Direct payments to subcontractors: a guide for employers
A recent case from Hong Kong highlights the risks involved in making direct payments to subcontractors. The law in this area is complex and employers who make such payments without careful advice may end up paying twice over. This Law-Now considers a recent example of direct payments being unwound and provides an overview of the options available to employers who find themselves wishing to make such payments.
Paying subcontractors directly
Employers can sometimes find themselves wishing to make direct payments to subcontractors engaged by their contractor. This might be the case if a payment dispute arises at subcontract level or if the contractor suffers cashflow difficulties. Subcontractors may threaten to terminate or suspend work in such circumstances and the employer may feel that direct payments are necessary to keep the project afloat.
Where direct payments of this nature are not agreed to by the contractor, a number of difficult legal issues can arise when an employer seeks to recover these payments from the contractor. For a closer look at some of these issues, please see our earlier Law-Now here.
Where direct payments have been agreed to by the contractor, whether on an ad-hoc basis or as part of the original contract terms agreed with the employer, complications can arise where the contractor subsequently enters an insolvency process. This Law-Now considers a recent example from Hong Kong before considering the position under English law.
Hsin Chong Construction (Asia) Ltd (in liq) v Wong Po Kee Ltd
Hsin Chong Construction (“HCC”) agreed to carry out certain works for Capital Court Ltd (“CCL”). Subsequently, a supplementary agreement was executed permitting CCL to make direct payments to certain of HCC’s subcontractors, on the basis that such payments would be “deemed to have been paid via [HCC]” and that HCC waived “any claims against [CCL] that [HCC] has not received any amount in connection with the payments to the … Sub-Contractors”. Notably, the subcontractors were not parties to this agreement and were only notified of the arrangement by letters from HCC.
CCL made a number of payments under this arrangement after HCC was placed into liquidation. HCC’s liquidators demanded the return of these sums, arguing that such payments were void under Hong Kong insolvency law.
The Hong Kong High Court held that the subcontractors were required to return the money to the liquidators, despite being paid directly by CCL. This was on the basis that:
- HCC’s right to receive payments from CCL was not varied by the supplementary agreement.
- The subcontractors were not parties to the supplementary agreement and the payments they received were to be regarded as coming directly from HCC, which under Hong Kong insolvency law, could not be permitted post-liquidation.
The Court contrasted the case with one where a tri-partite agreement had been reached between an employer, contractor and subcontractors resulting in the contractor giving up rights to payment in return for the employer agreeing to pay the subcontractors directly – effectively “cutting out” the contractor from the payment chain (Golden Sand Marble Factory Ltd v Easy Success Enterprises Ltd). This was permissible as the agreement was reached prior to the contractor’s liquidation and payments made after the liquidation did not involve any dealings with the contractor’s rights or property.
The English position
In the UK, the only authority that has dealt with a similar question is from the early 20th century. In Re Wilkinson, a clause in a construction contract provided: “If the engineer shall have reasonable cause to believe that the contractor is unduly delaying proper payment to [certain sub-contractors], he shall have power if he thinks fit to order direct payment to them.” The contractor was declared bankrupt, which prompted the engineer to make an order for direct payment by the employer under this clause (i.e. after bankruptcy). The order and the subsequent payment were upheld on the basis that the clause was an irrevocable authority from the contractor to re-direct payments which would otherwise be made to it.
The decision in Re Wilkinson would require reconsideration today in light of modern insolvency law and the pari passu principle. The decision has been heavily criticised in academic writings, and was rejected in a recent Northern Irish case: Re McLaughlin v Harvey Plc (in liq).
The position under English law is therefore uncertain, but may well prove to be similar to that reached by the Hong Kong court in this case.
Ways to manage subcontractor payments
Employers seeking to safeguard their interests when direct payments to subcontractors are necessary should consider the following mechanisms.
Tri-partite methods
As in the Golden Sand case noted above, this model involves establishing a direct payment relationship between the employer and subcontractor and effectively cuts the contractor out of the payment chain. Such an agreement may be difficult to achieve, however, when considering the competing interests and priorities of all three parties.
Bespoke amendments
Various amendments to standard contractual provisions can be made to better protect an employer's ability to make direct payments to subcontractors. For example, clearly drafted clauses that permit the employer to cut out the contractor and establish a direct payment relationship with a subcontractor where there is reasonable evidence of non-payment.
Sub-contractor assignments
The employer may take an assignment of a subcontractor’s entitlement to payment by the contractor in exchange for making direct payment to the subcontractor. The employer may then seek to enforce the subcontractor’s assigned claim against the contractor, such as by setting-off the claim against amounts due under the main contract.
Such an approach is not without difficulties, however. The main contractor is likely to put the employer to proof as to the assigned claim and the employer will usually know very little about any disputed claims at subcontract level. It may, therefore, struggle to prove that the contractor was liable to pay such sums to the subcontractor. The employer might protect against this risk by obtaining the subcontractor’s agreement to lend such assistance as may be required in the enforcement of the assigned claims against the contractor. However, the subcontractor may be unwilling to provide such assistance or may not do so in a sufficiently timely or fulsome way.
Breach of contract and restitutionary claims
Absent any of the above methods, employers who feel compelled to make direct payments to subcontractors may seek to recover those payments from the contractor by alleging a breach of contract. Construction contracts often include clauses requiring contractors to properly manage their supply chain and to ensure that payments are made to subcontractors when due. Alternatively, employers may potentially have rights to claim in restitution on the basis that payments made directly to subcontractors have conferred a benefit on the contractor (i.e. by satisfying the contractor’s payment obligations).
Such issues are not straightforward and the law in this area is far from certain. If employers are unable to recover direct payments by these means, they risk being required to make payment a second time to the contractor. For a real life example of such a scenario, please see our previous Law-Now here.
Conclusions and implications
The making of direct payments to subcontractors can be a helpful tool for employers to manage supply-chain issues and ensure the timely completion of a project. Various methods exist to ensure that direct payments can be made, and recovered, by employers. However, careful advice is needed to sure that an employer does not end up paying twice, once to subcontractors and again to its contractor.
References:
Wilkinson Ex parte Fowler [1905] 2 K.B. 713
Re McLaughlin & Harvey Plc (In Liquidation) [1996] 86 BLR 1
Golden Sand Marble Factory Ltd v Easy Success Enterprises Ltd [1999] 2 HKC 356
Joint and Several Liquidators of Hsin Chong Construction (Asia) Ltd v Wong Po Kee Ltd [2025] HKCFI 1020
