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(The following outline was used in a presentation to the Overseas Construction Association of Japan, Inc. (OCAJI) The Dynamics of Payment
As a construction project moves toward completion, the Contractor loses leverage, and the Employer gains leverage. This is based on the reality that the Contractor builds the project, and the Employer simply pays money. As the project nears completion, the Contractor has less leverage because the Employer is close to obtaining what he bargained for – a completed project. This is the time when the Employer will be inclined to suspend or reduce payments to the Contractor, not early in the Project. The Wrong Response to Non-Payment The natural inclination of the Contractor near completion is to continue working, regardless of the non-payment, and complete the Project. This can be the wrong step for the Contractor to take. With the Project complete, the Contractor has lost all commercial leverage – the Employer has what he needs. The unpaid Contractor must give notice of intent to suspend work in the event of non-payment. Standard Contract Language Regarding Suspension of Work Many standard contract forms in use is Asia do not give the Contractor the right to suspend work in the event of non-payment. But, all of the standard contract forms give the Employer the right to suspend work for cause or for the Employer’s convenience. The Contractor must include language in every prime contract that allows the Contractor to suspend work in the event of non-payment. An Employer that refuses to agree to Contract terms allowing the Contractor to suspend work for non-payment probably is an Employer for which the Contractor should not work. The Law When There Is No Express Right to Suspend Work for Non-Payment Without the express right to suspend work in the event of non-payment, the issue is whether the non-payment constitutes a material breach of contract. Although the law varies from country to country, in general it is fair to say that the issue of when non-payment becomes a material breach of contract, justifying suspension or termination, is a grey area. As a matter of policy, Contractors with Contracts that do not include an express right to suspend work should wait a minimum of two months without receiving any payment before suspending work. Depending on the payment terms of the Contract, this can leave the Contractor exposed for the value of four to five months of work. Payment Clauses from FIDIC Red Book, 4th Edition Monthly Statements
Monthly Payments
Time for Payment
Default of Employer
Contractor’s Entitlement to Suspend Work
Month 1 Work is performed Month 2 Work is performed Contractor submits payment application for Month 1 Certificate issued for Month 1 (28 days after submission) Month 3 Work is performed Contractor submits payment application for Month 2 Payment due for Month 1 (28 days after Certificate) Certificate issued for Month 2 (28 days after submission) Month 4 Work is performed Contractor submits payment application for Month 3 Payment due for Month 2 (28 days after Certificate) Notice of intent to suspend work (28 days after non-payment for Month 1) Certificate issued for Month 3 (28 days after submission) Month 5 Work is performed Contractor submits payment application for Month 4 Payment due Month 3 (28 days after Certificate) Work suspended at beginning Month 5 on the basis of non-payment for Month 1 Certificate issued for Month 4 (28 days after submission) Managing the FIDIC Red Book Payment Delay Even when the Contract gives the Contractor the right to suspend work for non-payment, the Contractor still can be exposed to working for four months without receiving any payment until the Contractor can give notice of its intent to suspend work. And, if the Contractor is not paid the first progress payment at the end of Month 3 and does not promptly give notice of its intent to suspend work, the Contractor will quickly find that five months of work have been performed without receiving payment. This underscores the importance of giving notice of the intent to suspend promptly upon the expiration of the payment due date. Three Suggestions for Managing Payment Delays
Month 1 Work is performed Month 2 Work is performed Contractor submits payment application for Month 1 Certificate issued for Month 1 (14 days after submission) Payment due for Month 1 (14 days after Certificate) Month 3 Work is performed Contractor submits payment application for Month 2 Certificate issued for Month 2 (14 days after submission) Notice of intent to suspend work (14 days after non-payment for Month 1) Work is suspended in the middle of Month 3 (instead of at beginning of Month 5) Payment due for Month 2 (14 days after Certificate) Suspension or Termination In Response to Non-Payment The FIDIC Red Book gives the Contractor the right to terminate the contract or suspend or reduce the rate of work in the event of non-payment. The choice of which path to take is a critical one. Generally, suspension of the work will be the preferred alternative, as it is the less drastic remedy. But, there may be cases when the non-payment provides an opportunity for the Contractor to escape from an unprofitable contract by terminating the contract. Reducing the Rate of Work In Response to Non-Payment FIDIC gives the Contractor the option of reducing the rate of work in response to non-payment. This must be considered as a first option. It shows the Employer that the Contractor is serious about taking action in response to the non-payment. While reducing the rate of work does cause the negative cash flow to continue (although at a reduced rate), suspending work also has financial consequences (de-mobilization and mobilization costs), assuming that the Contractor re-commences work, as usually will be the case. Slowing down the work as an initial response to non-payment, followed by a suspension and, ultimately, termination if necessary is a reasonable sequence of actions to take in response to non-payment. Notice The key to suspending or reducing the rate of work for non-payment is providing notice of the intent to reduce or suspend. FIDIC Clauses 69.1 and 69.4 require advance notice of the intent to reduce the rate of or suspend work. The purpose of this advance notice is to give the Employer an opportunity to cure the breach of contract by issuing payment to the Contractor. In the notice, the Contractor should advise that it reserves the right to reduce the rate of work, suspend the work or terminate the Contract, citing the relevant provisions of the Contract. Extreme care must be taken to ensure that the notice strictly conforms to the terms of the Contract, as the notice will be a key document in any subsequent litigation. Frequently, the notice works, and the Employer pays the Contractor. So, giving notice does not mean that the Contractor will need to suspend or terminate the Contract. It simply gives the Contractor that right. Legal advice should be obtained before suspending or reducing the rate of the work or terminating a Contract for non-payment. Different Non-Payment Scenarios “Non-payment” or “failure of payment” can mean many different things on a construction project. Non-payment scenarios include:
Each of these scenarios presents substantially different challenges. Non-Payment After Certification This is the purest form of non-payment and the strongest basis for suspending work or terminating the contract. Under this scenario, payment is certified but not made. Although this is rare, it does occur. This scenario presents the most serious and compelling case for the Contractor to suspend work, as it suggests that the Employer may be having severe financial difficulties. Reduced Payment After Certification The reduced payment scenario is far more common than pure non-payment. This scenario presents much greater risks for the Contractor that is considering suspending work. The basis for the reduced payment may be a legitimate difference of opinion as to the percentage of completion or the validity of some Employer backcharges. If the Contractor guesses wrong and suspends work for non-payment and if a court later finds that the reduction was justified, the suspension of work may justify the Employer in terminating the Contractor, which can have dire financial results. The reduced payment scenario, particularly late in the Project, may suggest that the Employer is attempting to generate a large pot of “disputed” money to leverage a favorable settlement with the Contractor after completion of the Project. Non-Payment of Change Orders The scenario of an Employer not processing and issuing payment for a substantial amount of change orders is common to the international Contractor. It will be a rare case when counsel will advise the Contractor to suspend work based on non-payment of disputed change orders. None of the standard forms of contract in use in South Asia give the Contractor the right to suspend work or terminate based on non-payment of change orders. Indeed, most standard forms of contract state that in the event of a dispute over whether an instruction from the Engineer is in fact a change order, the Contractor must perform the work and pursue a claim for the change order and may not suspend work. Refusing Further Change Order Work as an Alternative Strategy for Non-Payment of Change Orders A better option for the Contractor that is not being paid for a substantial amount of change orders is to refuse to perform any additional change order work until the Employer processes a significant portion of the outstanding change orders. This may constitute a breach of the contract by the Contractor. But, if the Employer was in breach of contract because it was obvious that a substantial number of the change orders being requested by the Contractor were valid, then a court could find that the Employer was in breach of contract, justifying the contractor is refusing to perform further change order work. While it must be conceded that a strategy of refusing to perform additional change order work is quite risky, it may give the contractor commercial leverage. The Employer has two choices: process the change orders or terminate the Contractor. The third option, hiring another Contractor to perform the change order work, will not be practical in most cases. For example, the Employer would never want to hire a separate contractor to perform change order work on an electrical or plumbing system, where a sole source of responsibility is critical. Termination also is not a very plausible option for the Employer. If the Employer wants to terminate the Contractor, the Employer faces the risk that a court will find the Contractor’s refusal to perform further change order work was justified and, therefore, the Employer committed a material breach of contract when it terminated the Contractor. Termination of the Contractor, justified or not, also will cause a substantial delay to the completion of the Project. So, the Employer faces tremendous pressure, in response to a refusal to perform additional change order work, to simply process at least a portion of the outstanding change orders. The international contractor with a long list of change orders to negotiate at the end of a project faces risks. The employer may try and obtain a steep discount on the change orders. The Contractor should consider refusing to perform additional change order work as a method of pressuring the Employer into processing and paying what should be undisputed change orders before the completion of the project. After the project is completed, the Contractor has lost all leverage. Disputed or “gray area” change orders can await completion of the project. Payments to Subcontractors It is common for subcontracts to provide that the Contractor will pay the Subcontractor within a certain number of days after the Contractor receives payment from the Employer. So, the impact of non-payment by the Employer to the Contractor is reduced, in theory, as the Contractor also is not required to issue payments to the Subcontractors. In reality, in developing countries, particularly in South Asia, the subcontractors are not financially strong, so the unpaid Contractor issues payment to the Subcontractors to keep them working. This negative cash flow situation makes it even more important for the unpaid Contractor to quickly use the available tools in the event of non-payment. The Importance of Being Able to Request Evidence of Financing A clause in the prime contract allowing the Contractor to request evidence of the Employer’s ability to finance the balance of the costs of the work provides an important alternative to the Contractor. Employers may reduce the amount of progress payments because the project is in financial difficulty. Being able to ask for evidence of the ability to finance the costs of the work and then being able to suspend work if such evidence is not provided provides a strong alternative basis for suspending work.
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