SOUTH AFRICA: THE RISKS OF PAYING CONSTRUCTION SUBCONTRACTORS DIRECTLY

By Daryn Byron,Stephanie McDonald,Lize-Meré Ludick Wednesday, September 21, 2022
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Some construction contracts do not provide an employer with the right to pay a subcontractor directly where the main contractor fails to do so. This gives rise to the question as to whether an employer is nevertheless entitled to make such a payment, and what the consequences of doing so might be.

The short answer, under South African law, is that unless the contract expressly provides for such a right, an employer is not entitled to pay a main contractor’s subcontractors. This is due to the well-established legal principle of privity of contract, which provides that an agreement cannot confer rights on a person who is not a party to such agreement, unless there is a stipulatio alteri, being a contract for the benefit of a third party. It is also, some would argue, a consequence of the contracting structure adopted by the employer, because the main contractor is carrying responsibility for the performance of its subcontractors; direct participation by the employer in those downstream arrangements might interfere with this overall risk allocation.

Despite this, employers do encounter situations where making direct payments to subcontractors becomes necessary, particularly where the main contractor is failing to perform its duties, and the employer wishes to ensure that subcontractors complete their work. The upshot of an employer making a direct payment to a subcontractor without an express entitlement to do so, is that the employer runs the risk of non-recovery of this payment from the main contractor. The employer may be regarded as having made this payment on a voluntary basis, with no right to deduct or claim the amount paid from the main contractor.

Although case law on this topic is limited, it is worth noting the issues that were considered in the English case of Nobiskrug GmbH v Valla Yachts Ltd [2019] EWHC 1219 (Comm). Certain subcontractors submitted claims for additional costs to the main contractor, who rejected the claims and denied any responsibility for payment. The employer elected to pay the amounts directly to the subcontractors (even though this right did not exist in the employer’s contract with the main contractor), because of concerns that non-payment would lead to suspension of works. In doing so, the employer expressly reserved its right to recover the payments from the main contractor. The arbitration tribunal ordered the main contractor to reimburse some of these payments but on grounds that were not sufficiently clear from the award.

On appeal, the court referred the issues back to the tribunal for further consideration; in particular:

  • the fact that the tribunal concluded that the employer would not be entitled to recover payments made to subcontractors on a purely voluntary basis unless it could establish that the main contractor was obliged to make those payments under the applicable subcontracts; and yet the tribunal made no findings on the main contractor’s liability to make such payments; and
  • the grounds for a finding that the main contractor was unjustly enriched at the employer’s expense.

What is clear is that the court, perhaps unsurprisingly, concluded that a mere reservation of rights by the employer is insufficient, on its own, to secure reimbursement of the amounts paid directly to subcontractors.

Question marks remain over what an employer would need to establish in order to recover such amounts, but insofar as this case is concerned, the argument for unjust enrichment seemed to hold some weight, particularly as the court felt a restitutionary claim had “considerable force”.

Notwithstanding the risks, an employer may still be tempted to pay a subcontractor where a defaulting or cash-strapped main contractor fails to do so, to alleviate the pressure on the supply chain. That decision becomes further complicated in cases where the main contractor becomes insolvent. An employer in this situation will have to make a commercial decision as to whether it is worth paying a subcontractor directly, in order to ensure the continuity of the project, but at the risk of paying twice for the same subcontracted work.

There are mechanisms available to avoid or reduce these risks if an employer plans for such direct payments in advance. For example, the UK construction market has in recent years introduced project bank accounts as a means of ensuring greater control over payments to subcontractors. Here, an employer makes payments into a project-specific bank account, and these payments are apportioned and released directly to the main contractor and subcontractors, as and when payments are due. This approach creates transparency in the payments process and reduces the risk of the main contractor being a blockage for the flow of funds to subcontractors. Project bank accounts have not gained traction in the South African market as yet, but the benefits are clear and perhaps South African construction industry players need to look more closely at what type of structure or mechanism would work for projects within the context of South African law and market practice.