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Managing Contractor Insolvency: A Legal and Practical Guide

23 October 2019 | London
Legal Briefings – By Harith Canna

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One of the biggest risks faced by an employer in a construction project is the impact of the main contractor becoming insolvent, particularly in the current economic climate where it has become clear that main contractors are not regarded as being “too big to fail”. 

In this article, we discuss how this risk can be managed through a variety of legal and practical measures which a prudent employer would be well advised to take, starting with the key signs and implications of contractor insolvency and what insolvency means in the context of a joint venture contractor. We then discuss the legal, commercial and other practical considerations for mitigating the impact of contractor insolvency; and we conclude by exploring options for completing the project, engaging with the 2nd tier supply chain and the relationship between insolvency and adjudication.

Signs of insolvency

An employer should be alert to any early warning signs which are likely to be a precursor to a contractor becoming insolvent; for example a slowdown in the works or the receipt of requests for direct payments from sub-contractors or requests for early payment from the contractor. Where such signs fall below the radar, a contractor may in any case (e.g. under the JCT design and build contract) be required to notify the employer in the event of it becoming insolvent.

Implications of insolvency

Whether or not a contractor is in fact insolvent for contractual purposes will depend on the definition of insolvency under the relevant building contract. Once it is determined that the contractor’s status falls within the definition of insolvency, the building contract should be consulted to ascertain the automatic implications which flow as a result. Under the JCT form of design and build contract, the immediate consequences of insolvency are that:

  1. no further sums become due to the contractor;
  2. the contractor’s obligation to carry out works is suspended; and
  3. the employer can take reasonable measures to ensure that the site, the works and the site materials are adequately protected and that the site materials are retained on the site (free from any hindrance or delay which the contractor may cause).

The right to suspend payments to the contractor is a contractual and not a statutory right. This right to suspend payment must be effected by issuing a pay less notice if this can be done within the prescribed timeframe under the contract. Where the insolvency event occurs after the time for issuing a pay less notice has passed and no such notice was issued, the contract may expressly provide that payment may nevertheless be suspended. Determining whether a pay less notice should be issued is therefore one of the critical first steps which the employer should take.

If the building contract does not expressly entitle the employer to stop paying the contractor, the employer will still be liable to pay the contractor for any sums in respect of which the final date of payment has occurred, in accordance with the Housing Grants, Construction and Regeneration Act 1996 (the "Construction Act").

Further consequences of insolvency involving a joint venture contractor

The consequences of insolvency become all the more complicated where the contractor is an integrated joint venture entity or an unincorporated joint venture.

Where the contractor is an integrated joint venture entity, the insolvency of one of the joint venture participants may trigger the right to terminate under any joint venture or shareholders’ agreement. It would be common therefore for the right to terminate under the construction contract to arise where the joint venture or shareholders’ agreement is terminated or becomes terminable.

On the other hand, where the contractor is an unincorporated joint venture, in addition to being linked to the joint venture or shareholders’ agreement, the construction contract is likely to feature a termination right where one of the joint venture participants becomes insolvent. The construction contract should also address whether the remaining joint venture entity is jointly and severally liable for works carried out by the insolvent contractor.

While insolvency may be perceived to be a remote or theoretical risk at the time of contract inception, the risk should not be discounted. It is easy to think that all eventualities have been addressed by providing for joint and several liability and the right to terminate. But that is short-sighted. The insolvency of a joint venture party does not always mean the end of the joint venture. A well-considered joint venture provision could afford the remaining joint venture member(s) the opportunity to complete the work and should expressly prohibit any payments to the joint venture made after the insolvency event occurring from being received by the insolvent member.

Properly executed documentation

As a general rule, the employer’s entitlement to enforce its rights against the contractor and sub-contractors is dependent on the existence of properly executed documentation. Adopting an effective document management process early on in the life of a project to ensure that any parent company guarantees, collateral warranties (including from sub-contractors) and bonds are properly executed and in force, will be of great significance to the nature of the remedies and scope of options available to the employer.

Securing the site

Another important practical step for an employer is to take possession of and secure the site. This should be done as soon as possible. It may be expedient for the employer to appoint a logistics contractor to assist it with managing the site (i.e. securing and making safe the site, managing statutory certificates for temporary erections, orderly removal of sub-contractor plant and equipment including that which is hired). It should be noted that if the contractor has gone into administration, the statutory moratorium may prevent the employer from taking certain actions e.g. seeking to repossess goods subject to a hire purchase agreement in the contractor’s possession, without the consent of the administrator or the permission of the court.

Plant and materials

Transfer of ownership of materials will depend on the parties’ contractual arrangements. In the absence of express provisions, title to materials will remain with the contractor until they are incorporated into the works, at which point title will pass to the employer.

Under the JCT design and build contract, title to materials transfers upon payment for such materials. Note however that in respect of off-site materials, payment is subject to certain conditions to ensure that they are readily identifiable.

The employer should carry out a comprehensive audit of all of the plant, materials and documents on the site and ensure that the site is secured in order to protect such items. The same applies for any off-site materials for which the employer has made payment.

Title to temporary plant and equipment does not typically transfer to the employer as they are often hired and are not in any event incorporated into the works.

Insurance

The employer will need to make sure that the necessary insurance arrangements remain in place. The contractor is likely to have been in financial difficulty during the period leading up to insolvency. This gives rise to the risk that insurance premiums have not been paid. Any such insurance premiums are likely to be paid annually and so insurance may remain in place depending on when the policy was last renewed. As PI insurance operates on a claims made basis, any claims for design defects will need to be brought before its renewal date. The employer should be in a position to check the insurance arrangements as a building contract will typically require a contractor to provide evidence that it has complied with its insurance obligations.

Under the Third Parties (Rights Against Insurers) Act 2010 (effective from 1 August 2016), where the contractor was responsible for maintaining insurance and subsequently becomes insolvent, the employer will be able to bring an insurance claim directly against the insurer without adding the contractor to the proceedings. In order to do so, the employer will have to establish the insured’s (i.e. the contractor’s) liability and that he was insured against the risk in question. Under the previous statutory regime (Third Parties Act 1930), an employer would have had to bring a claim against a contractor which would have involved seeking leave from a court if the contractor was in liquidation or applying for the contractor to be restored to the register of companies if it was dissolved.

CDM Regulations

An employer should take steps to ensure that it continues to comply with its obligations under the Construction (Design and Management) Regulations 2015 (the “CDM Regulations“).

The CDM Regulations require the employer to make suitable arrangements for managing a project so that construction work can be carried out, so far as is reasonably practicable without risks to health and safety. The employer must maintain and review these arrangements throughout the life of the project.

An employer should bear in mind that, where there is no principal designer and/or contractor appointment in place, the CDM Regulations provide that the employer will be responsible for fulfilling their respective duties. The prompt appointment of a replacement is therefore essential.

Payment

As soon as the employer takes possession and secures the site, it should instruct its quantity surveyor to value the works which have been carried out. In doing so, the employer should check how much has already been paid to the contractor in order to assess whether the contractor has been overpaid.

The employer should rely on contractual provisions to avoid making any further payments to the contractor, as discussed above.

In practice, the employer will wish to suspend/minimise payment to the contractor until it has determined the next steps e.g. terminating the contractor’s employment or seeking to continue under the contract to complete the project. The employer should review the terms of the contract to understand the implications of non-payment.

Where the employer wishes to continue with the contract notwithstanding the insolvency of the contractor, it may seek to agree arrangements with the insolvency practitioner for continued provision of services by the contractor and periodic payments to the contractor on completion of the agreed milestones etc.

Performance security

An employer should consider what recourse it has against any performance security provided by a contractor. Such recourse will typically take the form of a parent company guarantee and/or a performance bond.

Parent company guarantee

If a parent company guarantee is in place and the parent company remains solvent, an employer should check its entitlement to make a claim against the guarantor. A guarantee is typically enforceable in the event that the contractor is in breach of contract. However, insolvency of a contractor does not automatically mean that the contractor is in breach of contract. Therefore, it is common for a guarantee to expressly specify that insolvency automatically gives rise to a right to make a claim under the guarantee.

Once the right to make a claim is established, the employer must ensure that the technical requirements under the guarantee are complied with.

A demand under a guarantee should also specify what is being sought from the guarantor. This will typically be the performance and fulfilment of the contractor’s duties and obligations under the building contract or compensation for losses, damages and expenses which the employer has suffered as a result of the contractor’s breach or failure.

Whilst the guarantor may elect to complete the works, the employer will not be able to compel the guarantor to do so. As a general rule, specific performance is not ordered where this would require performance of the building contract or constant supervision by the courts. Damages from the guarantor would be a more suitable remedy in this case.

Performance bond

Unlike a guarantee, a performance bond will be provided by a third party (e.g. a bank or a surety company). This is likely to be more beneficial to the employer as the issuer of the bond will not be suffering from the same financial difficulties as the contractor. However, the amount that can be drawn under a bond is typically capped at 10% of the contract sum.

An employer needs to establish the right to make a call under a performance bond. In the case of a conditional performance bond, the employer typically needs to establish breach of contract in order to draw on the bond. As with a guarantee, it is common for a bond to treat the insolvency of a contractor as a breach of contract. Accordingly, this would entitle the employer to call on the bond.

An employer should ensure that any claims are notified strictly in accordance with the technical requirements under the bond and prior to the expiry date of the bond.

Termination rights

Insolvency of the contractor does not automatically mean that the contractor is in breach of contract. The building contract should be consulted to determine whether the employer can terminate the contractor’s employment in the event of insolvency.

How a contract is terminated (whether in accordance with its terms or at common law for repudiatory breach) will have a significant bearing on the contractor’s liability flowing from such termination. Termination solely in accordance with the terms of the contract will generally mean that the contractual consequences apply. Conversely, termination for repudiatory breach will generally mean that the contractual consequences will not apply, but instead, an employer would be entitled to damages for loss of contract.

The consequences of terminating the contractor’s employment in the JCT design and build contract are that the employer can:

  1. employ and pay another contractor to complete the works; and
  2. take possession of the site and works and use all temporary buildings, plant, tools, equipment and site material for the purposes of completing the works.

The most common express remedy available to an employer in the event of termination is the contractor’s obligation to pay for any additional amounts incurred by the employer in completing the works and rectifying any defects.

Finally, consider whether any consent is required for terminating the contractor’s employment under, and the possible implications for, any third party agreements. For example, if there is a facility agreement in place, consider whether termination must be approved by lenders or, in the case of pre-let agreements, consider the implications on any longstop dates for achieving practical completion.

Completing the project

The options available to the employer include:

  1. completing the project with the existing contractor notwithstanding the insolvency of the contractor (see below);
  2. terminating the contractor’s employment (see above);
  3. leveraging its rights under a guarantee so that either the guarantor completes the project or it compensates the employer for losses incurred in appointing a replacement contractor; or
  4. entering into a new building contract with a new contractor.

In the event that a new building contract is entered into with a new contractor, an employer should expect that the works will be completed on a different basis because a replacement contractor is unlikely to assume responsibility for works already carried out by the insolvent contractor.

Contact with the insolvency practitioner

Before deciding on what action to take, the employer should seek to make contact with the insolvency practitioner (administrator or liquidator) to get as much information as possible as to the status of the contractor and the insolvency practitioner’s initial views as to the ability/willingness of the contractor to perform its obligations under the contract. The employer should seek to make contact with the insolvency practitioner as soon as it becomes aware of the insolvency. It may be the case that the contractor is in a position to carry out the works notwithstanding the onset of insolvency. This option will be most viable where the project is nearing completion and is also dependent on the nature of the insolvency proceedings (e.g. this will not be an option where the contractor is being liquidated).

Where a contract does not terminate by reason of insolvency/the liquidation of the contractor, a liquidator could disclaim the contract if he regards it as unprofitable. This sometimes happens where the contract imposes continuing obligations and the liquidator believes that the performance of those future obligations (e.g. allowing the employer to use plant and equipment owned by the contractor to finish the job notwithstanding that the contractor’s employment has ceased) would prejudice the liquidator’s duties to collect in the assets, sell them and make a distribution to creditors. In such circumstances, the employer cannot rely on the continuation of the contract to protect its position/the project in circumstances where the contractor becomes insolvent.

If the liquidator does disclaim the contract, the contractor’s liabilities would be crystallised and the employer could bring a claim for breach of contract/damages. However, where the contractor is insolvent and therefore has little/no cash to distribute to creditors, the value of the employer’s claim may be nil. The employer could seek an order for specific performance but this obviously adds delay and cost etc.

Key sub-contractors and suppliers

The position of the key-subcontractors and suppliers will depend on whether or not the main contractor’s employment is terminated. If the main contractor completes the works notwithstanding the insolvency event, the key sub-contractors will continue to be engaged by the contractor.

Step-in rights

If the contractor’s employment is terminated, the employer should seek to contact the key sub-contractors to understand their position and, where possible, put in place arrangements to protect the provision of goods/services that are critical to the works. In addition, the employer may seek to establish a direct relationship with any key sub-contractors or suppliers through any step-in rights it has through a collateral warranty or third party rights schedule.

Replacement contractor

Where a replacement contractor is appointed, the sub-contractor collateral warranty may require the sub-contractor to enter into a novation agreement and a new collateral warranty with the employer and the replacement contractor. As a result, the sub-contractor’s employment would be transferred to the replacement contractor, provided this has been agreed by the parties.

Direct payments to sub-contractors

Unless there are express provisions in the building contract allowing for payment to be made directly to sub-contractors, an employer should avoid making any direct payments until such time as the employer has established a direct relationship with the sub-contractor.

Legal advice should be sought if the employer intends to make payments directly to sub-contractors as this may fall foul of the principle that assets should be shared equally amongst an insolvent company’s creditors.

Insolvency and adjudication

There is no definitive statutory guidance which clarifies the relationship between the Insolvency (England and Wales) Rules 2016 (the “Insolvency Rules 2016”) and the right to adjudicate under the Construction Act. However, the two regimes often intersect where, for example, an unpaid contractor, who is or becomes insolvent, commences an adjudication to recover unpaid amounts from an employer.

On the one hand, section 108 of the Construction Act provides that “a party to a construction contract has the right to refer a dispute arising out of the contract for adjudication". Such referral can be made “at any time", but will involve a quick and cheap determination of a single dispute. On the other hand, Rule 14.25(2) of the Insolvency Rules 2016 provides that, when a company goes into liquidation, “[a]n account must be taken of what is due from the company and the creditor to each other in respect of their mutual dealings and the sums due from the one must be set off against the sums due from the other". In other words, all claims and cross-claims between an insolvent contractor (e.g. for work done up to the date of insolvency) and the employer (e.g. for termination damages) are considered together and amounts are set off against one another, as appropriate, following a careful calculation of the net balance. There is therefore a fundamental incompatibility between the adjudication process under the Construction Act and the accounting exercise under the Insolvency Rules 2016, which can give rise to markedly different outcomes.

For example, an employer, faced with an adjudication for money due to the contractor, would, in the absence of a pay less notice having been issued, have to pay such amount (regardless of what cross-claims the employer may have). The employer then has to prove for its claim against the contractor for losses arising out of the insolvency; the likelihood is that it will only be able to recover a small portion of what is claimed (given the contractor’s financial position). Contrast this with the outcome arising from applying the Insolvency Rules to deal with both claims. The respective claims are set off against one another and the balance is paid by whoever owes more to the other. To the extent the employer can off set money due to the contractor against its cross-claim, it effectively recovers the full portion of that amount. If, after the off setting exercise, a balance is payable to the employer, it receives an amount pro rata to the value of that balance. The critical difference is that, applying the Insolvency Rules 2016, the proration applies to the balance only, whereas applying the adjudication process, the proration applies to the entirety of the employer’s cross-claim.

Let’s take a simple example; a contractor is owed £100 for work done to date but the employer in turn has suffered losses of £100 due to the contractor’s insolvency (e.g. because it has had to engage a third party to complete the work). Applying the Insolvency Rules 2016, these amounts are set off against one another, meaning that the employer effectively recovers the £100 it is claiming in full. If on the other hand, the employer has to pay the £100 it owes to the contractor and then subsequently seeks to recover its losses from the contractor, the likelihood is that it will only be able to recover on the same basis as other unsecured creditors who may be receiving a prorated distribution of 5p for every £1.

The leading judgment which offers guidance on the interplay between adjudication under the Construction Act and the Insolvency Rules 2016 is Bresco Electrical Services Ltd (In Liquidation) v Michael J Lonsdale (Electrical) Limited [2019] EWCA 27 (Civ),[1] in which it was acknowledged that the adjudication process and the insolvency regime were incompatible due to, amongst other reasons, the potential of divergent outcomes as explained above. Accordingly, it was held that whilst a contractor subject to insolvent liquidation could refer a dispute to adjudication, in circumstances where there is a cross-claim by the employer and in the absence of exceptional circumstances, the decision of an adjudicator would be incapable of enforcement. In effect, therefore, the process of adjudication in such context was said to be a futile exercise.

In the second appeal, it was held that the outcome would not necessarily be the same where a contractor is subject to a Company Voluntary Arrangement (“CVA”), which, unlike liquidation, is intended to enable a company to trade its way out of hardship. A court may also be inclined to permit an adjudicator’s decision to be summarily enforced if the employer’s refusal to pay amounts owed to the contractor has led to the contractor’s adverse financial position, resulting in the CVA. However, in the subsequent case of Indigo Projects London Limited v Razin and another [2019] EWHC 1205 (TCC), the courts held that the timing of the CVA (i.e. whether it came into effect before or after an unsatisfied adjudicator’s decision) would be a significant factor in deciding whether or not to permit the enforcement.

It is clear therefore that a contractor will not automatically lose its right to refer a dispute to adjudication if it becomes insolvent. However, whether or not a court will permit the enforcement of an adjudicator’s decision will depend on a variety of factors such as the nature of the contractor’s insolvency, whether or not the employer has any cross-claims and the cause of the contractor’s financial position.

It is noted, however, that permission to appeal to the Supreme Court was granted on 24 June 2019(UKSC 2019/0036).

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