Insolvencies on construction projects – Part 2
The construction sector has reportedly had the highest insolvency rates of any UK sector in the past 12 months due to Brexit.
We previously examined how employers might seek to limit the effects of insolvency at the pre-contract stage here. But in the event a contractor does become insolvent during a project, there are a number of legal and practice issues that need to be considered.
There are many reasons why a contractor may become insolvent. The main triggers are:
- cash flow issues caused by late payments, bad debts and most construction contracts providing for stage payments in arrears;
- low margins in the sector meaning that profit can be obliterated by unexpected delays or increased costs in the works which the contractor may take the risk of; and
- the collapse of a main contractor triggering a domino effect on subcontractors, as seen with Carillion's insolvency.
All of these factors have been brought into sharp focus with the impact of Covid-19 on projects. It seems inevitable that, despite the available government support for businesses, we will see a sharp increase in the rate of insolvencies in the sector. Indeed the UK government has announced proposals to amend certain aspects of insolvency law in response to Covid-19, which we have reported on here.
Monitor early warning signs
It is important that employers monitor the early warning signs of a distressed contractor such as:
- poor trading results
- pricing which is "too good"
- unpaid sub-contractors or suppliers
- a contractor seeking to renegotiate payment terms
- the late filing of Companies House accounts
- an unexplained slowdown in progress or suspension of works
- unexpected removal of personnel, equipment or materials from site
- high staff turnover negative press reports and industry rumours
If the contractor becomes insolvent
The first step should be to review the contract. How is "insolvency" defined and is there an express right to terminate for insolvency? Absent express wording, an insolvency event of itself would not usually constitute a breach of contract (although it may lead to other breaches). You must strictly follow any termination procedure in the contract and get any required notices right. If you terminate too early, or when you wrongly thought you had the right to do so, you can risk a 'repudiatory' breach of contract, which the contractor can accept and claim damages.
There have been cases where, due to changes in the insolvency legislation, the form of insolvency process used was not covered by the relevant clause and so the employer's termination was deemed wrongful. This is important to bear in mind given the new insolvency measures the government is looking to bring in.
If the right to terminate for insolvency has not yet arisen you can consider your options for terminating for performance issues or at will but advice should be obtained.
Employers will also need to consider the following practical issues:
- getting access to and securing the site to prevent unpaid creditors from taking goods or materials instead of payment;
- undertaking an audit of the materials on site and whether they have been paid for and title has passed;
- whether or not to complete works. If completing the works, consideration should be given to procuring a replacement contractor or possibly entering into direct contracts with the sub-contractors and the impact of these choices on the delivery of the project and recovering costs in the insolvency;
- contract administration issues and serving the correct termination notices and payment/ pay less notices;
- obtaining design drawings and other build documentation;
- being proactive in having discussions with the insolvency practitioner (they are usually not as scary as they may seem!); and
- beware of direct payments to subcontractors/suppliers for works that have already been done or materials that have already been supplied. The employer's contract is with the contractor and so its obligation to pay for them is to the contractor.
Post completion insolvency and defects
If you discover defects post completion and the contractor has become insolvent the following options can be considered:
- Issuing proceedings against the insolvent contractor but this is unlikely to be attractive. If the defects are design-related and the contractor's professional indemnity insurance is still be available (i.e. the premium has been paid) you may be able to bring proceedings against the insurer directly under the Third Party (Rights Against Insurers) Act 2010.
- Whether the defect would be covered under any latent defect policies such as NHBC or Zurich.
- Bringing a claim under any performance bond or parent company guarantee (if they have not expired).
- Bringing a claim against sub-contractors or consultants under collateral warranties or (if they are not available) under the Defective Premises Act 1972 (the DPA).
Given the current issues contractors are facing due to Covid-19, employers should monitor warning signs and be proactive in discussing these with the contractor. If a contractor becomes insolvent on your project, the most important thing is to not panic! The contract should be carefully reviewed to ascertain your rights and notice obligations and these should be strictly followed.