Incidents of insolvency in the construction industry are under the spotlight after the recent failure of a number of construction companies1. Insolvency events affect not only the insolvent company, but all of those involved in the project supply chain, from suppliers and subcontractors who have not received payment for goods and works supplied, to owners and developers who experience delays and increased costs to their projects.

Although developers and principals typically seek to minimise the ripple effects of a contractor’s insolvency by terminating the contractor’s contract and removing them from the project, this article illustrates that parties need to act carefully when seeking to terminate contracts for the insolvency of another party. Not only does there need to be an express right to terminate for insolvency, but the insolvency event specified by the contract must have occurred prior to the contract being terminated. Parties must always be mindful that wrongful termination of a contract will entitle the other party to sue for damages.

What’s wrong with just terminating the insolvent party?

Given the disruption that can be caused to a project by the insolvency of one party, it is useful to have the right to remove the insolvent party from the project and replace them with a party that is capable of performing the relevant works. This is typically effected by the termination of the insolvent party.

It is important to note however that a contract can only be terminated for the insolvency of a party if there is an express right to do so. As a general starting point, there is no common law right to terminate for insolvency. There are some limited exceptions to this2, but generally speaking they do not apply in a construction context.

How about terminating for substantial breach?

Although construction contracts typically include a right to terminate for substantial breach, it should be noted that the insolvency of a party may not necessarily be enough to cause it to be in substantial breach of the contract.

A party’s inability to pay its debts on time, or even just being in the position of continuing to trade but trading while insolvent, is unlikely to, in itself, cause it to be in substantial breach of the contract. However, the consequences of an insolvency event, such as the inability of the contractor to progress works due to non-delivery of materials by unpaid suppliers or serious delay caused by subcontractors walking off-site due to non payment, may give rise to a substantial breach. Although such consequences may give rise to a substantial breach and in turn the right to terminate, such right to terminate will arise some time after the insolvency event itself may have occurred – and during this time other parts of the work may have been delayed and time may be lost with respect to the ordering of goods with long lead times.

The ripple effects across a project caused by the insolvency of a contractor are why termination due to the contractor’s insolvency should be treated differently from termination due to the contractor’s substantial breach. In many instances, a substantial breach may be rectifiable. Accordingly, the termination regime for substantial breach by the contractor typically allows for prior notice to be issued by the principal to the contractor of its intention to terminate if the contractor does not show cause or rectify the breach. Such an early notification regime is impractical with respect to the insolvency of a contractor as an insolvency event cannot be rectified.

Furthermore, the giving of prior notice of a party’s intention to terminate for the other party’s insolvency carries with it the risk that the insolvent party will remove from the site without hindrance, its assets that the principal could have recourse to (if allowed under the contract) in order to recover any outstanding debts.

Accordingly, it is important that the contract specifically entitles a party to terminate immediately and without the need to issue a show cause notice where the other is insolvent.

Standard form contracts

There are some quirks in commonly used standard form contracts that parties should be aware of, and typically amend, before entering into such arrangements.

Both the AS2124-1192 and the AS4000-1997, provide for a regime for determining the parties’ rights in the event that either of them may suffer an insolvency event, and each helpfully set out a clear and comprehensive list of events which are taken to be events of insolvency for the purposes of the contract. What is unusual about the regime however is that although the contractor has a right to terminate, the principal does not. The principal’s only right is to take work out of the hands of the contractor (and take possession of, and use, any constructional plant and other on-site assets of the contractor for the purpose of completing the works).

If contracts in the standard forms are not amended in this respect, then the principal is left in the position of having to wait for a substantial breach to arise, such as the contractor wrongfully suspending the work or failing to proceed with due expedition and without delay, before it can terminate the contract. Furthermore, the principal’s right to terminate will not arise until it has first issued a notice to show cause and the contractor has failed to do so within the required time.

Tread carefully

Wrongful termination of a contract will entitle the other party to sue for damages. Accordingly, it is vital first that parties have an actual right to terminate for insolvency and secondly that an actual event of insolvency has occurred.

Developers and principals should ensure that their contracts grant them the express right to terminate in the event of the contractor’s or supplier’s insolvency. In drafting such provisions, parties should include an extensive list of events which are deemed to be insolvency events to ensure that they are properly protected.

If there is no express right to terminate for the insolvency of a party, then a project could be unnecessarily delayed and held-up, and the parties left waiting for a substantial breach to occur before the insolvent party can be removed from the project.