Despite several high profile attempts to reform the industry, unfair payment practices and the risk of insolvency continue to present significant issues for those involved in delivering infrastructure projects, where main contractors routinely outsource all work to supply chains, while employers are often SPVs with limited assets.
This article considers how escrow accounts and project bank accounts may be used to mitigate the these risks. Both forms of financial security are based on the principle that, in the event of insolvency, trust property is not included in the assets available for distribution to creditors.
Escrow Accounts: Protecting against employer insolvency
It is increasingly common for contractors to request that employers deposits funds into escrow accounts as security for the employers’ payment obligations.
How do Escrow Accounts Work?
Put simply, an escrow account is a bank account with defined conditions for the release of funds. An escrow agent is appointed by the employer and contractor to hold a sum of money on trust.
The escrow monies might be:
- used to fund every payment on a regular basis; or
- released only in the event of employer default or insolvency.
When funds are released to the contractor, the employer usually has an obligation to ‘top up’ the escrow account by reinstating the funds within a specified period of time, failing which the contractor will be entitled to suspend performance or terminate its employment.
At the end of the project, any remaining monies (including interest) held in the escrow account are released to the employer.
If the employer becomes insolvent, the contractor has the security of knowing that the funds in the escrow account should not be included with the employer’s other assets for distribution to creditors.
When preparing an escrow agreement, consider the following points:
- How much money should the employer be required to place in the escrow account?
- Under what circumstances should the funds be released? As well as the regular payment cycle, consider how disputes, early termination and the insolvency of either party will be dealt with.
- Is the escrow agent independent, trustworthy and creditworthy?
Some other options to protect against employer insolvency:
- Parent company guarantees and payment security bonds from the employer.
- “Front-loaded” stage payments, with more payable at the start of the project and less near completion.
- Advance payments may be justifiable if the contractor has pay for plant, equipment, materials upfront (although note that the employer is likely to require an “on demand” advance payment bond in return).
- Direct payments to the contractor under the building contract from the employer’s funder.
Project Bank Accounts: Protecting against contractor insolvency
The UK Government has estimated that public sector clients could save up to 2.5% on construction costs by introducing better payment practices. Many of the principles are equally applicable to private sector and international projects.
One main recommendations was to introduce project bank accounts (“PBAs”) where practical and cost effective. PBAs enable the supply chain to receive payment from a single bank account rather than through the main contractor. Effectively the employer makes direct payments to the subcontractors. This mitigates the risk to the employer and subcontractors of insolvency in the contractor’s supply chain by ensuring that all participating subcontractors receive timely payment of monies due to them. It is hoped that the reduction in risk and greater efficiencies will lead to an overall reduction in costs.
In the last 10 years there has been increasing use of PBAs: drafting bodies have made provision for PBAs in the NEC, JCT and PPC range of contracts and a number of banks have launched PBA products. However, uptake still appears relatively limited (with the notable exception of Highways England).
In principle PBAs can be used on any size of project. However, due to the time and cost involved in set up and administration, PBAs provide better value for money if linked to a programme of work or larger one-off projects.
How do Project Bank Accounts typically work?
- Appropriate modifications are made to the tender invitations and contract documentation.
- The employer, contractor and participating subcontractors sign a trust deed, containing provisions for administering the PBA (further subcontractors can be jointed to the trust deed as the project progresses).
- A bank mandate is completed and the PBA is opened with the bank.
- Interim payments are certified as usual, with the contractor’s application stating the amount due to each participating subcontractor.
- The employer pays the certified amount into the PBA, subject to any withheld sums notified to the contractor.
- The bank then distributes the funds to the contractor and the subcontractors.
- The trust deed provides that any funds paid into the PBA are held on trust for the contractor and the participating subcontractors. If properly drafted, this should prevent an administrator seizing the proceeds of the account should the employer or a supply chain member become insolvent.
- Use of a PBA helps to prevent contractors in financial difficulties from unfairly withholding payment from their supply chain.
- The PBA may reduce administration and speed up payment, by preventing long chains of payments through the supply chain.
- Savings in subcontractor tender prices may be achieved in return for greater payment certainty and improved cash flow.
- The employer gains greater transparency regarding the contractor’s payment arrangements with subcontractors.
- There is no additional risk to the employer as it only releases funds in respect of certified works.
- Project bank accounts are complementary to the principles of collaborative working and partnering.
The aims of PBAs are laudable, but there is still some doubt as to the practical benefits that may realistically be achieved. Potential limitations and issues include the following:
- Time and money must be invested in the initial set up and ongoing administration. It has been suggested that PBAs are unsuitable for use on lower value projects.
- PBAs only offer limited protection to the supply chain against employer (as opposed to contractor) insolvency, since the amount paid into the PBA is only that amount already due to the contractor.
- Even if there is surplus cash in the PBA at the point of insolvency, the trust arrangements have not yet been fully tested by the courts.
- The contractor must be persuaded to permit a degree of open book transparency regarding the amounts paid to the participating subcontractors.
- Some contractors rely on retaining cash to enhance profitability.
- It may not be practical to include smaller supply chain members (in terms of package value) in the PBA arrangements.
- Non-standard payment terms, including the use of PBAs, may actually deter some subcontractors from tendering or increase their tender costs, at least until standard forms of PBA are more widely used in the construction industry.
- It has proved difficult to quantify the savings realised by the use of PBAs.
There would be a number of significant challenges to using PBAs on international projects, particularly where a number of currencies and jurisdictions may be involved. However, it is notable that a number of Australian states have begun to consider mandating the use of PBAs for certain construction projects.