On 27 August 2024, the Supreme People’s Court issued the Official Reply on the Validity of Clauses Stipulating Third-Party Payment as a Precondition in Agreements between Large Enterprises and Small and Medium-sized Enterprises (SMEs), declaring such back-to-back clauses invalid. The release of this reply has posed new challenges to the traditional business models of general contractors. In response, general contractors need to reassess their contract terms and adopt proactive measures.

Understanding the reply

Legalisation of central government policies to address corporate payment arrears. The reply, issued to further implement the spirit of the 20th National Congress and the second and third plenary sessions of the 20th Central Committee, aims to resolve issues of corporate payment arrears, ensure fair market competition for SMEs, protect companies’ legal rights, and boost business confidence.

To further legalise the policy direction, the reply explicitly states that back-to-back clauses that condition payment of third-party payments violate mandatory provisions of articles 6 and 8 of the Payment Regulations. Consequently, such clauses are deemed invalid under article 153 (1) of the Civil Code.

Limited invalidity of back-to-back clauses. The reply specifies that back-to-back clauses are invalid only in the context of large enterprises’ construction projects and procurement of goods or services, where large enterprises are the payers and SMEs are the payees. Not all back-to-back clauses are invalid. Payment agreements between large enterprises, between SMEs, or where SME enterprises are the payers and large enterprises are the payees, are not necessarily invalid. Their validity must still be assessed under article 153 of the Civil Code.

Impact on general contractors

Mounting financial pressure. The reply mandates that large general contractors must pay SMEs in a timely manner even if they have not been paid by the owners. This will directly increase the financial pressure on general contractors. If large general contractors fail to manage their cash flow effectively, the project progress, and even their own financial status, would be impacted.

Piled contract risks. Probably the traditional payment terms and funding arrangements no longer fit large projects. Large general contractors must accurately assess contract negotiations and performance prospects with owners, and effectively evaluate SMEs to select the right collaborators.

Countermeasures

In response to new challenges posed by the reply, large general contractors can make adjustments in the following areas.

Reinforcing bidding process and contract management. General contractors are suggested to carefully select the proper owners and subcontractors, and diligently conduct the bidding process, contract negotiations and contract reviews. Special attention should be paid to key contract terms, while contract performance management requires greater elaboration.

First, the importance of conducting due diligence on owners is highlighted, compelling a better balance between new contract value and contract risk. The selection of legitimate subcontractors should also be more cautious, with collaboration terms carefully tailored to the size of subcontractors.

Second, performance metrics should play a stronger role in project management. For subcontractors specified by the owner, it is preferable for the owner to directly sign contracts and make payments, with the general contractor charging a management fee for oversight as appropriate. Construction quantity surveying and evaluation bears greater significance. If payments from the owner are delayed, it is crucial to promptly assess the owner’s payment capacity and financial status. To avoid advance payment, general contractors may consider actions such as construction suspension, request for extensions and additional cost claims.

Payment and acceleration disputes with owners should be resolved in timely fashion during contract execution, rather than being put off to final stages of the project.

Additionally, for back-to-back clauses in compliance with the reply, large general contractors should enforce stringent contract management. This includes strengthening detection of illegal assignment of contracts, subcontracting and affiliation, ensuring timely wage payments to migrant workers, etc. Payment terms should be honourable and well observed without unfair terms, methods, conditions or penalties imposed on small and medium-sized subcontractors.

Finally, underscore remedies for owners’ breach of contract. Jurisdiction clauses with legitimate subcontractors should align with the main contract to resolve disputes comprehensively. Given the exclusive jurisdiction of construction contracts, arbitration by a reputable committee is preferred over litigation.

Revising contract structures and payment arrangements. Traditional back-to-back clauses should be re-evaluated, with compliant payment terms to be agreed upon in a supplementary agreement. Implement stricter payment standards for subcontractor performance assessments, and exercise caution when allowing owners to occupy the site before fulfilling payment obligations.

Enhancing financial management and risk control. To address increasing financial pressures, large general contractors should strengthen financial management by establishing rigorous mechanisms of cash flow forecast and management. This helps ensure timely payments to SMEs, even when payments from owners are delayed.

Implementing risk allocation mechanisms in contract negotiations. During contract negotiations with owners, large general contractors should scrutinise the effectiveness of risk allocation mechanisms. For instance, advisably collaborate with other large enterprises including design firms, service providers, specialised subcontractors and other entities that meet the standards of large enterprises. Also, stipulate in contract that all parties are to share the risk of delayed payments from the owner and agree on reasonable payment terms. This ensures the risk allocation mechanism functions effectively when cash flow is impacted.

Conclusion

While the reply has advanced protection for SMEs, it also requires large general contractors to rebuild their contract and financial management. Back-to-back clauses are not universally invalid. By adjusting contract structures, enhancing financial management and improving risk allocation mechanisms, general contractors will be better equipped to navigate the new legal landscape.