Dealing with an Insolvent Contractor
A large number of UK companies are in significant financial distress at the moment.
Construction businesses account for a disproportionately high number of these distressed companies according to the January 2023 Begbies Traynor Group Red Flag Alert Report (around 12.6% are construction companies - which is over 77,000 companies). The risk of insolvencies in the UK construction sector throughout 2023 and beyond is therefore high.
So why is the construction industry suffering so badly? In addition to the high interest rates and high inflation affecting most industries, reasons more specific to the construction industry include:
- Cashflow: delays between work performed and payment, though, since the introduction of the Housing Grants, Construction and Regeneration Act 1996 (since amended and commonly referred to as the “Construction Act”), the UK has legislation in place intended to improve cashflow in the industry;
- Domino effects: one company in the chain becoming insolvent can have a ripple effect on the entire project and others in the supply chain; and
- Low profitability: due to the competitive nature of the industry, construction companies may need to offer work at low prices to secure tenders, which can result in low profitability.
The practical guide below will be of relevance to employers who are seeking to anticipate and minimise the impact of contractor insolvencies on a construction project.
What is insolvency?
Under the Insolvency Act 1986 (the “1986 Act”), a company is insolvent if it is unable to pay its debts.
Section 123 of the 1986 Act sets out that, in England and Wales, a company is considered to be unable to pay its debts if it meets one of the following criteria:
- failing to comply with a statutory demand for a debt of over £750;
- failing to satisfy the enforcement of a judgment debt;
- the court being satisfied that the company is unable to pay its debts as they fall due (the “cash flow” test); or
- the court being satisfied that the liabilities of the company exceed its assets (the “balance sheet” test).
The 1986 Act sets out several insolvency procedures, not all of which signal the ‘end of the line’ for a company. The insolvency procedures include administration, administrative receivership, company voluntary arrangements, schemes of arrangement, winding-up and liquidation.
The JCT suite of contracts use a narrower definition of insolvency and provide that a company is insolvent when:
- it enters administration;
- on the appointment of an administrative receiver;
- on the passing of a resolution for voluntary winding-up; or
- on the making of a winding-up order.
These events are assessed by reference to the 1986 Act and do not, for example, include failure to meet the “balance sheet test”.
How to recognise insolvency
At the pre-contract stage, the employer is advised to carry out due diligence (including a credit check) on the proposed contractor’s finances. This may provide the employer with an early indication of the any insolvency warning signs.
Once the works have commenced, common indicators of contractor insolvency can include:
- industry rumours about the contractor’s finances;
- the contractor filing its annual returns late;
- multiple members of the contractor’s key project team leaving the contractor at the same time;
- the project not progressing at the expected rate;
- reduced numbers of people working on the project (which you may notice by simply walking the site);
- an increased occurrence of defects on the project;
- sub-contractors not being paid or not, at least, being paid on time. Sub-contractors may even approach the employer directly for payment; and
- the contractor making inflated applications for payment.
While any single one of the above indicators may not necessarily mean an immediate risk of contractor insolvency, employers should recognise that these warning signs can indicate that a contractor is in financial difficulty. The employer may then have the opportunity to take steps to manage the potential effects of contractor insolvency on the project.
How to deal with an insolvent contractor
Let’s look at various stages in the lifecycle of a construction project:
1. Employer protections to consider at the outset
Even before a contractor insolvency is on the horizon, employers are advised to take practical steps to protect themselves from the risk of contractor insolvency. Some good examples are:
- procuring latent defects insurance policy to cover the costs of defective work, if the contractor later goes insolvent;
- withholding retention from contractor payments;
- procuring security such as a parent company guarantee (if there is a parent company) and/or a performance bond;
- procuring sub-contractor warranties in the employer’s favour early in the project, which include step-in rights. Such warranties would give the employer a right to ‘step into’ the main contractor’s shoes in the event of contractor insolvency, and thereby to directly employ the relevant sub-contractors to complete on the project;
- avoiding advance payments where possible, and instead pay for work that has been independently certified as properly completed. If this is not possible, then it may wish to obtain an on-demand advance payment bond as security for any advance payments.
Such measures can help protect the employer’s position should the contractor become insolvent.
2. Prior to insolvency
Once a contractor insolvency appears to be imminent, employers are advised to take steps to understand the contractor’s situation and its potential effects on the project e.g.:
- further due diligence to understand the contractor’s current position;
- prepare to immediately secure and protect the site in the event of insolvency;
- check that the contractor’s insurance policies remain in place;
- carry out a site audit to assess the progress of the project;
- review the terms of the building contract to assess the options available, particularly in relation to termination;
- monitor payments and ensure that the appropriate payment notices and pay less notices are issued at the right time under the contract so that you do not overpay the contractor; and
- consider whether to deduct any liquidated damages if the works are running late. Deducting your full entitlement to damages is not always the correct decision, as it this could push a contractor over the edge, leading it to insolvency. However, if insolvency is inevitable then you would usually want to recover any liquidated damages prior to insolvency. Maintain clear communications with your contractor to ascertain the commercial impact of any liquidated damages and, where appropriate, take a pragmatic approach to delay.
3. On insolvency
Upon insolvency, the employer will need to take practical steps including securing the site and notifying funders.
A well drafted construction contract will set out what happens upon each party’s insolvency. In the JCT suite of building contracts, for example, the most notable consequences of the contractor being insolvent (if coming within the definition of ‘Insolvent’) are:
- no additional sums fall due to the contractor, other than those already due, and the employer may not be required to pay those sums already due where a pay less notice is given or the insolvency has occurred after the last date when a pay less notice could be given but before the final date for payment;
- there will be a right for the employer to terminate the contract (see clause 8.5.1 of the JCT Design and Build Contract (2016));
- the works are automatically suspended, whether or not the employer issues a termination notice; and
- the contractor is liable for those expenses properly incurred by the employer as a result of the termination or otherwise (see clause 220.127.116.11 of the JCT Design and Build Contract (2016)).
Employers should, however, be careful to exercise their termination rights in strict accordance with the contractual requirements, which are often very prescriptive. We recommend that employers seek the advice of their professional advisors before termination to minimise the risk of inadvertently repudiating the contract. For example, terminating too early or excluding the contractor from the site where the contractor is not strictly ‘insolvent’ (as defined in the contract) may be a repudiatory breach of contract, entitling the contractor to seek to recover its losses from the employer, including loss of profit. Equally, the employer may have grounds for termination before the contractor is contractually insolvent, for example, if the contractor fails to proceed regularly and diligently with the performance of its obligations.
Even where the contractor is insolvent, the employer may face claims from the insolvent contractor. Case law shows that the contractor can still refer disputes to adjudication under the Construction Act, and the Supreme Court has held that “construction adjudication…is not incompatible with the insolvency process” (Bresco Electrical Services Ltd (In Liquidation) v Michael J Lonsdale (Electrical) Ltd  UKSC 25, at 71). However, even though insolvent contractors can refer disputes to adjudication, they may still find it difficult to enforce an adjudication decision. The court in Bresco also considered enforcement, stating that “in many cases the liquidator will not seek to enforce the adjudicator’s decision summarily…in others the liquidator may offer appropriate undertakings, such as to ring-fence any enforcement proceeds” and that where there remains a “real risk” that summary enforcement of an adjudication decision will deprive the respondent of its right to have recourse to the company’s claim as security for its cross claim, “then the court will be astute to refuse summary judgment” (Bresco, at 67). In John Doyle Construction Limited v Erith Contractors Limited, the Court of Appeal set out guidance for a company in liquidation seeking to summarily enforce an adjudicator’s decision, including a comment that the insolvent company should “take all necessary steps to ensure that the hearing itself is as efficient as possible”, that any undertakings or security it offers “need to be clear, evidenced and unequivocal”, and that “it needs to be unequivocal about any offer that it is making to ring-fence that money or otherwise protect it” (John Doyle Construction Limited v Erith Contractors Limited  EWCA Civ 1452 at 31-32).
4. What happens after termination for insolvency?
Employers will want to minimise the impact of contractor insolvency on the project. A key consideration will be how the works will be completed following the contractor’s insolvency. Depending on the nature of the outstanding works, this may involve running a competitive tender process. The replacement contractor would then be able to bring the project to practical completion. Notably, the replacement contractor is unlikely to agree to assume design responsibility for the whole project, which may prove problematic when rectifying defects.
Where a project involves sub-contractors, employers may (depending on how the sub-contract documents have been drafted) have a right to step into the contractor’s position and administer these sub-contracts or novate them to the replacement contractor. This may assist the replacement contractor to move the project toward completion. Employers should be wary of agreeing to make direct payments to subcontractors, unless they are contractually obliged to do so following any step-in rights. Legal advice should be sought before any direct payments are made.
The insurance position will also need to be considered, as this is likely to become the employer’s responsibility after termination of the building contract.
The effect of contractor insolvency can be disastrous for a construction project; however the risk of inadvertently engaging a contractor on the verge of insolvency can be lowered if the employer undertakes proper due diligence at the outset of the project. Employers are advised to remain alert to the indicators of contractor insolvency throughout the life of a construction project. If the employer becomes aware of these insolvency indicators, then communication between the employer and the contractor can be key to managing the risk and potential fall out.