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Apocalypse Now? Contractor insolvency: an employer’s survival guide

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Summary: Last year, a developer client raised concerns about the solvency of its main contractor, Carillion. With over 50% of the works still to be completed, the client wanted some advice as to how it could manage the risks (legally and practically) if the contractor did go “pop”. In January this year, the concerns became a reality. This blog addresses these key questions and what followed in the wake of Carillion’s demise.

Cease payment?

The employer’s first concern was that it did not want to be paying money unnecessarily into a sinking ship. As is typical, our building contract (an amended JCT Design and Build Contract, 2011 Edition (DB 2011) provided that the employer could cease payments from the date that the contractor became “Insolvent” (as defined in clause 8.1). On insolvency, clause 8.7.3 provides that no further sum becomes due to the contractor and the employer is not required to pay any sum that has already become due, provided that it serves a pay less notice or the contractor became insolvent after the date for giving a pay less notice. An employer may even be able to issue a pay less notice for “zero” if it thinks that its losses from the insolvency will exceed the amount requested.

Direct payment to sub-contractors

Once payments to the main contractor have been stemmed, an employer will likely face a dilemma. It is neither obliged nor entitled to pay sub-contractors, but doing so could help to keep the project moving and minimise delay.

If the employer does choose to leap-frog the main contractor and pay sub-contractors directly for work done, there is a risk that this could be deemed to be a preference under insolvency law. The contractor may still be entitled to payment for the work, leaving the employer having to pay twice. To protect against this, we advised our client that any payments it made directly to sub-contractors should be backed by an indemnity, requiring the sub-contractor to re-pay the monies if they were ever clawed back on behalf of Carillion.

Securing the site

Immediately on insolvency, the employer should secure the site, so unpaid creditors do not help themselves to valuable goods or materials in lieu of payment. It is also worth tracking down any off-site materials that have been paid for but not yet delivered to site.

Right to terminate?

As is usual, our contract allowed the client to terminate if the contractor became “Insolvent”, but not in anticipation of insolvency (clause 8.5). We had to ensure that, no matter how bad the news in the press, the client did not terminate prematurely and followed the proper contractual formalities, to avoid the well-documented pitfalls of wrongful termination.

Consequences of termination

On termination, clause 8.7.2 of DB 2011 requires the contractor to:

  • Remove temporary buildings, plant, tools, equipment, goods and materials.
  • Provide the employer with copies of its design documents.
  • Assign to the employer, if requested, the benefit of any supply contracts for goods and/or materials, so far as lawfully possible.

The employer may then employ another contractor to complete the works and recover any increased costs as a debt from the insolvent contractor (clause 8.7.5). However, in reality, the employer will rank as an unsecured creditor and should not expect to be made whole. In our case, it may be less than a penny in the pound. There are also timing issues, because the employer may struggle to substantiate its additional costs until after completion. In light of this, employers are likely to face irrecoverable additional costs to finish the project.

Performance security

Clients often seek security by way of a performance bond and/or parent company guarantee (PCG). Many clients opt for a PCG over a bond, because bonds have an associated cost and are typically limited to 10% of the contract sum, which is arguably not enough in the event of serious default. However, as we found, the problem with only having a PCG is that, in the event of insolvency, it’s possible (and even probable) that the parent company is also in trouble, making the PCG not worth the paper it’s written on.

Step-in

If you are lucky enough to have prior notice that the contractor is in difficulty, it’s worth pushing for delivery of any outstanding sub-contractor warranties (while you still have a contractor obliged to procure them). The warranties should include step-in rights, allowing the client to step into the contractor’s shoes and maintain continuity.

One point to note is clause 3.4.1 of an unamended DB 2011 (and JCT DB 2016), which requires the contractor to include a condition in its sub-contracts that the sub-contractor’s employment will terminate immediately upon the termination of the main contractor’s employment. In an insolvency situation, this is less than helpful if the client wants to step-in, so it’s worth checking that your contract does not provide for this.

Still, failing a step-in mechanism, there are other creative solutions that can be adopted, such as entering into new contracts with the sub-contractors, incorporating the terms of their existing sub-contracts.

Warranty package

Unfortunately, the insolvency of the main design/build contractor will probably strike a dagger through the heart of the existing contractual structure aimed at achieving single point design and construction responsibility for the works. The reality is that no well-advised replacement contractor will accept full responsibility for the insolvent contractor’s work, so the client will no longer have a single party on the hook for defects.

In the absence of a main contractor, it is prudent for the employer to procure collateral warranties or third party rights from sub-contractors and sub-consultants to close any gaps in the warranty package. Doing so will not only ensure that the employer has recourse in the event of a defect, but also give comfort to third parties when trying to market the building.

Latent defects insurance, if in place, may provide another form of comfort that can be given to third parties in the absence of a main contractor warranty. It’s worth checking that the contractor’s insolvency does not adversely affect the cover provided.

Completing the works

In terms of completing the works, the employer is likely to have two main options: seeking a new main contractor or procuring the works on a construction management (CM) basis.

Each option has its pros and cons. For example, CM would avoid having to pay a main contractor’s fee, but not all employers are adequately resourced to administer works on a CM basis. It would also take time converting (and negotiating) the existing sub-contracts into trade contracts, and time may not be on the employer’s side.

Bear in mind practical issues

Each contract and project will, of course, raise its own issues. There are also practical matters to bear in mind if there is a risk of main contractor insolvency. Some are linked to the contract, for example, ensuring that the contractor is “insolvent” as defined. Others are administrative, such as keeping track of materials that have been paid for, whether located on or off site.

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