Managing Contractor Insolvency: Part 2 – legal, commercial and other practical considerations for mitigating the impact of contractor insolvency

This is part 2 of our 3-part blog series. In part 1, we discussed the key signs and implications of contractor insolvency, as well as the further consequences of insolvency involving a joint venture contractor. In this part 2, we discuss the legal, commercial and other practical considerations for mitigating the impact of contractor insolvency.  Part 3 will explore the employer's options for completing the project and engaging with the 2^nd tier supply chain.

Properly executed documentation

As a general rule, the employer's entitlement to enforce its rights against the contractor and sub-contractors is dependent on the existence of properly executed documentation. Adopting an effective document management process early on in the life of a project to ensure that any parent company guarantees, collateral warranties (including from sub-contractors) and bonds are properly executed and in force, will be of great significance to the nature of the remedies and scope of options available to the employer.

Securing the site

Another important practical step for an employer is to take possession of and secure the site. This should be done as soon as possible. It may be expedient for the employer to appoint a logistics contractor to assist it with managing the site (i.e. securing and making safe the site, managing statutory certificates for temporary erections, orderly removal of sub-contractor plant and equipment including that which is hired). It should be noted that if the contractor has gone into administration, the statutory moratorium may prevent the employer from taking certain actions e.g. seeking to repossess goods subject to a hire purchase agreement in the contractor's possession, without the consent of the administrator or the permission of the court.

Plant and materials

Transfer of ownership of materials will depend on the parties' contractual arrangements. In the absence of express provisions, title to materials will remain with the contractor until they are incorporated into the works, at which point title will pass to the employer.

Under the JCT design and build contract, title to materials transfers upon payment for such materials. Note however that in respect of off-site materials, payment is subject to certain conditions to ensure that they are readily identifiable.

The employer should carry out a comprehensive audit of all of the plant, materials and documents on the site and ensure that the site is secured in order to protect such items. The same applies for any off-site materials for which the employer has made payment.

Title to temporary plant and equipment does not typically transfer to the employer as they are often hired and are not in any event incorporated into the works.

Insurance

The employer will need to make sure that the necessary insurance arrangements remain in place. The contractor is likely to have been in financial difficulty during the period leading up to insolvency. This gives rise to the risk that insurance premiums have not been paid. Any such insurance premiums are likely to be paid annually and so insurance may remain in place depending on when the policy was last renewed. As PI insurance operates on a claims made basis, any claims for design defects will need to be brought before its renewal date.  The employer should be in a position to check the insurance arrangements as a building contract will typically require a contractor to provide evidence that it has complied with its insurance obligations.

Under the Third Parties (Rights Against Insurers) Act 2010 (effective from 1 August 2016), where the contractor was responsible for maintaining insurance and subsequently becomes insolvent, the employer will be able to bring an insurance claim directly against the insurer without adding the contractor to the proceedings. In order to do so, the employer will have to establish the insured's (i.e. the contractor's) liability and that he was insured against the risk in question. Under the previous statutory regime (Third Parties Act 1930), an employer would have had to bring a claim against a contractor which would have involved seeking leave from a court if the contractor was in liquidation or applying for the contractor to be restored to the register of companies if it was dissolved.

CDM Regulations

An employer should take steps to ensure that it continues to comply with its obligations under the Construction (Design and Management) Regulations 2015 (the "CDM Regulations").

The CDM Regulations require the employer to make suitable arrangements for managing a project so that construction work can be carried out, so far as is reasonably practicable without risks to health and safety. The employer must maintain and review these arrangements throughout the life of the project.

An employer should bear in mind that, where there is no principal designer and/or contractor appointment in place, the CDM Regulations provide that the employer will be responsible for fulfilling their respective duties. The prompt appointment of a replacement is therefore essential.

Payment

As soon as the employer takes possession and secures the site, it should instruct its quantity surveyor to value the works which have been carried out. In doing so, the employer should check how much has already been paid to the contractor in order to assess whether the contractor has been overpaid.

The employer should rely on contractual provisions to avoid making any further payments to the contractor, as discussed above.

In practice, the employer will wish to suspend/minimise payment to the contractor until it has determined the next steps e.g. terminating the contractor's employment or seeking to continue under the contract to complete the project. The employer should review the terms of the contract to understand the implications of non-payment.

Where the employer wishes to continue with the contract notwithstanding the insolvency of the contractor, it may seek to agree arrangements with the insolvency practitioner for continued provision of services by the contractor and periodic payments to the contractor on completion of the agreed milestones etc.

Performance security

An employer should consider what recourse it has against any performance security provided by a contractor. Such recourse will typically take the form of a parent company guarantee and/or a performance bond.

Parent company guarantee

If a parent company guarantee is in place and the parent company remains solvent, an employer should check its entitlement to make a claim against the guarantor. A guarantee is typically enforceable in the event that the contractor is in breach of contract. However, insolvency of a contractor does not automatically mean that the contractor is in breach of contract. Therefore, it is common for a guarantee to expressly specify that insolvency automatically gives rise to a right to make a claim under the guarantee.

Once the right to make a claim is established, the employer must ensure that the technical requirements under the guarantee are complied with.

A demand under a guarantee should also specify what is being sought from the guarantor. This will typically be the performance and fulfilment of the contractor's duties and obligations under the building contract or compensation for losses, damages and expenses which the employer has suffered as a result of the contractor's breach or failure.

Whilst the guarantor may elect to complete the works, the employer will not be able to compel the guarantor to do so. As a general rule, specific performance is not ordered where this would require performance of the building contract or constant supervision by the courts. Damages from the guarantor would be a more suitable remedy in this case.

Performance bond

Unlike a guarantee, a performance bond will be provided by a third party (e.g. a bank or a surety company). This is likely to be more beneficial to the employer as the issuer of the bond will not be suffering from the same financial difficulties as the contractor. However, the amount that can be drawn under a bond is typically capped at 10% of the contract sum.

An employer needs to establish the right to make a call under a performance bond. In the case of a conditional performance bond, the employer typically needs to establish breach of contract in order to draw on the bond. As with a guarantee, it is common for a bond to treat the insolvency of a contractor as a breach of contract. Accordingly, this would entitle the employer to call on the bond.

An employer should ensure that any claims are notified strictly in accordance with the technical requirements under the bond and prior to the expiry date of the bond.

Termination rights

Insolvency of the contractor does not automatically mean that the contractor is in breach of contract. The building contract should be consulted to determine whether the employer can terminate the contractor's employment in the event of insolvency.

How a contract is terminated (whether in accordance with its terms or at common law for repudiatory breach) will have a significant bearing on the contractor's liability flowing from such termination. Termination solely in accordance with the terms of the contract will generally mean that the contractual consequences apply. Conversely, termination for repudiatory breach will generally mean that the contractual consequences will not apply, but instead, an employer would be entitled to damages for loss of contract.

The consequences of terminating the contractor's employment in the JCT design and build contract are that the employer can:

1. employ and pay another contractor to complete the works; and
2. take possession of the site and works and use all temporary buildings, plant, tools, equipment and site material for the purposes of completing the works.

The most common express remedy available to an employer in the event of termination is the contractor's obligation to pay for any additional amounts incurred by the employer in completing the works and rectifying any defects.

Finally, consider whether any consent is required for terminating the contractor's employment under, and the possible implications for, any third party agreements. For example, if there is a facility agreement in place, consider whether termination must be approved by lenders or, in the case of pre-let agreements, consider the implications on any longstop dates for achieving practical completion.