Mitigating Contractor Insolvency: A Developer’s Toolkit

June 10, 2022, By

As the construction industry faces yet more headwinds, developers should guard themselves against contractor insolvency to avoid a fatal blow to business, says Matt Grellier, our Head of Construction and Engineering.

With spiralling costs and expiring Covid loan repayment periods, a growing number of UK businesses are experiencing severe financial distress. The latest Begbies Traynor report unearthed some particularly bleak findings: in April 2022, the risk of UK businesses going under increased 19% year-on-year while County Court Judgements grew by 157%, raising alarm of future insolvencies.

Along with hospitality, construction is the sector most exposed to business failures. Hangovers from the pandemic and Brexit, coupled with inflated energy bills, growing wage costs and a critical staffing crisis, have resulted in the perfect storm.

The effect of contractor insolvency on the parties involved in a project can be catastrophic. When South West construction giant Midas announced it was going into administration last January, almost 2,000 businesses in its vast supply chain were left with outstanding payments, three major construction projects ceased works, and over 300 employees lost their jobs.

As financial pressures on the construction sector show no imminent let-up, developers are urged to take steps to guard themselves against contractor insolvency, minimise impact on their projects, and reduce the likelihood of contractual disputes.

 

What precautions can developers take when entering into contracts?

Due diligence

Checking the contractor’s financial status at tender stage and again before entering into contract is crucial. This can be done via credit checks and making enquiries as to whether they are paying sub-contractors and suppliers on time on other projects. A lack of progress and inadequate resource on other projects raises red flags about performance and may also indicate problems with financial health.

Performance security

There are also more proactive ways in which to guard against a contractor failing to perform its obligations, such as obtaining a parent or other group company’s guarantee. However, the guarantee is only as good as the company giving it and if the contractor has become insolvent it is often the case that the wider group of companies are equally suffering financial distress.

Perhaps a more reliable form of security is a performance bond from an insurer or a bank of good standing. Performance bonds provide a specified sum of money, usually calculated as a percentage of the contract price (often 10%), on which the employer can call when the contractor is in default. The bond amount and premium for procuring the bond is influenced by several factors, including project risk and the contractor’s reputation.

Developers need to carefully consider the wording of the bond to check how and when they can call on the bond. It’s also critical to ensure that the right to call on the bond includes the scenario of contractor insolvency as defined under the building contract.

Collateral Warranties

It’s common practice to require the contractor to procure collateral warranties in favour of the developer from key subcontractors and members of contractor’s professional team (e.g. novated consultants). Collateral warranties create a direct contractual link between the developer and such parties. This can provide a crucial means of recourse for the developer if said parties are responsible for loss suffered by the developer.

Retention

Retention can incentivise a contractor to meet its obligations regarding time for completion and quality of the works.

Usually, developers retain a percentage of each interim payment due to the contractor as security. Half the retention fund is typically released upon practical completion with the balance usually being released after the expiry of the defects liability period.

Step-in rights

In the event of contractor insolvency, a developer may also benefit from having ‘step-in’ rights set out in the contract documentation which would allow them, or their nominee, to ‘step in to the shoes’ of the contractor in the relevant professional appointment or sub-contract. This can help maintain progress and keep the continuity of the project team.

Staying on the safe side

As we head into yet more months of rising costs and lower margins, insolvency remains a matter of growing concern for those operating within the industry.

Being aware of the precautions that can help mitigate the risk of contractor insolvency is not only vital to protecting the developer’s business interests, but also integral to reducing the adverse effects that the derailment of projects can have on society at large.