In the construction industry, contractor insolvency delays projects, increases costs and may deprive the employer of remedies and third parties of meaningful warranty protection. In 2008, it was reported that the number of construction firms facing grave financial concerns was 547 per cent higher than in 2007 (Building, 14 November 2008). As contractor insolvencies are likely to increase in 2009, how can an employer protect its position at the start of a project and when contractor insolvency occurs?
Building contracts generally provide that, on contractor insolvency, either the contractor’s employment is automatically terminated or its employment is determinable at the employer’s option. It is preferable for a building contract to provide for determination at the employer’s option by notice and to define insolvency events of default as widely as possible. Such a pre-notice period may allow some dialogue between the employer and the contractor or the contractor’s insolvency practitioner, which can result in an agreement to complete the works rather than terminate the contract. An employer should obtain legal advice before agreeing to any arrangements put forward by the contractor or an insolvency practitioner.
It is essential to check thoroughly a contractor’s financial position before entering into a contract. If the contractor is a subsidiary company, the employer should consider obtaining a parent company guarantee. As a subsidiary’s insolvency may be accompanied by the insolvency of other group companies (including the parent company), a performance bond should also be considered. A performance bond is essential where the contractor is the ultimate parent company.
Performance bonds are provided by a third party on behalf of the contractor. In general, the issuer of the bond (the surety) undertakes to pay a sum to the bond recipient if the contractor fails to perform the contracted services on time or in accordance with the terms of the contract. A performance bond is usually capped at 10 per cent of the contract sum.
Default performance bonds usually allow the surety to raise the same contractual defences the contractor would have under the building contract and provide that the amount that the employer can claim cannot be quantified until completion of the works. This will cause significant problems if the employer cannot complete the works without securing additional funding. Unconditional or on-demand bonds can permit immediate recovery of estimated additional costs of completing works but they are becoming increasingly rare in the current economic climate.
Contractor insolvency may also mean that the employer is left without an enforceable remedy for future defects. Therefore, the employer should insist on collateral warranties from the contractor’s material subcontractors so that it has direct rights of recourse against the relevant subcontractors. The employer should also seek step-in rights that enable it to step in to the contractor’s position under the relevant subcontract before the subcontractor can terminate the contract for the contractor’s insolvency.
The 2005 editions of the suite of Joint Contracts Tribunal (JCT) standard building contracts (JCT 2005) do not require the contractor to procure a performance bond, a parent company guarantee or collateral warranties from its subcontractors so, if used, should be amended accordingly. The employer should also consider taking out a latent defects insurance policy.
Under the Housing Grants Construction and Regeneration Act 1996 (1996 Act), unless a valid withholding notice is served on the contractor within the prescribed period before the final date for payment, the employer must make the relevant payment to the contractor. Contracts can provide that, as from the date of the contractor’s insolvency, the employer is relieved from making any further payments that would otherwise be due under the contract. The House of Lords has held that such wording in the 1998 editions of the suite of JCT standard building contracts meant that an employer did not have to make further payment to an insolvent contractor, even though the appropriate withholding notice had not been served in accordance with the 1996 Act (Melville Dundas Ltd v George Wimpey UK  UKHL 18).
The JCT 2005 contracts provide that ‘other provisions of this Contract which require any further payment or any release of Retention shall cease to apply’. They also allow the employer to use the unpaid sums (retention) to complete the works and only account to the contractor for any unused amounts. While this gives the employer much needed relief, there is a risk of double payment if the employer uses the money to pay subcontractors for work carried out before termination of the contractor’s employment (see below).
To minimise delay and maintain continuity following the insolvency of the contractor, employers may want to retain the subcontractors and enter into direct contracts with them. However, the subcontractors are likely to require the employer to pay any outstanding sums due for works carried out before the main contractor’s insolvency. Despite the risk of double liability (that is, having to pay the contractor and the subcontractor), it may still be in the commercial interests of the employer to ‘do a deal’ with the subcontractor to ensure that the works are completed.
The employer will not be able to make a claim for the subcontractor’s right to payment from the contractor unless there is an express right of subrogation in the contract or the subcontract. Therefore, the employer should ensure that the debt/liability owed by the contractor to the subcontractor is assigned to the employer. However, in some circumstances this may be prohibited under insolvency law.
Materials on site
Immediately on a contractor’s insolvency, the employer should take all measures to secure the site so that materials are not removed by unpaid subcontractors or other creditors.
At common law, goods and materials that are affixed to land become the landowner’s property, and most building contracts provide that payment for unfixed materials on the site will pass ownership to the employer. However, title to materials from a subcontractor cannot pass to the employer if the title has not passed from the subcontractor to the contractor. Therefore, contractors should be required to procure that subcontracts are ‘back to back’ with the main contract so that the subcontracts do not contain any retention of title clauses. There will remain a risk where the employer has paid the contractor for materials but the contractor has not made the corresponding payment to the subcontractor.
Materials off site
The employer’s position is much weaker when it comes to unfixed materials off site as it is not in control of these. Simply providing that ownership of offsite materials passes to the employer on payment will be of limited practical protection if the materials are in a supplier or subcontractor’s warehouse. A better position is found in contracts such as the JCT 2005, which provide that:
- the contractor must provide reasonable proof that ownership of offsite materials is vested in the contractor; and
- it must be identified clearly where the materials are to be manufactured or kept, that they are held to the order of the employer and that their destination is the development site. An employer’s most effective protection is to require an offsite materials bond as a pre-condition to payment, which would entitle the employer to make a demand up to the value of the offsite materials
To safeguard its position in the event of contractor insolvency, an employer should:
- carry out financial investigations to ensure that the contractor is in good financial standing;
- obtain a performance bond (preferably on-demand) and/or a parent company guarantee;
- ensure that the building contract contains suitable provisions to deal with insolvency and its consequences, for example:
- no payment obligation on the employer following insolvency;
- no automatic termination of the main contract on insolvency (to provide flexibility and allow the employer to liaise with the insolvency practitioner);
- early insolvency triggers to give the employer more time to consider his position;
- provisions in the main contract and subcontracts that deal with the passing of title to the employer for on and offsite materials;
- if the employer forgoes the right to hold a retention, the provision for a retention bond to be provided on an ondemand basis; and/or
- collateral warranties/third party rights from subcontractors that contain ‘step-in rights’;
- obtain bonds before paying for offsite materials;
- keep alert for early indications of possible insolvency (for example, contractor’s subcontractors often complain on site about not being paid); and
- if making direct payments to a subcontractor for works completed before termination of the main contract, get the subcontractor to agree that they would repay the relevant sums if the direct payment is subsequently found to be unlawful under insolvency law. If the subcontractor does not agree to this, get the subcontractor to assign over its right to be paid for those works under its subcontract with the insolvent contractor.