What do you do when your contractor becomes insolvent?
22 November 2021
When we think about contractor insolvency, it is hard not to think back to Carillion, who entered compulsory liquidation in January 2018 with liabilities of almost £7bn.
In times of political and economic uncertainty, even the largest contracts can be terminated and the biggest contractors fail. Notably, the construction industry has the highest number of insolvencies out of all sectors, with 1,801 having taken place by the end of the second quarter of 2021. Unfortunately it seems this number is likely to rise further, as the effects of material price inflation and labour shortages continue to bite.
However, as an employer, what can you do if your contractor becomes insolvent? In this article, we discuss the position following contractor insolvency under both the unamended JCT Design and Build 2016 (JCT DB) and the NEC4 ECC (NEC4) forms of contract.
Position under the JCT DB
Insolvency is defined in clause 8.1 of the JCT DB. For the purposes of a company, this extends to circumstances where:
- the company enters into administration within the meaning of Schedule B1 to the Insolvency Act 1986 (the Act)
- an administrative receiver or receiver is appointed to manage the property of the company under either of Parts II or III of the Act
- the company passes a resolution for voluntary winding up, without a declaration of solvency of the company under section 89 of that Act; or
- a winding up order is made in respect of the company under Parts IV or V of the Act.
It is worth noting that the JCT DB does not expressly refer to the new insolvency procedures which were introduced by the Corporate Insolvency and Governance Act 2020 (CIGA). These being:
- a statutory moratorium process (Part A1 moratorium); and
- a restructuring plan procedure (Part 26A restructuring plan).
Bespoke amendments would be required to ensure that the rights on insolvency under the JCT DB extend to the occurrence of either of these two procedures.
Clause 8.5 of the JCT DB requires the contractor to notify the employer “immediately” if it makes a proposal, gives notice of a meeting or becomes subject to processes relating to being insolvent.
Once the contractor does actually become Insolvent:
- clause 8.5 further provides that the employer can terminate the contractor’s employment under the building contract immediately by serving notice on the contractor “at any time”;
- the employer is granted additional rights, whether or not the employer terminates the contractor’s employment, such that:
- no additional sums fall due to the contractor
- the contractor’s obligations to perform the works is suspended; and
- the employer may take “reasonable measures” to protect the site and retain site materials on the site.
Following termination of the contractor’s employment under clause 8.5, the employer can employ other contractors to complete the works and/ or rectify defects (as applicable) and use the contractor’s temporary buildings, plant, tools, equipment and site materials for the purposes of doing so. The contractor is also required to provide the employer with a copy of all contractor’s design documents for this purpose, though please note that under the JCT DB the employer’s copyright licence in these design documents is subject to payment of all sums due under the contract.
Following completion of the works, the employer is able to claim as a debt the difference between (a) the sum it would have paid to the contractor, had the contractor not become Insolvent and his employment under the contract been terminated, and (b) the amount it actually cost the employer to complete the works – including any loss and expense suffered by the employer. In order to do this, the employer must submit a proof of debt claim to the relevant insolvency practitioner, though the chances of full recovery will ultimately depend on the number of creditors and value of assets held by the contractor at the time of becoming Insolvent.
Position under the NEC4
Under clause 91.1 of the NEC4, Reasons R1 to R10 set out the types of insolvency procedures which, should they occur, entitle the other party to terminate the contract. Where the client and/ or the contractor is a company, this includes:
- the making of a winding up order against it
- the appointment of a provisional liquidator
- the passing of a resolution for voluntary winding up (other than for the purposes of amalgamating debts)
- the making of an administration order against it, or the appointment of an administrator over it
- the appointment of a receiver, receiver and manager or administrative receiver over the whole or a substantial part of its undertaking or assets; or
- the making of an arrangement with its creditors.
If any such event occurs, the client is required to give notice to the project manager and the contractor, citing the reason for terminating the contractor’s obligation to provide the works. The project manager then issues the termination certificate where the reason for termination complies with the contract (clause 90.1). This helps protect the client from any argument that there has been a repudiatory breach of contract by reason of invalid termination.
Following issue of the termination certificate, the contractor’s obligation to provide the works immediately comes to an end; and the client is not required to pay any further sum to the contractor – including any certified payment unless the conditions of contract provide otherwise.
Much like the position under the JCT DB, the client is then able to:
- complete the works and use any plant and materials to which it has title
- instruct the contractor to leave site and to remove any equipment, plant and materials from site and to assign the benefit of any subcontracts or other contracts relating to provision of the works to the client; and
- use any equipment to which the client has title to complete the works.
The client must then pay to the contractor the difference between what the client would have paid to the contractor to provide the works, and how much the client forecasts it will actually cost to complete the works.
Like with the DB 2016, the NEC4 does not take into account CIGA. While the part 26A restructuring plan may be covered by the current wording of R10 (“making of an arrangement with its creditors”); the new Part A1 moratorium is not covered. The effect of this is that the client will not be able to terminate the contractor’s obligation to provide the works immediately where the contractor enters into a Part A1 moratorium.
Ultimately, if the contractor has entered a Part A1 moratorium, it will either be rescued as a going concern or enter into a subsequent insolvency process, at which point the client may exercise its right to terminate the contractor’s obligation. However, in the absence of guidance or relevant contract drafting, clients are likely to continue to amend the termination provisions to ensure they capture the new insolvency processes.
Particularly in the current climate employers should be alert to signs that a contractor may be experiencing financial difficulties. Whilst not determinative; these signs could include:
- inactivity, or a lack of materials or plant on site
- late payment to supply chain members
- an increase in the number of disputes or claims, and/or exaggerated claims
- requests for advance payment; and/or
- a lack of response to communications.
It is, nonetheless, essential that parties follow the correct termination procedure. If an employer purports to terminate a contract where the contractor is not strictly ‘insolvent’, as defined in either contract, that contractor would be entitled to treat the purported termination as a repudiatory breach of contract. In turn this would entitle the contractor to seek to recover its losses for repudiatory breach from the employer, including any loss of profit.
Where an employer is suspicious that a contractor is in financial trouble and there are outstanding sub-contractor warranties, the employer would be well advised to ensure that those warranties are completed as soon as possible. The warranties should also include step-in rights which would enable the employer to replace the contractor as employer under that sub-contract; thereby ensuring continuity of the workforce on site.
Further, the first few days following main contractor insolvency are crucial. Employers should ensure that they secure the site and plant and materials. Otherwise there is a danger that unpaid creditors could help themselves to valuable goods and materials in lieu of payment.
Finally, whilst parties often agree additional security documents such as parent company guarantees and/or performance bonds, it is worth noting that under the model ABI performance bond; contractor insolvency does not immediately trigger a surety’s liability under that bond. This is because the bond requires the surety to pay a sum of money (up to a maximum amount) where the employer suffers losses as a result of a breach of contract by the contractor. Contractor insolvency does not constitute a breach of contract. As such, employers often request bespoke performance bonds, or seek to amend the model ABI performance bond to specifically respond to contractor insolvency.
If you are concerned that your contractor is about to become insolvent, or require advice on drafting and negotiating bespoke amendments to your contract and security documents, please do not hesitate to contact a member of Birketts’ Construction and Engineering Team.
The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at November 2021.