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Contracting party insolvency - a rough guide

13 September 2013

Whilst the green shoots of economic recovery may appear to have finally arrived, the threat of insolvency remains and may even now increase - according to Experian Business Information Services, "as businesses start to think about growth and companies start to restock and rehire, the insolvency rate could well go up as cash flow becomes an issue" (Max Firth, Managing Director). With this in mind, we have set out below a rough guide to some of the common insolvency issues that arise in the construction industry.

How can I spot if a counterparty is headed towards insolvency?

Whilst not necessarily determinative, typical signs of insolvency can include:

  • employers: repeatedly delaying payments to the contractor; making regular omissions from the project; suspending the project, without explanation
  • contactors: employees not attending site; plant, equipment and materials being removed from site; a general slow down in the progress of work or works being carried out of sequence; non payment of subcontractors applications for payment; seeking to change payment mechanisms (e.g., requesting advance payments).

How can I protect myself against the risks of counterparty insolvency?

The best protection against insolvency is likely to come in the form of your contract or methods of working which have been agreed before the project begins. For example, parties can:

  1. Define insolvency as a termination event in their contract (for examples, see the JCT and NEC forms of contract(1)).
  2. Consider setting up a project bank account. In the event that an employer becomes insolvent, it is likely(2) that the funds in a properly drafted project bank account(3) will not be swallowed up with the employers other assets, but can instead be used to pay the contractor and its supply chain. There is a cost and administrative burden in setting up and maintaining the account which may be uneconomical on a smaller project.
  3. Obtain a parent company guarantee. In the event of an insolvency, this can oblige a contractors parent guarantor to indemnify the employer for loss and damage, or an employers parent guarantor to pay any outstanding amounts due to the contractor. Of course, a parent company guarantee only provides protection in the event that the company providing it is itself solvent.

Employers could also consider:

  1. seeking a performance bond;
  2. inserting step-rights in all collateral warranties (saving the time and cost of formally novating each contract);
  3. including a clause in the building contract allowing it the ability to enter the site to secure and use the plant, equipment and materials(4); and/or
  4. including a clause in the building contract allowing it to recover the cost of engaging a new contractor to complete the works from the original contractor(5).

Contractors could consider the use of an escrow account(6).

During the course of a contract, if you suspect that a counterparty is at risk of insolvency, it is important to consider whether you have a crystallised dispute. If so, you may want to consider commencing adjudication before insolvency, since you will require a courts permission to do so post insolvency. We have commented on particular steps employers and contractors can take below.

I am an employer and my contractor is insolvent - what do I need to do?

First, check whether or not the liquidator will adopt the building contract and complete the works. This will avoid the cost of engaging a new contractor and disrupting the progress of the works. If this is not possible, then consider the following:

Immediately

  • are all relevant insurances in place? Commonly the contractor is responsible for these. Check with the insurance broker that all premiums are fully paid up
  • check if under the building contract the contractor has retained title to the plant, equipment and materials/goods on site, and practically confirm whether or not such items are secure and cannot be removed
  • are all copyright licences, drawings and documents fully paid up and provided? You will want to pass these onto any new contractor.

Continuing the works

  • is the contractors insolvency an event of termination under the building contract? Do you need consent from any third parties in order to terminate the building contract?
  • is all the security documentation (e.g. a parent company guarantee or performance bonds) in place and completed? Check the terms of these documents to see how and when the guarantors obligations are discharged(7)
  • are any payments outstanding to the contractor? Does your building contract provide for set off or abatement?
  • will the consultants and sub-contractors continue to carry out the works and services? Do your collateral warranties have step-in rights? If so, when are you are obliged to exercise them and what is the process for stepping-in?
  • public bodies - will you need to retender the works and/or services to comply with the EU Public Contracts Regulations 2006?
  • any new contractor may seek to negotiate the building contract. Consider which clauses you are willing to take a view on ahead of negotiations in order to keep legal costs to a minimum.

I am a contractor and the employer is insolvent what do I need to do?

Immediately

  • are all your plant, materials and equipment on site secure? Have you retained title to these goods under the building contract? (In the case of materials incorporated into the building, you will only be able to claim as an unsecured creditor as opposed to owner of the goods.) Are you able to enter the site to recover them?
  • are you able to take advantage of any pay when paid clauses? The Construction Act(8) generally prevents the use of such clauses, save in the event that the third party who is making the payment is insolvent. You will need to check that the party in question is insolvent for the purposes of the Construction Act(9).

Continuing the works

  • will any third party (e.g. a funder or tenant) be stepping-in to the building contract?
  • are any payments outstanding? You may want to submit a proof of debt form in the event a third party does not step-in to the building contract.

(1) Clauses 8.5.1. and 8.10.1 of the JCT Design and Build Contract 2011 edition and clauses 90.1 and 91.1 of the NEC3 Engineering and Construction Contract 2013 edition.

(2) This has not been tested by the courts.

(3) The project bank account must create a trust and the funds must not be mixed with the ordinary trading funds of the employer.

(4) For example, see clause 92.2 (P3) of the NEC3 Engineering and Construction Contract 2013 and clause 8.7.1 of the JCT Design and Build Contract 2011 edition.

(5) For example, see clause 93.1 and 93.2 (A3) of the NEC3 Engineering and Construction Contract 2013 edition Clause and clause 8.7.1 of the JCT Design and Build Contract 2011 edition.

(6) For more detail, see our previous article what is the issue with late payments.

(7) For example, on termination of the building contract, appointment of a new contractor or negotiation of the scope of works.

(8) The Housing Grants, Construction and Regeneration Act 1996, as amended.

[9) Sections 113 (2) to (5).

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