Contractor insolvency – an Employer’s viewpoint

The construction industry depends on regular cash flow and the financial disaster of contractor insolvency can derail an entire construction project. Here we consider the measures an employer may take to protect itself from a contractor becoming insolvent during or at the end of a construction project.

  1. Due Diligence

Regardless of whether there is an existing commercial relationship with the contractor or it is the first time the contractor has been engaged, an employer should always carry out due diligence against the contractor before undertaking a construction project.

To reduce risk, it is vital to understand an organisation’s financial status before they are appointed and throughout the project. This can be done in a number of ways including credit checks; considering the filed accounts at Companies House; requesting performance references following recently completed projects and awareness of any joint ventures or partnerships between the contractor and other companies.

  1. Payment

The prudent employer knows and monitors how much has been paid to the contractor and whether they have been overpaid or underpaid.

Is the contractor paying his subcontractors and suppliers their due entitlement on time? It is not always easy to know for sure but the site rumour mill should not be ignored. Progress in accordance with the programme, or lack of it, is another indicator of the health of the contractor, as is the adequacy of the level of resources employed. If this all sounds rather obvious it is surprising how often such warning signs are present but ignored.

Any over payment should be promptly recovered by deduction or action having regard always to the contract terms and the payment provisions of the Housing Grants, Construction and Regeneration Act 1996 (as amended).

  1. Performance security

Most employers will require performance security from the contractor. One of the most common forms of security is the parent company guarantee, where the performance of a contractor is guaranteed by its parent or another group company. Naturally, the guarantee is only as good as the company giving it. If the contractor is in financial difficulty, the same could be true for the whole group. It may be possible to obtain a personal guarantee from a director or directors, though this is unusual and the financial strength of such a guarantee may be difficult to judge despite enquiries.

Alternatively, an employer could ask for a performance bond from an insurer or bank. It is necessary to ensure that the definition of the ‘default’ or ‘event’ under the bond triggering the right to call for payment includes contractor insolvency and that the term ‘insolvency’ itself is defined to fit in with the term as used in the building contract. The cost of a bond is usually added to or allowed for (transparently or otherwise) in the contractor’s price but it could prove to be a worthwhile investment, if it comes to finding another contractor to complete the project. Note also the commentary on termination for insolvency (see below).

  1. Retention

Retention is a contractual practice intended to provide security against defective work or insolvency and incentivise contractors to complete the works on time. It usually involves the employer withholding a percentage (typically 3 – 5%) of the amount due for payment. Ordinarily, the first half of retention is released upon completion of the work or the employer’s taking over of possession of the work (whichever is earlier) and the other half is released following the expiry of an agreed defects liability period (typically 12 to 24 months).  Employers should therefore consider the amount of the retention and the period for its release to help protect from non-performance. A higher percentage of retention is an incentive for contractors to complete works timeously and see the project through to the end. It means if the project is not completed, that money remains with the employer and may be available to go towards the additional costs of completion of the project.

  1. Warranties

The contractor should be required to procure warranties in favour of the employer from key subcontractors and members of the contractor’s professional team. See further under Defects (next).

  1. Defects.

If the right to compel the contractor to repair defective work is lost due to insolvency, the employer may have rights against the professional team (for design defects or negligent certification) or sub-contractors involved in carrying out the defective work.

Protection for patent or future or latent defects in the works can be found against those who have given collateral warranties. Provision for which should be made in the building contract.

If contractor insolvency occurs during the course of the works, the employer may benefit from having “step-in” rights allowing the employer to step in to the shoes of the contractor in the relevant appointment or Subcontract. Such step in rights will also provide for any outstanding liabilities and whether these are to be met by the employer. If so the employer will need to consider if the benefit of stepping in outweighs the outstanding liabilities.

  1. Termination

Where works are ongoing, it may be appropriate or necessary to terminate the contractor’s employment under the building contract for contractor default. Termination may then give rise to rights under a performance guarantee or bond. In the case of insolvency, the building contract may provide that termination happens only upon the giving of notice, or without notice (so called automatic termination). The legal effects of the different provisions is beyond the scope of this article. However it is important to consider the particular termination provisions and the process for carrying out termination, including the need for notice and when and how it needs to be given.

It is also prudent to consider whether to amend the termination provisions to widen the definition of insolvency. As stated above, the employer should consider how ‘insolvency’ is described in the contract and in any security documents or warranties giving step in rights.

Slater Heelis’ Construction & Engineering Team has extensive experience advising employers looking to manage risk on construction projects.

Please contact us on 0161 672 1255 or get in touch with our Construction & Engineering team.