Hybrid contracts – are hybrid payment notices valid?

The Court of Appeal has confirmed that hybrid payment notices are valid under the Housing Grants, Construction and Regeneration Act 1996 (“the Act”).

Background

The Act sets out a mandatory payment regime applicable to contracts for “construction operations” as defined by Section 105 of the Act. There are a number of exclusions from the definition of “construction operations” within the Act, meaning in practice that “hybrid contracts” can be created – i.e. contracts concerning both construction operations (covered by the Act) and non-construction operations (not covered by the Act).

These hybrid contracts can give rise to a number of legal problems. The Spencer case raised one such problem that had not previously been decided by the courts: whether, in the case of a hybrid contract, a valid payment notice must identify separately the sum due in respect of construction operations and non-construction operations.

The Court of Appeal confirmed in this case that a payment notice does not need to separately identify sums due for construction and non-construction operations to be valid under the Act.

The facts

By way of sub-contract dated 20 November 2015, CSL was engaged by MW in relation to the design and construction of a power plant. The sub-contract was a ‘hybrid’ in that it included both construction and non-construction operations for the purposes of the Act (the non-construction operations were the assembly of plant and erection of steelwork to provide support and access to plant and machinery. Such operations are excluded from the Act under s.105(2)(c).

CSL issued payment application no.32 in the sum of circa £3.3 million, which detailed that circa £2.6 million was due in respect of construction operations, the balance being non-construction operations. MW issued a payment notice indicating a negative sum due to CSL, but its attached breakdown did not differentiate between construction and non-construction operations (in line with all previous payment notices).

CSL commenced Part 8 proceedings seeking payment of £2.6 million on the basis that MW’s payment notice was invalid for its failure to identify the sum due in respect of construction operations and the basis of that calculation.

First instance

At first instance, O’Farrell J disagreed with CSL and found that the payment notice was valid. Although the Act sets out that statutory payment requirements under the Act would only apply to construction operations, there was no express provision stating that a payment notice must separate out the sums relating to construction operations. In addition, the express payment requirements of the sub-contract mirrored the Act and applied to both the construction and non-construction operations. As such, both were subject to the same payment requirements, and there was no requirement for the payment notice to differentiate between construction and non-construction operations.

CSL appealed.

Appeal

The central issue of the appeal concerned the words in s.104(5) of the Act:

“Where an agreement relates to construction operations and other matters, this Part applies to it only so far as it relates to construction operations” [emphasis added].

CSL argued that the underlined words had to be read into every section of the Act concerned with payment, and therefore the “notified sum” in a payment notice had to be in respect of construction operations, and separated out.

MW disputed this interpretation, stating that it would result in confusion, complexity and additional cost.

The Court of Appeal agreed with MW, stating that:

(a) The starting point was the sub-contract. It is permissible (indeed welcomed) for parties to agree payment terms that comply with the Act in respect of both construction and non-construction operations. There was nothing in the sub-contract requiring a separated payment notice.

(b) There is nothing in the Act that requires the payment notice to be separated out between construction and non-construction operations. The sub-contract was therefore compliant with the Act.

(c) There was no requirement to “read in” the words from s.104(5) to all later sections of the Act. The Act itself created the concept of hybrid contracts, and therefore must be taken to have them in mind in all subsequent provisions.

(d) In contrast to the payment provisions, the sub-contract did contain an adjudication provision stating that adjudication only applied in respect of construction operations. The payment provisions could have included the same limitation, but did not, indicating that the parties were content for the provisions to apply to both construction and non-construction operations.

(e) Practically, requiring parties to hybrid contracts to deal separately with construction and non-construction operations would create additional layers of complexity and cost, and would be a change to the way the industry currently deals with such contracts.

Practical considerations

This decision should be welcomed by the industry as a practical, common-sense solution to a difficult and previously unanswered legal question.

However, parties must keep in mind that although hybrid payment notices are permissible, it may not be possible to adjudicate on them successfully under the Act. Adjudication under the Act is only available in respect of construction operations, and so if a payment application or payment notice does not split out the sums due in respect of each, the adjudicator is unlikely to have jurisdiction to determine the dispute (as was the case in an earlier payment dispute between the parties to this case). It may therefore be sensible for parties to keep their own records of which costs relate to construction vs non-construction operations under the Act, for the purposes of any possible adjudications.

Read others items in Construction and Engineering Brief - March 2020