Introduction Overview of Study

CHAPTER 1

Payment was identified as one of ten priority areas in the Malaysian construction industry during a construction industry roundtable in June 2003. Payment has been said to be the lifeblood of the construction industry.

In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant (condition) of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay their debt. This can occur with all debt obligations including bonds, mortgages, loans, and promissory notes.

In the construction industry payment is an issue of major concern. Unlike many other industries, the durations of construction projects are relatively long. Besides that the size of each construction project is relatively large and each progress payment sum involved is often relatively large. Payment terms in construction industry are usually on credit rather than payment on delivery.

Aim

The aim of this research is to analyze the impact of payment default in construction industry.

Objectives

The objectives of this research are:

• To study the right to payment.
• To identify mode of payment available in construction industry.
• To investigate how payment system are being preferred for sub-contract practice.
• To study the factors influence the payment default for sub-contract in construction industry.
• To identify remedies available for payment default in construction industry.

Problem statement

Payment is one of the famous issues that always occurred in construction industry. Payment has been said to be the lifeblood of the construction industry. Yet the industry knows payment default, specifically delayed and non-payment, remain a major problem. Chronic problem of payment default in construction industry will lead to negative effect of the entire construction delivery chain. How far does the payment default issue affect the construction delivery chain? If payment default does affect delivery chain badly, what are the remedies available to cover the injured party? Nevertheless, no one wants to be blindsided by an inexplicable negligence as the first indication of a problem. Hence, the party that indicates the payment default should have the proactive step to overcome the problems.

Scope and limitation of study

The scope of this research will focused on construction contracts between main contractor and sub-contractor. This will be specific on Sub-Contractor Class E and F in Kuching, Sarawak.

The research will be based on the following limitations :

Legal issue and problems on payment default in construction industry.

The questionnaires are distributed among sub-contractors only.

Research methodology

Figure 1.1: General flow chart of research methodology

In ensuring the objectives of research can be achieved, some methods and process should be taken into considerations. To achieve the research aim, all gathered data have been compiled and analysed. The implementations stage is planned in detail in order to ensure the success of this research.

To achieve research objectives, two types of research methodology were carried out. They are:

Data collection

Data analysis

1.6.1 Data collection

Data collection can be classified into two categories as follow:

1.6.1.1 Primary data

Primary data is obtained directly from the study and analysed. The primary data will be obtained by :

Questionnaire survey – Questionnaire will be distributed to relevant group.

1.6.1.2 Secondary data

Secondary data consists of data from literature review such as from books, journals, articles, and relevant sources from website.

1.6.2 Data analysis

Analysis was carried out on the data obtained from primary and secondary sources. Data analysis can be analysed by using diagrams, charts, schedules and graph.

1.7 Tentative chapter headings

1.7.1 Chapter 1

Introduction – this chapter consists of introduction to the study, objective, and scope of work as well as the research methodology of the study.

1.7.2 Chapter 2

Payment default in Malaysian construction industry – this chapter present the overview of payment in construction industry. It consists of the right of payment in different type of contract and mode of payment available in construction industry. Nonetheless, it also consists of the payment default issue in relation with sub-contractor in construction industry.

1.7.3 Chapter 3

Cause, effect and remedies for payment default –This chapter indicate the factors that cause the payment defaults as well as the effects of payment default in construction industry. Nevertheless, this chapter also contain on remedies available for the injured party due to payment default .

1.7.4 Chapter 4

Research methodology – this chapter comprises the methodology use to carry out the research.

1.7.5 Chapter 5

Questionnaire analysis – this chapter analysed the data collected from questionnaire survey.

1.7.6 Chapter 6

Conclusion – the final chapter present the conclusions for the research and recommendations for further study.

CHAPTER 2

Payment Default in Malaysian Construction Industry

2.1 Introduction

The construction industry is an important cog in the wheel propelling the Malaysian economy. The industry then provides work for many ranging from professionals such architects, engineers, and surveyors to main contractor, sub-contractors, suppliers and ultimately manual labourers who are employed by these contractors. The industry works and only will continue to work on the premise that these people are paid for work and services that have been properly rendered. The quantum of payment for work and services rendered are often huge in the thousands, if not in the millions of Ringgit. (Lim, 2005)

This chapter provides an overview on the importance of payment and payment default issue in the construction industry. In addition, the right to payment is different when differ type of contract is approach. Same goes with mode of payment applied.

2.2 Importance of Payment in Construction Industry

Figure 1.2 Sequence of payment claims in construction industry

Source : (Vester, 2005)

Payment has been said to be the life blood of the construction industry. Yet the industry knows payment default, specifically delayed and non-payment remain a major problem. Payment was identified as one of the ten priority areas in the Malaysian construction industry during a construction industry roundtable in June 2003. (Ali, 2006)

A survey of causes of delay in building construction projects in Egypt was discovered that one of the cause that delay the building construction projects is delays in contractor’s payment by owner. (El-Razek et al, 2008)

For this reason, the Malaysian construction industry should execute the construction project with effectively and efficiently. The critical of late and non-payment issue will strictly concern the flow of the construction in terms of time aspect and financial aspect particularly.

According to CIDB (2008), payment in any industry is generally an issue of concern. Particularly in the construction industry, payment is an issue of major concern. This is because:

(a) Unlike many other industries, construction projects are of long durations, involving multiple phases of construction works such as site works, substructure, superstructure, finishes, external works, utilities, mechanical and electrical services etc. Payment problems in a construction project can severely affect cash flow and as a consequence the timely performance and quality of the project.

(b) The implementation of a construction project involves many parties from clients, developers, architects, engineers, quantity surveyors, contractors, sub-contractors, suppliers, skilled and unskilled workers etc. Problems in payment at the higher end of the hierarchy will lead to a serious knock-on cash flow problem down the chain of contracts.

(c) Terms of payment are usually based on credit rather than payment upon delivery which means contractors need a bigger capital outlay to undertake construction works before progress payment is made. Likewise, it is also common practice that architects and other construction professionals render their services before progress payment is made. Once projects are completed, the infrastructure becomes a fixture to the ground disabling any party to recover non-payment by removing any part of the completed infrastructure. Parties in the construction industry have no other effective remedy to recover non-payment.

2.3 Payment Problem Related With Sub-Contractor in Construction Industry

A subcontractor is a person or a company hired by a general contractor to perform part of the work of a construction job. For example, a contractor might be building a house, but might hire a firm or a person specializing in electrical engineering to install the electrical systems needed in the house. Generally the subcontractor will either relieve the main contractor of part of the building work, or will be able to perform work at lower expense or at a greater skill level than the general contractor could. (http://civilengineering blog.com)

Subcontractors are very important to the successful completion of most construction projects, yet the many issues involved in subcontracting practice are seldom acknowledged. A literature review indicates that these issues include the timeliness of payments by general contractors, the process of selecting subcontractors, subcontractor bonding, construction insurance, safety issues on the construction site, partnering arrangements with various parties, and productivity issues. (Arditi and Chotibhongs, 2005)

The problem of late and non-payment is felt not only in a fast developing economy, as in the case of Malaysia, but also in a developed countries, such as United Kingdom and Australia just to name a few. For instance, a survey of the Payment Performance in Britain has shown that the construction industry, in particular, was prone to late-payment culture, with payment of debts due to subcontractors and suppliers being made, on average, 53 days after invoices or applications for payment have been rendered. (Johnston, 1999)

A rising number of small contractors are facing delays in payment, shrinking contracts as well as difficulty in getting loans due to the tougher operating environment in the construction industry. MBAM has been pushing the Government to enact the Construction Industry Payment and Adjudication Act since 2004 in an effort to give some assurance and security to contractors in the issue of payments. But so far, there has been a little progress. Australia, New Zealand and Singapore had such legislation to protect their contractors. (http://biz.thestar.com.my)

For the time being, Ksaw Kead Chye, a class G7 contractor in Penang, said the company had turned from building works to renovation jobs, as big projects had stopped. “Recently, an RM4mil contract for building an electronic factory was cancelled just after we had mobilized our machinery,” he said, adding that payments to contractors could be delayed by up to one year. Another contractor said he was facing difficulties in getting loans, which had affected his cashflow and ability to bid for contracts. IdealHome Construction & Renovation Sdn Bhd proprietor Kevin Tan said his renovation business had dropped by 30% since October 2008, noting that a higher number of renovation jobs that cost more than RM200, 000 had been put on hold. (http://biz.thestar.com.my)

A survey done by Construction industry Development Board (CIDB) in collaboration with University Malaya (UM) merely formally documents what many in the construction industry already know – there is a chronic problem of delayed and non-payment in the Malaysian construction industry affecting the entire delivery chain. (Ali, 2006)

In 1994, Sir Michael Latham, in his report – Constructing the Team, it was observed that : “The cascade system of payment in the industry – normally client to main contractor, main contractor to subcontractor, and so on down the chain – makes the exposure of different parts of the process to the insolvency of one particular serious. (Tony, 2006)

A survey on late and non-payment was conducted by Construction Industry Development Board (CIDB) Malaysia to address the current problems in relations to late and non-payment issue encountered by main contractor, sub-contractor and consultants in the local industry. The survey was conducted on two sets of construction players, namely the contractor and the consultant. 44.1% of the contractors reported that they had encountered late payment situations in government funded projects while 53.5% had experienced late payment in private funded project. About 14.4% of the contractors indicated that they had experienced non-payment situation in government funded projects and 33.3% pointed out they had not been paid by their private client. (Tony, 2006)

2.4 Right to Payment

Under a construction contract, a person is entitled to a progress payment if the person has undertaken to carry out construction work, or supply related goods and services, under the contract. (Queensland, 2009)

In case United States Steel v. M. DeMatteo Construction Co., 315 F.3d 43 (1st Cir. 2002), A contractor “cannot recover on the contract itself without showing complete and strict performance of all its terms.” If the contractor fails to perform completely but substantially performs in good faith, the contractor may recover in quantum meruit. But, ” ‘an intentional departure from the terms of the contract without justification or excuse in matters other than those so trifling as to be properly regarded as falling within the rule of de minimize will bar all recovery for material supplied and work performed.’“ Therefore, the court concluded, as a matter of Massachusetts law, the subcontractor was not entitled to recover under the contract or in quantum meruit. Based on that, the general contractor believed that it did not owe any money to the subcontractor. The creditor asserted the subcontractor was owed the balance left over when the cost of completion was deducted from the value of work actually performed by the subcontractor. (http://www.constructionweblinks.com)

The expression quantum meruit means “the amount he deserves” or “what the job is worth” and in most instances denotes a claim for a reasonable sum. It is used to refer to various circumstances where the courts award a money payment whose amount at least is not determined by a contract. In some instances, the basis for the payment also is less than contractual.

“A quantum meruit claim (like the old actions for money has and received and for money paid) straddles the boundaries of what we now call contract and reinstitution; so the mere framing of a claim as a quantum meruit claim, or a claim for a reasonable sum, does not assist in classifying the claim as contractual or quasi-contractual.”

According to Abdullah (2009), the right to payment is different based on the type of contract applied:

2.4.1 Fixed Price Contract

These contracts are lump sum contracts. The contractor is entitled to payment provided he completes substantially the whole of the work (Hoenig v Isaacs (1952)). The fact that interim payments are made does not alter the position. Failure to perform substantially means that the contractor cannot recover (Bolton v Mahadeva).

In Hoenig v Isaacs (1952). Lord Justice Denning pronounced that the RIBA contract was a lump sum contract with provision for interim payments. In this case, where a contract has been substantially completed, payment must be made.

In Ming & Co v Leong Ping Ching (1964), Gill J held that an entire contract is one in which the entire completion of the work by the contractor is a condition precedent to payment. A contract in respect of which progress payments are made from time to time is not an entire or lump sum contract.

Construction contracts no longer need to be regarded as ‘entire”. A lump sum contract can be agreed with the provision for interim payments, provided they are expressed in the contract. Modern construction standard forms of contract usually are lump sum contracts with provision for interim payments.

2.4.2 Cost Reimbursement Contract / Cost Contract

The basis of payment is not any pre-agreed lump sum but the actual cost (prime cost) of the works performed.

The term reimbursable costs means those cost for performing the work under the contract for which the contractor receives direct reimbursement from the client as opposed to indirect reimbursement using fixed rate.

2.4.3 Guaranteed Maximum Price (GMP)

The contract sum becomes the guaranteed maximum price for the carrying out of the contractor’s obligation under the contract, and that broadly means there is no further scope for the contractor to make further claims. (Except in limited circumstances)

Under GMP provisions the contractor is to pay for all additional sums above GMP which arise from the project in order to complete the works. In other words, the normal claims are not exist. The paymaster only pays the negotiated guaranteed amount. Other expenditure cost is to be responsible by the contractor himself.

2.5 Mode of Payment

Different project will have different mode of payment. This is somehow depends on type of project and the size of project and other consideration that need to take into account. Mode of payment chose must be relevant and can ease the flow of the construction project to avoid any payment issue arise during the time.

According to Lee (2007), there are several modes of payment available in construction industry. They are:

2.5.1 Payment in Cash

Where a contractor does not make special provision as to payment, the contractor is entitled to be paid in cash; in some contracts, however, special provisions are contained stipulating that payment may be made either in whole or in part in bills of exchange, debentures, shares, land or Lloyd’s bonds.

2.5.2 Payment in Bills

If a contractor takes bills which are dishonored, he, the contractor, unless he has accepted them in complete satisfaction of his debt, may either treat them as a nullity or sue on the contract, or he may elect to sue upon the dishonored bills. The holders in due course of such bills do not acquire any charge over or lien on the subject matter of the contract even when it is, as in the case of a ship, not being construed on the land of the employer.

2.5.3 Payment in Debentures or Shares

If payment is to be by way debentures or shares either party can insist on the prescribed mode of payment though the price of the debentures or shares may have increased or decreased since the contract was made.35 If a builder agrees to take shares in a company in consideration of being employed as a contractor to execute works for the company, this is a conditional contract, and if he is not given the contract he need not take the shares and is entitled to be struck off the list of contributories.

For example: a contractor was to be paid a large proportion of his contract price in shares to be issued to him upon certificate of the chief engineer, except works to the value of £10,000 to form a retention fund. In the course of the works delay was caused by the refusal of the resident engineer to approve certain materials and the consequent suspension of operations until the chief engineer in London had been consulted. During the delay certain Argentine stocks in which retention moneys were not responsible for the mistakes of the engineer under the contract, the loss in respect of the securities could not be cast upon them.

2.5.4 Payment in Land

If the payment is to be made in land the contractor will, it seems, be entitled to claim specific performance of the contractor if he has performed every condition precedent to his right of payment, or he may treat the contract as at an end and bring an action for quantum meruit for the work done, or he may bring action for breach of contract, in which case it is suggested the damages recoverable will be limited to the value of the land.

For example: H agreed to pay K a weekly sum for board and lodging which was to be satisfied by certain furniture at a fixed valuation. After the agreement the furniture was seized under a judgment by a creditor of H. it was held that the effect was the same as if H had himself taken away the furniture and sold it, and K was, therefore, entitled to recover the value of the board and lodging by an ordinary action of debt as if the special contract had never existed.

2.6 Conclusion

As a conclusion, payment is considered one of the important areas in construction industry. However, there are problems regarding payment in any industry. In construction industry, payment default mostly happens to the main contractor, sub-contractor as well as the suppliers.

Right to payment can be as a guideline for the contractor to know their right in claiming the payment. Right to payment is clearly defined in different type of contract approached. In addition, there are several mode of payment which use as a payment system in construction industry. Different mode of payment is chose depends on several considerations to ensure that it is applicable to that particular project.

CHAPTER 3

Cause, Effect and Remedies for Payment Default

3.1 Introduction

Chronic problem of payment default in construction industry will lead to negative effect of the entire construction delivery chain. Payment default will surely affect the construction delivery chain badly, and these would happen for many reasons. To solve and prevent the problem, variation of remedies is available to be utilized.

This chapter will discuss major on factors that cause payment default in construction industry. In addition, the effects of payment default also discovered in this chapter together with the remedies available for payment default.

3.2 Causes of Payment Default

Cause of payment default must be identified because it is the main root that arise payment default issue in construction industry. There are various factors have been identified as the causes of payment default mainly in construction industry.

3.2.1 Paymaster’s poor Financial Management

Client is the main financial resources for the project, either using his own capital, through investment or by loan from the bank. Client as the paymaster of the project must have an excellent financial background. The contractors normally will not bid the project for client whose financial capability and background is bad. Hence, the client should manage his financial aspect properly and ensure that the financial history of the company is maintained or improve. Paymaster’s poor financial management definitely will cause the payment default issue arise.

3.2.2 Paymaster withholding of Payment

As stated in many form of contracts, the client have right to withhold the payment to contractor or sub-contractor for many reasons. Any causes arise from the contractor himself can be an acceptable reason for the client to withhold the payment. And the contractor has no right to claim at such. For example, major defective of construction work. This reason can cause the client refuse to pay the contractor which consequently will lead to payment default.

3.2.3 Local Culture / Attitude

Normally, when an attitude is being accepted by the industry or society, it will be a culture. No one wants a negative culture to be widened into the construction industry. If the payment default has acknowledged as one of the culture in the construction industry, there somehow will cause the payment issue in the future.

3.2.4 Conflict among Parties Involved

Payment, not unexpectedly, has always been the main subject of disputes. In this point, when disputes are not settled within the reasonable time, it will lead to a serious payment problem. (Munaaim, 2006)

3.2.5 The use of “Pay when paid” and “Pay if Paid” in sub-contract

Pay when paid clauses are those clauses which defer the time when payment is due from say a main contractor to a sub-contractor until the main contractor has received payment from the client. Pay if paid clauses are clauses which attempt to exclude even the liability for payment to a sub-contractor until the main contractor is paid. (Ali, 2006). These circumstances will be one the factor of payment problem in construction industry.

3.2.6 Delay in Certification

Payment claim is normally certified by the Architect. Any delay in certification which arises because of his own default or other reasons will affect the run of progress payment. This can contribute to payment problem too.

3.2.7 Short of Current Year Project Budget

It may happen that the total amount of work done exceed the allocated budget for that year. If this happen it may cause late payment especially in the government project since the payment due to the contractor has to be postponed to the following year because of inadequate budget. The payment will release only if the fund allocated for has been received by the related government’s agency. (Munaaim, 2006)

3.2.8 Financial Crisis

Financial crisis is one of the factors that lead to payment default in construction industry. Due to the financial crisis, many developers in the region have had finance issues, which have resulted in their being unable to pay contractors for work done. (http://www.constructionweekonline.com)

3.3 Effect of Payment Default

Each party in construction industry knew that payment default will brought a negative effect to the entire construction delivery chain. There are various negative effects which have been identified when the payment default issue arises.

3.3.1 Creates Financial Hardship

It is anticipated that late and non-payment can create financial hardships on the contractor. For instance, the main contractor is obliged to pay the sub-contractor/ supplier for their work done. Therefore, unless the contract expressly required the contractor to self-finance the project or it is a Built Operate and Transfer project, the contractors must not be expected to self-finance the job for their clients. The financial hardship will not only affect the main contractor but other parties such as sub-contractor and suppliers. (Munaaim, 2006)

3.3.2 Creates Negative Chain Effect on Other Parties

“If payment is not prompt, contractors have to stop work. And a lot of suppliers have not been paid too. This will have a (negative) chain effect because the construction industry involves many trades,” said Master Builders Association Malaysia (MBAM) president Ng Kee Leen. (http://biz.thestar.com.my)

As described before, payment default will affect the entire construction delivery chain badly. When the paymaster fails to pay the main contractor, consequently the main contractor is unable to pay the sub-contractor, and this will result the suppliers and workers under sub-contractor having payment problem too.

One of the factors that give direct impact to other parties is the use of “paid when paid” and “pay if paid” clauses in sub-contract. The effect of such clauses is that sub-contractors may end up not being paid for reasons beyond their control. Worse still is a situation where a client may set off amounts due to a main contractor’s own fault. The sub-contractor then does not get paid although they may have done their work properly and were not in breach of their contract. (Ali, 2006)

3.3.3 Create Cash Flow Problems

Payment default can result a critical cash flow problem. Most contractors in the industry have limited working capital, and rely on cash flow projects to pay their subcontractors, suppliers and labourers.

Cash flow in the construction industry is critical because of relatively long duration of projects. Any deviation due to either projects delay or cash flow delays can have major impact on the project. (Ali, 2006)

3.3.4 Results in Delay in Completion of Projects

Delay in completion of projects occurs mostly because of the affected cash flow as discussed above. When the particular contractor did not have cash on hand or any available fund for them to precede the project, for this reason the project will stop and subject to delay.

3.3.5 Leads to Bankcruptcy or Liquidation

When the contractor or sub-contractor is facing the payment default especially in non-payment situation, most of them will face bankruptcy and have the critical liquidation problem.

“If we’re not getting paid, what’s the point in putting in a tender?” asks Philippe Dessoy General Manager of Six Construct, which is part of a consortium working on the finishing touches on the Burj Dubai, scheduled to open on January 4 2010. “We’re not a bank, we are providing a service and we expect to be paid for it. It’s simple business. If we’re not paid, how will our business survive and in the end that would affect any company’s decision to be here,” he added. (www.constructionweekonline.com)

Hence, the payment default consequently will decrease the contractor’s performance in commencing the project.

3.3.6 Leads to Abandonment of Projects

A project is classified as abandoned if, within this six- month period, the developer has been wound-up and the company taken over by an official receiver or private liquidator recognised or affirmed by the Housing Controller, who is the Secretary-General of Ministry of Housing & Local Government. There are a number of factors behind the abandonment of a housing project. One is the financial problem of a developer caused by incidences such as the 1997-98 economic crisis. (http://findarticles.com)

This is clear that the financial or payment problem also contributing the increase of number in abandoned projects.

3.3.7 Results in Formal Dispute Resolution E.g Litigation / Arbitration

A failure on timely payment could possibly lead to formal dispute resolution. According to Bob (2005), in the past, to recover payment the claimant was forced to commence arbitration or litigation; those processes are very costly and time consuming. (Munaaim, 2006)

3.3.8 Creates Negative Social Impacts

According to the researcher’s observation, if construction delays are caused by the late payment or non-payment, buildings such as the car park of medical centre, students’ residential flats and so on could not be put into use on time. These will cause problems such as patients could not be healed in time, new students have troubles in finding a house, and etc. If delay caused by this reason happens in the road and bridge projects, traffic problem may arise. (Munaaim, 2006)

3.4 Remedies for Payment Default

Getting paid is not always as easy as it should be and threatening to terminate the contract is usually a last option. There are intermediate steps that can be taken as well as including some protective measures in the contract terms.

On 28 August 2007, the Malaysian Construction Industry Master Plan (CIMP) was approved by the Cabinet Committee for Investment and Infrastructure, wh