Are Conditional Payment Clauses In Construction Contracts Valid?

A.    Introduction

Conditional payment clauses stipulate the obligation of one party (X) to pay another party (Y) to be contingent upon X receiving payment from a 3rd party (Z). These clauses are also commonly known as "pay-when-paid" "pay-if-paid" or "back-to-back" clauses.

B.    Section 35 CIPAA

Section 35 of the Construction Industry Payment and Adjudication Act 2012 (CIPAA) provides that: -

1. Any conditional payment provision in a construction contract in relation to payment under the construction contract is void.

2. For the purposes of this section, it is a conditional payment provision when-
   

3. the obligation of one party to make payment is conditional upon that party having received payment from a third party; or

4. the obligation of one party to make payment is conditional upon the availability of funds or drawdown of financing facilities of that party.

In brief, conditional payment clauses are void under Section 35 CIPAA, which effectively removes the right of parties to regulate their payment regime using these provisions. Examining the legislative history before the enactment of CIPAA, it is intended from Clause 35 of the Explanatory Statement to the Construction Industry Payment and Adjudication Bill 2011 for Section 35 CIPAA to nullify conditional payment provisions in construction contracts to prevent unfair cash flow practices prevalent in the industry.

However, 2 schools of thought emerge on whether conditional payment clauses in the construction industry are invalid only in adjudication proceedings.

C.    Two Schools of Thought: A Divergence of Judicial Interpretations

I.     Conditional Payment Clauses are Void in ONLY Adjudication Proceedings

The recent Court of Appeal case of JDI Builtech (M) Sdn Bhd v Danga Jed Development Malaysia Sdn Bhd [2024] MLJU 414 shed light on the validity of such clauses in arbitration or litigation proceedings. In this case, the Main Contractor failed to make payment pursuant to an adjudication decision. Consequently, the Sub-Contractor filed a lawsuit in the High Court to seek direct payment from the Employer.

The parties adopted the standard form PAM Contract 2006 (With Quantities) containing Clause 25.4 in respect of the event where the employment of the Main Contractor is terminated.  Clause 25.4 (d) stipulates that the Employer is not required to make any further payment to the Main Contractor, including payments which have been certified but not yet paid at the point of the termination, until the completion of works. This clause effectively postpones payment until the final accounts are concluded and the works are completed. The High Court held this clause to be void and unenforceable as it defeats the purpose of CIPAA.

A crucial issue before the Court of Appeal was whether a conditional payment provision is applicable in an arbitration or litigation claim. The Court of Appeal held that conditional payment provisions which are prohibited under Section 35 CIPAA in adjudication proceedings may still be upheld in arbitration or court proceedings. The Court prioritized upholding the parties’ freedom of contract and the terms they have agreed upon regarding payment procedures.

The Court of Appeal’s judgment in JDI Builtech is consistent with the earlier High Court ruling in Bond M&E (KL) Sdn Bhd v Isyoda (M) Sdn Bhd (Brampton Holdings Sdn Bhd, Intervener) [2017] MLJU 376 and UDA Holdings Bhd v Bisraya Construction Sdn Bhd & Anor and another case [2015] 11 MLJ 499. The High Court’s interpretation in Bond M&E hinges on a conjunctive reading of Sections 35(1) and 35(2) CIPAA that the conditional payment provision is void solely for adjudication purposes. The High Court further elucidated that if Parliament had intended for the prohibition to have a general application in the construction industry, it would have amended the Contracts Act 1950, rather than confining its application to statutory adjudication under CIPAA.

Although UDA Holdings Bhd v Bisraya Construction Sdn Bhd & Anor and another case [2015] 11 MLJ 499 is not mentioned by the Court of Appeal in the judgment of JDI Bultech, it is pertinent to note Mary Lim J (as she then was)’s judgment in the High Court that while CIPAA contains liberal provisions on construction contracts, it does not purport to govern every aspect of these contracts. Her Ladyship considered among others, the objective of CIPAA, the Hansard of CIPAA and the Explanatory Statement of the Bill on CIPAA and emphasised that: -

1. CIPAA only deals with a very specific and narrow aspect of construction contracts, and that is, the payment aspect;

2. Pursuant to CIPAA, adjudication was offered as a simple, fast and cheap mechanism for resolving these payment problems or payment disputes faced by the construction industry as opposed and in addition to the existing resolution through arbitration or the courts of which are more time consuming and more costly options that may be concurrently invoked; and

3. Adjudication is only an interim remedy to uncork the blockage in the cash flow which is the life blood of the construction industry.

The Court of Appeal in JDI Builtech had also considered the flipside of the coin by analysing several court decisions[1] by Wong Kian Kheong J (as he then was) who was a strong proponent of the view that Section 35 CIPAA is applicable to even non-adjudication proceedings. These decisions are elaborated in the following paragraphs.

II.     Conditional Payment Clauses are Void in GENERAL

In the High Court case of Khairi Consult Sdn Bhd v GJ Runding Sdn Bhd [2021] MLJU 694, which was affirmed on appeal to the Court of Appeal, the contract between the Engineering Consultant and the Main Consultant contains Clause 9 which provides that the Engineering Consultant will only be paid upon the Main Consultant’s receipt of payment from the Employer. The Engineering Consultant sued the Main Consultant for the balance unpaid fees. Although this case did not involve adjudication proceedings under CIPAA, Wong Kian Keong J (as he then was) held that the Clause 9 runs afoul of Section 35(1) and (2)(a) CIPAA in light of the following: -

1. Parliament has employed a wide term “any” in Section 35(1) CIPAA;

2. Parliament provides for 2 instances of a “conditional payment provision” in Section 35(2)(a) and (b) CIPAA;

3. The 2 specific instances stipulated under Section 35(2)(a) and (b) CIPAA cannot limit the wide effect of the term “any” in Section 35(1) CIPAA; and

4. This means that the conditional payment provision in a construction contract is not meant to be narrowly defined to only include adjudication proceedings instituted pursuant to CIPAA.

His Lordship further elucidated that Section 35 CIPAA has a general application provided that the following requirements under Sections 2 and 4 CIPAA are met: -

1. There is a “construction contract” or “construction consultancy contract” between the parties;

2. The contract is made in writing;

3. The work under the contract is carried out wholly or partly within the territory in Malaysia; and

4. The contract is not one which is: -

   1. Entered into by a natural person for any construction work in respect of any building which is less than four storeys high and which is wholly intended for his occupation under Section 3 CIPAA; and

   2. Exempted from the application of CIPAA pursuant to a gazettement by the Minister under Section 40 CIPAA.

In MN Global Venture Sdn Bhd v CB Bersatu Sdn Bhd [2022] MLJU 998, his Lordship considered the purposes of CIPAA enshrined in its long title and dissected the different parts of CIPAA as reproduced below: -

(a)   Long title of CIPAA

        i.          Facilitate regular and timely payment;

        ii.         Provide a mechanism for speedy dispute resolution through adjudication; and

       iii.        Provide for remedies for the recovery of payment” in the construction industry.

(b)   Parts of CIPAA

       i.          Part II (Adjudication of Payment Disputes);

       ii.         Part III (Adjudicator);

       iii.        Part IV (Enforcement of Adjudication Decision);

       iv.        Part V (Adjudication Authority); and

       v.         Part VI (General).

Parts II to V CIPAA concern provisions regarding adjudication proceedings filed under CIPAA in attaining the purpose of providing a speedy dispute resolution mechanism. Parliament has expressly placed Section 35 CIPAA under Part VI and therefore, demonstrates the legislature’s intention for it to be of general application irrespective of whether adjudication proceedings have been instituted pursuant to CIPAA or not. His Lordship further reasoned that had the legislature intended to confine the application of Section 35 CIPAA to only adjudication proceedings, Parliament would have easily stated as such in Section 35 CIPAA.

D.    Conclusion

The legislative mechanism introduced by Section 35 CIPAA is a necessary curtailment of absolute freedom of contract, designed to prevent potential abuse by one party to seek refuge behind the conditional payment clause to avoid and frustrate payment obligations. The Federal Court in Jack-In Pile (M) Sdn Bhd v Bauer (M) Sdn Bhd and another appeal [2020] 1 MLJ 174 held that Section 35 CIPAA provides a substantive right which is nothing less than the right to freedom of contract where parties are entitled to regulate their business affairs subject to any prohibitions recognised by law.

The Court of Appeal's judgment in JDI Builtech represents a pivotal and pragmatic approach in the application of Section 35 CIPAA in striking a balanced compromise between:-

(a) Preventing the abuse of conditional payment clauses during adjudication to promote prompt payments and alleviate cash flow issues; and

(b) Honoring the parties' autonomy in other dispute resolution mechanisms such as arbitration and litigation.

This interpretation ensures that Section 35 CIPAA does not overreach into areas where parties have willingly accepted the risks and terms of their contracts, thus preserving the freedom of contract outside the adjudication process. As the law continues to evolve, it stands to be seen whether there will be a decision from the apex court to finally determine this issue.

***This article is prepared based on the relevant case-law, legislation and information available as of 5.7.2024.

[1] Lion Pacific Sdn Bhd v Pestech Technology Sdn Bhd and another case [2020] MLJU 2308; Uzma Engineering Sdn. Bhd. v Khan Co. Ltd. and another summons [2020] MLJU 1272; Ireka Engineering & Construction Sdn Bhd v Tri Pacific Engineering Sdn Bhd and another summons [2020] MLJU 548; Gandahan Sdn Bhd v Gigatech Engineering Sdn Bhd [2021] MLJU 2684; MN Global Venture Sdn Bhd v CB Bersatu Sdn Bhd [2022] MLJU 998; Multi Network Sdn Bhd & Anor v Pembinaan Jari Jaya Sdn Bhd [2022] MLJU 3452.