Insolvency within the supply chain in the construction industry and what to do about it – Part Five
This week we look at what steps the Employer may take once a Contractor becomes insolvent. It also applies to the steps that a Contractor may take in relation to its Subcontractor on the insolvency of the Subcontractor.
References to Employer therefore also include references to Contractor in relation to a contract with its Subcontractor.
Is the Contractor insolvent?
- One of the key things to check is that the Contractor is insolvent as strictly defined in the contract and which of the insolvency procedures has been started. If an Employer intends to terminate the contract due to Contractor insolvency, if it is not strictly insolvent, the Employer will find itself in repudiatory breach of the contract.
- If the Contractor is insolvent, the Employer should start engaging with the relevant insolvency practitioner.
- It is important to take steps quickly and be proactive.
What are my options?
- Is insolvency a ground for termination under the contract and is termination an appropriate step to take? Most contracts provide for termination on insolvency, but it may not always be an option that is best for the project.
- If the Contractor is insolvent in accordance with the contract and the Employer wishes to terminate, it must serve the correct notices strictly in accordance with the contractual procedures.
- It may also be possible to claim against PI insurers under the Third Parties (Rights against Insurers) Act 2010 if defective works are discovered.
- If insolvency is not listed as a ground for termination under the contract, there may be other options for termination. For example, under clause 8.4 of the JCT D&B, the Employer can terminate where the Contractor fails to carry out the works regularly and diligently, which could be the case where the Contractor is insolvent or about to enter into insolvency. The correct notices must be served. Some contracts, including NEC4 ECC, also enable the Employer to terminate at will.
What practical steps should I be taking?
- always ensure that proper records of losses arising out of the insolvency are maintained.
- Get hold of copies of all relevant contract documents relating to the project. This will include:
- payment applications and notices served to date;
- copies of sub-contracts;
- insurance policies;
- any vesting certificates regarding materials stored off-site;
- records of Building Regulations and CDM Regulations compliance;
- Up to date copies of drawings will be important; and
- any copyright licences that are in place to use certain materials.
- Make sure that the site is secured. There may be Subcontractors further down the supply chain that have not been paid and want to remove materials and equipment from the site.
- Is the Contractor responsible for insuring the site? If so, the Employer may need to insure the works now.
- Are there any external funders? If so, they will need to be informed. If there is a facility agreement in place, then there may be obligations to complete the works by a certain time and the Employer may be in breach of those. Funder’s consent will also be required prior to any termination of the building contract. There may be direct agreements in place that require Funder consent prior to exercising any termination rights under the contract between Employer and Contractor (e.g. large infrastructure projects often include these).
- What about any other agreements with third parties e.g. development agreements, leases, agreement for lease etc.,? There may be obligations under those agreements and the Employer may find itself in breach of those following a Contractor’s insolvency. Again, it is important to follow the precise steps set out in those agreements.
- Consider engaging a replacement Contractor to complete the works. If the Employer does not propose to exercise its step-in rights in relation to the sub-contracts, the alternative would be to engage a replacement main Contractor.
- If the Employer decides to engage a replacement main Contractor, it needs to consider the following:
- how quickly can it get another Contractor involved? This will depend on the nature of the works and how far they have progressed;
- Can the existing building contract be novated or is it preferable to enter into a new building contract with the replacement Contractor?
- If the new Contractor can be convinced to take on liability for the works carried out by the original Contractor, the replacement Contractor will usually require a fee for doing so;
- Any necessary consents to use any such plant, etc. used by the original Contractor to complete the works will need to be obtained before recommencing the works, i.e. arranging for the continued hire of plant and equipment (see for example clause 8.7.1 of the JCT D&B).
- It will need to inform the rest of the construction team of the main Contractor’s insolvency. The Subcontractors will be most affected by the Contractor’s insolvency and may have concerns over their own financial stability.
- Engage with the insolvency practitioner, interested third parties and the construction team to discuss the next steps.
- Consider terms of consultant appointments:
- Where the project is put on hold due to the Contractor’s insolvency, the Employer will also need to look at suspending the services being carried out by its consultants;
- heck the terms of the appointments and follow the prescribed steps relating to suspension, including service of any notices required, and payment for the services up to the point of suspension.
- Record the condition of the site:
- Have a report prepared of the state of the works (ideally by an independent professional), including the value of the completed works executed to date (including variations), all goods and materials on site, and a record of any defective works. This will be particularly important where the Employer intends to engage a replacement Contractor to avoid any dispute as to the existing condition of the site;
- Also consider whether there are any goods or materials located off site which have been paid for.
- Record payments made to the Contractor/Subcontractors:
- Most construction contracts provide for payments to the Contractor to stop upon its insolvency (but be mindful of requirements to serve pay less notices);
- The Employer will need to keep a full account of the payments made to the Contractor to date, and then a detailed account of the costs of completing the works, as a final account will need to be prepared. Clause 8.7.5 of the JCT D&B provides, for example, that a balancing exercise is carried out once the works have been completed;
- The Employer needs to calculate the actual cost of completing the works (and making good defects) plus the costs associated with protecting the site and materials, and the amount of any direct loss or damage caused to the Employer which the Contractor is liable for (whether due to the termination or otherwise), plus the payments made to the Contractor so far. If these costs are more than the costs that would have been paid to the Contractor under the contract (as is usually the case), then the difference is payable by the Contractor as a debt. The NEC3/NEC4 ECC on the other hand takes a prospective approach and provides that the Employer is entitled to the forecasted additional costs of completing the works. Detailed accounts must be kept in any case.
What about any security packages?
- Is there a parent company guarantee? If so, does the guarantee cover the present situation? If it does, notify the guarantor that the security is going to be enforced. The issue, however, with such guarantees in an insolvency situation is that the parent company may well also be in financial difficulty, if it is not already insolvent, and the parent company guarantee may therefore be of little value.
- Is there a performance bond? Has the Contractor procured a performance bond in the Employer’s favour? If so, carefully consider whether the Employer can make a call under the bond in the event of Contractor insolvency, and if so, comply with all requirements in relation to making such a call.
- Is there an advance payment bond? Where the Employer has made an advance payment to the Contractor, e.g. for materials which the Contractor has had to secure with a long lead time, then it may have provided an advance payment bond which could provide recourse in the event of Contractor insolvency. Consider whether the Employer can now call on the bond.
What about collateral warranties and step-in rights?
- Are there any collateral warranties? Check that the Contractor has obtained all the Subcontractor collateral warranties it is required to obtain under the building contract in favour of the Employer, or that all required third party rights notices have been served. If these have not yet been obtained, ensure that they are supplied urgently to provide contractual recourse in the event of defects in the absence of the main Contractor. The Employer will usually require collateral warranties/third party rights in its favour (including step-in rights) from the Subcontractors with design responsibility and responsibility for key areas of the works, but this will be set out in the particular building contract.
- Check that all other collateral warranties/third party rights have also been procured in favour of third parties as required by the building contract, i.e. in favour of tenants, purchasers and funders.
- Consider step-in rights under Subcontractor warranties. Does the Employer have step-in rights under the collateral warranties provided by Subcontractors? If so, this can provide the Employer with the option to step into the Main Contractor’s place in the sub-contracts and employ the Subcontractors directly to complete the works instead of engaging a new Contractor. If the Employer cannot step in, it could seek to enter into new direct contracts with the Subcontractors as an alternative. The Employer must take care if it proposes to make any direct payments to the Subcontractors outside of the exercise of step-in rights, as these may fall foul of the pari passu rule and be deemed to be invalid under insolvency law. The Employer could find itself making the payment twice: to the Subcontractor, but also to the Contractor if it is found that the payment should have been made to the Contractor— consider whether an indemnity from the Subcontractor may be appropriate where the Employer does wish to make direct payments.
What about the Corporate Governance and Insolvency Act?
- The introduction of the Corporate Governance and Insolvency Act (CGIA) which came into force on 26 June 2020 impacts in particular the rights of a Contractor or Sub-Contractor to terminate on the insolvency of the Employer. In other words, the supplier of goods or services loses its right to terminate upon its client becoming subject to an insolvency procedure.
- We touched on this briefly in Part Two of this series and there are exceptions to this. A Contractor or Subcontractor may still be able to terminate if the Employer or the administrative receiver or liquidator consents or the court grants permission due to the potential hardship that may be caused to the Contractor or Subcontractor.
- Another interesting point to note is that there may be an automatic termination of the sub-contract where the main contract is terminated for e.g. Contractor insolvency. Within the JCT suite of contracts, there is automatic termination of the sub-contract where the employment of the main contractor occurs for any reason. However, it may be argued that this will not operate where the main contract is terminated due to main contractor insolvency and the above points may therefore apply in relation to potential step-in rights.
As set out above, there is a lot to think about if a Contractor or key Subcontractor becomes insolvent on a project. Insolvency amongst construction Contractors is likely to be a common occurrence in the months ahead. However, by taking the rights steps prior to engaging a Contractor or Subcontractor, making sure the contract includes the right provisions and being proactive should insolvency occur, Employers can go some way towards protecting their financial position and completing a project with the minimum amount of disruption.
Please note that this article does not constitute advice. For advice on insolvency in the construction supply chain and further information on any of the issues addressed in this article, please contact Elizabeth Vago, Construction, Engineering, Infrastructure and Energy partner, at Spencer West LLP elizabeth.vago@spencer-west.