Insolvency in construction: a contract toolkit

While post-Brexit data indicates that the economy performed better than expected in the short term, it is always prudent to assess insolvency risk. Here's a reminder of your legal defences.

29 November 2016

While not an exhaustive list, here is a reminder of some measures you might want to think about to help mitigate the effects of insolvency on construction projects. As with all these measures (and with insolvency generally) there are a number of complicated issues to be considered, so do seek advice as necessary.

Performance security

Bonds: There are a broad range of bonds available, which typically pay out a percentage of the contract price upon certain defaults of the contractor/subcontractor. A third party "surety" or "guarantor" will be the party that pays in the event of default. The purpose of the bond is to protect the employer against the additional costs he will incur if the contractor fails to complete the works properly; e.g. if the contractor becomes insolvent part way through a development.

Parent company guarantees: Guarantees are often provided by parent companies where a party is contracting with a subsidiary without substance.  Guarantees can either be performance guarantees or finance guarantees.  Under the former, the guarantor will fulfil the obligations of the contractor under the building contract.  Under the latter the guarantor will compensate the beneficiary for the loss it has suffered as a result of the principal debtor's fault.

There are various issues and options that can be included in these instruments, and whilst there are some "off the shelf" forms, these documents can be negotiated in detail to suit specific requirements.

No further payments on insolvency

Include express clauses in your contract so that:

  • upon insolvency of the contractor, there is no further obligation to make payment until the works are complete
  • the employer can engage other contractors to complete the works, with the cost of doing so being (a) recoverable from, or (b) offset against any sums owed to, the insolvent contractor.

Direct payment clauses

Alongside the potential for setting up a project bank account (discussed in the previous edition), contracts can allow for direct payment to subcontractors or sub-suppliers in the supply chain, by-passing the main contractor.  These clauses tend to be included for the benefit of employers and subcontractors - as the employer can pay directly, rather than paying the contractor first, and then having the risk of the contractor becoming insolvent in the meanwhile. There are risks in relation to direct payment clauses – for example in the event of insolvency of the contractor, if employer has paid subcontractors directly, this may not discharge the employer's obligation to pay the insolvent contractor. To the extent they are agreed by employers and contractors, they tend to be a "last resort" option for the employer.

This article was written by James Horton.

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Steven James

Steven James Partner

  • Energy, Power and Utilities
  • Construction and Engineering Disputes
  • Construction and Engineering Contracts

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