How to mitigate the risk of contractor insolvency on construction projects

Following our article in November 2021 on what to do when your contractor becomes insolvent, our prediction that the number of insolvencies would only continue to rise has certainly rung true. By November 2023 Construction News reported a new monthly record of company insolvencies at 421. Its latest reports show that the construction industry still “tops the insolvency table”, with the number of business failures within the sector raising to 4,274 in the year to May 2024. As we have seen from the likes of Carillion, and more recently the Buckingham Group, who sadly appointed administrators at the beginning of September last year despite posting a record turnover of £665million in 2021, even the so-called ‘big guys’ are not immune.   

Whilst it is often difficult for employers to fathom ‘what went wrong’ and take action accordingly, the prospect of contractor and supply chain insolvency remains a very real and prevalent risk to the success of construction projects. As such, protecting against contractor and supply chain insolvencies remains crucial for those engaged in construction projects. 

In this article we highlight some of the practical steps parties may wish to consider when planning a construction project, with a view to mitigating the effects of this risk.    

(A) Do your due diligence  

It perhaps goes without saying, but before entering into a contact employers should carry out thorough due diligence to ascertain the financial standing of the proposed contactor or supplier.  Whilst this can include undertaking checks of accounts filed at Companies House and obtaining credit reports, both of which can certainly prove illustrative of a company’s financial status, parties should nevertheless be mindful that this is all historic data. The more ‘live’ information a party is able to obtain on their counterpart the better! The same is true of contractors and their employers.   

This due diligence will help parties determine whether there is a potential risk of insolvency and, if so, what additional steps they may wish to take to mitigate against that risk. 

(B) Bonds and guarantees 

Where there is some concern as to the liquidity of a contracting party, thought should be given as to the need for project security. This usually takes the form of one or all of performance bonds, parent company guarantees and/or personal guarantees from directors of the company.  Whilst the orthodox position is for the contractor to procure this security in favour of the employer, there is nothing to stop a contractor with valid concerns requesting equivalent security from the employer.  

What is a performance bond? 

Put simply, performance bonds are insurance backed guarantees usually procured by contractors in favour of their employer. They include: a guarantee by the surety of (typically) the contractor’s performance of their obligations under the contract, and an obligation on the surety to make a payment to the beneficiary in circumstances where the (typically) contractor is in default. This obligation to pay, or value of the bond, is ordinarily limited to 10% of the contract sum. The bond is usually released either on issue of notice of completion of making good defects, or more typically, practical completion of the project.   

Despite bonds being to provide employers with a fast and efficient means of accessing cash, changes in the insurance market and the rise of claims have conflated to restrict the availability of performance bonds, with many contractors no longer able to procure them.  

Where bonds are available, they are generally only available at increased premiums which the contractor will pass on as part of the contract sum, and on standard terms imposed by the Association of British Insurers. As you would expect, these are drafted in favour of the surety and so are not ideal in that: 

1.  the obligation to pay under the bond is not triggered by contractor insolvency; and  

2. only applies to sums which the beneficiary has established and ascertained as due to it, after having followed the dispute resolution process under the contract.  

Employers should therefore undertake a cost benefit analysis of performance bonds, to be completed on a project-by-project basis having regard to the premium payable and the prospects of calling upon the bond.  

Guarantees  

Where a performance bond is not available, employers may wish to consider guarantees as an alternative form of security – either from a parent company, or one of the directors, whereby they: 

1. guarantee the contractor’s continued performance of their obligations pursuant to the contract; and  

2. agree to indemnify the beneficiary against any liability which they may incur as a result of the contractor’s failure to do so.  

Parent company guarantees also typically include an obligation requiring the parent to step into the contractor’s shoes and make good the default itself. Whilst this would help maintain continuity of work force on the project, and potentially avoid lengthy delays in securing alternative labour, the attractiveness of this proposition will ultimately depend on why the beneficiary has called upon the guarantee in the first place. If the relationship between employer and contractor has completely broken down, the beneficiary may want to sever all ties with the group and appoint a new contractor instead.  

However, before accepting a guarantee the employer will need to undertake due diligence on the guarantor to ensure that, if called upon, they have sufficient assets to satisfy any claim under the guarantee. Otherwise there is a risk that the guarantee will be worthless. 

(C) Payment mechanisms  

Timing and stage payments  

As we know, contractors appointed under ‘construction contracts’ are entitled to payment in stages where the construction works will take longer than 45 days. These ‘stage payments’ will either be through monthly valuations calculated according to the value of works completed and the cost of site materials and goods at the due date for payment, or on completion of certain stages as defined within the contract. The final date for payment is then calculated as a set number of days from the due date for payment. Unless the parties agree otherwise, the contractor is not entitled to payment of off-site materials and goods. 

Employers should therefore discuss payment terms with the contractor, having regard to the specific programme requirements of the particular project to help manage the contractor’s cash flow. The parties should then seek to agree: 

1. suitable stages in the programme which will trigger payment (both in terms of frequency and value); and/or  

2. mutually convenient timescales for payment – noting that most contractors prefer there to be no more than 30 days between the date of their application for payment and the final date for payment. 

Advance payments 

In addition to acceptable payment terms, employers may be inclined to agree advance payments. These can be beneficial to both the employer and the contractor – particularly where the project utilises materials and/or goods which are only available on long lead times through third party suppliers. This has a number of benefits, in that: 

1. contractors can definitively calculate their contract price without worry that their profit will be eroded by material price inflation;  

2. materials can be secured at the outset of a project often at lower prices; and 

3. by ordering materials early, the parties avoid the prospect of those materials not being available on site when they are required.  

Where an employer is minded to agree an advance payment, we recommend that they secure this payment via a separate bond. This will allow the employer to recover the value of the advanced payment from the surety in circumstances where the contractor subsequently becomes insolvent before the advanced payment has been recover pursuant to the contract.  

Fluctuation options 

Whilst parties have typically excluded the operation of fluctuation options from contracts, in times of material price inflation and rising costs generally, this is something they may wish to reconsider. Rather than risking contractors artificially inflating their tender prices to guard against the impact of rising costs, contract sums should instead be calculated as a fair and accurate price for the works. The contract sum would then be adjusted only to reflect additional costs which are actually incurred, thereby also protecting contractors from the impact of rising costs. Because the fluctuation options also take into account cost savings, this has an added benefit for employers, in that the contract sum can also be adjusted down in the event that prices fall.  

The JCT suite of contract has three separate fluctuation options, which are now available on line under the 2024 revisions. These are:  

Option A 

This is the default position under the JCT suite of contracts. It applies unless the entry is explicitly deleted in the Contract Particulars.  

Where it does apply, fluctuation Option A allows the contract sum to be adjusted in relation to changes in tax, levies, and contributions that a contractor has to pay in respect of their employees. It also allows for adjustments to the contract sum for changes to taxes or statutory duties affecting goods, materials, fuel or electricity.  

Option A does not provide any cost relief for changes in the price of labour and materials themselves. 

Option B 

Unlike Option A, Option B allows the parties to recover changes in the actual cost of labour and materials, as well as the taxation provisions contained in Option A.

Option C 

Finally, Option C allows for the contract sum to be adjusted in accordance with the Formula Rules issued by the JCT. The formula is complex to calculate and is based on a number of factors, so it is advisable that a cost consultant is engaged before engaging this Option. Contractors must include a list of articles required and their current market prices in their contractor’s proposals.  

Retention

Retention is a percentage of payment held back by an employer (usually up to 5% of the contract sum). Its purpose is twofold, in that it provides: 

1. an incentive for the contractor to continue to comply with their obligations under the contract, by holding a sum of money back until such time as the contractor has complied with its obligations; and  

2. the employer with a pot of money to use, in the event that the contractor fails to comply.  

Release of the retention will depend on how the construction contract has been drafted, albeit the generally accepted position is that retention is released in the following tranches: 

1. 50% on practical completion; and  

2. the balance following the expiration of the defects liability period and issue of the notice of completion of making good defects. 

However, this can be adjusted where necessary. In particular, employers should take into consideration (especially when dealing with smaller contractors) that withholding retention can have significant impact on a contractor’s cash flow and profitability.  

The Birketts View

Although the economy is showing signs of improvement and insolvencies within the construction industry appear to be on the decline (albeit still higher than all other industries), the last few years have shown us just how turbulent and unstable things can get.  

We should all learn lessons from this and ensure that we are ‘insolvency proofing’ our contracts so far as practically possible to best protect all parties involved. It is, nevertheless, a balancing act. Employers should be mindful that the more stringent and robust measures it puts in place to protect against contractor insolvency, could be the very measures which conflate to actually push the contractor into insolvency. As always, frank and open discussions at the outset are best.