Lowering risks of ‘back-to-back’ clauses in subcontracts

In construction engineering, it is fairly common to find the “back-to-back” clause, under which the general contractor will pay a subcontractor only after receiving payment from the employer. In both litigation and arbitration, there have been many disputes focusing on the validity of back-to-back clauses, and whether they can be grounds for refuting the subcontractor’s demand for payment. Court opinions from such cases may shed some light on the matter.

UNDERSTANDING ‘BACK-TO-BACK’

Current judicial interpretation does not resolve how the clause is to be understood and applied in practice. Although China is not a case law country, some precedents of Chinese courts still serve as valuable points of reference.

In such disputes, subcontractors generally believe that the back-to-back clause violates the principle of fairness, and thus is invalid; while general contractors mostly hold that the back-to-back clause is an expression of the true will of both parties, and should be deemed valid and observed in contract performance. General contractors believe that subcontractors have no right of claim for payment before employers make payments.

For example, in the case of Wuchuan Heavy Engineering v Shanghai Urban Construction (Group) (2020), the parties agreed in the contract that the subcontractor shall not require the contractor to make the project payment (advance payment or progress payment) in advance, and the subcontractor agreed that the contractor would make the project payment to the subcontractor in proportion to the project payment it received from the employer, or the contractor would make the project payment only after receiving its own project payment from the employer in full. Subsequently, a dispute arose over the back-to-back clause.

The Jiangxi Province High People’s Court issued two opinions in its decision: In the construction engineering subcontract, the back-to-back clause was a valid agreement on conditional project payment between the parties, which in form was a conditional contractual term and binding on all parties to the contract; and, article 159 of the Civil Code stipulates that “for a conditional civil legal action, if any party improperly prevents the achievement of the condition for its own interests, the condition shall be deemed to have been achieved; if any party improperly contributes to the achievement of the condition, the condition shall be deemed to have not been achieved.”

After examining and reviewing the project price, Shanghai Urban Construction delayed in demanding project payment, which in turn hindered the achievement of the project payment conditions for Wuchuan Heavy Engineering, followed by its refusal to make the project payment on the grounds that the payment conditions agreed in the contract had not been achieved, constituting a violation of the principle of good faith.

Two conclusions can be drawn from the above example:

1. 1. the validity of the back-to-back clause in the construction engineering subcontract can only be judged according to the specific legal provisions, namely, the relevant provisions of chapter 6 of title I of the Civil Code (there is currently no invalid provision for the back-to-back clause in construction engineering subcontracts); and
   2. since the back-to-back clause requires the achievement of the condition of “receipt of the project payment from the employer”, the achievement of the condition needs to be determined, and it is necessary to analyse on a case-by-case basis whether the circumstances specified in article 159 of the Civil Code applies to either party.

PRACTICAL SUGGESTIONS

• In the tendering procedure prior to the signing of a contract, the back-to-back clause as a payment term should be explicitly included in the tender announcement document, and the acceptance of such a clause by bidders should be considered as one of the must-meet conditions.
• The conditions attached to the back-to-back clause should be specified in the negotiation documents and minutes signed by both parties.
• In the formal contract, the attached conditions may be detailed under the following template: “Both parties recognise the meaning and connotation of this clause and the legal consequences and liability arising therefrom. Each party has a full estimate and expectation of the commercial risks and other burdens that may be brought to itself, and the subcontractor shall not pose any challenge to this clause in the event of disputes arising from the performance of this contract. If the subcontractor fails to provide evidence that the contractor improperly prevents the achievement of the payment conditions, the subcontractor shall actively assist the contractor in claiming the relevant payment from the employer. If the payment is still not received after the contractor has already made a claim to the employer through payment reminders, lawyer’s letters or any other means, the subcontractor shall be obliged to continue providing assistance.”
• Relevant evidence of claimable rights, such as payment reminders, emails, minutes, business travel air tickets, and audio and video recordings should be well preserved.
• In general contracts and subcontracts, it is suggested that the dispute resolution clause should be consistent, such as choosing the same arbitral institution or court, so that the hearing proceedings may be combined in case of litigation or arbitration. It is also recommended that the following dispute resolution clause be added:
  “If a dispute arises between the contractor and the subcontractor due to the performance of this contract, the contractor shall first notify the employer and organise a payment co-ordination meeting within 10 days. If the meeting is not convened by the due date or no unanimous meeting opinion is formed, either party may have the right to submit it to an arbitral institution for settlement in accordance with the provisions of this clause.” This additional clause is suggested because it may be more conducive to the recovery of funds with the assistance of the subcontractor, and thus will be beneficial to the settlement of contract payment disputes between the contractor and the subcontractor.