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Proposals for a subcontractor’s escape from a conditional clause

Proposals for a subcontractor’s escape from a conditional clause

July, 2015
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The common practice is that the main contractor will contractually delegate various elements of its works to specialist subcontractors. Such subcontractors may be sourced and chosen by the main contractor or may be specifically nominated by the employer. The UAE Civil Code1 at Article 8902 expressly provides for the right of the main contractor to subcontract, provided there are no contractual terms preventing this in the main contract. Therefore, main contractors are potentially exposed to making payments to their subcontractors when they have not themselves received the corresponding payments from the employer. Main contractors, therefore, often include conditional payment clauses in subcontracts so as to confer payment related risks onto the subcontractor.

Types of conditional clauses

Conditional clauses can be broadly divided into two categories, namely ‘pay when paid’ and ’pay if paid’ clauses.

Pay when paid clauses generally contain a condition such that payment by the main contractor to the subcontractor will be dependent upon payment being first received by the main contractor from the employer.

The main purpose of a pay when paid clause is to defer payment to a point in time that is determined by a specific event, namely payment by the employer to the contractor.

The occurrence of pay if paid clauses in the UAE is relatively uncommon. In general, whenever pay if paid clauses are included in subcontracts internationally, they may amount to specific wording that aims to clarify that a shift of the risk of non-payment has been agreed to. Instances of pay if paid clauses, identified in primarily US cases, can be particularly focused in clearly and aggressively reflecting the parties’ intentions.

As indicated above, the intention of pay if paid clauses depends on the eventuality rather than on deferring the timing of payment and to shift the risk of non-payment from the main contractor to the subcontractor.

UAE statutory law background to conditional payment structures in construction

UAE law provides a protective barrier for the employer and confirms, in the Muqawala section of the UAE Civil Code, Article 891 that no claim may be addressed by the subcontractor to the employer, save for instances of assignment.3

This being the position, one must ask, what consideration does the subcontractor enjoy in return for this unenviable shift in risk-taking that conditional clauses impose?

For conditional clauses to have a fair sense of purpose in a subcontract, the answer to that question must revolve around the following:

  • the main contractor is obliged to adopt the subcontractor’s claims for payment as if the claims were its own;
  • to the extent it considers the claims valid, the main contractor must then pursue them with the employer, again as if they were its own; and
  • any failure to do so, should prohibit the main contractor from relying on any conditional clause, thus rendering it directly accountable to the subcontractor.

In terms of legal authority, the concept of conditional payments seems to fall squarely within the ambit of Part 3, Section 1 of the UAE Civil Code, relating to ‘Dispositions conditional by suspension or deferment’,4  article 428 of which supports the view that if the performance of an obligation is subject to a condition, then efforts must be made for that condition to be observed.5

It is not relevant how much time has passed since payment to the subcontractor became due but rather what can be proven to have taken place during such time. This would appear to be a more dominant driver in determining the operation of a conditional clause under UAE law.

By contrast, if it can be shown that no demonstrable efforts (in the context of Article 428) have been made to observe the condition, then it would be arguable under UAE law that the main contractor can no longer rely on a conditional pay when paid clause and that to effectively avoid making payment to the subcontractor, it would have to resort to more substantive defences.

As will be seen below, recent UAE jurisprudence has indicated that, in the presence of a conditional clause, a claim against the main contractor based purely on a breach of the subcontract for non-payment, is likely to fail.

UAE jurisprudence

Whilst many disputes arising out of subcontracts will be referred to private and confidential arbitration, there have been a few instances where an arbitration clause was absent and litigation ensued.

From the cases readily reported, save one case in 1995, where a distinction was made by the Dubai Courts on whether a project had been completed or not6 before a conditional payment clause could be relied upon, most subsequent cases7 upheld the validity of a pay when paid clause and rejected the claims filed by the subcontractors on the basis of them being premature. In one such case,the application of conditional payment clauses in a subcontract was analysed as follows:

  • the contractor imposed a condition that payments to the subcontractor would be paid when such moneys from the employer were paid;
  • this is an obligation suspended until the conditional fact materialised; and
  • the subcontractor therefore did not have the right to claim the balance of its dues until the condition was met, that is, payment was received by the main contractor from the employer.

In all these cases, the subcontractor’s claims were made on the simple basis of a breach of contract for non-payment. They were not based on an argument that the true breach was that the main contractor had failed to fully pursue the subcontractor’s claims against the employer. Nor were they based on the employer having rejected such claims, thus containing the dispute strictly between the main contractor and the subcontractor. The subcontractor’s position was countered by a straightforward application of Article 420 of the UAE Civil Code,9 in that the condition precedent (of payment by the employer) had not yet occurred.

Alternative bases for the subcontractor to pursue its claims

In light of the above, and given the factors set out below, we explore the alternative bases upon which a subcontractor can successfully pursue its claims against the main contractor, including whether the timing of any actions it needs to take to achieve this:

  • pay if paid clauses are relatively rare in the UAE;
  • pay when paid clauses defer the timing of payment;
  • the UAE Civil Code acknowledges that some effort must be made for a condition to materialise; and
  • that the consideration that the subcontractor must enjoy is the main contractor’s obligation of pursuing the subcontractor’s claims.
Direct payment agreements with the employer

Although  the ability for subcontractors to successfully negotiate the terms of their subcontract are usually very limited, we have seen instances where nominated subcontractors managed to extract a direct payment obligation by the employer, at least for certified amounts, thus bypassing the main contractor.

This option is also envisaged by UAE law, in the Muqawala section of the Civil Code10 as a possible exception to be executed by way of assigning the obligation to pay the subcontractor from the contractor to the employer.

Two issues are of note in instances where direct payment mechanisms have been attempted in the UAE:

  • the standard obligation of the main contractor to effect payment to the subcontractor (on a pay when paid basis) is often not removed from either of the two subcontracts; and
  • court proceedings that are normally brought by the subcontractor against both the employer and the main contractor, have resulted in the court ordering the subcontractor to first proceed to arbitration under the subcontract against the main contractor and, if that were to fail or result in non-payment, then, and only then, could the subcontractor proceed in court against the employer under the direct payment agreement.

Direct payment agreements are seldom well coordinated with the contents of either the main contract or the subcontract and commonly serve as a tool for the employer to deflect liability for the subcontractor’s payments onto the main contractor and vice versa.

Lack of pursuit of subcontractor’s claims

A further option for the subcontractor is to argue that the true breach lies in the main contractor failing to pursue the subcontractor’s claims against the employer to the fullest extent permissible by law. The instances where the subcontractor could legitimately argue this include:

  • when the employer has rejected the subcontractor’s claim, the main contractor has not accepted such rejection but has failed to pursue the matter by way of a dispute resolution process or otherwise; or
  • when the employer has deferred payment to an indefinite point in time that can no longer be considered as reasonable and the main contractor again fails to pursue the matter whether by way of a dispute resolution process or otherwise.

Article 428 of the UAE Civil Code sets out the degree to which fulfilment of the condition must be pursued. This lends itself to an argument that a main contractor’s failure to pursue the subcontractor’s claims, could effectively amount to a failure to observe the condition (of payment by the employer) to the maximum degree possible.

One must be mindful of the fact that main contractors would commonly be reluctant to start a dispute resolution process against an employer, purely in order to pursue their subcontractors’ claims. In demonstrating such reluctance, the main contractor may argue:

  • that at the stage the subcontractor’s action commenced, it would be unreasonable for it (the main contractor) to have commenced legal proceedings; or
  • that this may be supported by reference to various commercial or contractual considerations.

Whichever option the main contractor adopts, it is likely that if pursuit of the subcontractor’s claim is to be argued as a condition precedent for any conditional clause to be relied upon, then such condition could be easily satisfied in most instances, save for the case of the main contractor formally commencing legal proceedings against the employer.

Employer’s outright rejection of a subcontractor’s claim

As indicated above, instances of an outright rejection by the employer of a main contractor’s claim that includes or relates to the subcontractor’s works, would convert the question of when payment would be made to a definite non-payment.

In terms of how this can be accommodated within the confines of UAE law, Articles 420 to 428 of the UAE Civil Code, deal with ‘Dispositions conditional by suspension or deferment’, essentially relating to conditional clauses.

The main contractor’s options in instances of outright rejection by the employer would be either to:

  • challenge the merits of the subcontractor’s entitlement (rather than simply its timing) and adopt arguments raised by the employer/engineer;
  • challenge the merits of the subcontractor’s entitlement (rather than simply its timing) and produce its own arguments for doing so; or
  • challenge the employer’s rejection, pursuing claims that would include those of the subcontractor.

Which option the main contractor adopts can be of critical relevance to the application of either a pay when paid clause or a pay if paid clause.

Pay when paid clauses are based on a presumption that payment would eventually be made. They would therefore become inapplicable if the employer refused to pay, for the simple reason that for the main contractor to rely on them, it would have to unilaterally convert the condition of ‘when’ to a condition of ‘if/whether’.

SEQUENCE TIMING S/C’s REQUEST/DEMAND BASIS
A. When invoices become overdue. Payment of its outstanding invoices/dues Contractual.
B. When negative reply is received from main contractor (MC) on first request. Evidence of inclusion of its work in monthly invoices to Employer (E). Contractual/correspondence based.
C. Once evidence of inclusion in monthly invoices/final statement of accounts has been provided. Evidence of rejection of payment by E. Contractual/correspondence based.
D. Pay When Paid (PWP): Once confirmation of E’s rejection and MC’s agreement to this is obtained. Payment of dues by MC. Legal: impossibility of condition, Art. 423 of Civil Code.
E. Pay If Paid (PIP)/PWP: Whether or not E has rejected payment & whether or not MC has contested any rejection by E. Evidence of pursuit of payment. Legal: lack of pursuit, Art. 420 and 428 of Civil Code.
F. Once the scope of Subcontractor’s (SC) work has been completed. Evidence of pursuit of payment. Legal: lack of pursuit, Art. 420 and 428 of Civil Code.
G. Again when the project has been handed over. Evidence of pursuit of payment. Legal: lack of pursuit, Art. 420 and 428 of Civil Code.
H. Again when the defects liability period has expired. Evidence of pursuit of payment. Legal: lack of pursuit, Art. 420 and 428 of Civil Code.
I. When negative reply is received from MC on the above request. Evidence of a legal notice issued for amounts inclusive of the subcontractor’s dues. Legal: Lack of pursuit, Art. 420, 428 of Civil Code.
J. When the deadline of a legal notice expires. Evidence of legal proceedings having been commenced. Legal: Lack of pursuit, Article 420, 428 of Civil Code.
Timing as a key factor to a subcontractor’s strategy

When being faced with a conditional payment clause, the subcontractor’s main strategy in pursuing its claims against the main contractor is one of timing. Therefore, a subcontractor that is deprived of its dues should sequence its approach to a conditional payment clause by documenting its requests as follows:

Once the main contractor is forced to file a legal action against the employer, the subcontractor’s claims against the main contractor are effectively carried over onto an action against the employer. Whilst the subcontractor can have little control over such proceedings (unless the main contractor encourages him to assist), the conditional clause will have been given the purpose and substance that the parties intended.

On the assumption that an award or judgment is eventually issued and despite the main contractor’s perceived best efforts, the subcontractor’s claims (or any part thereof) are not awarded, the question arises whether this would be the end of the road for the subcontractor. The answer to this question would depend a lot more on what the reason is behind the employer’s exoneration, rather than on whether the subcontract contained a pay if paid or a pay when paid clause.

Conclusion

In the presence of a conditional clause, it is generally accepted that it is unwise for the subcontractor to commence legal proceedings against the main contractor on the simple basis of a debt collection exercise as it is unlikely to succeed.

Ironically, the more unopposed (by the main contractor) a subcontractor’s claim is, the more difficult it is to control the payment process and the more hindered it is by a conditional clause. Conversely, any direct challenge to its claims by the main contractor may block the triggering of a conditional clause, thus making the dispute resolution process an affair that is confined solely between the main contractor and the subcontractor.

Finally, the question of whether a subcontractor can pursue its claims against the main contractor, even after the employer has been exonerated of any liability, will depend more on the reasons behind this, rather than on the nature of the conditional clause.

1 Federal Law No. 1/1987

2 An English translation of which states: (1) A contractor may entrust the performance of the whole or part of the work to another contractor unless he is prevented from so doing by a condition of the contract, or unless the nature of the work requires that he do it in person. (2) The first contractor shall remain liable as towards the employer.

3An English translation states that: ‘Article 891: A sub-contractor shall have no claim against the employer for anything due to him from the first contractor unless he has made an assignment to him against the employer.’

4Articles 420 to 428 of the Civil Code.

5An English translation states: ‘Article 428: A Condition must be observed as far as is possible.’

6Dubai Court of Cassation Case No. 281 of 1995: the distinction related to an obligation by the main contractor to pay the subcontractor, despite a conditional clause, if the project has been completed.

7Dubai Court of Cassation Case No. 267 of 2007, Dubai Court of Cassation Case No. 83 of 2009

8Dubai Court of Cassation Case No. 240 of 2006

9An English translation of which provides that: Article 420: A Condition is a future matter upon the existence or absence of which the full effectiveness (of a disposition) depends.

10Article 891, as previously mentioned.

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Published: June 2015
Publication: Construction Law International – IBA
Title: Proposals for a subcontractor’s escape from a conditional clause
Practice: Construction
Authors: Antonios Dimitracopoulos

 

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