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Below is a great article on contractor insolvency and how to plan for this contingency.  Of course, we are biased towards using a performance bond in lieu of guarantees.  The biggest reason is that it puts a third party - a SOLVENT third party - into the contract.  This does a few things.  First, it provides that this third party will guarantee the job.  Second, given that the surety doesn't want to pay any claims, it can oversee the project to make sure that there aren't any problems.  Third, and probably the most important, contractors don't want to go bankrupt and have a large surety go after them.  So, they take a bit more time and try to take on less risk in the bidding process so that they don't have to go bankrupt in the first place.

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When agreeing terms of contract for a construction project there are a number of security measures that can, and should, be put in place to assist an employer in the event of a contractor insolvency. Thes include the following:

Parent company guarantee

Where the selected contractor is part of a group and has a parent company, it is always worthwhile considering seeking a form of guarantee from that separate entity to guarantee the contractor’s performance under the building contract. Whilst there is no “standard from” parent company guarantee, most guarantees should cover all of the contractor’s obligations and will remain in place for the entire period of liability under the contract, whether this is 6 years for a contract signed under hand or 12 years if it is a deed. Naturally, where a contractor is in difficulties it may be that there are problems within the entire group, but it is possible that the parent will be able to provide a stronger financial covenant.

Performance bond

This form of security may be more beneficial on insolvency as it is a guarantee provided by an independent third party (typically an insurer), that will not be affected by the contractor’s financial difficulties. Where a bond is sought from a contractor, it will of course price for this as part of the price quoted for the works but it can be a worthwhile investment. There are technicalities to consider as regards the terms of the bond and steps to take should the need to call on it arise, but provided those matters are considered carefully, the bond amount can provide considerable financial assistance to an employer seeking to complete a project which has stalled as a result of the contractor downing tools. The bond will typically be obtained for 10% of the contract sum. Such bonds are typically not “on demand” meaning that the claim on the bond is “after the event” for losses sustained.

performance bond

Collateral warranties

Your building contract should also include provision for the contractor to provide collateral warranties, for the benefit of the employer and (where appropriate) third parties such as funders/subsequent tenants or purchasers of the completed building. Whilst an employer’s rights as against the contractor directly will be provided for under the terms of the building contract, it should still seek warranties from key members of the professional team and subcontractors with design responsibility for any element of the works. This will provide the employer with a level of protection as regards future defects in the works.

Whilst a claim against the main contractor might be considered to be the strongest and most straightforward, particularly in a design and build situation, if the contractor becomes insolvent, it may still be possible to bring claims against members of the professional team or specific sub-contractors that were involved in the particular works that are defective. Such warranties provide a second layer of protection and whilst litigating such claims is likely to be more complex and expensive, it may prove necessary if there is no alternative available.

Furthermore, employer warranties can (and should) include ‘step-in’ provisions. Such terms entitle an employer to ‘step-in’ to the contract between the contractor and the consultant or sub-contractor on termination of the building contract. This can be a useful tool where the employer takes the decision to terminate the building contract on grounds of insolvency.

The employer can give notice to step into key contracts in order to progress and complete the works on the same terms of the sub-contract and for the same sub-contract price. However, on stepin the employer will become liable for any amount unpaid under the sub-contract. This may be more cost effective than attempting to get another main contractor on board, who is likely to charge a premium for being asked to conclude someone else’s potentially defective work. The step-in provisions will also oblige the consultant/sub-contractor to give the employer notice in the event it considers that it has grounds to terminate the appointment/sub-contract so that the employer can elect to step-in before the relevant appointment or contract is no longer in existence. Receipt of such notice from a subcontractor might also give the employer a heads up that there are financial issues with the contractor.

Getting your security documents in place

It is all too easy when you have concluded the legal negotiations of the building contract to focus on the practical side of getting the works underway and the provisions of the contract are forgotten. This can prove disastrous in an insolvency situation.

It is common place for contract terms to be included which provide that any parent company guarantee and/or bond required to be provided by the contractor are provided at the same time as the contract is signed or within a period of, say, 28 days. Steps should be taken to ensure these terms are complied with.

As regards collateral warranties, again the contract should provide that each warranty is provided within a certain number of days (usually between 14 and 28) of a request from the employer. In practical terms, this means that on day 1 after the contract has been signed the employer (or a representative on their behalf) should request warranties from all sub-consultants (or novated consultants) and subcontractors who have been appointed at that stage. It is common for additional sub-contractors to be appointed as the project progresses and therefore necessary to appoint a representative to monitor the situation and make the necessary requests as and when further trades are brought on board. It will always assist if an agreed form of warranty is annexed to the contract, but it is notoriously difficult to obtain warranties unless time and effort is expended in chasing the various parties to conclude them.

One drafting point which can assist the employer is to include a provision whereby the employer is entitled to withhold a specified sum from monies otherwise due to the contractor under the building contract until such time as each requisite security document is provided. A clause requiring the production of such documents as a condition precedent to any payments runs the risk of being an unenforceable penalty. This can apply pressure on the contractor to conclude the documentation. Further, in the event that you consider that the contractor might be in financial difficulties, this could also provide you with additional justification for withholding money to avoid making further payments shortly before an insolvency occurs.

What steps should be taken on insolvency?

On receipt of notification of contractor insolvency, what immediate practical steps should be taken to limit the impact upon the project and to mitigate the losses that will inevitably be suffered as a result?

Considering the standard JCT 2011 Design & Build form of contract wording, clause 8 deals with termination for insolvency and defines insolvency for the purpose of the contract by reference to a series of events. If the contractor is insolvent (as defined) the employer may at any time by notice terminate the contractor’s employment under the contract. Further, as from the date the contractor becomes insolvent (whether or not the employer gives notice of termination) the contactor’s obligations to carry out and complete the works are suspended and the employer may take reasonable measures to ensure that the site, the works and ‘site materials’ (unfixed materials and goods delivered to and placed on or adjacent to the works which are intended for incorporation into the works) are adequately protected and that site materials are retained on site.

An employer should consider:

insurance and security arrangements for the site and materials. In particular the obligation on the contractor to maintain the Contractor’s All Risk policy will fall away on termination of his employment the terms of any performance bond and/or parent company guarantee and provide initial notification to the relevant parties that you intend to take action to enforce the security
whether and to what extent it has received executed consultant/sub-contractor collateral warranties and identify which consultants and/or sub-contractors it needs to negotiate with in order to conclude the project that it has all relevant documents/drawings in connection with the project and if not seek copies from the contractor and/or the professional team what funding or other agreements with stakeholders are in place and the impact upon those arrangements issuing the notice to terminate the building contract
Once the contractor’s employment is terminated, the employer may employ and pay others to carry out and complete the works and to make good any defects. The employer and the replacement contractor may enter and take possession of the site and the works and (subject to obtaining any necessary third party consents) may use all temporary buildings, plant, tools, equipment and site materials. The employer should, therefore, approach key suppliers to discuss terms regarding the continued use of hired buildings, plant and equipment.

No further sum should become due to the contractor and the employer does not have to pay any sum that has already become due either insofar as the employer gives a pay less notice or, if the contractor becomes insolvent after the last date upon which a pay less notice could have been given by the employer.

Further down the line following completion of the works and the making good of defects the employer will prepare a statement accounting for:

the amount of expenses properly incurred by the employer, including those incurred in completing the works and making good defects and, where applicable, those incurred in taking reasonable measures to ensure that the site and site materials are protected, and of any direct loss and/or damage caused to the employer and for which the contractor is liable, whether as a result of termination or otherwise
the amount of payments made to the contractor
the total amount which would have been payable for the works in accordance with the contract
If, which will be commonplace in such situations, the sum paid to the contractor and the total amount expended by the employer to conclude the works exceeds the sum that would have been payable for the works under the contract, the difference is payable by the contractor as a debt. If the sum is less then the employer pays the contractor. Generally the employer’s costs and expenses for getting the works completed by a new contractor (and associated other expenses) are likely to be higher than the amount which would have been payable to the contractor under the contract. The employer must prepare the statement within 3 months after completion of the works and the making good of defects. Where an employer has the benefit of a performance bond it will be looking to recover these additional costs from the bondsman and should build up the best evidence possible to support its position.

Whilst contractor insolvency can cause a number of problems for an employer, having your security documentation in place can help to progress the project through to completion at an earlier stage and can limit the financial implications for the business.

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