Overcoming Direct Payment Arrangements

by Chan Kheng Hoe, Head of Construction Law, Chong + Kheng Hoe

Direct payment arrangements have been plaguing main contractors for the longest time. The Employer who has no contractual relationship with the subcontractor nevertheless insists on making direct payments. This results in: (a) the subcontractor getting full payment for its works; (b) the main contractor losing the ability to supervise the subcontractor effectively; and (c) the main contractor losing the ability to penalize the subcontractor by way of delay damages, backcharges or set-off costs for late or defective works.

In Bond M&E (KL) Sdn Bhd v Isyoda (M) Sdn Bhd (Brampton Holdings Sdn Bhd, third party) [2017] MLJU 376, there was an agreement between the employer (Brampton) and the main contractor (Isyoda) that the employer would pay the subcontractor (Bond) directly. Such direct payment arrangement was captured in both a Supplemental Agreement as well as a Settlement Agreement between Isyoda and Brampton. When Bond was not paid its dues, it sued Isyoda being the main contractor. Isyoda tried to avoid liability by relying on the Supplemental and Settlement Agreements. However, Lee Swee Seng J (now JCA) held that as Bond was not a contracting party to the Supplemental and Settlement Agreements, it could not sue on the same. Such being the case, Bond would still have to look to Isyoda for its payments.

The Bond case was a reiteration of an earlier decision by Mary Lim J (now FCJ) in Sigma Elevator (M) Sdn Bhd v Isyoda (M) Sdn Bhd & Anor [2016] 10 MLJ 635. Sigma stated clearly that the existence of a Settlement Agreement would not absolve the obligation of the main contractor to pay the subcontractor for works done. This was by reason of the doctrine of privity of contracts, whereby only a party to a contract may sue or be sued unless a tripartite agreement had been entered into between the Employer, Main Contractor and Subcontractor to transfer the payment obligation from the Main Contractor to the Employer.

The law would seem reasonably settled until we come to the case of Hong Xin Construction Sdn Bhd v Tewara Sdn Bhd [2020] MLJU 552. In this case, the Main Contractor (Hong Xin) received a Payment Claim under the Construction Industry Payment and Adjudication Act 2012 (CIPAA 2012) from its subcontractor (Tewara). Instead of resisting the CIPAA 2012 claim, Hong Xin decided to file suit for a declaration that it was not a “non-paying party” under CIPAA 2012. The reason for such a declaration was because: (a) the main contract between the Employer (Adawan Development Sdn Bhd or Adawan) and Hong Xin expressly provided that Adawan would pay Tewara directly; (b) the subcontract between Hong Xin and Tewara also stipulated that Adawan would pay Tewara directly.

Tewara resisted the action by stating that the direct payment clause only relates to a “mode of payment” and that Clause 26.5 of the PAM Sub-Contract form stated that “any direct payment… shall not create a privity of contract between the Employer and Sub Contractor”.

However, Hong Xin countered that by Clause 6 of the PAM Sub-Contract form, the Letter of Appointment takes precedence over the conditions of contract in the PAM Sub-Contract form, and therefore the direct payment clause in the Letter of Appointment should prevail. Furthermore, Tewara had agreed to accept payment from a third party (i.e. Adawan) and should be estopped from insisting on payment from Hong Xin.

See Mee Chun J (now JCA) agreed that the matter was an issue of contractual interpretation. Since the express terms of the subcontract provided for Adawan to make direct payments and such a term was agreed by Tewara, then Tewara ought not be allowed to resile from it. Hong Xin’s application for a declaration was duly allowed.

Hence, even though Hong Xin did not dispute the CIPAA 2012 claim, the Adjudication Decision favouring Tewara could not be enforced seeing that there was a declaration to the effect that Hong Xin was not a non-paying party.

The learned Wong Kian Kheong J disagreed with See Mee Chun J (now JCA) in Otis Elevator Company (M) Sdn Bhd v Casmet Sdn Bhd [2020] MLJU 2306. In his Lordship’s view:

“The fact that the contract between X and Y stipulates that a stranger (Z) shall pay X for the contract, does not mean that X cannot sue Y for breach of the contract when Z fails to pay X (Z’s Failure). This is because in the event of Z’s Failure, there is nevertheless a breach of contract by Y (for not ensuring Z’s payment to X) and consequently X has a statutory remedy to sue Y for Z’s Failure (breach of contract) under s 74(1) CA. Section 74(1) CA provides as follows –

“Compensation for loss or damage caused by breach of contract
74(1) When a contract has been broken, the party who suffers by the breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from the breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it.”

His Lordship goes on to say that upon the breach by the employer to pay, Casmet therefore was obliged to make payment and in such a circumstance, Casmet becomes a “non-paying party” under CIPAA 2012.

With respect, a liability to pay arising from s 74(1) of the Contracts Act 1950 may nevertheless not be the same as a liability as a “non-paying party” under CIPAA 2012. Clearly a claim under s 74(1) Contracts Act 1950 is a claim for damages for breach of contract, whilst a claim under CIPAA 2012 is a statutory claim arising from a payment dispute under the express terms of a written construction contract. This distinction did not appear to have been brought to his Lordship for consideration.

In any case, Tewara appealed to the Court of Appeal which heard the appeal on 8.11.2021. Tewara on appeal relied heavily on Casmet and the arguments raised in Casmet. In response, Hong Xin submitted that: (a) there was in fact differences in the way the Tewara subcontract and the Casmet subcontract were drafted; and (b) as CIPAA 2012 provides for an expedited procedure of temporary finality, one should give due regard to the express words of the written construction contract.

The Court of Appeal agreed unanimously with Hong Xin and dismissed the appeal.

In conclusion, when an employer insists on making direct payments, the main contractor should in the best case scenario, enter into a tri-partite agreement between the Employer, Main Contractor and Sub-Contractor clearly stipulating that payment obligation lies with the Employer. Having direct payment clauses within the subcontract may nevertheless be unsafe, as evidenced by the contradictory decisions of Hong Xin and Casmet.

At the start of the contract, it is likely that the subcontractor would agree to sign a tri-partite direct payment arrangement. Similarly, an employer who insists on such a practice surely has no legitimate ground to refuse to sign.