Contractor Insolvency – What do you do when it affects your project?

What is the difference between liquidation, administration and insolvency?

Issues regarding liquidity are sadly commonplace in the construction industry for companies of all sizes. Small margins and drawn out payment processes can put a real strain on a company’s cashflow. If projects do not proceed as intended, disputes over variations and delays can also lead to restrictive payments. If this impacts cash at hand and day-to-day business operations, creditors may move to claim the company is unable to pay its debts, that it’s essentially insolvent, and can petition to the courts to have the company wound up in order to seize its assets in order to recover the debt.

If an individual is unable to pay their debts, they’re made bankrupt, but an insolvent company is put into administration or liquidation. According to the Insolvency Act 1986, as amended by the Enterprise Act 2002, and updated by the Insolvency Rules 2016, there are broadly four types of action when a company becomes insolvent and these are:

• Administration
• Receivership
• Winding Up
• Company Voluntary Arrangements

Under administration, the company’s Directors apply to the court for an administration order on the basis they are unable to pay their debts. The court will need to satisfy themselves the company is unable to pay its debts and that administration will be able to rescue the company i.e. that administration is a better outcome as opposed to winding the company up. An administrator may dispose of company assets to defend legal proceedings or to simply shut down loss making parts of the business, usually with immediate effect.

Administrative receivership was previously more widely used by creditors to essentially asset strip insolvent companies in order to recover debts. However, after the Enterprise Act was passed, the onus was on rescuing companies and helping them to survive, therefore administrative receivership is no longer common practice.

A ‘winding up’ can be carried out voluntarily by company Directors or by court order if creditors can present evidence that the company is unable to pay its debts. Evidence can include statutory demands for debts having been served on the company or by court judgement. In the case of Carillion, for example, the share price dropped to such a low level compared to the size of their debt, compounded by their lack of assets and cash in hand, which effectively made them insolvent and unable to pay their debts and a winding up order was made in January 2018.

Company Voluntary Arrangements or CVAs are essentially an offer by an insolvent company to repay their creditors typically over a period of time. To make such a case, the company will need to present the structure of a deal including income, current debts, assets, and any other funding streams to give confidence that their repayment plan will succeed. The creditors then call a meeting and vote to accept or reject the CVA. Failure to agree may move the company into administration or winding up proceedings.

What action should you take?

As an Employer, if you are on site and have been informed of a Contractor’s insolvency directly or otherwise, you should first consider the security of the site as unpaid subcontractors could seek to recover debts by removing assets and you will need to consider what insurance is in place if the works are abandoned. Under a JCT Standard Form of Contract, the Employer has a general obligation to take reasonable measures to ensure that the site, the works, and unfixed materials and goods are adequately protected and retained on site.

From a contractual perspective there may be a provision for a parent company guarantee or performance bond. If there is, check that you have received these in full and then notify the parties involved that you intend to invoke them citing your reasons why. As an Employer, if you included a requirement for collateral warranties, ensure that you have received them, along with any similarly executed subcontractor warranties, as this will you identify the subcontractors required to complete the works.

If you are tied to certain funding arrangements with a developer, you will need to notify them of the situation and inform them of the likely impact upon the agreed arrangements. Good practice is to inform them of your recommendations, including actions, and seeking their approval for the plan.

In terms of the contract administration, you will need to prepare a detailed valuation of the works completed to date, plus any materials and equipment on site, and contact the administrator with your valuation already prepared. It is important that you do not make any further payments if you are in the process of terminating the contract.

Does the form of contract make a difference?

As an Employer operating a JCT Design and Build Contract you may terminate the Contractors employment at any time if they are insolvent. The Contractor will need to provide to the Employer all relevant documents, including subcontracts, drawings and other supply agreements.

Alternatively, you can decide not to terminate and instead negotiate a novation of the works to another Contractor who goes on to complete the works. If the Contractor is in administration then such negotiations are likely to be very complex. The appetite for such an agreement is likely to be dependent on what stage the project is at i.e. before construction has started is easier to negotiate with a new contractor than half way through the build.

If the intention is for an Employer to negotiate directly with the existing subcontractors to complete the works, there is a risk that some subcontractors claim they have not been paid for works completed even though you may have already paid the main contractor.

As an Employer under the NEC ECC form of contract, if the Contractor becomes insolvent, you may terminate the contract, bring in a third party to complete the works, and use equipment that remains on site. In terms of payment, as per JCT Contracts, you will need to assess the value of works complete plus any cost for plant and materials on site, but deduct the forecast of the additional cost the Employer will incur in completing the whole of the works.

Under the Housing Grants, Construction and Regeneration Act 1996, with 2011 amendments, or the ‘Construction Act,’ any clauses inserted into contracts which seek to operate payment provisions on a ‘pay when paid’ basis are made invalid. However, the exception to this is if the party making payment is insolvent. Therefore, if such a clause is included in the contract between a contractor and subcontractor and the Employer becomes insolvent the Contractor could resist payment to the subcontractor on this basis.

Can you simply replace the Contractor with another?

Under both JCT and NEC ECC forms of contract, once the contractor’s employment is terminated, the employer can contract to other parties to carry out and complete the works, including the making good of any defects.

This will involve the replacement contractor looking at the current site, the state of the current works, the value and condition of any materials, plant and equipment on site, and the scale and scope of all outstanding works. They will then return a price to complete the works. In many instances, the replacement contractor may propose to complete the works on a cost reimbursable basis, but this means a lot of the commercial risk remains with the employer. A reasonable compromise is partial cost reimbursable and partial measured works against an agreed programme.

What if you’ve been contacted by a third party to recover the Contractors debt – should you pay them what they ask for?

Essentially, the answer here is no. If you have been contacted by a third party stating that outstanding amounts are due then you are within your contractual rights to wait until the works are complete, upon which you prepare a statement of the expenses incurred in completing the works. This includes making good any defects, plus the costs of site security and safeguarding materials, plant and equipment on site. You will also need to add the cost of any loss or damage due to the contractor’s insolvency or a result of their termination.

Once you have the statement of expense, this is added to the amount paid to the contractor to date and compared to the original cost of the package of works. It is almost entirely the case their expenses plus the cost to date will exceed the original package of works value.

Can you recover any losses?

As described above, the employer needs to prepare a statement of the costs they have incurred in dealing with the insolvent party. If these are more than the original package order value, the employer will be a creditor to the insolvent party. If they are under administration, you will need to make a case to the administrators to recover the debt.

Unfortunately, unless there is a performance bond to call on, the additional cost incurred by the Employer in completing the works will not be recoverable. If there is a performance bond, then investing time in good records that link back costs claimed to the cause is important if you are to recover all costs.

Does Insurance play a part?

The Contractor will have carried Public Liability, Employers liability, Professional Indemnity insurance (if providing design) and Contractors All Risk. The Employer, under the Third Parties Act 2010, will become responsible for insurance if the Contractor becomes insolvent, but as Professional Indemnity operates on a claim made basis, any claims against the Contractors design will need to be made before the insurance renewal date.

Notwithstanding the taking over of insurance, the Employer will be able to bring about an insurance claim directly from the Contractors insurer without the Contractor being part of the proceedings, albeit this will only be possible if the Contractor was insuring against the matter in question from the outset. This is why it is always important to check insurance policies taken out by the Contractor at the start of the project.

Case law involving contractor insolvency

To protect the supply chain in the case of contractor insolvency, project bank accounts are becoming more prevalent. These types of project specific accounts operate on the basis that specific amounts of money paid by the Employer are essentially held in trust in the account, meaning that even in the case of liquidation the money will not form part of the contractor’s assets and therefore a liquidator will have to pay the money back to the Employer.

In the case of Barclays Bank Ltd v Quistclose Investments Ltd, the House of Lords ruled that if money is lent for a specific purpose, but that purpose fails, the money was essentially held in trust. The liquidator in this case wanted to use the money to be set off against other debts but the ruling was “money advanced for the specific purpose did not become part of the bankrupt’s estate”.

The Construction Act makes clauses concerning ‘pay when paid’ invalid unless in the case of insolvency. In the case of William Hare versus Shepherd Construction (2009), Hare had entered into a subcontract with Shepherd. The subcontract excluded pay when paid provisions except for insolvency. When the Employer did become insolvent, Shepherd tried to withhold payment, but Hare argued, and the courts agreed, that the type of insolvency in question was not listed in the sub-contract. The lesson to learn here is that careful drafting is important and that it reflects your intentions.

Conclusion and take away thoughts

If you have been involved on a project where a contractor has become insolvent, you will be aware that the first few days afterwards are crucial if you are to secure the site plus any assets within it. There may be creditors who believe the best way to recover debts will be to remove anything of value as opposed to put their case to the administrators.

However, there are more proactive ways to try and avoid finding yourself in the situation where the contractor or a subcontractor has become insolvent. These include obtaining information from a credit reference agency about the supplier in question in order to study their accounts for the past three years. If this illustrates a history of poor financial performance and minimal cash reserves, you may decide not to proceed to contract. Alternatively, you could take out a performance bond or where possible seek a parent company guarantee.

About Dean Suttling

A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.