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In cases of contractor default, employers are faced with a choice: should they pay the subcontractor directly? Or should they relook at the contractual clause? Shourav Lahiri, a partner in the international law firm Pinsent Masons LLP, argues the issue

Consider this: An employer on a project believes that the project is running relatively smoothly when a number of subcontractors claim non-payment of dues by the main contractor.

The employer, on his part, has paid the main contractor for the subcontractors work. The subcontractors are now threatening to suspend the works or leave the site because of non-payment. What are the employer’s options in the face of a potential walk-out?

Let’s look at the risks posed to the project if the subcontractors are not paid and do subsequently stop work. In such circumstances the project will face delays while either the subcontractor awaits payment before returning to the site or while a replacement subcontractor is appointed.

Chances are, the replacement subcontractors may not bring the same expertise and efficiency as the current subcontractors. New subcontractors coming into an ongoing project midway may not be able to properly integrate their works with those that have already been executed. All this could pose risks to the timely completion of the project.

Another option is that the employer could put pressure on the contractor to make payments to the subcontractor and wait for them to do so. Or he could pay the subcontractor directly. What would be the pros and cons of the latter course of action?

Paying the subcontractor directly will of course relieve the immediate risk of delay as it will bring the subcontractors back to work. But this means the employer will have paid twice for the subcontractor’s works: once to the main contractor and once to the subcontractor.

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Is the employer entitled to recover this second payment from the main contractor? Yes, but only if there is a direct payment clause in the main contract entitling the employer to make direct payments upon certain conditions being met.

However, while the employer may be entitled to do so, this may not be an ideal situation as it appears to be.

The employer may be making a rod for his own back by paying the subcontractor directly once. Having been granted a direct payment once, the employer may have raised a legitimate expectation in the subcontractor that subsequent requests will also be met. The subcontractor will feel emboldened to make this request each time payments are not received from the main contractor.

This could lead to the employer having an uncomfortable discussion with the contractor if the latter has legitimately withheld payments from the subcontractor. There will also be an impact on the employer’s cash flow in paying twice for the subcontract works and then waiting to deduct the direct payment from the contractor at a later date.

Secondly, by exercising such a right under the contract, the employer may inadvertently be damaging the relationship with the contractor and also the latter’s standing in the eyes of the subcontractors. This could well have an adverse impact on the effective administration of the works.

Thirdly, in the worst-case scenario, if the contractor becomes insolvent, issues may arise as to whether the direct payment was a preferential payment in contravention of insolvency laws.
 
Therefore, while direct payment clauses can often be an employer’s ally in allowing it to advance the works when faced with main contractor default, their use should be considered with care given the potential risks to the employer and to the project as discussed above.

The author wishes to thank Ms Nancy Hobbs of Pinsent Masons LLP for her assistance with this article.

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