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Partial Regulatory Impact Assessment
Proposals to amend Part II of the Housing Grants, Construction and Regeneration Act 1996 (the Construction Act) and the Scheme for Construction Contracts (Scotland) Regulations 1998 (the Scheme)
1. Objective
Disputes under construction contracts can jeopardise the effective delivery of projects on time and within budget. They can also threaten the viability of individual businesses and can undermine the longer-term health of the construction industry. The proposals being considered in this Partial Regulatory Impact Assessment seek to improve the statutory framework set out under the Construction Act to reduce the incidence and impact of these disputes.
We are seeking to introduce a better, more focused and effective regulatory framework by:
- improving the transparency and clarity in the exchange of information relating to payments to enable the parties to construction contracts to better manage cash flow; and
- encouraging the parties to resolve disputes by adjudication, where it is appropriate, rather than resorting to more costly and time consuming solutions such as litigation.
The proposals are proportionate amendments to the existing framework which has, in large part, worked well - rather than wholesale reform.
2. Background
The Chancellor announced in the 2004 Budget Report that:
"Following concerns raised by the construction industry about unreasonable delays in payment, the government will review the adjudication and payment provisions of the Housing Grants Construction and Regeneration Act in order to identify what improvement can be made. "
In April 2004, the then Construction Minister, Nigel Griffiths MP appointed Sir Michael Latham to undertake the first stage of the review. The purpose of this first stage was to identify the extent, for all sectors of the industry, to which the Act:
- Was working well;
- Needed improvement; and
- What any potential impacts on other parties or processes might be.
Sir Michael's report to Nigel Griffiths (September 2004) concluded that the industry had come a long way since the Construction Act was introduced in 1996 and that it was generally working well. However, the report identified some areas where further progress was desirable. The Department Trade and Industry ( DTI), (now Department of Business, Enterprise and Regulatory Reform or BERR) and the Welsh Assembly Government's March 2005 Consultation exercise, Improving Payment Practices in the Construction Industry, explored some of these in more detail.
Over the course of this review, the Scottish Executive has worked with BERR in considering a wide range of proposals to change the operation of the adjudication and payment provisions in the Construction Act. The proposals in the Improving Payment Practices in the Construction Industry consultation mark the latest stage of that review. We have identified the changes we consider can be made to improve the operation of the Act and have set these out in this document (see paragraph 4 below).
Rationale for Government intervention
Sir John Egan, Chair of the Construction Task Force said in the Foreword to Rethinking Construction (1998):
"A successful construction industry is essential to us all. We all benefit from high quality housing, hospitals or transport infrastructure that is constructed efficiently. At its best the UK construction industry displays excellence. But, there is no doubt that substantial improvements in quality and efficiency are possible. Indeed, they are vital if the industry is to satisfy all its customers and reap the benefits of becoming a world leader"
Disputes under construction contracts can pose a major threat to the effective delivery of projects on time and on budget. At the broader industry level, the culture evidenced by such disputes can only undermine the industry's ability to achieve the performance improvements set out in Rethinking Construction (1998).
As Sir Michael Latham's report in 2004 confirmed, the Construction Act has been generally welcomed since it came into force on 1 May 1998. The adjudication process in particular appears to have reduced the number of disputes reaching the courts. However, payment practices in the construction industry continue to cause concern. Problems of disputed, late and non-payment continue to be commonplace.
3. Consultation
The development of the proposed changes to the current legislation has involved extensive formal and informal consultation with the construction industry, its clients, other stakeholders and Government ( BERR).
Within Government
The Scottish Executive have liaised with BERR who have co-ordinated discussions across Government with:
- The Cabinet Office
- Office of Government Commerce
- HM Treasury
- The Department for Communities and Local Government
- Department for Constitutional Affairs; and
- Welsh Assembly Government
With industry
Consultation with the industry has included:
- The Scottish Executive Improving Adjudication in the Construction Industry Consultation in 2003.
- The review undertaken by Sir Michael Latham in 2004;
- The first DTI consultation Improving Payment Practices in the Construction Industry in 2005;
- The Analysis of Improving Payment Practices in the Construction Industry 2006;
- Industry Stakeholder events organised by the DTI Construction Sector Unit in June 2005 and February 2006;
- Industry Stakeholder events organised by the Construction Umbrella Bodies during the 2005 consultation period;
- A pre-consultation exercise by DTI on adjudication in Autumn 2006;
- DTI sounding board, established with members who did not represent specific sectors of the industry but assisted with their personal knowledge, experience and access to industry networks; and
- Soundings taken by The Scottish Executive from practising adjudicators and industry specialists.
4. Options
One of the options considered was to maintain the legislation as it stands and take forward a voluntary process of improving construction contract and payment practices through guidance.
Government and all parts of the industry have a good track record on working together to improve adjudication. An example of this has been the work of the Construction Umbrella Bodies Adjudication Task Group ( CUBATG) in preparing guidance in response to a number of issues and concerns raised during a previous review of the operation of the adjudication provisions of the Construction Act. This guidance is available from the Construction Industry Council Website 7
The Scottish Executive has sought to build and maintain a positive working relationship with CUBATG in the development of proposals to amend legislation on adjudication and to develop suggestions for areas where further guidance will be helpful.
Throughout the process of this review a number of issues have been raised where it has been decided that 'doing nothing' is the best option. The reasons for taking this approach in those cases have been set out in the public information which is available on the construction pages of BERR's website 8. The key documents are:
Nigel Griffiths' letter of 21 October 2004 to Sir Michael Latham
Improving Payment Practices in the Construction Industry
- March 2005 Consultation Document
- January 2006 Analysis of Consultation Responses
Option 1 - Targeted regulation
The payment and adjudication proposals identified below facilitate the 'targeted regulation' route, i. e. to intervene where it is clear that the legislation is not meeting the original objectives effectively. This supports 'fine tuning' rather than re-invention of the existing statutory framework.
This package of legislative measures allow the weaknesses to be addressed and improve the clarity of operation and effectiveness of the existing legislation. Many of these measures are technical and have low regulatory impact. They are outlined below.
Proposals
Prompt and fair payment practice throughout construction supply chains will better enable the industry to adopt integrated team working.
The amendments to the Construction Act will:
- improve the transparency and clarity in the exchange of information relating to payments to enable the better management of cash flow;
- encourage the parties to resolve disputes by adjudication, where it is appropriate, rather than by resorting to more costly and time consuming solutions such as litigation; and
- improve the right to suspend performance under the contract.
This will be done on:
Adjudication
- improving access to the right to refer disputes for adjudication by:
- applying the legislation to oral and partly oral contracts
- preventing the use of agreements that interim payment decisions will be conclusive to avoid adjudication on interim payment disputes
- ensuring the costs involved in the process are fairly allocated
Payment
- preventing unnecessary duplication of payment notices
- clarifying the requirement to serve a section 110(2) payment notice
- clarifying the content of a notice
- ensuring the payment framework creates a clear interim entitlement to payment
- prohibiting the use of pay when certified clauses
Suspension
- improving the statutory right to suspend performance by allowing the suspending party to claim the costs and consequential delay.
These proposals are not wholesale reform and are intended to be light touch and proportionate amendments to the existing framework to address specific issues that have arisen during the nine years the Construction Act has been in operation.
Option 2 - Extensive regulatory intervention
An alternative option is that of 'extensive regulatory intervention'. As the review of the Construction Act has progressed, some proposals have been suggested which, in our view, would undermine the compromises that were reached in 1996 or would fundamentally alter the existing statutory framework. Throughout the review process, we have tried to be mindful of the finely balanced compromise that was struck by the original legislation and only proposed changes where it has been considered that the legislation has shown to not have delivered its original objective. The proposals are targeted interventions to "fine tune" the existing statutory framework in order that the existing structure of the legislation is not undermined.
Following a more regulatory route would be to change fundamentally the Construction Act and the contracts it regulates. At the very least this would impose considerable transitional burdens on the industry and its customers. For instance the large number of standard forms of contract (as an example the Joint Contracts Tribunal has some 20 contracts) would need to be revised extensively as the transition was made from one statutory framework to another with the resultant additional costs and disruption that entails.
6. Costs and benefits
The questions at Annex D of the Consultation paper on regulatory impact are important as they will help us to carry out the Impact Assessment that will be needed if we go forward with legislation. Detailed and reliable information has been very hard to come by and while we appreciate that this may be difficult, we should be very grateful if you would answer as many of these questions as you are able to. Your responses will enable us to assess whether the proposals deliver better payment practices than the legislation as it currently stands.
The proposals we are seeking to introduce to amend the Construction Act will:
- improve access to the adjudication system by applying the legislation to oral and partly oral contracts and ensuring the costs involved in the process are allocated fairly;
- improve the operation of the payment framework in the legislation by removing the duplication between statutory payment notices and contractual payment certificates; and,
- ensure the payment framework operates effectively to create a clear interim entitlement to payment which can be finally determined through arbitration or adjudication if necessary.
The costs and benefits that we have available for each of the proposals in Option 1 are summarised in the following table. However, it is not possible to quantify the costs of Option 2 but there is little doubt that wholesale reform would cause considerable transitional burdens on both the industry and its customers resulting in additional costs and disruption.
Proposals | Benefits | Costs | Net Benefit |
Prevention of unnecessary duplication of payment notices | A significant reduction in the number of payment notices that need to be issued by the payer. This reduction in the requirement for Section 110(2) notices will save the industry in Scotland approximately £540,000 . | | Our proposals create a clear connection between the information in the section 110(2) notices 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. |
Clarification of the requirement that a section 110(2) payment notice should be served. | At present there is no clear link between the 'sum due' under the contract and the amount notified in a Section 110(2) notice, this crates a range of problems unders contracts without certificates, as the payee does not have a clear entitlement to payment. This measure brings the following benefits under these contracts: - It will not be possible to withhold payment without notice.
- It will be much clearer when the payee is entitled to suspend performance.
| | The current drafting of section 110(2) may lead the payer to conclude that he need not issue a payment notice because of certain deductions from the sum that would otherwise have been due. |
Clarity of the Content of Payment and Withholding Notices | 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 | This proposal will increase the number of section 111 withholding notices that must be issued under contracts without certificates as the obligation is extended to all deductions. It is possible to estimate the cost to the construction industry of this change using DTI's estimate that 32,500 payments are made each year under contracts without certificates (40% of main contract payments and an additional 50% as an estimate for the number of payments made under subcontracts).
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. | |
Clarity of the sum due | By introducing much greater transparency about the sum due by providing a statutory definition. We believe this will: - improve communication between the parties;
- enable cash to flow down the supply-chain;
- enable contractor to plan cash flow and address poor performance; and
- potentially improve liquidity and reduce costs of servicing debt.
| There will be an additional cost which will be borne by the payer as the Section 110(2) payment notice does not make it clear whether the payer needs to account for abatements and/or set-offs.
This is an administrative inconvenience which the industry has chosen to deal with by issuing separate notices under section 110(2) and 111. | |
Preventing 'pay when certified' | Improves the predictability of cash flow and provides the supply-chain with a degree of certainty about what sum they will receive and when. | We understand that traditional civil engineering subcontracts continue to include pay when certified clauses. BERR statistics suggest that 1,600 payments are made each year under civil engineering subcontracts 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 completion of the work 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. | - Improves communication between the parties; and
- ensures money flows down the supply-chain.
|
Enhancing the existing right to suspend performance where there has been non-payment | This proposal creates a statutory right for the payee to receive compensation for losses caused by the suspension.
The payee will also have a sufficient length of time to remobilise on site.
Threat of having to pay the additional costs of suspension incurred by the payee is intended to incentivise the payer to administer payment in a fair way | This proposal does not introduce any overall increase in costs | Suspension is a remedy of last resort and the current incidence of its use is low.
The limitation to only loss and expense reasonably incurred makes the balance between enabling the payee to utilise the right to suspend and the new obligations which will fall on the payer a fair one. Prompt payment is essential to ensure an effective construction industry |
Introduction of a statutory framework for the costs of the adjudication | Greater access to adjudication for all. | Each party to a dispute is encouraged to be responsible for their own legal and other costs;
Parties will also need to pick up the adjudicator's fees and expenses which the joint DTI / CIC survey found are approximately £5,000 on average | Legal and other costs will be kept low.
Prompt resolution of disputes.
Still cheaper and quicker than going to court. |
To prevent the application of "final and conclusive" clauses to interim or stage payments. | The joint DTI / CIC survey of adjudicators found that 50% of adjudication disputes relate to interim payments while the remainder relate to final payments or other matters. The survey also found that resolving payment disputes at the interim stage reduced the cost of adjudication by approximately 10%, or £2,000. This means that approximately 90 adjudications in Scotland relate to interim payments. If adjudication of interim payments was encouraged by increasing the number that may be disputed by a factor of 115/100, this would represent an additional 14 interim payment adjudications. Compared to adjudication of the final account, this would result in an approximate reduction in the average cost of £35,000 or £187 per adjudication on average. Any arbitration or litigation cases that were also averted would increase this figure | | |
Deleting the existing section 107 requirement that contracts need to be evidenced in writing. | A large number of construction contracts contain orally agreed terms. Our proposal extends the application of the Construction Act to oral and partly oral construction contracts. Thus providing greater access to adjudication for more varied forms of construction contracts. | Responses to the joint DTI/ CIC survey of adjudicators revealed that the additional complexity of adjudicating on oral contracts would not lead to a significant increase (<5%) in the cost of adjudication | |
7. Small firms impact test
The proposed amendments will apply to all construction contracts within the scope of Part II of the Housing Grants, Construction and Regeneration Act 1996. The legislation applies to contracts for construction work and professional services including mechanical, electrical, civil engineering and groundworks. A table showing some key statistical data on these sectors for Scotland is set out below. These cover 2004 as this is the latest data available.
| Construction Contracting | Construction Professional Services | Total % of Whole Economy |
|---|
Number of Enterprises | 13,385 | 1,098 | 8.9% |
|---|
% of small or micro enterprises | 98. 19% | 98. 2% | |
|---|
Total Turnover | £12,038m | £585m | 7. 4% |
|---|
Gross Value Added | £4,712m | £363m | 7.6% |
|---|
% of output** funded by public sector | 30% | 27% | |
|---|
Average Employment | 114,700 | 10,000 | 6. 1% |
|---|
Total Net Capital Expenditure | £233m | £12m | 2.7% |
|---|
Number of company insolvencies | 80 | Not available | 13. 6%* |
|---|
* Based on contracting only
** Based on DTI output survey for contracting and CIC survey of construction professional services
Engagement of small firms
As with the previous Scottish Executive consultation, we are once again inviting stakeholders of all sizes to voice their concerns/views either through their federations, trade associations or as individuals.
Given this general industry context, engagement of small firms, at all points in the supply chain, has been fundamental to the development of these proposals.
There have been a number of stakeholder events organised by DTI during the last eighteen months. Those attending have included construction trade associations whose main membership consists of small firms and other industry stakeholders. The National Specialist Contractors Council and the Specialist Engineering Contractors Group in particular have been very helpful in ensuring that representatives from SMEs attended these events (and in encouraging firms from within their membership to respond to DTI March 2005 consultation exercise). The purpose of these events has been to encourage those who would be affected by the proposals to voice their concerns and come up with suggestions for amending the Construction Act.
Among the many proposals considered, was whether "the payment framework under the Construction Act would benefit from the inclusion of a definition of what should constitute an adequate mechanism for payment?" The responses received to this suggestion indicated it would provide clarity for smaller firms and make clear on what date payment was due.
Likewise, support was also forthcoming for the proposal to "introduce a fallback provision should the payer not issue the advance notice of payment (Section 110(2) Notice)". The payer is already duty bound by the existing legislation to notify the payee of the amount they will be paid and of any deductions being made.
The cost of monitoring cash flow, negotiating credit, as well as the financing costs and administration, information and legal cost involved in disputes can bear disproportionately on smaller businesses. Not only does this constrain development by increasing relative costs and reducing the ability of small businesses to compete but it can also divert resources from training, innovation and management.
Late payment is a particular issue for all in construction, particularly among SMEs. This is borne out from the most recent Small Business Survey, which reported that 46% of construction firms saw late payment as a major obstacle. It was also reported in the same survey that late payment also significantly had a detrimental impact on cash flow.
The survey also reported that 31% of construction firms have had to resort to the courts as a result of late payment.
The benefits of the proposed amendments to small and micro businesses are:
- introducing greater transparency and clarity into the payment framework to assist in the management of cash flow
- increasing access to a simple mechanism for resolving disputes
- improving communication between payer and payee on what will be paid and when
- encouraging prompt administration and communication of payment and improve the efficiency and productivity in the industry; and
- enabling the parties to continue to work together effectively to deliver high quality construction projects on time and on budget.
8. Test Run of Business Forms
Although amendments to current forms and contracts is likely no new business forms will be introduced as a result of these proposals.
9. Equity and fairness
The gender mix of the UK construction industry is generally accepted as being dominated by white males, with women and ethnic minorities being under-represented.
According to the 2006 Labour Force Survey, there are approximately 800,000 self-employed individuals working in the UK construction industry of whom approximately 25,000 are black and minority ethnic or 3% of the total self-employed.
The proposed amendments to the Construction Act affect contracts between businesses and self employed individuals. They will apply equally to all businesses and individuals drawn from all ethnic groups, age groups and to men and women alike. Our proposals are unlikely to have a greater impact on any group as compared to another. The amendments all put in place regulatory reform that will remove burdens by:
- Improving the operation of the existing legislation by introducing greater clarity and transparency and reducing disincentives to use adjudication where appropriate;
- Help to maintain a level playing field in a competitive market with a large proportion of small firms; and
- Underpin existing best practice in the industry.
These amendments will better enable contractors to plan cash flow, address poor performance, and potentially improve liquidity and reduce the costs of servicing debt. They are intended to benefit small businesses in particular.
10. Competition assessment
The construction industry is extremely competitive. There is no dominant firm in the construction sector. Many firms report very low margins. Competition is healthy to the point of sometimes being extremely fierce affecting profitability.
Similarly, there is no small key group of dominant firms in any sub-sector other than perhaps some very small specialist feeds. The legislation does not set up barriers to entry to any sectors or to the construction industry and is unlikely to affect the size of firms or number, though it may reduce the churn brought about by the combination of insolvencies and new firms being established.
11. Enforcement, monitoring and sanctions
The Scottish Executive is not proposing to change the enforcement mechanisms introduced through the original legislation. The main enforcement mechanism for the legislation other than the courts or arbitration is the adjudication process, which the legislation provides. The decision of the adjudicator is binding on the parties and enforceable through summary judgement in court.
The only sanction being introduced is where an application for payment becomes due if the payer fails to issue a payment notice. No other sanctions are proposed.
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