Managing Contractor Insolvency: Part 3 - completing the project, engaging with the 2nd tier supply chain and relationship between insolvency and adjudication

This is part 3 of our 3-part blog series focusing on contractor insolvency. In part 1, we discussed the key signs and implications of contractor insolvency followed by part 2, which discussed the legal, commercial and other practical considerations for mitigating the impact of contractor insolvency. This part 3 concludes by exploring an employer's options for completing the project and engaging with the 2^nd tier supply chain.

The options available to the employer include:

1. completing the project with the existing contractor notwithstanding the insolvency of the contractor (see below);
2. terminating the contractor's employment (see the 2^nd part of our blog);
3. leveraging its rights under a guarantee so that either the guarantor completes the project or it compensates the employer for losses incurred in appointing a replacement contractor; or
4. entering into a new building contract with a new contractor.

In the event that a new building contract is entered into with a new contractor, an employer should expect that the works will be completed on a different basis because a replacement contractor is unlikely to assume responsibility for works already carried out by the insolvent contractor.

Contact with the insolvency practitioner

Before deciding on what action to take, the Employer should seek to make contact with the insolvency practitioner (administrator or liquidator) to get as much information as possible as to the status of the contractor and the insolvency practitioner's initial views as to the ability/willingness of the contractor to perform its obligations under the contract. The employer should seek to make contact with the insolvency practitioner as soon as it becomes aware of the insolvency. It may be the case that the contractor is in a position to carry out the works notwithstanding the onset of insolvency. This option will be most viable where the project is nearing completion and is also dependent on the nature of the insolvency proceedings (e.g. this will not be an option where the contractor is being liquidated).

Where a contract does not terminate by reason of insolvency/the liquidation of the contractor, a liquidator could disclaim the contract if he regards it as unprofitable. This sometimes happens where the contract imposes continuing obligations and the liquidator believes that the performance of those future obligations (e.g. allowing the employer to use plant and equipment owned by the contractor to finish the job notwithstanding that the contractor's employment has ceased) would prejudice the liquidator's duties to collect in the assets, sell them and make a distribution to creditors. In such circumstances, the employer cannot rely on the continuation of the contract to protect its position/the project in circumstances where the contractor becomes insolvent.

If the liquidator does disclaim the contract, the contractor's liabilities would be crystallised and the employer could bring a claim for breach of contract/damages. However, where the contractor is insolvent and therefore has little/no cash to distribute to creditors, the value of the employer's claim may be nil. The employer could seek an order for specific performance but this obviously adds delay and cost etc.

Key Sub-Contractors and Suppliers

The position of the key-subcontractors and suppliers will depend on whether or not the main contractor's employment is terminated. If the main contractor completes the works notwithstanding the insolvency event, the key sub-contractors will continue to be engaged by the contractor.

Step-in rights

If the contractor's employment is terminated, the employer should seek to contact the key sub-contractors to understand their position and, where possible, put in place arrangements to protect the provision of goods/services that are critical to the works. In addition, the employer may seek to establish a direct relationship with any key sub-contractors or suppliers through any step-in rights it has through a collateral warranty or third party rights schedule.

Replacement contractor

Where a replacement contractor is appointed, the sub-contractor collateral warranty may require the sub-contractor to enter into a novation agreement and a new collateral warranty with the employer and the replacement contractor. As a result, the sub-contractor's employment would be transferred to the replacement contractor, provided this has been agreed by the parties.

Direct payments to sub-contractors

Unless there are express provisions in the building contract allowing for payment to be made directly to sub-contractors, an employer should avoid making any direct payments until such time as the employer has established a direct relationship with the sub-contractor.

Legal advice should be sought if the employer intends to make payments directly to sub-contractors as this may fall foul of the principle that assets should be shared equally amongst an insolvent company's creditors.

Insolvency and adjudication

There is no definitive statutory guidance which clarifies the relationship between the Insolvency (England and Wales) Rules 2016 (the "Insolvency Rules 2016") and the right to adjudicate under the Housing Grants, Construction and Regeneration Act 1996 (the "Construction Act").  However, the two regimes often intersect where, for example, an unpaid contractor, who is or becomes insolvent, commences an adjudication to recover unpaid amounts from an employer.

On the one hand, section 108 of the Construction Act provides that "a party to a construction contract has the right to refer a dispute arising out of the contract for adjudication". Such referral can be made "at any time", but will involve a quick and cheap determination of a single dispute.  On the other hand, Rule 14.25(2) of the Insolvency Rules 2016 provides that, when a company goes into liquidation, "[a]n account must be taken of what is due from the company and the creditor to each other in respect of their mutual dealings and the sums due from the one must be set off against the sums due from the other". In other words, all claims and cross-claims between an insolvent contractor (e.g. for work done up to the date of insolvency) and the employer (e.g. for termination damages) are considered together and amounts are set off against one another, as appropriate, following a careful calculation of the net balance. There is therefore a fundamental incompatibility between the adjudication process under the Construction Act and the accounting exercise under the Insolvency Rules 2016, which can give rise to markedly different outcomes.

For example, an employer, faced with an adjudication for money due to the contractor, would, in the absence of a pay less notice having been issued, have to pay such amount (regardless of what cross-claims the employer may have). The employer then has to prove for its claim against the contractor for losses arising out of the insolvency; the likelihood is that it will only be able to recover a small portion of what is claimed (given the contractor's financial position). Contrast this with the outcome arising from applying the Insolvency Rules to deal with both claims. The respective claims are set off against one another and the balance is paid by whoever owes more to the other. To the extent the employer can off set money due to the contractor against its cross-claim, it effectively recovers the full portion of that amount. If, after the off setting exercise, a balance is payable to the employer, it receives an amount pro rata to the value of that balance. The critical difference is that, applying the Insolvency Rules, the proration applies to the balance only whereas applying the adjudication process, the proration applies to the entirety of the employer's cross-claim.

Let's take a simple example; a contractor is owed £100 for work done to date but the employer in turn has suffered losses of £100 due to the contractor's insolvency (e.g. because it has had to engage a third party to complete the work). Applying the Insolvency Rules, these amounts are set off against one another, meaning that the employer effectively recovers the £100 it is claiming in full. If on the other hand, the employer has to pay the £100 it owes to the contractor and then subsequently seeks to recover its losses from the contractor, the likelihood is that it will only be able to recover on the same basis as other unsecured creditors who may be receiving  a prorated distribution of 5p for every £1.

The leading judgment which offers guidance on the interplay between adjudication under the Construction Act and the Insolvency Rules 2016 is Bresco Electrical Services Ltd (In Liquidation) v Michael J Lonsdale (Electrical) Limited [2019] EWCA 27 (Civ),[1] in which it was acknowledged that the adjudication process and the insolvency regime were incompatible due to, amongst other reasons, the potential of divergent outcomes as explained above. Accordingly, it was held that whilst a contractor subject to insolvent liquidation could refer a dispute to adjudication, in circumstances where there is a cross-claim by the employer and in the absence of exceptional circumstances, the decision of an adjudicator would be incapable of enforcement. In effect, therefore, the process of adjudication in such context was said to be a futile exercise.

In the second appeal, it was held that the outcome would not necessarily be the same where a contractor is subject to a Company Voluntary Arrangement ("CVA"), which, unlike liquidation, is intended to enable a company to trade its way out of hardship. A court may also be inclined to permit an adjudicator's decision to be summarily enforced if the employer's refusal to pay amounts owed to the contractor has led to the contractor's adverse financial position, resulting in the CVA. However, in the subsequent case of Indigo Projects London Limited v Razin and another [2019] EWHC 1205 (TCC), the courts held that the timing of the CVA (i.e. whether it came into effect before or after an unsatisfied adjudicator's decision) would be a significant factor in deciding whether or not to permit the enforcement.

It is clear therefore that a contractor will not automatically lose its right to refer a dispute to adjudication if it becomes insolvent. However, whether or not a court will permit the enforcement of an adjudicator's decision will depend on a variety of favours such as the nature of the contractor's insolvency, whether or not the employer has any cross-claims and the cause of the contractor's financial position.

[1] It is noted, however, that permission to appeal to the Supreme Court was granted on 24 June 2019 (UKSC 2019/0036).