Worse, however, was that Mainzeal also owed its subcontractors $130 million for unpaid progress payments; payments which it had itself received under its head contracts. Similarly, Ebert Construction had a $3.7 million shortfall in retentions, but left $37 million owing to unsecured creditors; and Arrow International failed with a $4.5 million shortfall in retentions and $40 million owing to unsecured creditors.
While much ink has been spilt on retentions over the 6 or so years since the new regime was introduced, it is clearly not the problem. Failure to pay subcontractors has resulted in losses far greater than retention shortfalls.
Payment of subcontractors is ultimately an issue which owners must take more interest; they are paying for a project which is largely constructed and supplied by subcontractors.
Warranties
Direct warranties and undertakings from subcontractors have been the norm in major projects for many years; they are also the sole means of establishing any rights in contract between the owner and the subcontractor.[17] Requiring such warranties is typically a condition for subcontractor approval.
Those warranties cover a number of issues:
(1) the subcontractor warrants that the subcontract works will meet the requirements of the head contract,
(2) an indemnity in favour of the owner, enabling the owner to have direct contact with the subcontractor, for example for rectification of defects,
(3) advance notice of default by the head contractor, enabling the owner to novate the subcontract, and
(4) ensuring continuity of upgrades, maintenance and pricing, in the case of monopsony in technology heavy supply items.
Some aspects of these warranties can take negotiation between subcontractors and owners, however as they deal with pertinent and sometimes critical issues, such negotiation is almost always productive.
In more complex projects, further, more wide-ranging agreements regulating how each project participant exercises its rights can be required. Their respective interests vary, but are intertwined:
- the owner, ensuring that if the contractor falls over, the subcontractors remain available to complete their work under the supervision of a new head contractor;
- the financier, ensuring that if the owner is unable to complete the project, the head contract can be taken over by their nominee;
- the contractor, to ensure payment; and
- any tenants, or other beneficial users, will have project completion on time.
Each participant then agrees to exercise their rights under their respective agreements only after consultation with the other, and agreement to rectifying the relevant default.
Dispute resolution
There is rarely any consistency between dispute resolution procedures in the various contracts associated with major projects. Most agreements ultimately provide for arbitration as the final forum for determination of disputes; adjudication under the Construction Contracts Act is now available as of right for all construction work, which now includes design work; and most construction contracts contain multi-tiered dispute resolution provisions providing for:
- notice of dispute,
- formal review and decision by the Engineer,
- statutory adjudication,
- mediation,
- expert review, and
- arbitration.
There are a number of problems with these procedures.
First, most contractors are reluctant to invoke the disputes procedures as they almost always trigger a significant deterioration in project relationships. Most subcontractors fear that invoking the disputes procedures will adversely affect future works flows. In a small construction industry, such fears are well founded.
Second, by the time the disputes procedures are invoked, relationships have deteriorated, and there is little point in working through the various stages. In most projects, all parties either want a facilitated expert review to give them an early indication of the likely outcome of the more formal procedures; or they go straight to adjudication or arbitration.
Third, as the Engineer is the owner’s agent, it will have been integrally involved in any dispute. Typically, it will be an Engineer’s decision on project administration which is the subject of the dispute.
Fourth, responsibility for the dispute will frequently extend across a number of contracts. A system failure, for example in a process plant or electrical and mechanical services, will touch on design (covered by the design consultant’s engagement agreement and potentially a subcontract) or workmanship (under the head contract and/or the subcontract). Neither adjudication nor arbitration lend themselves to multi-party determination.
Under the Construction Contracts Act, parties to a construction contract may refer a dispute to adjudication under section 25. However, where issues of design are concerned, a design consultant and the contractor cannot be joined to the same adjudication as their respective responsibilities and liabilities arise out of separate contracts. Similarly, the subcontractor is not a party to the head contract. Section 40 of the Construction Contracts Act does provide for the consolidation of adjudication proceedings, but that is available only in limited circumstances.
Similarly, arbitration is only available to parties in a legal relationship who have agreed to go to arbitration.[18] While all relevant project agreements may include arbitration clauses, they are between distinct parties under separate contracts. Consolidation of arbitral proceedings can be achieved, but only in very specific circumstances under clause 2 of Schedule 2 to the Arbitration Act, if it applies.
The difficulty with both adjudication and arbitration is that conflicting decisions may be given, where for example an adjudicator or arbitral tribunal finds for the designer in one proceeding and for the contractor in another, leaving the owner with no remedy. As legal submissions and factual findings will frequently differ, this is not an unusual occurrence.
There are a number of solutions to this enduring problem:
- promote the early identification of potential disagreement at a project level, and appoint an independent neutral to assist with avoiding or resolving the disagreement, either through negotiation or a non-binding determination;
- agree to refer a discrete issue for formal determination, either by adjudication or arbitration; and
- make provision for consolidation of the arbitration of all related disputes in all project documentation.
Conclusion
Subcontractors generally have been poorly treated in the construction industry, particularly in procuring payment; the misuse of retentions; dealing with contract claims; and managing disputes.
Improving the integration of subcontract terms in standard form contracts, increasing the involvement of subcontractors in project decision making and owner responsibility for payment is key to reducing contract disputes; that, and making greater provision for the early identification and avoidance of disputes.
[1] Keating on Construction Contracts (9th Ed) para 13-027
[2] Under English law, while a benefit may be assigned as of right, most commonly the right to receive payment, obligations may not be assigned without the consent of the holder of the benefit of those obligations – see St Martin’s Property Corporation Ltd v Sir Robert McAlpine & Sons Ltd [1994] 1 AC 85.
[3] Conditions of contract for building and civil engineering construction NZS3910:2013, published by Standards New Zealand.
[4] A simple solution to this issue would be to define subcontractors as being “any subcontractor or supplier of any tier engaged to carry out the works”.
[5] A convenient arrangement, not without its problems – see Bickerton v N.W. Metropolitan Regional Hospital Board [1970] 1 W.L.R. 607.
[6] An arrangement designed to avoid the complications of nominated subcontractors. Owner supplied items do not fall into the category of subcontracts, though the installation of such items is caught by the contract as a whole as part of the works.
[7] There are significant problems simply applying the head contract terms into the subcontract without further consideration – see Chandler Bros Ltd v Boswell [1936] 3 All ER 179.
[8] See Alstom Ltd v Yokogawa Australia PTY Ltd (No. 7) [2012] SASC 49 for authority, likely to find favour in NZ, for the proposition that there is an implied obligation on the part of both head contractor and subcontractors to act in good faith if their respective contractual obligations demand a high degree of cooperation.
[9] Multiplex Constructions (UK) Ltd v Honeywell Control Systems Ltd [2007] EWHC 477.
[10] AMF International v Magnet Bowling [1968] 1 W.L.R. 1028
[11] Dawnays Ltd v FG Minter [1971] 2 All ER 1389, cited with approval in Gilbert-Ash (Northern) Ltd v Modern Engineering (Bristol) Ltd [1973] 3 All ER 195, at 214 (HL) Lord Diplock
[12] A-G v McMillan & Lockwood [1991] 53; B. Mullan & Sons Contractors Ltd v Ross (1996) 86 BLR 1; and Ebert Construction Ltd v Sanson [2017] NZCA 239 for an analysis of where such payments may become voidable transactions for offending the pari passu principle. Cf Sydenhams (Timber Engineering) Ltd v CHG Holdings Ltd [2007] EWHC 309 and Brican Fabrications Ltd v Merchant City Developments Ltd [2003] BLR 512.
[13] See A Vigers & Sons & Co Ltd v Swindell [1993] 3 All ER 590 and Yew Sang Hong Ltd v Hong Kong H.A. [2008] B.L.R. 563.
[14] See Julian Bailey, Construction Law (2nd Ed) at para 20.46
[15] The failure of Hartner Construction in 2001 being a case in point.
[16] Bennett v Ebert Construction (in liq) [2018] NZHC 2934, the first, and it has to be said problematic decision on the application of the retention trust regime.>span >
[17] See Shanklin Pier Ltd v Detel Products [1951] 2 K.B. 854
[18] See section 10 of the Arbitration Act 1996.