15 January 2018
How can a contractor protect itself against employer insolvency?
This article considers the measures a contractor may take to protect itself against employer insolvency:
- When negotiating the terms of a building contract
- During the construction phase of a development
and what protection measures to put in place should the employer become insolvent.
A common thread which is regularly repeated in our discussions with contractors is that recent developments show that employers have not priced their projects correctly. This has led to employers receiving tenders at higher sums than they and their funders expected. As a result employers often find themselves running short of cash before a project is completed.
What contract provisions can protect a contractor?
There are a number of payment provisions a contractor should consider requesting in the building contract:
- Shortened payment periods. The JCT contract provides for a payment period of 14 days. Employers will usually seek to lengthen this period
- Escrow account. An escrow account is a bank account with defined conditions for the release of funds to the contractor
- If the contractor is concerned about the employer's ability to pay for the project, it may insist on funds for the project being paid into an escrow account. The escrow agreement should state:
o who is entitled to interest accruing on funds in the escrow account; and
o whether one party is entitled to the release of funds in the escrow account if the other becomes insolvent.
- Project Bank Account. The employer is obliged to maintain a positive balance in a project bank account. In theory, this ensures that funds are always available to pay the contractor and its supply chain. Although it has not been tested by the courts, it is widely thought that, if the employer becomes insolvent, the funds in a project bank account will not be swallowed up with the employer's other assets. Instead, the assets can be used to pay the contractor and its supply chain.
Employers will not readily agree to having their funds tied up in such accounts. A compromise would be to agree to hold the equivalent of the estimated three highest payment application. In this way the Contractor can be confident that he will be paid should the employer fail to deal with the application for payment.
- Weighted stage payments. The contractor may insist that payments to it are "front-loaded", with more payable at the start of the project and less as it nears completion.
- Advance payments. A contractor may be able to justify an advance payment where it has to commit funds before the project commences in order to ensure that plant, equipment, materials or sub-contractors are available when work starts.
- Direct payment by a funder. Although an employer and a funder will resist any provision that obliges the funder to make a payment (the funder will not want to act as the employer's guarantor), the parties may agree that regular payments under the building contract pass direct from the funder to the contractor (without passing through the employer's bank account). The contractor will need to consent to this arrangement with the contract duly amended, so that it is clear that a payment by the funder discharges the employer's payment obligation under the building contract.
- Retention bond. If the employer becomes insolvent, any retention monies held by the employer may be difficult to recover. Most Contracts will state that the retention is not held in escrow. In some cases an employer may agree not to deduct a retention from payments to the contractor in exchange for the contractor procuring a retention bond in favour of the employer. Typically in the UK, a retention bond will be an on demand bond.
- Specific clause allowing termination on insolvency. The building contract should specifically permit the contractor to terminate its employment under the building contract on employer insolvency. This is important because insolvency is not automatically a repudiatory breach of contract at common law.
- Define insolvency widely. The definition of insolvency in the building contract should include all possible varieties under English law. However, note that many rights to terminate a contract in the event of insolvency are reciprocal, so by arguing for a wide definition of insolvency for the employer, the contractor will be subjecting itself to the same regime.
- Specific clause allowing termination for prolonged or repeated late payment. Delay or failure to pay is not a material breach at common law that would allow a contractor to terminate its employment under the contract. The contractor should consider whether the building contract should contain an express right for the contractor to terminate on grounds of prolonged or repeated late payment.
Materials and documents
- Retention of title clause. This expressly reserves the contractor's rights over materials used in the project. It is generally ineffective once materials are fixed, but reserves the contractor's title over unfixed materials.
- Rights conditional on payment by the employer. A contractor proposes provisions that suspend the employer's rights to copy and use the design documents if the employer fails to pay the contractor in accordance with the building contract.
Parent company guarantee
The contractor should consider whether to require the employer to procure a parent company guarantee, ideally from its ultimate parent.
Provisions in sub-contracts
In the UK, "pay when paid" provisions in construction contracts are unenforceable except to the extent that they apply only in a case of "upstream insolvency". Accordingly, in the UK, a contractor should include a "pay when paid" clause, limited to employer insolvency, in its sub-contracts. This would mean that the contractor is not required to make payment to its sub-contractors if it has not received payment itself.
How can a contractor protect itself during the project?
- Monitor the employer's behaviour for signs of impending insolvency.
- Regular and complete invoicing. The contractor should make applications for payment in accordance with the agreed payment schedule and must not allow sums owed to it by the employer to mount up.
- Strict compliance with the building contract. The contractor should make all claims under the building contract within the contractual time limits. Failure to do so may result in the contractor losing its right to claim.
- Consider starting an adjudication before the employer goes insolvent. Once the employer is insolvent the court (or an insolvency practitioner) may have to give permission before a claim against the employer is started. Also, adjudication is quick and effective and may be the difference between securing payment before the employer becomes insolvent and ending up in a queue of unsecured creditors.
What should a contractor do when the employer goes insolvent?
- Establish it is not just rumour. It is important to ensure that the employer is actually insolvent, not just rumoured to be so.
- Secure plant, equipment and materials. Subject to any provisions in the building contract that prevent it from doing so, the contractor should secure its plant, equipment and materials. This is particularly important for plant and equipment that is on hire or may be needed for other projects.
- Review payment obligations to sub-contractors, professional consultants and suppliers. The contractor may be entitled to withhold payment in some situations. See section 113 of the Construction Act 1996, which allows conditional payment in cases of "upstream" insolvency.
- Do not terminate the building contract without considering the situation. Contact the employer or the insolvency practitioner and anyone else interested in the project, such as a funder. These parties may wish to complete the project using the contractor, either by novating the original contract or entering into a new arrangement with the contractor.
- Monitor insolvency proceedings. If necessary, submit a proof of debt to recover a share of any monies available to unsecured creditors.
If the contractor is the largest creditor, it is possible to influence who is appointed as the liquidator. Whilst this will not guarantee any payment, it will give confidence that matters are being properly dealt with.
Employer insolvency: the warning signs
- Official announcements to shareholders or the stock market, such as a profit warning.
- Persistent rumours about the employer's financial position in the press and from other sources.
- Repeated delayed payment to the contractor and/or contractors on other projects.
- The employer inexplicably removes personnel from the project.
- The employer makes unexpected or unexplained omissions from the project.
- The employer suspends the project without explanation.
- If the employer is a company, late filing of accounts or annual returns at Companies House.
- Unsatisfied court judgments against the Employer. These may be revealed by a credit or business information report on the contractor from a specialist business information provider.
Dually qualified in English and Scottish law, Head of Construction Phil Morrison has over 25 years’ experience working with large private and public sector bodies to deliver infrastructure projects and to maintain their property portfolios.