What happens when a contractor becomes insolvent mid-project? page C-Link

What happens when your contractor becomes insolvent mid-project?

by Chris Williams

Have you ever wondered what the demise of Carillion meant for the numerous government projects they were involved in? Or how a Client deals with the fallout of such an event occurring on a project? What does a major development like this mean for the Client and how does the project move forward when such an integral part of the delivery is abruptly removed from the process?

There can be several ramifications for a wide range of stakeholders when a Contractor on a project enters insolvency midway through the programme. This is especially the case on large public developments such as hospitals or complex infrastructure projects, the likes of which Carillion were heavily involved in.

There are several ways in which an Employer can safeguard themselves and minimise the damage to a project’s health in terms of the potential time and cost implications that occur due to the unfortunate scenario of the Main Contractor becoming insolvent mid-contract. As with most matters in the construction industry, an Employer’s tolerance to such disruption is more resolute if careful planning is carried out at the pre contract stage and decisive action is taken to determine the best way of getting a project back up and running if the contract needs to be terminated with the existing contractor.

The options available to Employers

Crucially, the Employer has to decide what measures they are going to take to secure performance and deliver the final asset. Broadly speaking, the Employer has 5 main options.

  1. Do nothing and abandon the project
  2. Establish if the contractor can actually complete the works
  3. Re-tender the remaining part of the project on a competitive basis
  4. Novate the contract to another Contractor
  5. Establish direct relationships with the subcontractors

The process of establishing the best way to proceed will require reviewing the contract documents to understand what mechanisms have been drafted into the agreement whilst concurrently considering the main options available.

The best way to get things moving forward

It is highly unlikely that abandoning the project is going to be the optimal option for most Employers when considering how they are going to proceed. It is of course possible that in exceptional circumstances, where the levels of exposure are too high for an Employer to continue, that a project may be abandoned. However, it is reasonable to assume that going with this option does not lead to a desirable outcome for any stakeholder.

Determining the best way to proceed depends on a number of key factors in terms of how much time and risk can be allocated to completing the works. We can now take a look at the individual options and see what the financial and programme implications are when contemplating an Employer’s attitude towards time and risk.

Establishing if the contractor can actually complete the works

If time is of the essence, an obvious and sometimes overlooked option is to determine whether or not the insolvent Contractor is actually in a position to complete the works. A useful first step for the Employer would be to contact the insolvency practitioner who is dealing with the case concerning the relevant contractor. The Employer should try to get as much information as possible from the liquidator to ascertain if the Contractor is in a position to finish the works despite its status.

The liquidator can consider this type of proposal but can also disclaim the contract if it believes such an initiative is not going to be profitable for the contracting organisation. Alternatively, it is plausible for the two parties to come to an understanding and mutually agree a way in which the works can be completed rather than having to terminate the contract. When a project is nearing completion, this could be the quickest and most valuable way of bringing things to a conclusion.

Re-tendering the project on a competitive basis

If the client has sufficient time available, the most effective way of minimising risk and ensuring the works are priced competitively would be to re-tender based on a revised schedule of works and pricing document. In a lot of cases, where there is a need for a replacement contractor, it’s usual practice for organisations to propose undertaking the works on a cost reimbursable basis due to the tight timescales associated with needing to take over a project. This can be risky for an Employer.

If time is available, the preferred option would be to have a clearly defined scope of works consisting of quantities and agreed rates. This would be the most effective way of forecasting the additional costs associated with a Contractor insolvency.

There can be challenging aspects to having a new contractor involved in this way, especially if the project is done on a design and build basis. From a buildability perspective, the new contractor or their subcontractors might not hold the same view as the insolvent contractor with regards to certain elements of the design and its overall fitness for purpose. To avoid problems like this occurring in what is a transitionary phase, it may be beneficial to consider other options in which the existing subcontractors can possibly be retained on the project.

Novating the Contract to another Contractor

There will be scenarios where time is of the essence and given that a re-tendering process can be quite time consuming, other options may need to be considered. One of the best methods is to novate the contract to another contractor. This can be a rapid way of moving the works forward, especially if the Employer has a Parent Company Guarantee meaning that there is scope for a sister company to step in and carry on the works.

However, bear in mind that novation can be a very complex process, especially in situations where a parent company cannot step in to complete the works. Successful novation’s often depend on what stage the project is at i.e. it is much easier to novate before works are at a developed stage as opposed to doing it midway through the project. From a commercial perspective, this whole process can be extremely risky to the Employer as there are usually difficulties in arranging revised collateral warranties for integrating new works with completed works.

Step in and agree direct relationships with the existing subcontractors

A potential and extremely effective way of reducing setbacks caused by a Contractor insolvency is for the Employers themselves to take the initiative on the project. Some (not all) developers may have in house construction management teams, meaning they are able to cover the work and establish direct relationships with the subcontractors.

If the Employer is under pressure in terms of time, it may be worthwhile for them to contact the key subcontractors to grasp their position and if possible make arrangements to protect the provision of goods and services that are critical to the works. It may be possible, depending on the wording in the contract, for the employer to establish a working relationship directly with the key sub-contractors by way of a step in rights clause contained via a collateral warranty or even third party rights, which may have been incorporated into the contract. This option can reduce risk on a project as the existing subcontractors are likely to possess extensive knowledge of the build, meaning a probable reduction in uncertainty, which is always valuable.

What can the Employer do to protect themselves against the threat of Contractor Insolvency?

As mentioned earlier, careful planning is key to developing a buffer around the threat of contractor insolvency. Traditionally from a legal perspective, safeguarding the Client’s commercial interest has centred around three legal structures.

Parent Company Guarantees

A Parent Company Guarantee is useful where a large contractor is using a regional subsidiary or a special purpose vehicle to carry out the project. This mechanism essentially means that the Employer is protected by a Contractors Parent organisation in the event the Contractor becomes in breach of contract.

In the negotiation phase, the employer must consider the group structure of the contractor i.e. if is a parent of part of the group of companies. This can determine if it is going to be more suitable to opt for a performance bond or a parent company guarantee. When considering what option to take, a potential issue to be concerned about, is the high likelihood of a parent company having the same liquidity problems as the Contracting organisation. If the Employer believes this might be an issue based on their due diligence, then a performance bond might be the preferred choice.

Performance Bonds

Performance bonds, sometimes known as retention bonds, are essentially withheld reserves of capital provided by a surety company or a bank. On completion of a project, these bonds will be paid to a Contractor providing they have satisfied the conditions of the contract. However, in the event the Contractor does not complete the project because they have become insolvent, the monies reserved can be claimed by the Employer to cover the losses incurred as a result of the Contractor going out of business.

From the Employers perspective, performance bonds can be more advantageous over Parent Company guarantees as they are protected by independent 3rd parties meaning the risk of the Parent Company being subject to same financial difficulty is not an issue.

Collateral Warranties

Collateral warranties are agreements in which parties are to provide a duty of care to other parties they are not directly in contract with. This essentially enables direct claims to be made against these firms in the event of problems arising with the works they have carried out.

Therefore in relation to risk concerning Main Contractor solvency, it is important for the Client to obtain collateral warranties from as many different companies engaged on the project so that they have a right to claim against any subcontractors they wish to carry out defective works.

The collateral warranty is important in ensuring the Client has step in rights to pursue the subcontractors. However, it has to be realised that these do not normally take effect until the end of the project. They are useful in the event of latent defects but are of limited use in the event the Main Contractor becomes insolvent midway through the project.

Practical Measures

From a practical standpoint, there are several things an Employer can do to ensure the right contractor is selected for the project. However, it has to be appreciated that this might not be enough meaning the Client must also be vigilant in the post contract phase which requires an awareness of certain warning signs. If problems are detected early enough, then there still may be time to make provisional plans to ensure the Contractor has the liquidity to at least finish the build.

As part of a due diligence initiative, Employers can strengthen their resolve by looking at the trading history and financial position of those submitting tenders. Credit checks should be carried out where necessary and Employers should do all they can within reason to gather as much information as they can about the company e.g. Have they had to pay liquidated damages on any recent projects?

Common warning signs of potential Contractor liquidity problems may come in the form of requests for large advance payments or there may be complaints form subcontractors or suppliers about a lack of payment. For larger publicly listed companies, profit warnings are clear indicators of financial difficulty and could be a sign of potential problems for Employers.

Employers are encouraged to implement several other initiatives on projects designed to protect their interest. These may come in the form of escrow accounts so that the Contractor can only withdraw monies once they fall due. Employers may also insist on the Contractor using a separate dedicated project bank account as opposed to their own for the purposes of managing money owed to their subcontractors and suppliers specific to the development. Ring fencing measures like these can often be an extremely effective way of ensuring a projects finances do not get out of control.

A final point to consider for Employers centres around efficient record keeping and management of documents. Ensuring that all of the Contractor’s documentation is up to date including test certificates, warranties and H&S information can remove the worry of having to reproduce all of this material if the Contractor becomes insolvent. Without their specialist expertise and historical knowledge of the project, such documentation could be very expensive to restore placing huge emphasis on good record keeping. Another key aspect closely linked to this, is ensuring all the security documents i.e. performance bonds and collateral warranties are signed as early as possible.

Final Thoughts

There are 3 main issues that the Employer needs to address as a result of a Contractor entering into insolvency.

  1. Completion of the works
  2. Site security and safety
  3. Outstanding payments and debts

Employers may face a lot of disruption and adversity when a Main Contractor goes insolvent. It can be a very testing time, especially when a lot of skilled operatives with knowledge about the project suddenly go missing. The implications can be substantial, which is why it is critical to have a robust process in place when selecting the Contractor for the project.

Due diligence is key, and it often takes huge amounts of effort and resource to select the most suitable contractor. Employers should not fall into the trap of accepting the lowest offer and if possible, avoid deviating away from their selection criteria. This can be hugely important as any oversights can be extremely costly and detrimental further down the line.

Image credit: iStock.com/SbytovaMN

About Chris Williams

Chris is a Chartered Surveyor with 6 years experience in the UK Construction industry, working for a range of clients, undertaking Quantity Surveying, Claims Management and Project Co-ordination roles.

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