Construction Act strikes again – take care to avoid introducing pay when paid provisions through Escrow Agreements

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

Escrow agreements are commonly used to give a building contractor comfort that it will be paid for its work should its employer run into financial difficulty. Under a typical escrow arrangement, an escrow agent (typically a bank, solicitors’ practice or accountancy firm) will hold a certain sum of money received from the employer. This is then released to the contractor under specified circumstances – for example, the employer failing to pay an interim payment under the building contract where the contractor’s entitlement to that amount is not disputed.

The judgment in the recent case of JB Leadbitter & Co Ltd v Hygrove Holdings Ltd [2012] EWHC 1941 serves as a reminder that escrow agreements can potentially contravene the requirements of the amended Housing Grants, Construction and Regeneration Act 1996 governing construction contracts, most notably Section 113 which renders “pay when paid” clauses unlawful.

An example of a pay when paid clause would be a condition in a construction contract that the contractor will not be paid unless and until the employer has been placed in appropriate funds from a third party.

In the Leadbitter case, an escrow agreement (called a “supplemental agreement”) was entered into by three parties. Two of these were Leadbitter and Hygrove – respectively contractor and employer under a related building contract. Coastal Housing Group Ltd, which had entered into an upstream agreement with Hygrove, was the other party to the supplemental agreement. By virtue of the agreement, Hygrove would be paid a profit share by Coastal for completing a residential development near Swansea. Leadbitter would then be paid by Hygrove through the same account from this profit share. A firm of solicitors acted as the escrow agent.

The supplemental agreement purported to vary the Leadbitter building contract to include an undertaking by the escrow agent that it would reduce payments due to the contractor proportionately should the escrow account not be in sufficient funds to pay in full. Leadbitter had made two applications for payment (Certificates 10 and 11) totalling £196,267. Hygrove failed to serve a withholding notice in respect of either payment application. Under the Act, this meant that the full amount was due and payable. Hygrove also admitted that the escrow agent had erroneously retained more monies from Leadbitter against payment applications than it should have done.

Hygrove did not deny in court that the sums claimed had become due and payable on their final dates for payment. Instead, in its defence, it pleaded the following:

• that it was owed more money by Coastal than the latter had paid into the escrow account but having not received sufficient funds it could not be liable for failing to pay Leadbitter the full amount; and/or
• Hygrove could not be expected to be liable for errors made by the escrow agent.

In light of Midland Expressway Ltd v Carillion Construction Ltd and others (No. 2) [2005] EWHC 2963, HHJ Havelock-Allan QC in the TCC held that the provisions of the supplemental agreement were ineffective in delaying payment by virtue of the fact that pay when paid provisions contravened Section 113 of the Act. Leadbitter was therefore entitled to the full amount claimed for Certificates 10 and 11.

While the supplemental agreement breached Section 113, it’s important to emphasise that the judge did not hold that it constituted a “construction contract” under Section 104 of the Act. In fact, Section 113 only became relevant because clause 1.1 of the supplemental agreement stated that the supplemental agreement must be treated as if it were part of both the Leadbitter building contract and the Coastal-Hygrove agreement. These were clearly construction contracts and hence caught by the Act. Neither party disputed that Section 113 applied to the Supplemental Agreement.

While HHJ Havelock-AllenQC’s decision may come as little surprise, there are a couple of useful lessons to learn. Firstly, parties and their advisors should ensure that any escrow agreement which varies a construction contract – as the supplemental agreement sought to here – does not, in doing so, cause the construction contract to breach the payment provisions of the amended Act. Secondly, escrow agents need to be vigilant in operating payment mechanisms to ensure that the provisions of the Act are complied with.

It’s important to remember that the Supplemental Agreement in question was a less than typical escrow arrangement. Most escrow agreements in the UK construction industry serve as payment guarantees, i.e. they only pay out when the employer is in breach of its payment obligations under the relevant construction contract (which should be compliant with Section 113). They are thus less likely to have drafting which breaches Section 113. This one, on the other hand, served as the primary means of payment to both Hygrove and to Leadbitter and that made the Section particularly pertinent.