This is a suggested backup strategy for Employers dealing with the risk of Contractor Insolvency.

Because the construction industry is built on contract chains the insolvency of one link will impact on the contractual performance of others. Employers, just like banks do, or did, should therefore be looking for the early warning signs of financial difficulty.

When it comes to the valuation and certification process, if there is the slightest hint of insolvency, an Employer would be wise not to include on and off site materials that have not yet been incorporated into the Works and therefore into an interim payment.

Liquidation, Administrative Receivership, Voluntary Arrangements and Administration are some of the names you will be familiar with.

Liquidation: Compulsory

Under this process the Company is divested of all of its assets which are in turn distributed to its creditors and members according to an order of priority payment. In a compulsory liquidation no proceedings against the company are allowed without the Court’s permission.

Liquidation: Compulsory

Voluntary liquidation under Section 165 (3) of the Insolvency Act 1986 gives the Liquidator the power to trade for the beneficial winding up of the Company as may be necessary; a Liquidator may therefore trade and may decided to complete on going contracts. No such power arises in a compulsory liquidation without Court sanction (Section 167 of the Insolvency Act 1986).

In practice if ongoing trading is possible, the Liquidator is likely to apply for an administration order.

The role of a Liquidator is therefore wholly limited to selling the Company’s assets and collecting debts on completed contracts, by institution of legal proceedings if necessary.

Administrative Receivership

This is normally following an appointment by a Bank under the terms of its floating charge. The use of this secured creditor remedy has been greatly restricted as a result of the Enterprise Act 2002. The appointment of a Administrative Receiver by a Bank is about the Bank recovering its lending without regard to much else.

Administration

An Administrator may be appointed by the Court or by the holder of a qualifying floating charge and by the company or its directors.

In practice most administrators are appointed by the company.

The primary purpose of administration is to rescue the company as a going concern. The process is intended to last for 12 months but it can be extended.

The secondary purpose is to achieve a better result for the company’s creditors than would be likely on a winding up. If that does not prove possible the Administrator can aim to realise the company’s assets (frequently by sale to its directors) and make a distribution to its creditors.

Legal proceedings can only be commenced or continued against the company with the consent of the administrator of the permission of the Court (paragraph 43 Schedule B1 of the Insolvency Act 1986).

This can give the company some breathing space to recover, where in other circumstances it might face a series of claims, each taking resources away from work on other contracts which might themselves result in claims against the company. Administration is popular in the construction industry.

Voluntary Arrangements

This is a Court approved procedure where the company puts proposals to creditors for the repayment, or partial repayment, of the debts owed by it. It is a contract to deal with debt on terms. If the proposal is accepted by a majority of 75% of creditors, (all of the creditors are prevented from bringing any legal proceedings to recover the debt), but not any future debts which would fall outside the scope of the Arrangement.

There is no requirement that the company be or about to be insolvent and frequently the company will continue trading paying a percentage of its monthly income to its creditors over a period of time typically between 3 to 5 years.

Once you hear the contractor has gone “bust” your foremost concern is to get another contractor on site, to get the work completed. What you will want is a smooth transition from the insolvent contractor to the replacement contractor. To do this the Employer will need to have some knowledge of the insolvency regime in place and of legal issues which are specific to construction contracts.

Immediate steps

Immediate steps an Employer should take to protect its position and to mitigate the consequences of the insolvency include:

1...To establish the type of insolvency;
2...Notify all relevant parties including insurers and funders;
3...Secure the site, including all plant equipment and materials on it;
4...Cease all payments to any parties until legal advice on payment obligations has been obtained;
5...Prepare an auditable financial statement of payments made (and due) to the contractor and the status of any outstanding work;
6...Ensure that there are no breaches of its own employer obligations under the building contract;
7...Reviewing the terms of the building contract and any rights of set-off and performance bond or guarantee terms.

What next

Once appointed the Insolvency Practitioner will push for payment but the Employer should be certain of its legal position before making any agreement. The Employer may have set-off rights which can be exercised along with security or guarantees which can be called upon to improve its position.

As to the completion of unfinished works, the Employer may have several options to choose from. These will include:

1...To novate the Building Contract to a new contractor;
2...To send the Works out to tender;
3...To complete the Works from its own resources;
4...To enter into direct agreement with sub-contractors to complete the Works either through the exercise of step-in rights or by reaching a new agreement;
5...To allow the insolvent contractor to complete the Works through reaching an agreement with the Insolvency Practitioner. (This will occur if the amount of the outstanding works is relatively minor. The Insolvency Practitioner will want paying for this).

An Employer can think about these options in advance; the commercial decision will be driven by a concern to save time or money.

Materials

Upon notification of the Contractor’s Insolvency, the Employer should take immediate steps to secure the site and materials on it. A Contractor (or Supplier) may have a residual license to enter the site, so removing goods may not amount to trespass. It is better from the Employer’s perspective to be arguing over whether it should release or pay for goods rather than trying to get them back.

By operation of law, title to materials vests in the owner of the land once they have been attached to the land through incorporation to the Works regardless of any retention of title clauses.

Use of plant and equipment

The ownership and use of plant and equipment is a less clear position. In the event of contractor insolvency many building contracts provide an Employer with rights over the contractor’s plant and equipment including the right to use it and sell it.

If the Employer simply wishes to use the plant and equipment to complete the Works then it will be possible if the terms of the Building Contract allow it. If however, the terms of the Building Contract include a power of sale this will almost certainly amount to a floating charge.

In order to rely on the right of sale to show that the plan was given a security, an Employer must have registered the charge under Section 870 of the Companies Act 2006 within 21 days of the signing of the Contract. (See Smith Administration of Coslett (Contractors) Limited V Bridgend County Borough Council [2000] 1 ALL ER 292.)

Some building contracts automatically terminate on the insolvency of one of the parties. Others give the insolvent party the right to terminate the Building Contract within a reasonable period of time of the insolvency.

Where the Building Contract does not terminate automatically or provide the Employer with a discretionary right to determinate the contract, the Employer must rely on other terms in the contract to terminate. This will leave him in the position of having to find a breach which flows from one of the practical consequences of the insolvency, rather than the insolvency itself,for example, the failure to complete the Works.

Set-off

The rules on the manner in which set-off will apply will depend on which type of insolvency has occurred. The Employer would be wise therefore not to make any payments once the Contractor has gone into insolvency in case they can be set-off and to obtain legal advice on the applicability of the relevant rules.

The general rule in liquidation is that the parties own contractual agreements as to set-off arrangements are replaced by mandatory set-off (Rule 4.90) of the Insolvency Rules 1986 (as amended) which requires for the set-off of the mutual dealings.

If the Administrator gives notice of the intention to make a distribution to creditors, the same set-off regime will apply as in liquidation pursuant to Rule 4.90.

A company in voluntary arrangement can expressly modify the common law rights of set-off.

Performance bonds

The major problem with performance bonds, in the event of insolvency is that some contracts do not equate insolvency with constituting a “breach”. Therefore the surety may have no liability to pay out on the Bond until completion of the Works and settlement of the account.

In practice, where there is a Bond, the Employer should consider carefully the instances which allow the Bond to be called in and ensure that the contract has not been terminated or determined before it attempts to do so.

Direct payments

Many standard forms make provision for an Employer to make direct payment to a sub-contractor where the Main Contractor is insolvent, but the general view is that it is unwise because the practice contravenes the insolvency rules. (See British Eagle International Airlines Limited V Compagnie Nationale Air France (1975) 1 WLR 758)

On the liquidation of the company all the unsecured creditors have to be treated equally, direct payments to nominated sub-contractors put them in a privileged position – but do nothing to diminish the Employer’s responsibility to make outstanding payments to the Liquidators or Administrator of the insolvent company.

So although the JCT Contracts indicate a direct payment may be made, a prudent Employer may choose never to make one less it should find itself liable to pay twice.