If cash is king, then cashflow must be the king’s right-hand-man. The effect of poor cashflow on any business but particularly on those entities in the engineering and construction sphere is disastrous. A chief cause of this unending saga is the so-called “pay-when-paid” clause, more formally known as the conditional payment clause. But is such a clause legal?
Consider this scenario: Mega-Malls Construction is hired by Vega Property Developers to construct a shopping mall. Mega-Malls hires a subcontractor, Scarab Excavation, to do the excavation on site. The contract between Mega-Malls and Scarab states that Mega-Malls shall only make payment of an amount certified in a payment certificate to Scarab once Mega-Malls receives payment from Vega. Scarab has never worked with the new type of building contract presented to it by Mega-Malls but having not had much work lately, Scarab’s directors scramble to sign it as-is so that the work can begin. Scarab complies with all the necessary payment application provisions in the contract when submitting monthly payment applications and Mega-Malls issues payment certificates to Scarab in consequence. Mega-Malls regularly makes payment within 30 days for the first three months but in the fourth month, payment to Scarab is absent. Scarab’s contracts manager complains about the missed payment, with the significant effects it has on the entity’s cashflow. Mega-Malls immediately refers to the conditional payment clause in the contract and says, ‘payment to you will only be made once Mega-Malls receives payment from Vega’. Fuming, Scarab’s contracts manager argues that the pay-when-paid clause is unenforceable and demands that Scarab be paid for the work done. However, Mega-Malls does not budge.
PAYMENT OBSTACLES BETWEEN PARTIES OF CONSTRUCTION CONTRACTS
With almost all projects relying on some form of third-party financing, modern engineering and construction contracts ordinarily contain strict payment provisions which usually favour the party required to make payment instead of the party receiving it. Some even contain what at first appear to be wholly unjust terms, such as a conditional payment provision, stipulating, for example, that a contractor will only make payment to a subcontractor once the contractor receives payment from the employer.
Such a term presents an enormous risk to a subcontractor. If not negotiated away, the term remains binding on the parties, with the effect that a subcontractor may be left in the untenable position of not being able to continue with the works because it has not been paid for work already done on the same project or worse, being forced to wind up shop. Many subcontractors argue that a pay-when-paid clause is not enforceable but are routinely rebuffed by main contractors on the basis that such clauses are entirely allowable, not least because of the fact that the subcontractor agreed to the inclusion of the term in the subcontract to begin with. Unfortunately for the subcontractor, the prevailing legal position on the topic – both legislation and case law – very much favours the contractor.
LEGALITY IN SOUTH AFRICA
In South Africa, legislation regulating the conditional payment provision is limited. Faced with the ever-growing late- and non-payment complaints lodged by both contractors and subcontractors, the Construction Industry Development Board (CIDB) and the Ministry of Public Works proposed an amendment to the 2004 Regulations made under the CIDB Act. The proposed amendments were entitled the “Prompt Payment Regulations”.
They stated that anyone who had executed works in accordance with an underlying contract is entitled to prompt payment therefor and such payment could not be withheld from the contractor or subcontractor without notice stating reasonable grounds. Furthermore, the Regulations sought to effectively outlaw the so-called pay-when-paid clause in all scenarios by providing that no construction contract may provide that payment is conditional on payment being received from a third party.
Despite being heralded as a significant move forward in South Africa’s burgeoning construction industry, the Regulations hit a deadly roadblock in 2017 when the Minister refused to make them law on the basis of a legal opinion received from the Office of the Chief State Law Advisor, which emphasised that “the regulations were ultra vires [beyond one’s legal power or authority] and if challenged would not pass the constitutional validity threshold”. The proposed Regulations have been stagnant ever since and pay-when-paid clauses remain valid and enforceable.
The South African courts have not tasked with interpreting the enforceability of pay-when-paid clauses. However, the English case of Durabella Ltd v J Jarvis & Sons Ltd provides guidance. The court acknowledged the shield that contractors may use with the “pay-when-paid” clause and it therefore placed the onus on the contractor to prove that any payments that it had received were not at all related to the subcontractor’s works. The court said that focus should be placed on the circumstances of each case instead of on the actual agreement between the parties. In this case, the contractor could not prove that it had not received any payment in respect of the subcontract works and the subcontractor’s claim for payment was upheld. A South African court may take the same approach when faced with similar facts.
In Scarab’s scenario, it is not left with many options but its contracts manager decides to complain to Vega and request direct payment. Here, too, Scarab will likely hit a dead-end.
PRIVITY OF CONTRACT
Can a subcontractor, in the event of the contractor not paying due and owing invoices, make a claim against the employer?
Due to the doctrine of privity of contract, the contractor will be responsible for making any contractual payments due to the subcontractor. The doctrine essentially means that parties who are not privy to a contract cannot bring any contractual claims against the parties to that contract. The established law of contract creates rights and duties exclusively for the parties to that contract and does not include third parties. Privity of contract has been frequently dealt with by the South African courts. As recently as 2022, the High Court in Johannesburg ruled, in Structra Group (Pty) Ltd v Van Niekerk and Others, that it is a “trite principle” that the privity and sanctity of a contract should prevail, with the only circumstances in which it should not being when the contract is fraudulent or the term to be enforced is unreasonable or against public policy. The Supreme Court of Appeal, in Mohamed’s Leisure Holdings (Pty) Ltd v Southern Sun Hotel Interests (Pty) Ltd, referred to its own 1927 decision in Wells v South African Alumenite Company, in which it said that “contracts, when entered into freely and voluntarily, shall be held sacred and enforced by the courts of justice.”
In the given scenario, Scarab, as a subcontractor, has no contractual relationship with Vega, as the employer. Therefore, Scarab, as a third party to the contract, will not have any claim for payment against Vega. Scarab’s only path forward is to either concretely establish whether Mega-Malls did receive payment for Scarab’s works from Vega and to then hold Mega-Malls liable for payment, or, if permitted by the contract, to suspend the excavation works pending its receipt of amounts certified and due to it.
Projects often run into cashflow difficulties. In some events, employers withhold payments due to contractors, which creates a ripple effect of a lack of payment to subcontractors. Contractors often rightfully rely on the dreaded “pay-when-paid” clause, meaning the subcontractor’s resources are limited when seeking payment for their completed works. Generally, a subcontractor cannot hold an employer liable for payment in such a case.
It is clear that South African legislation needs to be developed in order to regulate payments between parties of construction contracts and protect the rights to payment for completed works for both contractors and subcontractors. The “Prompt Payment Regulations”, although stalled at present, remain a development option. In their absence, however, all parties to construction contracts must be cognizant of all conditions included in their contracts to safeguard their own interests. Irrespective of what role you play on a construction project or what type of contract is entered into, it is important to ensure your contracts are properly and strategically considered to account for prompt payment.
By Ryan du Preez | Director