India: Pitfalls Under Back-To-Back Contracts: Are Back-To-Back Contracts A Minefield?

I. Introduction

Back-to-back contracts involve at least three or more parties pooling-in their resources at different levels for execution of a same or connected project. The parties include – an employer (i.e. party floating the work / tender), a main contractor (i.e. party to whom the work / tender was awarded), a level 1 sub-contractor (i.e. party to whom the work (or part thereof) has been sub-contracted by the main contractor) and (in certain cases) a level 2 sub-contractor (i.e. party to whom the sub-contracted work (or part thereof) has been further sub-contracted by the sub-contractor).

In a back-to-back contract, rights and duties of the sub-contractor (or a level 2 sub-contractor, as the case may be) are closely mirrored with those of the main contractor towards the employer under the main contract. Back-to-back contracts are a common feature in construction, mining and even IT-ITES sectors.

Back-to-back contracts can be structured either by specific incorporation by reference of the clauses of the main contract (which are intended to be included / excluded and varied) into the sub-contract or by re-iteration of the clauses of the main contract into the sub-contract. Consequently, back-to-back contracts can be classified into 2 categories:

1. Complete back-to-back contract: wherein the sub-contractor assumes full liability of the work stipulated in the main contract with marginal difference in the pricing agreed under the main contract; and
2. Partial back-to-back contract: wherein the sub-contractor undertakes some but not all of the work stipulated in the main contract.

Although back-to-back contracts can prove to be practical, time-saving and cost-efficient, at the same time, such contracts create complex legal issues amongst the contracting parties, few of which have been discussed in this piece.

II. Critical clauses under back-to-back contracts

Contractually, a back-to-back arrangement composes flow of mutual promises across the chain of three or more parties collaborating together and performing their respective obligations in relation to the same / connected project(s) (or part thereof). Such contracts must be carefully drafted to ensure that the rights and obligations of each party ties in with the other party. Certain crucial clauses are set out below:

1. Payment terms: issue arises when the payment to a sub-contractor is conditional upon or time-linked to the main contractor receiving its payment from the employer. In case where the sub-contractor has completed the performance of the sub-contracted work, it may still not be entitled to receive its payment if the main contractor has not received its payment from the employer;
2. Contractual deadlines: in case of a true back-to-back contract all the deadlines which are to be adhered to by the main contractor (in its contract with the employer) are mirrored as part of the timelines which a sub-contractor needs to comply with under the relevant sub-contract; and
3. Dispute resolution: absence of privity between the employer and the sub-contractor makes the possibility of inter-se dispute resolution challenging at best and impossible at worst. As a result, each dispute has to be routed through the main contractor, separately, leading to bifurcation of disputes.

Further, certain clauses such as extension of time, price escalation, defect liability period, compensation, termination, liquidated damages, interface issues (in case where there is more than one sub-contractor) could also increase the complexity of issues among the parties involved.

III. Legal position in India

Indian courts have adhered to the rules of privity of contract and have held that the jural relationship between an employer and the main contractor on the one hand and between the main contractor and sub-contractor(s) on the other will be quite distinct and separate.

The Supreme Court of India ("SCI") in the case of Zonal General Manager, Ircon International Ltd. v. Vinay Heavy Equipments¹ after analyzing the provisions of the relevant contracts, held that Zonal General Manager, Ircon International Ltd. (main contractor) could not evade from its liability to pay to Vinay Heavy Equipments (sub-contractor) on the contention that the payments have not been released to it from SIPCOT (employer). It was reasoned by SCI that in the absence of a covenant of back-to-back in the main contract, the distinct and sole liability of the middle-contractor is presumed and that the rules in relation to privity of contract will mean that the jural relationship between the employer and the main contractor on the one hand and between the sub-contractor and the main contractor on the other will be quite distinct and separate.

Similarly, in the case of Sharma & Associates Contractors (P) Ltd. v. Progressive Constructions Ltd,² the SCI held that while entering into the contract with Hindustan Steelworks Construction Limited ("HSCL") (main contractor), Progressive Constructions Limited ("PCL") (level 1 sub-contractor) ensured that benefit of the price escalation or enhancement of rates received by HSCL from National Hydroelectric Power Limited (employer) will be passed on by HSCL to PCL. However, Sharma & Associates Contractors (P) Ltd. ("SAPL") (the level 2 sub-contractor) failed to negotiate this and therefore in absence of a similar clause in the contract between PCL and SAPL, PCL was not liable to pass on the benefit received by it (from HSCL), to SAPL. Resultantly, the contract between PCL and SAPL with respect to price escalation clause was found to be not back-to-back in nature.

In another case of Larsen and Toubro Limited v. Mohan Lal Harbans Lal Bhayana,³ the SCI held that pursuant to the supplementary agreement, the arbitration clause was modified, and it was agreed between Larsen and Toubro Limited ("L&T") (main contractor) and Mohan Lal Harbans Lal Bhayana ("Bhayana") (sub-contractor) that all the claims of Bhayana would be taken up by L&T with Standing Conference of Public Enterprises ("SCOPE") (employer) and Bhayana would assist L&T for pursuing the claims. The SCI further held that as the arbitration clause was modified, L&T was obligated to escalate the claims of Bhayana to SCOPE. In the event where Bhayana remained dissatisfied with the determination (with respect to the final bill) and it feels that its claims are legitimate then it would be treated as a dispute between L&T and Bhayana and only then the arbitral tribunal can be constituted as per the arbitration clause.

IV. International practices

Incorporation by specific reference or re-iteration

The Courts in Singapore have taken the route of specific incorporation either by reference or by reproduction of the contents of the main contract in the sub-contract in order to make the sub-contract back-to-back in nature with the main contract. The High Court of Singapore in the case of Hi-Amp Engineering Ltd v Technic Delta Electrical Engineering⁴ and GIB Automation Pte Ltd v Deluge Fire Protection (SEA) Pte Ltd⁵ has held that the relevant provisions, which contains the common phrase that - all terms and conditions of the main contract shall apply, mutatis mutandis, to the sub-contact, are ambiguous and not precise enough so as to incorporate the terms of the main contract as part of the sub-contract. For a contract to be back-to-back in nature there has to be specific incorporation of the clauses of the main contract in the sub-contract either by reference to the main contract or reproduction of the contents of the main contract.

A similar approach (incorporation by specific reference) has also been taken by the Court of Appeal, United Kingdom in the case of Yorkshire Water Services Ltd. vs. Taylor Woodrow Construction Northern Ltd & Ors.⁶

'Pay-when-Paid' and 'Pay-if-Paid'

With respect to payment terms, the United States Court of Appeals, Sixth Circuit in the case of Thos. J. Dyer Co. vs. Bishop International Engineering Co.⁷ and Supreme Court of Florida in the case of Peacock Construction Co. vs. Modern Air Conditioning⁸ have distinguished a 'Pay-when-Paid' ("PWP") and a 'Pay-if-Paid' ("PIP") clause and have stated that both the clauses determine the liability of the main-contractor distinctly.

The US Courts have held that a PWP clause, which provides that the main contractor will pay to the sub-contractor within a certain number of days of receiving payment from the employer, are merely a 'timed mechanism' and does not excuse the main contractor from the obligation of payment to the sub-contractor, in case the employer fails. Such PWP clauses put an obligation on the main contractor to chase the employer for the payments.

However, a PIP clause is a conditional payment clause which obligates the main contractor to pay the sub-contractor only if, the main contractor is first paid by the employer. Accordingly, non-receipt of payment by the main contractor from the employer can essentially enable the main contractor to escape its payment liability to the sub-contractor.

V. Concluding remarks

Drafting back-to-back arrangement is a task that requires careful consideration as to which specific terms shall be passed down the contractual chain. There is no specific rule to various possible pitfalls associated with back-to-back contracts. A badly drafted sub-contract or main contract runs the risk of re-characterization by courts. Few drafting considerations are set out below:

Employer's perspective: The employer may insist to incorporate clauses in the main contract which could make way for more extensive or direct dealings with the sub-contractor. The employer may insist on having "step-in" rights and enforce the main contractor's rights against the sub-contractor directly, in case the main contractor fails or avoids pursuing its rights. The employer may also undertake collateral warranties from the sub-contractor (through a separate contract), so that it can sue the sub-contractor directly for any breach of warranties.

Main contractor's perspective: The main contractor may consider having: (a) a PIP clause, instead of a PWP clause; (b) specific incorporation of the terms of main contract into the sub-contract either by reference or by re-iteration; and (c) in case of more than one sub-contractor, a tailor-made standalone agreement with each sub-contractor (instead of back-to-back contracts), specifically defining the scope of work in each standalone agreement in accordance with the main contract.

Sub-contractor's perspective: The sub-contractor may insist on (a) executing tailor-made standalone agreement with the main contractor, precisely considering each and every term; and (b) having a dispute resolution with a direct recourse to the employer especially in case of payment defaults, either by a tri-partite agreement or by an express back-to-back dispute resolution clause.

Given that back-to-back contracts are quite prevalent in contracting arrangements, exercising necessary caution and careful scrutinization of the agreements, would go a long way in protecting the interest of all the concerned parties.

Footnotes

1. 2015 (7) SCJ 320.

2. AIR 2017 SC 847.

3. (2015) 2 SCC 461.

4. [1996] 1 SLR 751.

5. [2007] SGHC 48

6. [2005] EWCA Civ. 894.

7. 303 F.2d 655 (6th Cir. 1962)

8. 353 So.2d 840 (1977).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.