Construction Contracts and the Corporate Insolvency and Governance Act 2020

In our first two blogs on the Corporate Insolvency and Governance Act 2020 (CIGA), we looked at how:

• CIGA impacts construction and engineering contracts generally; and
• to what extent it may affect step-in and automatic termination rights.

As the first blog outlined, CIGA materially restricts a contractor or sub-contractor’s options in situations where the recipient of its services is insolvent (for example, through removing termination rights).

This blog focuses on the steps either party to a construction contract may, nevertheless, be interested to take in response to CIGA.  We conclude with a brief note on the international reach of CIGA.

Who may benefit from taking steps?

As will be clear from the earlier blogs, the relevant provisions of CIGA seek to protect recipients’ interests, while restricting suppliers’ rights, in insolvency situations. So the possible mitigations described here are primarily points which those supplying construction and engineering services may choose to consider. This reflects one of the main effects of CIGA: to transfer credit risk to the supply chain.

Even so, the recipients of such services will be interested to understand the measures which suppliers may propose. And, of course, many people in a construction or engineering supply chain will be both a recipient and supplier of services, given the prevalence of sub-contracting.

Some of the mitigations could be incorporated into new contracts. They could also be applied to existing contracts, though we think it unlikely that recipients will be willing to enter into agreements varying concluded terms.

No settled position yet

At this stage, there is no settled practice – it is too early: CIGA only came into force on 26 June 2020. Also, it seems likely that positions agreed in practice will be influenced by factors such as:

• the value and duration of the project;
• a supplier’s view of its counterparty’s financial strength;
• the respective bargaining power of the parties; and
• the positions adopted by sector standard form contracts.

Possible mitigations

Amending the definition of insolvency

One change we expect parties to consider is expanding the definition of “insolvent” used in termination provisions. This would be to include the two new insolvency-related procedures for companies introduce by CIGA:

• the moratorium introduced as Part A1 of the Insolvency Act; and
• the restructuring plan procedure introduced as Part 26A of the Companies Act 2006.

More information can be found in our CIGA soundbite series here.

The definition of “insolvent” used in many construction and engineering contracts (for example, the JCT standard forms) repeats that given in the Housing Grants, Construction and Regeneration Act 1996, which does not include anything equivalent to these new events.

Expanding the definition would, of course, entitle the recipient to terminate a supplier’s employment simply because the supplier had entered into a moratorium. Entry into that procedure would indicate that a supplier had insufficient financial strength to perform under the contract.

By contrast, an expanded definition will not entitle a supplier to terminate for the recipient entering into a moratorium, unless it first obtains the recipient’s consent or the permission of the court under section 233B(5) of CIGA.

Definitions of insolvent are typically written to apply to both recipient and supplier equally: we would expect this approach to continue under contracts including the moratorium and the restructuring plan as types of insolvency.

But we doubt that developers or project sponsors will readily agree to go further than current norms, by allowing suppliers wider or pre-emptive rights to terminate for the actual or perceived lack of financial standing of a recipient or its anticipated entry into an insolvency procedure. However, some suppliers may still consider asking for such rights as a hedge, given that CIGA will for them render typical insolvency termination clauses largely toothless.

Financial look-ahead tests and contractor due diligence

That said, clause 2.4 of the First Edition of the FIDIC Silver Book requires the employer to submit to the contractor reasonable evidence of the employer’s financial arrangements to pay the contract price. If the evidence is not provided within 42 days from the request, the contractor may terminate the contract.

It may be that where CIGA applies, it prompts contractors to be more zealous in making requests under clause 2.4. And, conceivably, contractors who are to be engaged on non-FIDIC terms may seek to negotiate the inclusion of similar “early warning” provisions. But, as already indicated, we would expect that to be opposed by UK developer clients (who may find such a term as “vague” or “unusual”).

What CIGA may – perhaps should – spur is increased pre-contract due diligence on an employer’s project finance arrangements. Even before CIGA was enacted, we were seeing this as an increasing trend among contractors, as they sought to improve their internal risk management.

Payment security

It is also possible that CIGA will encourage contractors more regularly or forcefully to request payment security from employers (particularly those that are SPVs). This would be to offset the increased risk to contractors due to CIGA requiring them to continue supplying construction or engineering services to insolvent counterparties.

Payment security could include:

• ring-fenced monies held in trust in escrow, on which the contractor would be entitled to draw in the event of non-payment;
• a payment guarantee given by a group company of the employer; or
• a letter of credit given by a bank or other financial institution (typically, we would only expect to see such letters on major non-UK projects, particularly where the contract is for the supply of expensive plant, such as turbines).

Unlike some other commentators, we do not think that section 233B(3) of the Insolvency Act 1986 (as introduced by CIGA) could prevent a contractor from enforcing a payment guarantee in an employer insolvency situation. (It is, of course, another question whether the guarantee will have any practical worth, as a group company which stands as guarantor may simultaneously have become insolvent.) Such guarantees are invariably standalone contracts, with the trigger for a claim under them being non-payment, not insolvency. Further, contracts for financial services consisting of providing guarantees are exempt from section 233B by virtue of paragraph 13(2)(a)(iii) of Schedule 4ZZA of the Insolvency Act 1986 (again, as introduced by CIGA). A payment guarantee would, accordingly, fall outside the scope of section 233B(3).

CIGA may also increase the desire of suppliers at tier two and below to see the introduction of project bank accounts. This would be a way to maximise cashflow to the supply chain, avoiding it becoming “lost” in insolvency higher up the chain. However, the reluctance of main contractors to embrace PBAs, as well as clients outside the public sector seemingly being unwilling to mandate them, makes any change in practice due to CIGA appear unlikely.

Reduced payment periods

Another possible mitigation suppliers under construction and engineering contracts may explore is reducing payment periods. The aim would be to maximise the supplier’s cashflow, including during any insolvency period during which CIGA applies.

While reducing a supplier’s risk of not being paid for its work in progress is understandable, it may be that there is relatively little scope to achieve this in practice, unless the proposed payment cycle is unusually long.

Certainly, in the UK the period from application to payment under tier one construction and engineering contracts is typically around four weeks and quite often less. Shortening such periods and increasing the frequency of payment applications may be a challenge, given an employer’s internal arrangements, as well as the constraints placed upon it by any financing documents.

Last words

As indicated, there is not yet any fixed response to mitigating the effects of CIGA. But aside from:

• revised definitions of insolvency; and
• (possibly) an increased focus by suppliers on financial due diligence leading to more requests for payment security,

we think it is quite likely that the legislation will impact relatively little on the negotiation and drafting of construction and engineering contract terms. That reflects CIGA being an unavoidable legislative overlay, where it applies.

Finally, a few words on the international reach of CIGA.  While CIGA clearly applies to a “relevant insolvency procedure” in the UK and to English law contracts, section 233B does not specifically address its application where the supplier is an overseas company and/or the supply contract is governed by the laws of a foreign jurisdiction.  Certainly in the construction industry it is common to have a supply chain that crosses international borders.  While a full analysis of the application of CIGA in an international context is beyond the scope of this blog series, it suffices to say that the question may not always be a straightforward one and will require careful consideration depending on the circumstances.