Hybrid Contracts: is a valid payment notice required to distinguish between the sums due for construction and non-construction operations?

17 October 2019

In the recent case of C Spencer Limited v MW High Tech Projects UK Limited [2019], the Technology and Construction Court (TCC) was required to consider whether, for the purposes of s.111 of the Housing Grants, Construction and Regeneration Act 1996 (as amended) (the "Act"), a valid payment notice is required to identify separately the sums due and the basis of the calculation of those sums for construction and non-construction operations.

We previously outlined what constitutes construction operations in our insight 'Are my works construction operations?'



Facts

MW High Tech Projects UK Limited ("MW") had engaged C Spencer Limited ("CSL") under a sub-contract (in the IChemE Form of Contract for Civil Engineering Subcontracts (the Brown Book) 3rd edition 2013 with amendments) to design and construct the civil, structural and architectural works for the completion of a power plant (the "Sub-Contract"). The Sub-Contract works included construction operations for the purposes of s.105 (1) of the Act and the assembly of plant and erection of steelwork to provide support of access to plant and machinery, which are deemed as non-construction operations for the purposes of s.105 (2) of the Act. The Sub-Contract provided for periodic interim payments.

In 2018, CSL submitted Interim Payment Application number 31. Both Interim Payment Application 31 and the payment certificate issued by MW did not separate out the sums due for the construction operations and the sums due for the non-construction operations. A dispute arose between the parties over Interim Payment Application 31 and in July 2018 CSL issued a notice of intention to refer the dispute to adjudication. MW challenged the adjudicator's jurisdiction, on the grounds that the adjudication provision in the Sub-Contract was limited to disputes in respect of construction operations within the Act. The adjudicator lacked jurisdiction because the dispute as framed did not distinguish between construction operations and non-construction operations, for the purposes of the Act, and the associated sums. CSL subsequently withdrew its adjudication claim as a result of the jurisdictional challenge.

On 4 February 2019, CSL issued Interim Payment Application 32 for £3,353,219.22 plus VAT, of which £2,683,617.09 plus VAT was claimed for construction operations. Interim Payment Application 32 included a breakdown of the sum claimed which distinguished between the construction and non-construction operations. In its covering letter, CSL stated that as the Sub-Contract is a hybrid contract, Interim Payment Application 32 draws a distinction between construction and non-construction operations and welcomed a payment certificate setting out separately the sums due in respect of the construction and non-construction operations. On 19 February 2019, MW issued Payment Notice 35 stating that, in respect of Interim Payment Application 32, it considered CSL owed it £6, 818, 521.70 excluding VAT. MW also attached a spreadsheet setting out a breakdown of the measured work and variations, which indicated a negative sum due to CSL. Both Payment Notice 35 and the breakdown did not distinguish between construction and non-construction operations.

CSL's solicitors wrote to MW claiming £2,683,617.09 plus VAT as the notified sum due in the absence of any valid payment notice or pay less notice. MW's solicitor's responded arguing that MW's failure to specify the sums due for construction operations and the sums due for non-construction operations did not invalidate MW's payment notice.

CSL subsequently commenced Part 8 proceedings seeking payment of £2,683,617.09 plus VAT and/or damages in the same sum and interest. CSL argued that the proper construction of the Act and clause 38.4 of the Sub-Contract required payment notices to separately identify the sums due for construction operations and the basis on which that sum is calculated; Payment Notice 35 was not a valid payment notice for the purposes of s.110A(2) of the Act because it failed to separately identify the sums due for construction operations and the basis on which that sum is calculated; and in the absence of a valid payment notice or pay less notice, pursuant to s.111 of the Act, the notified sum to which CSL was entitled was the amount assessed in Interim Payment Application 32. MW argued, amongst other things, that the payment provisions in the Sub-Contract were compliant with the Act; Payment Notice 36 complied with the requirements in s.110A of the Act; and that the parties had decided that construction and non-construction operations would be subject to the same payment regime.

Decision

The Court held that where, as in this case, a contract contains a payment mechanism that complies with the relevant provisions of the Act and applies to both construction and non-construction operations, a payment notice that does not separate the sums due and the basis of the calculation of that sum for construction operations is valid for the purposes of s.110A and s.111 of the Act. The Court reasoned that:

  1. "the express words of sections 111 and 110A do not stipulate separate identification of the sums due in respect of construction operations. Section 111 simply identifies the "notified sum" by reference to a valid payment notice in section 110A. Section 110A(2) contains two requirements for a valid payment notice, namely, the sum considered due at the payment due date and the basis on which that sum is calculated. To comply with section 110A(2), the sum considered due must include, but is not expressly limited to, such sum in respect of construction operations. That may be satisfied by stating the overall sum considered due in response to the relevant application."
  2. s.104(5) of the Act limits the application of the statutory payment requirements to construction operations. However, parties are free to agree a payment scheme that complies with and mirrors the statutory provisions for both construction and non-construction operations, as was the case in the Sub-Contract. It would then be possible for a payment notice to satisfy the statutory (construction operations) and contractual (non-construction operations) requirements and that payment notice would be valid under the Act and the contract.
  3. where the same payment provisions apply to construction and non-construction operations it is not difficult to implement s.111 of the Act, because "the validity of the payment notice in respect of both the construction and non-construction operations would be determined against the same parameters."
  4. such an "approach does not undermine the purpose of the statutory payment provisions. It could be described as a pragmatic solution to the illogical and uncommercial impact of section 104(5) of the Act. If parties agree a payment scheme that complies with, or mirrors, the statutory scheme in respect of both construction and non-construction operations, the cash flow benefits conferred by the Act are simply extended to cover those additional works."

The Court also held that CSL was required to identify the sums claimed for the construction operations and non-construction operations separately on the basis it sought to limit its claim to the notified sum payable under s.111 of the Act. However, MW was entitled to defend the claim "by relying on a payment notice, setting out the basis on which no sum is due in respect of any construction or non-construction operations."

MW's Payment Notice 35 was held to be a valid payment notice and on that basis, CSL was not entitled to monetary relief it sought.

Although MW was successful in defeating CSL's claim, the Court considered MW's alternative arguments in the event that the Court had held that Payment Notice 35 was not a valid payment notice, for completeness sake and concluded that:

  1. CSL was not prevented by previous conduct from arguing that the Sub-Contract requires applications and payment notices to distinguish between construction and non-construction operations, on the basis that the parties had not made this distinction in the first thirty-one applications. The Court reasoned that although it was the parties' common understanding that the Sub-Contract did not require a distinction between construction and non-construction operations, this changed when MW raised the hybrid contract ground in challenging the adjudicator's jurisdiction to determine the dispute over CSL's Interim Payment Application 31. CSL had also raised the hybrid contract issue in its Interim Payment Application 32 on 4 February 2019 and required MW to set out the sums assessed separately for the construction and non-construction operations, bringing the shared assumption to an end;
  2. If MW's Payment Notice 35 was held to be invalid, CSL would be entitled to rely on its payment application as the notified sum under s.111 of the Act. CSL's Interim Payment Application 32 distinguished between construction and non-construction operations. MW had not challenged the validity of that application and did not provide an alternative to CSL's breakdown in Payment Notice 35 or its position on the allocation of the works;
  3. MW would not be entitled to rely on its negative valuation as (i) a payless notice or (ii) a cross-claim or set-off.  Payment Notice 35 was not identified as a pay less notice and was not intended to read as one. Therefore, MW did not have the requisite contractual intention to serve it as a pay less notice. MW would not be able to avoid the operation of s.111 of the Act by relying on the defence of set-off or a cross-claim if it had not raised it in a valid payment notice. MW argued that this restriction did not apply to hybrid contracts. However, the Court took the view that "the Subcontract produces the same result as the Act. The premise of the argument is that MW failed to serve a valid payment notice. The Subcontract has replicated the effect of section 111 of the Act through clauses 38.5 and 38.7. If MW wished to pay less than the sum due in CSL's application "for any reason", including a set-off or counterclaim, it was obliged to serve a pay less notice. In the absence of a pay less notice, and in the absence of a valid certificate under clause 38.4, the amount applied for under clause 38.3 would be payable."

Commentary

In this case the contractual payment provisions were compliant with the Act and applied to both construction and non-construction operations. If the contractual payment mechanism is not compliant with the Act, the statutory scheme will apply to the construction operations and the contractual payment mechanism will continue to apply to the non-construction operations. In such circumstances, a payment notice that does not separately state the sums due in respect of the construction operations will be invalid and the payer will be at risk of being liable to pay the sums applied for by the payee. The Court's judgment, particularly its findings in relation to MW's alternative arguments, highlights the importance of checking the requirements of the payment provisions in hybrid contracts. The validity of a payment notice will turn on the facts of the case and the contract requirements agreed between the parties. The Court also reminded the parties that any "payment notice must be sufficiently clear and unambiguous in form, substance and intent so that the parties have proper notice of the sum assessed as due and the basis of calculation. It is possible that a paying party who declined to apportion or allocate the sums due or deducted as between construction and non-construction operations might struggle to rely on its notice for the purposes of the Act if a deficiency in the notice undermined the validity of its global assessment."


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