Pay When Paid: What does it mean?

1. The Readers of this journal must be very familiar with the phase “pay when paid”. From time to time, it has been raised by main contractors as a defence for not paying its sub-contractors. A classic “pay when paid” clause is found in clause 11(b) of the Standard Form of Sub-Contract for use when the sub-contractor is nominated under the Standard Form of Building Contract drawn up by The Hong Kong Institute of Architects, The Royal Institution of Chartered Surveyors (Hong Kong Branch) and The Society of Builders, Hong Kong (commonly known as the “Green Form”).

2. Clause 11(b) provides (amongst other things) as follows :-

“Within fourteen days of the receipt by the Main Contractor of payment from the Employer against any certificate from the Architect the Main Contractor shall notify and pay to the Sub-Contractor the total value certified therein in respect of the Sub-Contract Works …..”

3. The usual argument arising from clause 11(b) is whether payment by the employer to the main contractor is a condition precedent for the main contractor’s liability to pay the sub-contractor. Where the employer sets off liquidated damages for delay in completion of the main contract works against the amount due under an architect’s certificate which delay has nothing to do with the sub-contractor, a further argument arises as to whether such set-off amounts to “receipt of payment” referred to in clause 11(b).

CASE LAW

4. Contract clauses with wordings similar to clause 11(b) of the Subcontract have been subject to judicial scrutiny in many jurisdictions under different contexts.

5. The following is a summary of the cases in which the courts ruled on the true meaning and legal effect of “pay when paid” clauses :-

In the United States

The contract in question provided that :

“The total price to be paid to sub-contractor shall be $115,000 ….. no part of which shall be due until 5 days after owner shall have paid contractor ……. Nothing herein is to be construed as preventing contractor from paying to subcontractor all or any part of said price at any time thereafter as an advance or otherwise.”

The Unites States Court of Appeals found in favour of the sub-contractor and based its reasoning upon the presumed intention of the parties :-

“…… paragraph 3 of the sub-contract is a reasonable provision designed to postpone payment for a reasonable period of time after the work was completed, during which the general contractor would be afforded the opportunity of procuring from the owner the funds necessary to pay the sub-contractor …… To construe it as requiring the sub-contractor to wait to be paid for an indefinite period of time until the general contractor has been paid by the owner, which may never occur, is to give to it an unreasonable construction which the parties did not intend at the time the subcontract was entered into.”

It was held that in order to properly shift the risk to the subcontractor the subcontract must unambiguously express such an intention and the burden of clear expression is on the general contractor.

In this case, the Supreme Court of Louisiana had to interpret a clause reading :-

“3 ….. Contractor shall pay to Sub-contractor upon receipt of payment from the Owner …..”

“A final payment ….. shall be made within forty-five (45) days after the last of the following to occur : (a) full completion of the Work by Sub-contractor, (b) final acceptance of the work by the Architect … (c) final payment by Owner ……”

The court there held that that clause could not be interpreted to mean “if” the sub-contractor was to be paid but rather “when” it was to be paid. It interpreted the clauses in that case as relating to the time when a contractor must pay the sub-contractor and not to the issue of whether the sub-contractor got paid at all.

In decisions subsequent to Dyer, the courts have been much influenced by the rule that conditions precedent and ambiguous terms should be construed contra proferentum.

In Henry Yamanishi v. Bleily and Collishaw Inc. (1972) 29 Cal. App. 3d 457, the court explained the presence of a “pay when paid” clause by concluding that it indicated :-

“a purpose to assure the subcontractor that funds received by the contractor would not be diverted by it, but would instead be timely and faithfully applied toward the sub-contract. No other provisions being made for time for payment, it would follow that in any event the sub-contractor would be paid upon his performance or within a reasonable time thereafter”.

In Australia

This case involved a Brisbane gold club building a new clubhouse. Although there was some suggestion that the words in question may have been spoken in jest, an engineer assisting in the proposed construction said he would not require payment “until the first beer was pulled in the clubhouse”. The clubhouse was not completed and no beer ever flowed in or from it. It was found that the postponing of the time for payment of a debt to an event which did not occur did not mean that payment never became due or recoverable. A common intention was found that the engineers be paid for their work but that the condition precedent to performance by payment (being when the first beer was pulled) was discharged by its impossibility of performance :

“The time for payment of the work, as distinct from the right to charge for it at all, having been postponed to an event which had not happened, and a reasonable time having elapsed, the Plaintiffs are entitled now to recover the agreed sum for their services”.

An electrical contractor sub-contracted with the main contractor (Sabemo) to carry out the electrical works required in respect to Sabemo’s contract to construct offices and an ice skating rink. The sub-contractor made claims and received progress payments but its last claim was unpaid. Sabemo said it was not liable to pay the claim because its obligation to pay was conditional upon itself having been paid the amount of that claim by the employer. The employer was in receivership, had not paid Sabemo and was never expected to.

A relevant extract from the sub-contract is as follows :-

“Period for Payment after progress claim : Fourteen (14) days after payment from Proprietor”.

The matter went to arbitration where the arbitrator found that :

“Clearly the parties contemplated that in the ordinary course of events payment to [the sub-contractor] would come from moneys paid to [the main contractor] by [the employer], but there is no express provision in any of the contract documents that the payment of remuneration to [the sub-contractor] was conditional upon payment to [the main contractor].”

The arbitrator’s award found its way to the Supreme Court of Western Australia where Commissioner Heenan observed :

“….. there is nothing in the documents or, as far as I can see, in the authorities to which I have been referred by Counsel, which suggests that agreement upon the method of payment relieved Sabemo of payment if that method could not be used”.

It involved a sub-contractor, Crestlite, seeking payment of monies due to it under its final claim. Clause 5(b) of the Sub-contract provided that “Progress payments shall only become due seven (7) days after the receipt of payment of the amount of the Sub-contractor’s account by the [builder] from their Principal pursuant to the provisions of the Head Contract”. White Industries contended that by virtue of that clause it was not obliged to pay Crestlite any outstanding amounts unless and until they were received from the developer, Caboolture Park.

Ryan J disagreed :

“That condition is expressly attached only to the right to receive progress payment and I can discern no warrant in either the sub-contractor or the head contract for extending it to the sub-contractor’s right to be paid anything even after presentation of the final account ….. WIQ is bound, within a reasonable time after issuing its statement to the sub-contractor, to payment ……”

In New Zealand

This case is widely reported. Master Towle of the High Court of New Zealand analysed the decisions in this subject from the United States, Hong Kong and Singapore and granted a summary judgment in favour of the sub-contractor.

The “pay when paid” clause in question provided as follows :-

After reviewing authorities in Singapore and Hong Kong referred to by the defendant and American authorities referred to by the plaintiff, Master Towle agreed that in certain cases it may be possible for persons contracting with each other to include in their agreement clear and unambiguous conditions which have to be fulfilled before a sub-contractor has the right to be paid. Any such agreement would have to make it clear beyond doubt that the arrangement did not merely govern the time for payment. A distinction was to be drawn between clauses which imposed a condition precedent before liability to pay at all arose (an “if” clause) on the one hand and clauses limiting time for payment (a “when” clause). Unless the contracting parties spelt the “if clause” out clearly as a condition precedent, then it would not be upheld. It was not reasonably arguable that two particular clauses governing the relationship between the present Plaintiff and the Defendant were the category of being “if” clauses rather than “when” clauses.

In Hong Kong

6. Before Wo Hing Engineering Limited v Pekko Engineers Limited (unreported, Court of First Instance Action No.A5561 of 1996), there had been no direct authority on the construction of a “pay when paid” clause. This is perhaps due to the fact that most disputes relating to the issue are resolved by arbitration.

7. The High Court in Hong Kong Teakwood Works Ltd. v Shui On Construction Co. Ltd. [1984] HKLR 23 and The Court of Appeal in Schindler Lifts (Hong Kong Ltd. v. Shui On Construction Co. Ltd. [1985] HKLR 118 have considered the meaning of clause 11(b) in the context of an application for summary judgment. The Hong Kong Courts came to the view that it was arguable that “receipt of payment” in clause 11(b) means actual receipt of payment which does not embrace set-off for liquidated damages made under clause 22 of the Main Contract.

8. The Hong Kong Teakwood and Schindler cases cannot be regarded as authority to support the main contractor’s argument for not paying the sub-contractor since :-

9. Cases after Hong Kong Teakwood and Schindler which touched upon the “pay when paid” issue were also decided in the context of applications for summary judgment and/or stay of proceedings to arbitration. Such cases include Ryoden Engineering Co. v Paul Y Construction Co [1994] 2 HKC 578, On Lee General Contractor v The Garden Co. Ltd. (unreported, High Court Action No.A328, 330 of 1992) and Schindler Lifts (Hong Kong) Ltd. v Shui On Construction Co. Ltd. [1994] 3 HKC 598 and a Court of Appeal decision in Chung Kiu Development Ltd. & Another v Sung Foo Kee Ltd. & Another [1995] 2 HKC 777.

10. The Court of First Instance at last in Wo Hing Engineering Limited v Pekko Engineers Limited (unreported, No.A5561 of 1996) had the opportunity to decide the legal effect of a “pay when paid” clause in a full trial.

11. The defendant in this case was a subcontractor and the plaintiff was its sub-sub-contractor. The relevant clause provided that “this contract is based on back to back basis including payment”. The court had to decide whether on a proper construction of the above-mentioned term in the contract, payment of the final balance was only due to the plaintiff from the defendant after the defendant received payment from the main contractor as contended by the defendant, or whether the plaintiff was entitled to be paid after a reasonable time had elapsed from completion of the works as submitted by the plaintiff.

12. In giving judgment in favour of the plaintiff, Suffiad J. adopted the principle which can be gleaned from the decisions in United States, Australia and New Zealand, namely, when having to construe a “pay when paid” clause, sufficiently clear words will have to be used before a court will be prepared to construe that such a clause imposes as a condition payment to the main contractor (the sub-contractor in the Wo Hing case) which had to be fulfilled before the sub-contractor (the sub-sub-contractor in the Wo Hing case) had the right to be paid as opposed to a clause limiting the time for payment.

13. His Lordship agreed to the following passages in judgment in Smith & Smith v Winstone :-

14. Based on the above principle, his Lordship held that the payment clause in question merely provides for the time of payment and that the plaintiff’s right to be paid is not dependent upon the defendant getting paid first.

SET-OFF OF LIQUIDATED DAMAGES

15. Even if payment by the employer was a condition precedent to payment by the main contractor to the sub-contractor, it is still arguable that such condition precedent has been fulfilled by the set-off of the liquidated damages by the employer from the main contractor’s payment under clause 22 of the main contract.

16. Counsel in the Hong Kong Teakwood and Schindler cases submitted that by virtue of clause 22 of the main contract, the Employer is entitled to set off the amount due under that clause for liquidated damages against the amounts being held by it, the main contractor cannot say that it had not “received payment” from the Employer, although the Respondent might not have received the payment in cash.

17. The above submission is supported by Arsene A Larocque v Hyacinthe Beauchemin [1987] AC 358 in which Lord MacNaghten in the House of Lords approved the following dicta in Re Harmony and Montague Tin and Copper Mining Co. Ltd., Spargo’s case (1873) [1861-73] All ER Rep.261 :-

“In truth it appeared to me that anything which amounted to what would be in law sufficient evidence to support a plea on payment would be a payment in cash within the meaning of this provision ….. if a transaction resulted in this, that there was on the one side a bona fide debt payable in money at once for the purchase of property, and on the other side a bona fide liability to pay money at once on shares, so that if bank-notes had been handed from one side of the table to the other in payment of calls, they might legitimately have been handed back in payment for the property, it did appear to me in Fothergill’s case and does appear to me now, that this Act of Parliament did not make it necessary that the formality should be gone through of the money being handed over and taken back again; but that if the two demands are set off against each other, the shares have been paid for in cash ….. Supposing the transaction to be an honest transaction, it would in a court of law be sufficent evidence in support of a plea of payment in cash, and it appears to me that it is sufficient for this court sitting in a winding-up matter.”

18. It is also arguable that if the main contractor is to rely on Clause 11(b) as creating a condition precedent to payment by the main contractor to the sub-contractor, such clause must be construed strictly against the main contractor (i.e. contra proferentem) especially “payment” in the clause is not expressed as actual payment or payment in cash.

19. The above argument is powerful. Unfortunately, the judges in Hong Kong Teakwoodand Schindler cases appeared to be not in support of such argument. On the other hand, they merely held that in the context of an application for summary judgment, the sub-contractor had failed to show that such argument must be right in law. No firm view as to the validity of such argument was expressed. There has been no direct authority in the Hong Kong courts after the Hong Kong Teakwood cases which approved such argument.

CONCLUSION

20. The writer is of the view that in construing clause 11(b) of the Sub-contract, the judge or Arbitrator should also follow the same approach adopted by Suffiad J. in theWo Hing case, i.e. receipt of payment by the Respondent from the Employer in respect of the Subcontract Works certified by the Architect is not a condition precedent to payment by the Respondent to the Claimant. Alternatively, where the employer exercised its right of set-off against any payment due to the main contractor, the meaning of “receipt of payment” in clause 11(b) should be wide enough to embrace a set-off made by the employer pursuant to clause 22 of the main contract.

21. By virtue of section 13 of the Housing Grants and Regeneration Act 1996, “pay when paid” clauses are made illegal in England and Wales. Hong Kong has not followed suit. If a main contractor wishes to make receipt of payment from the employer a condition precedent for paying its sub-contractors, it is entirely free to do so provided that the clause in the contract is properly drafted to remove any ambiguity as to its true meaning and legal effect.

22. The writer understands that the Standard Forms of Building Contract are under reviewed, it is hoped that the intention of clause 11(b) of the Green Form will also be clarified in the new edition.

Whilst every effort has been made to ensure the accuracy of this publication, it is intended to provide general guidance and not definitive legal advice.

Deacons