PFI subcontracts: doubt cast on effectiveness of Equivalent Project Relief clauses

For some time practitioners in the field of PFI have grappled with the issues arising from the application of the Housing Grants Construction and Regeneration Act 1996 (referred to as the 'Act') to subcontracts in PFI projects (typically the construction contracts and the FM contracts). In particular there is a potential conflict between the needs of investors and funders to keep the project company whole on the one hand, (i.e. to match (both in quantum and timing) the liabilities which fall due from the project company to its subcontractors with the benefits which fall due to the project company from the contracting authority), and the provisions of the Act intended to promote prompt payment to subcontractors in a contractual chain on the other hand.

Issue and relevant legislation

Two points arise out of a consideration of the Act. The first is that S.108 provides that under a 'construction contract' as defined in the Act (which will cover a PFI construction subcontract and may cover the 'hard' services part of a facilities management/maintenance subcontract) either party is entitled to refer a dispute to adjudication at any time. This right cannot be excluded by contract. If a subcontractor invokes its rights under S.108 before the project company has had a chance to secure its position under the related project agreement, the project company could be exposed to costs it cannot recover. Further, there is a possibility that a decision by an adjudicator under the subcontract would be inconsistent with or conflict with a decision made pursuant to the dispute resolution procedure under the Project Agreement, again exposing the project company to a liability that it has not predicted or provided for.

The second is under S.113(1), which provides: 'a provision making payment under a construction contract conditional on the payer receiving payment from a third person is ineffective, unless that third person, or any other person payment by whom is under the contract (directly or indirectly) a condition of payment by that third person, is insolvent'. This has become known as the prohibition of 'pay when paid' provisions in subcontracts.

The result is that any provision whereby a subcontract may (i) defer or limit a subcontractor's right to go to adjudication 'at any time', and/or (ii) provide that the subcontractor's payment is conditional on the project company receiving payment, may be held to be unenforceable. While it has long been realised that the drafting of clauses that seek (by using any similar devices) to achieve this is beset with difficulty it was thought that clauses limiting the subcontractor's entitlement under the subcontract to the project company's agreed or determined equivalent entitlement (as opposed to actual payment) under the project agreement, would be effective.

The case

Midland Expressway Limited –v- Carillion Construction Limited & Ors [2005] EWHC 2963 (TCC)

The case in point was an application for an injunction brought by the project company, Midland Expressway Limited ('MEL') to prevent the construction subcontractors (each subsidiaries of Carillion, Alfred McAlpine, Balfour Beatty and AMEC, and referred to as 'CAMBBA') from pursuing a reference to adjudication under their subcontract. None of the subcontractors was an investor in the project company. The subject of the alleged dispute was the amount of the payment due to CAMBBA from MEL for a variation requested by the Secretary of State for Transport (the 'Department') as contracting authority to the project signed in 2000 to design, build, operate and maintain the M6 toll road near Birmingham. The variation related to the construction of the 'tie-ins' with the main M6 motorway at either end of the toll road.

The Department disagreed with the sum requested for variation works carried out by CAMBBA and CAMBBA instigated an adjudication against MEL for short of £10m. While the Project Agreement gave the Department the option to become a party to any dispute between MEL and CAMBBA, the Department decided on this occasion not to do so, preferring to await the result of the adjudication between MEL and CAMBBA. In its reference to adjudication, CAMBBA requested interim payment of the sum they claimed due, saying that MEL's pursuit of its entitlement under the Project Agreement should not hold up payment to CAMBBA. Mr Justice Jackson (Technology and Construction Court) considered each of the clauses relied on by MEL to defeat CAMBBA's claim in light of each of the relevant provisions of the Act.

S.108 (right to commence adjudication at any time)

Clause 7.1.3 of the contract between MEL and CAMBBA (the 'D&C Contract') limited CAMBBA's entitlement to payment or recovery in respect of a price adjustment (such as a variation) to such time as '(a) an agreement has been made between the Secretary of State and MEL or a determination has otherwise been made under or in connection with the [Project Agreement] establishing that [MEL] is entitled to Equivalent Project Relief in respect of such Price Adjustment…; and (b) [MEL] has received the Price Adjustment Funds or has certified that it has funds available to it for the purposes of payment of such Price Adjustment.'

This was agreed to at best be a defence to adjudication as opposed to a bar. However clause 7.4 of the D&C Contract stated: 'pending the determination, agreement or resolution of any Equivalent Project Relief under the [Project Agreement], [CAMBBA] shall take no steps to enforce any right, benefit or relief under this Contract to the extent that such right, benefit or relief relates to the same circumstances as those to which the Project Relief Event to which that Equivalent Project Relief relates'. Mr Justice Jackson held that there were two possibilities: first that clause 7.4 should be construed narrowly and in a manner compatible with the Act and second that the clause is contrary to the Act and thus the Scheme for Construction Contracts (which would give CAMBBA a right to go to adjudication at any time) is substituted in the place of the contractual adjudication provisions. In either case (and he did not decide which was correct) clause 7 of the D&C contract did not bar CAMBBA from pursuing its claim by adjudication.

S.113 (bar on 'pay when paid' provisions)

MEL relied on clause 39.6.2 of the D&C contract. It provides: 'subject only to clause 7 (Contractor's Rights) and notwithstanding any other provisions of this Contract, [CAMBBA]'s rights to any Price Adjustment under or in connection with clause 39 (Changes) in respect of a Secretary of State's Change shall in no event exceed the amounts, if any, to which [MEL] is entitled to be paid by the Department in respect of a corresponding change pursuant to Clauses 8.1.3.1 and 8.1.3.3 of the [Project Agreement].' Mr Justice Jackson held that the practical consequence of this clause was that CAMBBA would not be paid for variations requested by the Department unless and until MEL had received a corresponding sum from the Department, even where CAMBBA has or could show, under the D&C contract dispute resolution procedures, that it was entitled to payment or extra payment. In Mr Justice Jackson's view, this was what S.113 of the Act was designed to legislate against. He went on to say that the use in that clause of the words 'to which [MEL] is entitled to be paid' did not save the clause: words used as a device to get around S.113 will not assist. He went on to say that if that analysis were incorrect then clause 39.6.2 would, when read together with clause 7.1.3 would in any case be a 'pay when paid' provision in all circumstances other than where MEL had certified that it had funds available to pay CAMBBA.

Effect of the judgment

The outcome of this case will clearly cause waves in the PFI industry. However there are a few points to bear in mind. The first is that the case related to payment for a variation as opposed to the payments to which the subcontractors were entitled under the project as at financial close. The latter type of payments made to a construction subcontractor during the construction phase will not fall within the ambit of any equivalent project relief-type clause as they are paid through the project company from the project's funders on certification by the latter's technical adviser. They are thus not the subjects of any clause in the construction subcontract that relates the subcontractor's entitlement to a corresponding entitlement of the project company against the contracting authority. A similar analysis should, given appropriate drafting, apply to variation payments where the payment is being funded by the project company by way of an addition to its existing debt facility. Payment will be made to the construction subcontractor following certification by lender's TA and the unitary charge adjusted.

Second the case did not concern entitlement to extensions of time or relief from termination. While it is possible that a clause limiting the construction subcontractor's entitlement to time or relief to that agreed or determined under a project agreement could offend S.108, the 'pay when paid' considerations are irrelevant.

Third each case turns on its facts and the exact words of the relevant restrictions. In many of the clauses considered, the judge found wording which directly offended the Act. With different drafting the result could be different in another case. Other contractual provisions could be, and often are, included which are aimed at achieving by other means the protection for the project company that investors and funders are looking for and which facilitate the funding of these projects. Nevertheless the court's 'purposive' approach to the interpretation of the Act, particularly of S.113, must cause concern.

This leads onto the issue of Government policy. Part of the problem lies with the fact that whilst the Act does apply to many of the subcontracts on a PFI project, it does not apply to the project agreement. Any proposal to disapply the Act from PFI subcontracts is unlikely to be acceptable to the construction industry. On the other hand, the Government last year rejected a proposal that the Act should be amended so that it applies to the project agreements as well as the subcontracts. Government policy has always been that the public sector should not be embroiled in every dispute between the project company and its supply chain (and that the project company should ensure that decisions flow through the contractual chain by correct structuring). However given the difficulties illustrated by this case it may be that this policy should now be reviewed. If both the subcontract and the project agreement were subject to the same dispute resolution regimes there would be much more scope for ensuring that the construction subcontractor's entitlement would be determined at the same time as the project company's, and by the same process.

Meanwhile investors and funders will need to review subcontract provisions in both signed deals, particularly given the recent activity in secondary market transfers, and those approaching close, in the light of this case. If it is thought that these clauses could fail then they and their advisers will be looking for alternative ways to deal with the potential risk to the project company. They may now be looking for longer periods in the sub-contracts for the project company to respond to claims. The as yet untested back-up device of parallel loan agreements may come under greater scrutiny as a potential solution. The risk of a challenge may be higher in consortia that are not sponsor-led.