Managing Contractor Insolvency: Part 1 – key signs and implications of contractor insolvency and further consequences of insolvency involving a joint venture contractor

One of the biggest risks faced by an employer in a construction project is the impact of the main contractor becoming insolvent, particularly in the current economic climate where it has become clear that main contractors are not regarded as being “too big to fail”. In this 3-part blog series, we discuss how this risk can be managed through a variety of legal and practical measures which a prudent employer would be well advised to take. In part 1, we discuss the key signs and implications of contractor insolvency and what insolvency means in the context of a joint-venture contractor. In part 2, we discuss the legal, commercial and other practical considerations for mitigating the impact of contractor insolvency. In part 3, we conclude by exploring options for completing the project, engaging with the 2^nd tier supply chain and the relationship between insolvency and adjudication.

Signs of insolvency

An employer should be alert to any early warning signs which are likely to be a precursor to a contractor becoming insolvent; for example a slowdown in the works or the receipt of requests for direct payments from sub-contractors or requests for early payment from the contractor. Where such signs fall below the radar, a contractor may in any case (e.g. under the JCT design and build contract) be required to notify the employer in the event of it becoming insolvent.

Implications of insolvency

Whether or not a contractor is in fact insolvent for contractual purposes will depend on the definition of insolvency under the relevant building contract. Once it is determined that the contractor's status falls within the definition of insolvency, the building contract should be consulted to ascertain the automatic implications which flow as a result. Under the JCT form of design and build contract, the immediate consequences of insolvency are that:

1. no further sums become due to the contractor;
2. the contractor's obligation to carry out works is suspended; and
3. the employer can take reasonable measures to ensure that the site, the works and the site materials are adequately protected and that the site materials are retained on the site (free from any hindrance or delay which the contractor may cause).

The right to suspend payments to the contractor is a contractual and not a statutory right. This right to suspend payment must be effected by issuing a pay less notice if this can be done within the prescribed timeframe under the contract. Where the insolvency event occurs after the time for issuing a pay less notice has passed and no such notice was issued, the contract may expressly provide that payment may nevertheless be suspended. Determining whether a pay less notice should be issued is therefore one of the critical first steps which the employer should take.

If the building contract does not expressly entitle the employer to stop paying the contractor, the employer will still be liable to pay the contractor for any sums in respect of which the final date of payment has occurred, in accordance with the Housing Grants, Construction and Regeneration Act 1996.

Further consequences of insolvency involving a joint venture contractor

The consequences of insolvency become all the more complicated where the contractor is an integrated joint venture entity or an unincorporated joint venture.

Where the contractor is an integrated joint venture entity, the insolvency of one of the joint venture participants may trigger the right to terminate under any joint venture or shareholders' agreement.  It would be common therefore for the right to terminate under the construction contract to arise where the joint venture or shareholders' agreement is terminated or becomes terminable.

On the other hand, where the contractor is an unincorporated joint venture, in addition to being linked to the joint venture or shareholders' agreement, the construction contract is likely to feature a termination right where one of the joint venture participants becomes insolvent. The construction contract should also address whether the remaining joint venture entity is jointly and severally liable for works carried out by the insolvent contractor.

While insolvency may be perceived to be a remote or theoretical risk at the time of contract inception, the risk should not be discounted. It is easy to think that all eventualities have been addressed by providing for joint and several liability and the right to terminate. But that is short-sighted. The insolvency of a joint venture party does not always mean the end of the joint venture. A well-considered joint venture provision could afford the remaining joint venture member(s) the opportunity to complete the work and should expressly prohibit any payments to the joint venture made after the insolvency event occurring from being received by the insolvent member.