Termination rights
Payment entitlements
Bond/parent company guarantee
Step-in rights
Comment
The insolvency of any party to a construction contract can be disastrous for the project. It can cause significant additional costs and delays to completion, and deprive parties of remedies in respect of defects in the works. This update focuses on the effect of a contractor's insolvency and the rights available to the employer and other parties when such an event occurs.
Termination rights
An employer which is faced with an insolvent contractor will first need to determine whether it is entitled to terminate the contractor's employment under the contract. Insolvency itself does not create an automatic entitlement to terminate unless set out in the termination provisions of the contract. Under the public works contracts, the definition of an insolvency event giving rise to the employer's right to terminate is extremely broad. Events such as 'ceasing to trade' or 'threatening to cease to trade' are considered insolvency events under the public works contracts, but not under the Royal Institute of the Architects of Ireland (RIAI) or the Institution of Engineers of Ireland (IEI) standard forms.
Under the IEI contract, there is no express right to forfeit the contract on the grounds of the contractor's entry into examinership. This is in contrast to the RIAI and public works contracts, which all provide an express optional right to terminate on examinership. Furthermore, the RIAI contract does not provide for the employer's right to terminate on the grounds of a creditors' meeting or scheme of arrangement, whereas such an entitlement can be found in most of the other standard forms (including International Federation of Consulting Engineers forms).
Payment entitlements
The timing of and entitlement to payment is of paramount concern to all parties on the insolvency of the contractor. Pursuant to all of the Irish standard forms, including the public works contracts, if a contractor is due any moneys, on its insolvency, it must wait until the works have been completed by the employer and a balance undertaken between sums owed to it and the completion costs incurred by the employer. Under the IEI contract, the contractor must further await the expiration of the defects liability period before it becomes entitled to any sums which may be due. In reality, however, and depending on when the insolvency event occurs, the employer is most likely to be the party with the net balance due in its favour, representing the additional costs of finishing out the project with a replacement contractor.
Bond/parent company guarantee
A bond or parent company guarantee is a means by which an employer can safeguard the recovery of additional costs of completing the project in the event of contractor insolvency. A bond is generally preferable to a parent company guarantee, since if a subsidiary is in difficulty, it is likely that its parent may also suffer a similar fate.
An on-demand bond is the preferable form of security from an employer's perspective, since it is payable once a compliant demand is presented by the employer to the surety without proof of contractor breach or employer loss. It provides the employer with immediate cash in order to deal with the default by the insolvent contractor. In practice, on-demand bonds are rare, particularly in the domestic market for civil and building construction projects.
A more usual form of bond is a performance or default bond, which is a guarantee pursuant to which a right to payment will arise only if the employer proves the contractor's breach under the contract and that loss has been suffered as a result of that breach. The bond itself or the underlying construction contract should expressly provide that the bond may be called upon in the event of the contractor's insolvency, as insolvency of itself may not constitute an automatic breach of contract leading to an entitlement to call on the bond.
Step-in rights
In the event of main contractor insolvency, the employer will wish to retain the momentum of the project through the services of suppliers and subcontractors who have contracted with the insolvent contractor. Where the employer has collateral warranties with the principal subcontractors, these usually include a provision whereby the employer can step into the main contractor's shoes allowing subcontract works to proceed and ensuring that the employer has recourse to the subcontractor in respect of future defects. Under the public works contracts, the contractor is also obliged to assign any subcontract/supply agreement to the employer if requested to do so, and the employer may pay subcontractors and suppliers directly.
Comment
An employer should carry out thorough and regular checks of the contractor's financial position before entering into a construction contract and at regular intervals throughout the execution of the works. Before executing a construction contract, an employer should ensure some protection against contractor insolvency by insisting on the provision of a bond and/or parent company guarantee. At the outset of every project, the employer should also ensure that it obtains collateral warranties from principal subcontractors with step-in rights. Finally, the contract should define insolvency events as widely as possible and allow for determination of the contract on contractor insolvency.
For further information on this topic please contact Karen Killoran at Arthur Cox by telephone (+353 1 618 0000), fax (+353 1 618 0618) or email ([email protected]).
May 16 2011