Ontario’s prompt payment system under the Construction Act (the “Act”) has changed the way that parties to construction projects understand their payment obligations. But there are several significant gaps in the prompt payment scheme that produce significant uncertainty and risk for contractors. In this article, we discuss three such gaps.
First, when it comes to public-private partnership (“P3”) projects (also known as alternative financing and procurement or AFP projects), the language of the Act produces significant legal uncertainty that many parties involved in P3 projects are likely not even aware of – and that urgently demands a change to the Act’s regulations. Absent such a change, prompt payment will not apply, or will apply unevenly, to the construction phase of P3 projects.
Second, contractors may be stranded with liability to pay subcontractors following certification of completion of a subcontract, without the ability to recover from the owner. The problem is that the Act’s scheme for payment of holdback requires payment of holdback by a party who is directly liable for payment on a subcontract any time all liens under any subcontract expire; but it requires holdback release from the owner only when all liens under the contract have expired. This means that a contractor can be liable for mandatory payment of holdback to a subcontractor following certification of completion of a subcontract, without the ability under the Act to require or obtain release of holdback from the owner.
Third, holdback release from an owner to a contractor is mandatory following the expiry of a contractor’s lien rights. But the Act creates a potential issue if a contractor wants to enforce that mandatory release through adjudication, because the Act’s language means that, by default, adjudication will not be available if holdback payment is refused following completion of a contract or subcontract.
1. Prompt payment on P3 projects
Trigger for prompt payment obligations
The triggering event for prompt payment obligations is the giving of a “proper invoice.” It is only once a proper invoice is given that the payment deadlines in sections 6.4 to 6.6 are triggered.
Section 6.1 of the Act defines a proper invoice as “a written bill or other request for payment…under a contract”, and section 6.3 provides that proper invoices are “given to an owner.” As proper invoices are given by a contractor to an owner, the identity of the contractor and the owner matters – as does the way that funds flow on a P3 project.
Structure of a P3
On a P3 project, the provincial Crown (or a municipality) (often known as the “Contracting Authority”) will enter into a “Project Agreement” with a “Project Co”, which is typically a special-purpose entity formed for the project by the operating companies which will carry out the construction.
For a P3 in which Project Co is required to design, build, finance and maintain a project, Project Co will then typically enter into a series of contracts: a lending agreement to secure financing; a design-build “Construction Contract” with the “Construction Contractor” for the design and construction, and a maintenance contract with “Maintenance Co” for the long-term maintenance of the project. These contractual arrangements will vary depending on the precise scope of the P3; for instance, Project Co may also be required to operate the project over the long term, or there may be no maintenance component at all.
The key feature of P3 is that the private sector is responsible for financing a significant part of the cost of construction, and it recovers that cost (and can repay its lenders) only upon contractual “Substantial Completion” of the project (which is not the same as substantial performance under the Act). At the outset of a P3 project, Project Co, through its lenders, is typically financing all of the cost of construction. As Project Co hits certain milestones, the Contracting Authority will make milestone payments, and in the later stages of the project the Contracting Authority will start to contribute more of the cost of construction. The proportion will vary from one monthly draw to the next and will depend on the progress achieved.
This variability has significant consequences for the prompt payment system.
Owner and contractor on a P3
The Act specifies the identity of the owner and contractor on P3 projects. Section 1.1(2) of the Act provides that, except as provided in section 1.1, the Project Agreement between the provincial Crown (or a municipality) and Project Co is a contract, and the Construction Contract between Project Co and the Construction Contractor is a subcontract.
Section 1.1(5) creates an exception to the rule set out in section 1.1(2). It deems Project Co to be the owner, and the Construction Contractor to be the contractor, for the purpose of a number of specified sections (none of them having to do with prompt payment).
Importantly, section 1.1(5)(6) also provides that this exception applies to “Any other portion or provision that may be prescribed” by regulation. Section 88(1)(c) explicitly provides that Lieutenant Governor in Council may make regulations respecting section 1.1(5), but no such regulations have yet been made.
Invoicing and prompt payment on a P3 project
As a result of the unique financing arrangements on the P3 project, in many months there will be no invoices given by Project Co to the Contracting Authority – rather, Project Co will submit draws to its lenders.
Project Co’s lenders are not “owners” as defined by the Act: under section 1(1) of the Act, an owner is a person “having an interest in a premises at whose request…an improvement is made to the premises”. Project Co’s lenders will secure their loans with the assets of the operating/parent companies involved in the project, but the lenders will not take a security interest in the project lands; and it is the Contracting Authority, not the lenders, which makes the request for the improvement.
Recall that, under section 6.3, proper invoices are requests for payment which are “given to an owner.” As the draws between Project Co and the lenders are not given to an owner, they are not “proper invoices” within the meaning of the Act.
Under section 6.4, prompt payment obligations start to flow when an owner receives a proper invoice: the Act then requires that, subject to a notice of non-payment, “an owner shall pay the amount payable under a proper invoice no later than 28 days after receiving the proper invoice from the contractor.” (Emphasis added.) Sections 6.5 and 6.6 flow these prompt payment obligations down the construction pyramid.
As Project Co’s draws to the lenders are not proper invoices, the monthly invoicing by Project Co in the first phases of a P3 project will not trigger the prompt payment system. This will likely come as a surprise to the many subcontractors expecting prompt payment throughout the construction of P3 projects in accordance with the Act’s timelines.
Just as problematic is the mixture of payment streams which occurs later in a P3 project. There will be months when some funds received by Project Co come from the owner (the Contracting Authority), and others from the lenders. Under section 6.5(1), the contractor (Project Co) must, after receiving payment from the owner, “pay each subcontractor who supplied services or materials under a subcontract with the contractor that were included in the proper invoice the amount payable to the subcontractor.” (Emphasis added.) How is Project Co to determine which services or materials were “included in the proper invoice”, and which were included in a draw to the lenders?
Even more vexingly, how are the Construction Contractor and its subcontractors to make this determination in respect of their prompt payment obligations? The Construction Contractor’s subcontractors will have no visibility into the invoicing and financing arrangements at the Project Co level.
This produces enormous uncertainty and uneven outcomes in prompt payment on a P3 project, including a lack of certainty about when notices of non-payment must be given, or what claims for payment they must be given in respect of.
It cannot have been the intention of the Legislature in enacting a prompt payment scheme that it would apply to some but not all of the construction phase of a P3 project, or that it would apply in respect of some but not all of the payments made in a given month.
Fixing prompt payment on P3s
It seems clear that this is an unintentional gap in the Act. Fortunately, the solution is simple and requires only a change to the regulations, not to the Act.
Recall that section 1.1(5)(6) of the Act provides that Project Co is deemed to be the owner for the purpose of “Any other portion or provision that may be prescribed.”
The provincial cabinet need only pass a regulation prescribing that Project Co is deemed to be the owner for the purpose of Part I.1 of the Act (the prompt payment provisions).
Then, the monthly invoice from the Construction Contractor to Project Co would be a “proper invoice.” It would not matter how Project Co funded the payment of the Construction Contractor’s proper invoices – whether from its lenders or from the Contracting Authority. Payment of the Construction Contractor’s proper invoices would then trigger the prompt payment provisions down the construction pyramid, in respect of the full amount invoiced by the Construction Contractor each month.
Many of the major P3 projects currently ongoing – such as the Eglinton Crosstown, Finch West and Hazel McCallion LRT lines – are governed by the Construction Lien Act and not subject to prompt payment. But as major new P3s are now underway or in procurement, it is essential for the industry that the regulations be amended, sooner rather than later.
2 Holdback release for subcontracts
The prompt payment system aims to ensure smooth back-to-back payment from the owner through the contractor and down the chain to subcontractors. But a gap in prompt payment system under the Construction Act (the “Act”) means that contractors may be stranded with liability to pay subcontractors following certification of completion of a subcontract, without the ability to recover from the owner.
Background to the current mandatory holdback release provisions
Under the former Construction Lien Act (“CLA”), payment of holdback after the expiry of liens was permissive, not mandatory. Section 26 of the CLA provided:
26 Each payer upon the contract or a subcontract may, without jeopardy, make payment of the holdback the payer is required to retain by subsection 22 (1) (basic holdback), so as to discharge all claims in respect of that holdback, where all liens that may be claimed against that holdback have expired or been satisfied, discharged or otherwise provided for under this Act. [Emphasis added.]
Prior to lien expiry, a subcontractor was protected against an owner deducting amounts from the holdback, because section 21 provided that a lien was a charge on the holdback, and section 30 prohibited applying holdback funds to correct a contractor’s default.
However, once liens had expired, holdback funds became trust funds, and section 12 of the CLA permitted a trustee to exercise set-off rights against trust funds.
Collectively, these provisions led to the development of an unfortunate practice by some owners who would wait for the lien period to expire after certification of substantial performance before advising the contractor that they intended to exercise set off right against the holdback. It was then too late for subcontractors to secure their right to payment by registering a lien. So subcontractors were put in the position of either needing to lien pre-emptively (which is not a great way to get repeat business), or to hold their breath and hope that the holdback would be paid – neither being particularly attractive options.
The new prompt payment scheme for holdback release
One of the important changes to the Act under prompt payment was to make payment of holdback mandatory following the expiry of lien rights. Section 26 now provides:
26 Subject to section 27.1, each payer upon the contract or a subcontract shall make payment of the holdback the payer is required to retain by subsection 22 (1) (basic holdback), so as to discharge all claims in respect of that holdback, where all liens that may be claimed against that holdback have expired or been satisfied, discharged or otherwise provided for under this Act.
There are two key points to note here:
- First, this obligation applies to any “payer” on a contract or a subcontract. A payer is a person who is directly liable for payment on a contract or subcontract.
- Second, the payment is mandatory “where all liens that may be claimed against that holdback have expired.”
This means that the expiry of liens in respect of holdback on a given contractor or subcontract trigger a mandatory obligation to pay holdback by the party which makes payment on that contract or subcontract.
And what if there is a reason not to pay holdback?
For payment of holdback to a contractor by an owner, the way for an owner to avoid mandatory payment is for the owner to publish a notice of non-payment ahead of lien expiry, and for the owner to notify the contractor of publication. The Act now provides:
27.1(1) An owner may refuse to pay some or all of the amount the owner is required to pay to a contractor under section 26 or 27, as the case may be, if,
(a) the owner publishes a notice in the prescribed form specifying the amount of the holdback that the owner refuses to pay, and the notice is published in the manner set out in the regulations no later than 40 days after the date on which,
(i) the applicable certification or declaration of substantial performance is published under section 32, or
(ii) if no certification or declaration of substantial performance is published, the date on which the contract is completed, abandoned or terminated; and
(b) the owner notifies, in accordance with the regulations, if any, the contractor of the publication of the notice.
[Emphasis added.]
The balance of section 27.1 flows down the mandatory obligation to pay holdback from the contractor through to subcontractors. Note that a contractor may refuse to pay holdback to a subcontractor only where the owner has refused to pay:
27.1(2) A contractor may refuse to pay some or all of the amount the contractor is required to pay to a subcontractor under section 26 or 27, as the case may be, if,
(a) the owner refuses to pay some or all of the amount the owner is required to pay to the contractor under that section;
(b) the contractor refers the matter to adjudication under Part II.1; and
(c) the contractor notifies, in accordance with the regulations, if any, every subcontractor to whom the contractor is required to pay the amount that the amount is not being paid and that the matter is being referred to adjudication.
[Emphasis added.]
The problem
The problem is that, taken together, these provisions require holdback release from a payer on a subcontract when all liens on the subcontract have expired; but they do not require holdback release on account of that subcontract by the owner, because the owner is not a “payer” on the subcontract. The owner is only required to release holdback after all liens under the main contract have expired.
What’s more, a contractor can only refuse to pay holdback if the owner refuses to pay “some or all of the amount the owner is required to pay to the contractor under” section 26. But section 26 does not require the owner to pay anything when only a subcontractor’s lien rights have expired, because, as noted above, the owner is not a “payer” on the subcontract.
This creates a potentially serious cash-flow problem. Anytime a subcontractor can demonstrate that all liens on the subcontract have expired (by obtaining certification of completion of subcontract from a payment certifier, for instance), the payer (which could be a contractor or another subcontractor, depending on the level of the subcontract) becomes liable for payment under section 26, but has no ability to refuse to pay under section 27.1.
Mitigation strategy
A contractor could mitigate the effects of this gap in the prompt payment regime by requiring in the contract that the owner will release holdback on account of a subcontract when that subcontractor’s lien rights expire. The contractor could then deliver a proper invoice for the holdback amount, and if the owner refused to pay, it could take the owner to an adjudication.
If a subcontractor were also pursuing an adjudication for the payment of holdback, the contractor would be well-advised to require a consolidated adjudication under section 13.8(2) to avoid any inconsistency in the result.
On that point, however, there is another gap in the Act related to using adjudication to enforce holdback payment obligations after subcontract (or contract) completion.
3. Adjudication for holdback release following contract or subcontract completion
As noted above, holdback release from an owner to a contractor is mandatory following the expiry of a contractor’s lien rights. But the Act creates a potential issue if a contractor wants to enforce that mandatory release through adjudication.
Section 13.5(1)(6) makes adjudication available in the case of non-payment of holdback. However, section 13.15(3) of the Act provides, “An adjudication may not be commenced if the notice of adjudication is given after the date the contract or subcontract is completed, unless the parties to the adjudication agree otherwise.”
As we’ve seen above, holdback is released only when liens rights have expired. One of the ways that lien rights can expire is through the completion of a contract (section 31(2)(b)(i)) or the certification of completion of a subcontract (sections 31(3)(a)(iii) and 31(3)(b)(ii)).
The Act’s language means that, by default, adjudication will not be available if holdback payment is refused following completion of a contract or subcontract.
The point of adjudication is to arrive at a swift and efficient interim result which will allow funds to flow. There is no good reason that this process should be available if holdback release is being triggered by the publication of a certificate of substantial performance or a subcontractor’s last supply, but unavailable if a subcontract is certified complete or the contract is completed.
The Act should be amended to provide for an exception for adjudication of holdback release following completion.
Until that happens, contractors and subcontractors should include in their contracts and subcontracts and agreement that adjudication is available if the payer refuses holdback release.
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