Hybrid contracts - Should payment notices distinguish between sums due for construction operations and non-construction operations?

Hybrid contracts are one of the more unusual creatures arising from the Housing Grants, Construction and Regeneration Act 1996. They are contracts that include both “construction operations” (as defined in the Act) and works which are excluded from the operation of the Act. They have given rise to a number of cases considering how the statutory right to adjudicate applies to such contracts. Lord Justice Coulson referred to this as a “self-inflicted problem” which the courts must do their best to resolve until the Act is amended to do away with these “unnecessary distinctions”.

In the recent decision of C Spencer Limited v M W High Tech Projects UK Limited, the Court of Appeal considered hybrid contracts again in the context of the payment provisions in the Act.

Background

MW High Tech Projects UK Limited was the main contractor appointed for the design and construction of a power plant capable of processing refuse-derived fuel produced by waste. C Spencer Limited was engaged as MW’s sub-contractor to design and build the civil, structural and architectural works for the facility. The sub-contract price was over £35 million.

The sub-contract was substantially comprised of works falling within the definition of “construction operations” for the purposes of the Act. However, the works also included the assembly of plant and erection of steel to provide support or access to plant and machinery. Such works are expressly excluded from the definition of “construction operations” in the Act.

The sub-contract provided for milestone payments and included an Act compliant payment mechanism that did not distinguish between “construction operations” and “non-construction operations”.

A dispute arose in relation to a payment application submitted by C Spencer. This payment application made a distinction between construction and non-construction operations. It allocated approximately £2.6 million plus VAT to construction operations and provided a breakdown of that figure. However, MW issued a payment notice which stated that C Spencer actually owed MW approximately £6.8 million excluding VAT. MW’s payment notice (in line with previous payment notices) did not distinguish between construction and non-construction operations.

C Spencer argued that this was not a valid payment notice and therefore the sum they had applied for was due by default. The key point to this argument was that the payment notice was not valid because it did not distinguish between construction and non-construction operations. C Spencer commenced Part 8 proceedings seeking payment of approximately £2.6 million on this basis.

The Court’s decision

The issue for the Court was therefore whether a payment notice under a hybrid contract had to distinguish between “construction operations” and non-construction operations in order to be valid?

The Court of Appeal agreed with the TCC that this was not the case and so dismissed C Spencer’s claim on the basis that:

There was nothing in the sub-contract which required the parties to differentiate between construction and non-construction operations in their payment or payless notices.
Analysis must start with the contract terms in order to see if they comply with the Act. The Act envisages that the parties will contract on terms agreed between them. If those terms comply with the Act, the Act is no longer of relevance to the parties. The Act envisaged hybrid contracts but did not go on to say that hybrid contracts should require separate or distinct notification of sums due for construction operations. It could have done so. The contract therefore complied with the Act.
Parties are free to agree a payment mechanism for their contract that sits alongside the statutory provisions. In other words, they can “contract in” to the Scheme for Construction Contracts (which operates under the Act), but they cannot “contract out” of the Act for construction operations. In practice, this is commonly adopted in sub-contracts which include both construction and non-construction operations in certain industries. Lord Justice Coulson went on to say “that approach is not only permissible, it is to be welcomed”. It provides certainty and transparency and avoids the complications that having two separate payment regimes would bring.

The Court of Appeal also found that the importance of the distinction between construction and non-construction operations under a hybrid contract only arises if there is a dispute over the sum due. Unless it is extended by agreement between the parties (which it had not been in this case), an adjudicator will only have jurisdiction to deal with disputes relating to construction operations under the construction contract.

What does this mean for hybrid contracts?

It is likely that parties will continue to use one payment mechanism for hybrid contracts. This means the payment provisions needs to be compliant with the Act, otherwise the Act will imply the relevant provisions from the Scheme for Construction Contracts to replace any non-compliant terms in the payment mechanism for the construction operations only. This would result in two payments mechanisms in the contract.

The Act does not require payment applications or notices to distinguish between construction and non-construction operations.

The Act will only imply a right to adjudicate into the contract in respect of the construction operations. A party will therefore only be able to bring an adjudication claim in respect of the non-construction operations if there is a contractual right to do so. If not, any adjudication that does not clearly confine itself to the construction operations could be subject to a jurisdictional challenge. In such circumstances, the claiming party will have to make sure that the application subject to the adjudication claim clearly differentiates the sums applied for in respect of construction operations. Otherwise, it will be difficult to establish that there is a dispute in relation to the sums claimed for those specific items of work and that the adjudication claim only relates to sums due in respect of construction operations.

This article was written by Associate Katherine Keenan. For more information, please contact Katherine on +44 (0)20 7427 6512 or at katherine.keenan@crsblaw.com.