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CHAPTER 3: PAYMENT FRAMEWORK

Overall Background

To help achieve its objective of ensuring prompt cash flow and allowing the swift resolution of disputes by way of adjudication the Construction Act sets out a payment framework.

• Section 109 introduces a right to instalment, stage or periodic payments;
• Section 109(2) provides that the parties are free to agree the amounts of the payments and the intervals and circumstances in which they become due;
• Section 110(1) requires the contract to have an adequate mechanism for determining what will become due and when;
• Section 110(2) provides that the payer gives the payee early communication of what will be paid;
• Section 111 provides that the payer may not withhold money unless he has effectively communicated this to the payee;
• Section 112 provides that a payee may suspend performance when the amount due is not paid by the final date for payment;
• Section 113 prohibits so called "pay when paid" clauses.

This payment framework creates the means of crystallising the amount to be paid on or before the final date for payment for each instalment, stage or periodic payment. It does this by introducing the concepts of sum due and due date together with a requirement to issue notices during the payment period to communicate the basis on which the amount paid or proposed to be paid has been calculated.

• The due date is the contractually agreed milestone which starts the payment period.
• The payment period is the time between the due date and the final date for payment. The length of this period is a matter for contract.
• The sum due is a notional amount determined by the contract which begins the process of crystallising the amount payable on the final date for payment.
• The final amount for payment is the sum due minus deductions - some of which are required to be set out in section 111 withholding notices.

The problems associated with the operation of the payment framework have been considered throughout the review of the Construction Act. The proposals in this chapter have resulted from consideration with BERR and soundings taken from practising adjudicators and industry specialists and attempt to identify the most appropriate balance between effective regulation and reducing the regulatory burden, particularly in respect of the notice requirements sections 110(2) and 111.

1. Prevention of unnecessary duplication of payment notices

Background

Section 110(2) requires the payer to issue a payment notice setting out the payments made or proposed to be made not later than five days after the date on which a payment becomes due. However, under most contracts with certificates the information in the payment notice only duplicates the information already contained in the certificate. For those contracts, this represents a needless duplication.

Current legislation
Section 110(2) requires every construction contract to provide for the payer to give notice not later than five days after the date on which a payment becomes due from him under the contract, or would have become due if:
(a) the other party had carried out his obligations under the contract, and
(b) no set-off or abatement was permitted by reference to any sum claimed to be due under one or more other contracts,
specifying the amount (if any) of the payment made or proposed to be made, and the basis on which that amount was calculated.

Proposal

Intended purpose

To prevent unnecessary duplication by allowing a notice or certificate from a third party to act as section 110(2) payment notice.

The Construction Act

This proposal relates primarily to the drafting of section 110(2) of the Act. We consider that, as well as the party from whom payment is due, certain other people should be able to issue a payment notice complying with section 110(2). We propose that, where the contract provides, the Act should allow the notice to be issued by:

• a person identified in the contract; or
• a person who has been identified in a notice to the payee.

The Scheme

We propose to amend paragraph 9 of Part II of the Scheme to make provision for a payment notice in accordance with the new provisions in section 110(2) of the Act. Under the Scheme a payment notice cannot be issued by a named individual so we propose that it should be issued either by:

• the person from whom payment is due; or,
• a person who has been identified in a notice to the payee.

Discussion

The current framework creates notice requirements which duplicate certification procedures. Under approximately 60% of main contracts a certificate is issued by an architect, engineer or surveyor to determine the sum due. Shortly afterwards the payer must issue a payment notice stating the amount to be paid. The payer is usually happy to pay the sum due as certified and the information in the notice only duplicates that in the certificate. There is a significant financial cost associated with the administrative inconvenience of complying with both requirements. BERR statistics suggest that 36,000 main contract payments are made each year in Scotland. Responses to Improving Payment Practices in the Construction Industry suggest that the cost of issuing a payment notice is approximately £25 per payment. Overall this results in an estimated reduction of 36,000 x 60% x £25 = £540,000 per year.

2. Clarification of the requirement that a section 110(2) payment notice should be served

Background

Section 110(2) requires a payment notice to be served in certain circumstances. The simplest of these is where a payment is due. The other is where the payment would have been due had a combination of circumstances arisen. We do not consider that the drafting of these provisions is ideal: specifically, it is not clear that the obligation to issue a payment notice continues even where no payment is due because of abatement or set-off under the contract in issue.

Current legislation
Section 110(2) requires every construction contract to provide for the payer to give notice not later than five days after the date on which a payment becomes due from him under the contract, or would have become due if
(a) the other party had carried out his obligations under the contract, and
(b) no set-off or abatement was permitted by reference to any sum claimed to be due under one or more other contracts,
specifying the amount (if any) of the payment made or proposed to be made, and the basis on which that amount was calculated.

Proposal

Intended purpose

To make clear that a payment notice is always required if a payment would have become due under the contract. That will be the case even where there is no obligation to make any payment because the work has not been carried out or there has been set-off under the contract, or one or more other contracts, or abatement under the contract.

The Construction Act

We are proposing to amend section 110(2) so that a payment notice will be required where a payment would have been due if:

• the party performing work under the contract had carried out his obligations under the contract;
• no set-off was permitted by reference to any sum claimed under the contract or one or more other contracts; and,
• no abatement was permitted in respect of the work.

The Scheme

We will amend the payment notice provision in Part II paragraph 9 of the Scheme to reflect the amended requirements in the Act.

Discussion

The current drafting of section 110(2) may lead the payer to mistakenly conclude that he need not issue a payment notice because of certain deductions from the sum that would otherwise have been due. Payment notices are an important tool in ensuring early communication of payments made or proposed to be made. Such notices are therefore important even where no payment is proposed because the work has not been carried out, or there are set-offs or abatements that mean the payer is not obliged to pay.

3. Clarity of the content of payment and withholding notices

Background

The Construction Act introduced the requirement that the payer should serve section 110(2) payment and section 111 withholding notices to the payee. There is confusion in the industry about how they relate to each other, what each should contain and how they create a sum due. This lack of clarity can lead to the needless issue of two separate notices when a single payment notice would have sufficed.

Clearly, measures to improve the clarity of notice content will help address some of the issues relating to a sum becoming due which is considered in section 4 of this chapter.

Current legislation
Section 110(2) requires every construction contract to provide for the payer to give notice not later than five days after the date on which a payment becomes due from him under the contract, or would have become due if
(a) the other party had carried out his obligations under the contract, and
(b) no set-off or abatement was permitted by reference to any sum claimed to be due under one or more other contracts,
specifying the amount (if any) of the payment made or proposed to be made, and the basis on which that amount was calculated.
Section 111(1) requires a party withholding payment after the final date for payment of a sum due to give an effective withholding notice.
It also provides that a section 110(2) notice may be an effective withholding notice if it complies with section 111.
Section 111(2) describes an effective withholding notice. It must specify
(a) the amount proposed to be withheld and the ground for withholding payment, or
(b) if there is more than one ground, each ground and the amount attributable to it,
and must be given not later than the prescribed period before the final date for payment.
Section 111(3) allows the parties to agree the prescribed period and provides that in the absence of agreement the period is that provided in the Scheme.

Proposal

Intended purpose

• To introduce clarity as to the content of the payment and withholding notice framework;
• To prevent unnecessary duplication by making clear provision on how a section 110(2) notice can act as a withholding notice; and
• To align the information required in section 110(2) payment notices and section 111 withholding notices.

The Construction Act

We are proposing that the payer must set out in the payment notice the amount (if any) that he has paid or proposes to pay.

Where this is different from the amount that would have been paid had:

• the payee carried out his obligations under the contract;
• no set-off was permitted by reference to any sum claimed under the contract or one or more other contracts; and,
• no abatement was permitted in respect of the work,

we propose that the payer will have to set out the grounds for paying less than the amount calculated in accordance with the above formula. Where there is more than one ground for making deductions from that amount, the payer will be required to set out each ground and the amount attributable.

Further, we are proposing to require that all withholding notices should be in the same format as a section 110(2) notice with the effect that the withholding notice becomes a revision of the payment notice.

Once the 'prescribed period' under section 111(3) has passed, the payer cannot revise the amount in the notice any further.

We propose to make clear that the withholding requirement is in respect of any amount (i. e. including abatement) and not just withholding "of a sum due" as at present (which is thought by many only to relate to set-offs).

The Scheme

We will make changes to align the Scheme with the above in respect of payment notices.

Discussion

Our proposal creates a clear connection between the information in the section 110(2) notice and that required to withhold payment in accordance with section 111. This will remove unnecessary duplication in the system as we understand some payers routinely submit both a payment notice and a withholding notice at present where only one is necessary.

Our proposal sets out a framework where a withholding notice should take the form of a revised payment notice. This single format creates clarity and simplicity, though in places additional information is required.

The proposal that the withholding notice would be required to state the amount of the payment made or proposed to be made was supported in Improving Payment Practices in the Construction Industry in 2005. Though we had initially rejected that proposal following the consultation, further consideration has led us to conclude that it would allow the payment and withholding notice requirements to work more effectively and economically.

Administrative cost

It is arguable that this proposal will increase the number of section 111 withholding notices that must be issued under contracts without certificates. It is possible to estimate the cost to the construction industry of this change using BERR's estimate that 32,500 payments are made each year in Scotland under contracts without certificates (40% of main contract payments and an additional 50% as an estimate for the number of payments made under sub-contracts).

We are seeking responses from consultees on the proportion of payments that are subject to abatement after the payment notice deadline but, if it is one monthly payment every two and a half years, and the cost of a withholding notice is £25, we estimate that the additional inconvenience will cost the construction industry in Scotland 32,500 x £25 / 30 = £27,000 per year.

4. Clarity of the sum due

Background

In the Construction Act the sum due is the cornerstone on which the rest of the payment framework is built.

The concept of what constitutes the sum due is clear where the contract provides for certification of work by a third party (such as an architect). In these cases the courts have upheld the position that sum due is the amount in the certificate.

However, in contracts without certificates the position is less clear and the current payment framework can fail to create a clear understanding between the parties as to what is the sum due. As a result the Act can fail to effectively crystallise the amount to be paid on or before the final date for payment or allow access to the right of suspension.

Proposal

The Construction Act

We are proposing that where the payer has issued a payment notice as described in section 3 of this Chapter this amount becomes the sum due, which can then be subject to withholding. Non-payment of the remainder will provide the payee with the right to suspend performance.

We would then provide that -

• Where the payment notice is not issued, the sum due is determined by a new fallback provision. The sum due would then be the amount in a claim by the payee issued before the final date for payment.
• Where that claim determines the sum due but is issued after the due date, the payment period would then run from the date of the claim to allow the payer time to issue a withholding notice.

We would also provide that, like the current provision in section 111(4) for amounts to be withheld, the amounts to be paid under a payment notice could be referred to adjudication and the payment delayed until a week after the date of the adjudicator's decision.

The Scheme

We are proposing that the fall-back provision whereby the sum due is determined by a claim by the payee should take effect as a statutory fall-back, rather than a requirement that the contract should provide this fall-back. As such, no corresponding provision is necessary in the Scheme.

Discussion

Section 110(2) requires the contract to provide for the payer to notify the payee of "the amount (if any) of the payment made or proposed to be made". There are two practical problems with this.

• It is not clear how the amount specified in the notice relates to the sum due. The sum due is not then clear for the purposes of sections 111 and 112.
• Failure to issue the notice may be no more than a minor breach of contract. This is because nothing in section 110(2) compels the payer to issue it. Improving Payment Practices in the Construction Industry found that the notice is only issued for about 40% of payments.

Where these problems arise, their effect on sections 111 and 112 of the Construction Act raises the following issues.

Section 111 enables a payer to withhold payment from a sum due where he has issued a withholding notice. In the absence of a withholding notice the payer must pay the whole sum due. However, the lack of transparency about what constitutes the sum due (whether or not he has received a section 110(2) payment notice) can leave the payee with less payment than expected. This can result in costly legal proceedings to determine the 'sum due'. It can often be argued that no notice is needed as the abatements were never due. Generally, set-offs should be notified, though this may differ under certain contracts.

Section 112 provides a right to suspend performance where the payer fails to pay the sum due (subject to any withholding under section 111). However the lack of transparency about what constitutes the sum due acts as an effective barrier to the exercise of this right.

We therefore intend to introduce much greater transparency about the sum due by providing a statutory definition.

5. Prohibiting the use of pay-when-certified clauses

Background

As part of the proposal to create a clear understanding of the sum due under a construction contract we have concluded there may be value in restricting the use of pay-when-certified clauses. This ensures that there is clarity about when payments become due as well as what the sum due is.

Current legislation

• Section 110(1) of the Construction Act provides that "every construction contract should provide an adequate mechanism for determining what payments become due under the contract, and when". This provision allows payment to be triggered by the timing of a decision which is conditional on work under a separate contract.
• Section 113 of the Construction Act states that "A provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective". This prohibition of pay when paid clauses also does not appear to affect a clause making the timing of payment conditional on a decision about payment from a third person.

Proposal

The Construction Act

As part of a new payment framework, we are proposing to ensure that a certificate covering work under one contract cannot act as a mechanism to determine the timing of payment for work done under another contract. In effect we propose to prohibit pay-when-certified clauses.

The Scheme

No amendment to the Scheme is necessary.

Discussion

Respondents to Improving Payment Practices in the Construction Industry suggested that pay-when-certified clauses were a way for the main contractor to shift the burden of non-payment to the sub-contractor. The sub-contractor has no way of knowing whether a main contract certificate has been issued, or its contents, or whether the payer has grounds under the pay-when-certified clause to withhold payment.

Although prohibiting pay-when-certified clauses may have the result that the main contractor pays the sub-contractor before he himself is paid, it is in keeping with the purpose of the Act for funds to be distributed through the construction supply chain promptly.

Our proposal is seeking to ensure that, provided a sub-contractor has completed the work he has been engaged to do, once he issues his invoice the payer must pay regardless of whether a certificate has been issued under the main contract.

This will ensure that money flows through the supply chain thereby reducing the need for companies to service loans/debts. The benefit to the whole supply chain is that firms can better manage their cash flow. We would also expect there to be fewer disputes.

In assessing the impact of this proposal, we are only proposing to consider its effect on standard forms of sub-contract. We understand that traditional civil engineering sub-contracts continue to include pay-when-certified clauses. BERR statistics suggest that 1,600 payments are made each year under civil engineering sub-contracts in Scotland. As these will no longer become due under a pay-when-certified clause, the terms of the Scheme will apply and the payment will become due following the expiry of the relevant period or upon the issue of a claim by the payee, whichever is the later. The payer will then have to issue a payment or withholding notice. Assuming a main contract certificate has not been issued, this will require additional administration by the payer. Assuming a cost of £25 the total cost will be £40,000.

Overall benefits of the revised payment framework

We believe the revised framework will:

• improve communication between the parties;
• enable cash to flow through the supply-chain and improve liquidity and reduce costs of servicing debt; and
• enable the parties to address problems that give grounds for withholding payment.

The reduced burden of the revised payment framework is approximately £473,000.

The broader benefit of the new framework is the creation of clear entitlements to payment which may be reviewed at adjudication in an arrangement that is comparable to interim certification under many forms of construction contract. This will enable disputes to be resolved at an early stage in any given payment period. We believe this will reduce financial costs for both the payer and the payee prioritising the need for payment to crystallise and change hands at an early stage rather than being delayed by the determination of the amount legally payable irrespective of the delay. This is of considerable benefit to the industry and its customers.

Quantifying the saving to the construction industry and its clients in terms of reduced cost and improved productivity and efficiency is difficult. However, OGC recently commissioned research in support of the Fair Payment Charter which indicated that improvements to the payment framework to ensure contracts create clear and timely entitlements to interim payment are estimated to save 1% - 1.5% on the average project. If this were reflected across construction in Scotland, it would represent £100-150 million.

To identify overall the savings that result specifically from our proposals we have considered the comparison between the operation of contracts with certificates and of contracts without certificates. In future, the section 110(2) payment notice will act like a certificate in creating an entitlement to payment subject to withholding under section 111 and final determination by adjudication, arbitration or litigation. In the absence of a payment notice, a claim by the payee will determine the sum due on the same basis. A similar system also operated on the Joint Contracts Tribunal "With Contractor's Design" contract until its revision in 2005. Statutory support for this approach would be likely to ensure its effective operation.

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