Tips for managing contractor insolvency: making the best of a bad lot

The impact of the Covid-19 pandemic and lockdowns plus the consequences of Brexit are very much evident across the construction industry, not least due to the sharp and continued increase in the cost of materials. 

In this article, we set out some hints and tips for spotting a contractor in financial difficulty, relevant considerations around termination and how to minimise sums that you may be left trying to recover from the insolvent contractor.

Spotting insolvency
Unfortunately, it is not always possible to identify an at-risk contractor before an insolvency event occurs. Whilst many construction contracts will require a contractor to inform an employer of an insolvency event, that can still come as a surprise.

A keen-eyed employer may be able to identify early signs of insolvency risk from their contractor such as:

• Where works have inexplicably slowed down;
• Where sub-contractors suspend works or make contact to complain that the contractor has failed to meet multiple payments on time;
• Where contractors appear to be submitting disproportionate or exaggerated applications for payment; and/or
• Where there are rumours in the local market about the contractor’s solvency.

It may help to undertake regular reviews of contractors’ financial status, particularly if any of the above signs are present. You could also take steps to ensure that the contractor’s insurance policies and/or parent company guarantees are in place.

Termination
Most contracts enable an employer to terminate following a contractor’s insolvency event. Key termination provisions to review in your contract are:

• Whether termination is an automatic consequence of an insolvency event, rather than an employer’s right;
• Whether the contractor’s obligation to carry out the works is similarly automatically suspended as a consequence of an insolvency event, or only upon the employer giving notice of termination;
• The definition of an ‘insolvency event’ - this can vary between contracts, i.e. whether a company voluntary arrangement is caught; and
• When your right to terminate the contract and/or to directly engage sub-contractors or a third-party replacement contractor arises – usually after the insolvency event has occurred. Care should be taken not to take these steps before the relevant right has arisen.

It is important to ensure that the termination provisions are strictly complied with, including in relation to the termination notice itself.

Suspension of payments and final account following a contractor insolvency event
The Housing Grants, Construction and Regeneration Act 1996 allows employers to suspend the contractual payment mechanisms and interim payments to an insolvent contractor, but ONLY where the relevant contract expressly provides for this.

An insolvent contractor (or an administrator or liquidator) can adjudicate to recover any unpaid sums due to it, so it is important to check the contractual provisions before suspending payments.

Final account process
Following completion of works by a third-party contractor, an employer must undertake the final account process. The final account should show sums paid or payable to the insolvent contractor as well as any direct loss caused by the insolvency i.e. the replacement contractor’s costs to complete the works and/or rectify defects. Evidence of costs should be retained for the final account process.

The final account will therefore cover the actual total cost of the works; if this amount is higher than the contract sum, then often the difference will be contractually payable by the insolvent contractor to the employer. If that amount is lower, then sums may be due to the insolvent contractor.

In principle, an employer’s right to claim the increase between the contract sum and actual total cost prevents it from being penalised for a contractor’s insolvency. However, as an unsecured creditor, the debt would rank low in the list of debts. In reality, it is unlikely that full recovery will be achieved, but it is often worth providing proof of the debt in order to make a claim.

Limiting irrecoverable sums – prevention is better than a cure
They say hindsight is a beautiful thing, so just what can be done to minimise the level of sums that you may be left trying to recover from an insolvent contractor? Our top tip is to manage your payment mechanisms carefully and effectively throughout the contract term. This should prevent unnecessary sums from being paid to a contractor which later become irrecoverable. In particular:

• The contract administrator/employer’s agent should ensure that it is only approving/valuing payment applications that are accompanied by proper supporting information, and when it is satisfied that the work has been properly completed; and
• Similarly, ensure that the contract administrator/employer’s agent is serving payment notices and (where appropriate) pay less notices in the correct form and within the relevant contractual timescales.

When faced with contractor insolvency an employer can be faced with substantial irrecoverable sums where payment notices and/or pay less notices have not been utilised or validly served.

Rights and obligations under contracts will vary depending on their specific terms and you should therefore review those terms and seek legal advice before taking action, particularly when terminating a contract or withholding payment from an insolvent contractor.

For more information

If you would like any advice or support in relation to managing contractor insolvency then please contact Amy Callahan-Page or your usual ACS contact in our construction team.