Out-Law / Your Daily Need-To-Know

Advance payments under construction contracts

Out-Law Guide | 19 Mar 2021 | 2:18 pm | 5 min. read

Advance payment arrangements have become commonplace, not only in construction agreements but also in professional services agreements, supply agreements and many other commercial contracts.

The usual rationale for these payments is to assist with the cash flow required to cover initial expenses by the contractor, supplier or service provider. These expenses can include ordering items of equipment with long lead times; the provision of early design work; and labour mobilisation costs. In other cases, however, an advance payment is simply required as a 'lock-in fee' that triggers the commencement of work.

As a result advance payment regimes can vary significantly, with different consequences as to whether, and to what extent, the advance payment is recoverable and on what basis. In addition, while advance payments are often made to assist the contractor in mobilising labour or procuring plant and materials, depending on the terms of the contract the employer may not necessarily obtain the benefit from any saving in escalation costs in making the early payment.

Careful consideration and drafting may be required to give effect to the parties' intentions. This includes appropriately amending a standard form contract where the default provisions do not align with what is required.

Contracting for advance payments

The nature of an advanced payment is determined by the manner in which the contract is drafted. In most cases, the advance payment is simply an interest free loan since it is paid at a time when no value is received by the client in return. The loan is then repaid as the works are executed (or services are performed or goods are supplied), usually through deductions from the amount due at the relevant time. This type of regime is provided for in some of the standard form contracts including FIDIC (sub-clause 14.1) and the NEC (Option X14).

Advance payment regimes can vary significantly, with different consequences as to whether, and to what extent, the advance payment is recoverable and on what basis

However, nothing stops the parties from agreeing that the repayment of the advance payment will be subject to interest that runs from the date on which the advance payment is made until the date of repayment. This can act as a means of compensating the client for paying the amount upfront; or to deter late repayment - which, in this scenario, translates to the delayed performance of the milestones linked to repayment.

Should the contract be terminated before the advance payment has been repaid, and irrespective of the cause of termination, the unpaid balance of the advance payment would fall due. For the employer, this is the primary benefit of structuring the advance payment in this manner.

Where the value of the advance payment is significant, it is usually secured against a bond of equivalent value which reduces commensurately with the repayment of the advance payment.

The advance payment regime often does not specifically regulate how the amount is to be spent, affording the contractor some flexibility here. In other instances the advance payment might be made for a specific purpose which informs the requirements for payment of the advance payment as well as the progress milestones linked to repayment.

A good example of this is contained in sub-clause 14.5 of FIDIC (red and yellow books). Payments under construction contracts are usually linked to the value of works executed. This sub-clause creates an exception to this by allowing for an advance payment specifically for equipment or materials which are either on their way to the site, or which have been delivered but are not yet incorporated into the works.

Given that the purpose of the advance payment is known in this scenario, the clause provides that the advance payment will not be made unless there is proof that the goods have been duly shipped and have been secured by a bond of equal value or in the case of goods in transit, proof that the goods have been stored safely. In both instances, there is a requirement that sufficient evidence and records are provided in relation to the cost of the materials, including the transportation costs. In this way, the advance payment regime is more strictly regulated for the specific purpose for which it's made.

This loan structure can be contrasted with an upfront payment/first payment instalment structure, where the advance payment is treated simply as a payment due on signature in order to 'lock in' or 'confirm' the commencement of work. On this formulation it is an amount deemed to have been earned, and is not subject to repayment on the basis described above. In this case, recovery of the upfront payment is not possible unless the contract has been terminated for breach by the party to whom the payment was made and the employer has a valid claim for restitution.

Advance payments and escalation

A further consideration is whether or not the advance payment is subject to escalation where the cost of the underlying services, labour or plant and materials varies in respect of the period leading up to payment of the advance and the period between payment and repayment. Typically, under the 'loan'-type structure described above, the value of the advance payment and repayments are fixed; and are not linked to payment for specific items. The amount would, therefore, not be subject to adjustments for escalation. Neither FIDIC sub-clause 14.1 nor NEC Option X14, for example, provide for any adjustment for escalation to advance payment amounts. 

The regime provided for in FIDIC sub-clause 14.5, however, has a slightly different approach, under which the contractor is assisted with 80% of the actual cost of the specific plant and materials required to be procured in advance (thus taking into account actual escalation adjustments at the time). When the plant and materials are incorporated into the works, the contractor is entitled to an escalation adjustment applicable under sub-clause 13.8 but the advanced amount is then deducted. The employer is therefore placed in the same position it would be in if it simply paid for the value of the works executed at the relevant time, with the applicable adjustment under sub-clause 13.8. The 80% advance merely assists in the cash flow required to procure the goods based on actual cost at the relevant time.

In practice, the contractor may actually benefit from this arrangement if there is an escalation increase between the point at which the plant and materials are shipped or stored on site and the point at which they are incorporated into the works. There may also be a benefit to the employer, albeit a less likely one, resulting from any escalation decreases as at the date of incorporation.

The above illustrates that although advance payments can often allow for procurement of equipment or labour at an earlier stage, the potential saving in escalation cost is not necessarily secured for the benefit of the employer in the period between procurement and the incorporation into, or progress of, the Works. Different regimes could, however, be provided to alter this arrangement.

Finally, whether or not an upfront payment or 'lock-in' fee would be subject to escalation adjustment would depend on whether the amount is linked, or deemed to be linked, to specific labour or material costs; or is otherwise agreed to be subject to an escalation formula.