The current global financial crisis has increased the risk of insolvency for many businesses. In this economy, parties to construction and infrastructure contracts need to adopt strategies to minimise loss resulting from the insolvency of their contract counterparties. Strategies include considering contractual safeguards, identifying risk minimisation strategies at an early stage and adopting certain contract administration procedures.
This article looks at the typical contract life cycle (contract formation, delivery and post delivery) and considers what steps can be taken by principals and contractors to mitigate the negative impacts stemming from a contract counterparty running into financial trouble.
FORMING THE CONTRACT
Pre-Contract Due Diligence And Security
Prior to contract, a careful analysis of the financial capacity of the other party should be undertaken. When tenders or expressions of interest are called, principals or head contractors should ensure their tender documents have a process in place to permit such analysis. Parties should review published accounts, check credit references and undertake a basic ASIC search to determine the ownership of the counterparty's company. A useful approach is to supply contractors and subcontractors with a checklist for information to be provided on current litigation, previous projects and financial history.
Where there is any concern about the financial capacity of a contractor (or principal), consideration should be given to obtaining guarantees from parent or related companies. Under a parent company guarantee (PCG), the parent company guarantees the performance of the subsidiary. But for this to be effective the parent company must also have sufficient assets to meet a claim under the PCG.
Security in the form of bank guarantees or cash retention is routinely obtained from contractors by principals. The current market requirement is for security at 5% of the contract sum. Half of the security is returned to the contractor at substantial or practical completion, and the balance at the expiry of the defects liability period. In the current environment, principals may seek to increase the level of security above 5%. However, it is important to note that any increase in security provided by contractors comes at a price, namely reduced contractor cashflow and working capital availability. This in turn may result in increased contractor prices to compensate for the reduced cashflow.
It is important to bear in mind that variations to the contract can also substantially increase the contract sum and as such it may be appropriate for the principal to seek additional security.
Contractors providing cash retention must pay attention to ensuring that the retained money is safeguarded. One common approach is to ask for the retained money to be held in a joint trust account. This segregation of the retention money in a trust fund helps to protect the contractor's rights to the retained cash if the principal subsequently becomes insolvent.
The contractor should continually review the principal's compliance with the trust fund arrangements and, if the need arises, seek court assistance to ensure that the money is dealt with in the manner required by the contract.
While it might not be common to do so, there is no reason why a contractor should not seek security from a principal. In fact, Australian Standard contracts include optional drafting for the provision of security by the principal to the contractor. This may be appropriate depending on the nature of the project and the financial capacity of the principal.
Contract administrators need to diarise and follow up insurance renewal dates to obtain updated certificates of currency. If the necessary insurance policies are not maintained, most standard contract forms will include provisions entitling the other party to obtain the required insurance policies and charge the defaulting party the cost of the premiums and any other costs incurred as a consequence. Where the principal is required to obtain and maintain insurance policies, contractors should be equally vigilant in ensuring compliance with those obligations.
While not necessarily intended to remedy the impact of insolvency, insurance offers a potential avenue of recourse in the event of contractor or principal insolvency. If the contractor becomes insolvent, the principal's only right of recourse for defective design or damage to the contract works may be a claim against the relevant insurance policy.
It is critical that contracting parties verify that the insurance policies required by the contract are taken out with appropriate coverage in favour of the correct parties and that those policies are renewed regularly throughout the duration of the project. Often, a failure to renew insurance can be an early warning sign of insolvency.
Specialist insurance policies indemnifying principals for delayed project completion (such as advance loss of profits cover) are available. However, the associated premiums can be significant and the cost effectiveness of such nonstandard cover should be assessed accordingly.
Diversifying Rights Of Recourse – Subcontractors And Suppliers
In conventional construction and infrastructure contracts, the principal has no contractual relationship with subcontractors or suppliers who are contractually 'invisible'. In these circumstances the principal has no contractual recourse against the subcontractors or suppliers for defective or inadequate performance or supply.
In light of the current economic environment, principals should consider obtaining direct warranties from their subcontractors and suppliers. Such warranties will entitle the principal to make parallel claims against the relevant subcontractor or supplier for defective works or materials, even if the contractor is insolvent. Note however that the creation of a separate right against non-contract parties can create important consequences under the proportionate liability legislation in each state, so legal advice may be needed before taking this step.
Paying Subcontractors Direct
Principals should consider incorporating in the payment clause a right to make direct payments to subcontractors where the contractor has failed to do so. Direct payments by the principal may avoid a key subcontractor or supplier's suspension of work for non-payment, ensuring that work on the project continues without interruption or delay.
With proper drafting, the payment made to the subcontractor or supplier is treated contractually as a debt due from the contractor to the principal, and a corresponding set off is made against the amount otherwise due from the principal to the contractor. However, a principal considering exercising its right to make direct payments to subcontractors should consider:
- The potential risk that the payment to subcontractors could be defeated by the liquidator if the contractor is subsequently wound up. This may occur where the payment is deemed an 'unfair preference' under section 588FF of the Corporations Act 2001 (Cth). Legal advice should be obtained before making direct payments to subcontractors or suppliers if the principal has any concern about the contractor's solvency.
- Direct payments by the principal to a subcontractor or supplier may open the door for further subcontractor or supplier claims against the principal. For example, subcontractors or suppliers may pursue payment claims through the relevant state or territory Security of Payment (SOP) legislation.
Insolvency of the head contractor will invariably lead to both suspension of work (and then termination of the contract) followed by the rapid demobilisation of subcontractors from the site. Principals are then faced with the added problem of sourcing new subcontractors who, perhaps not unreasonably, often refuse to warrant the work of their predecessors and demand payment of a premium or significantly higher rates to complete the unfinished work.
The inclusion of a mandatory novation provision in each of the relevant subcontracts can minimise this risk. Head contracts should contain a requirement that the contractor include in each subcontract and supply agreement a novation provision (in terms specified by the principal). Under this provision, the principal should be provided with the right to compel the novation of the relevant subcontract or supply agreement to either the principal itself or to a nominated replacement contractor.
Such a provision compels the subcontractor to continue working on the same terms as its original subcontract. Restarting the project is significantly easier with a 'locked in' subcontract team on pre-agreed subcontract prices who will also continue to stand behind their work. The existence of continuing warranties is often of particular interest to subsequent purchasers of the completed project.
Principals or contract administrators should obtain copies of each subcontract. This will avoid the principal finding out too late that the relevant novation clause has not been included, leaving the principal with a (probably worthless) breach of contract claim against the insolvent head contractor.
Establishing An Open Book – Audit Rights
It is also worthwhile including a contractual right of access to the contractor's (or principal's) company accounts and to the appointment of an independent accountant to review the counterparty's solvency if concerns arise. This can also assist in situations where a principal is concerned that subcontractors or suppliers have not been paid but has no documentary evidence to support that concern. For example, in some cases the contractor may have provided 'proof' of such payment in the form of statutory declarations in accordance with the contract but the principal receives, at the same time, complaints from subcontractors that they have not been paid the full amount due.
Including Termination Rights For Insolvency Events
Infrastructure and construction contracts usually list a number of bases on which a party may terminate the contract. These grounds for termination almost always include 'insolvency events'.
It is important to check that the grounds defined as 'insolvency events' are comprehensive, covering each and every type of insolvency (ie bankruptcy, administration, receivership, voluntary and compulsory liquidation). An 'insolvency event' can also include preliminary events which are often considered to be advanced warning of insolvency such as an informal meeting with creditors.
The contract should permit immediate termination if an 'insolvency event' occurs, avoiding the need to use the more time consuming 'show cause' procedure which is more appropriate for non insolvency breaches of contract.
Additionally, contractors should include the insolvency of the principal as grounds for automatic termination of its subcontracts. This will help to ensure that the contractor does not continue to incur liabilities to subcontractors in circumstances where there is an insolvent principal.
Withholding Payment – Set Off
Construction and infrastructure contracts will generally include a broad set off provision, entitling the principal to withhold amounts due or claimed to be due from the contractor.
Principals and contractors frequently disagree on the 'trigger' entitling the principal to withhold payment. The principal often attempts to include a lower threshold entitling it to withhold money (for instance, where the principal 'believes' or 'reasonably considers' that money is due from the contractor such as for defective works or overpayment).
Contractors in turn may seek to impose a high threshold before money can be withheld (eg where money is 'due', implying that a court determination must first be made ordering money be paid by the contractor to the principal).
To lessen the likelihood of a dispute, the triggers entitling the parties to withhold payment should be considered in the contract negotiation stage.
ADMINISTERING THE CONTRACT
Principals should ensure that contractors are not overpaid by engaging a qualified quantity surveyor to review contractor cashflow and progress claims to support the contract administrator's certification of payment. Overall, contract administration should focus on ensuring that:
- Progress payments are valued accurately by an appropriately skilled person
- Any overpayments are reversed in subsequent progress certificates.
- Security is adjusted upwards to reflect any increase in the contract sum.
- Rights to make direct payments to subcontractors are exercised where appropriate.
- Adequate proof of subcontractor and supplier payments are included in each progress claim.
- Set off rights are exercised where appropriate.
- Claims made under SOP legislation are dealt with promptly to ensure that payment does not fall due by default.
SOP legislation (currently in force in New South Wales, Queensland, NT, WA and Victoria) holds particular dangers in the case of subsequent contractor insolvency. SOP legislation presumes that amounts payable under the legislation are interim only and can be recouped in subsequent litigation. However this will be cold comfort to a principal unable to recover an overpayment made under SOP legislation where the contractor which received an 'interim' payment has become insolvent. This is likely to leave the principal with an unsecured claim in any liquidation of that contractor.
Similarly, contractors should ensure that:
- Work performed is billed and paid for quickly.
- Payment entitlements are pursued vigorously (including through payment claims and adjudication applications under SOP legislation).
- Work can be suspended where appropriate to ensure that the contractor is not compelled to continue working while unpaid. (The statutory suspension rights under SOP legislation are of particular benefit to unpaid contractors in this situation.)
DELIVERY AND DISPUTES
Once the construction contract has reached practical or substantial completion and any defects liability or rectification period has commenced, vigilance is necessary to ensure that defects are tackled quickly. Many defect liability periods run for several years. Prompt notification of defects and vigorous management of the rectification work in a tight time frame obviously reduces the risks that may occur should a contractor become insolvent a couple of years down the track.
Contracting Out Of Proportionate Liability
This is a complex subject which cannot be addressed in detail in this article. However, parties asked to waive their rights to apportion liability under the Civil Liability Act 2002 (NSW) or its interstate equivalents (where this is permissible) should pay particular attention to the significantly adverse consequences that may occur if other companies involved on the same construction project become insolvent. The proportionate liability legislation is intended to reduce insurance costs by rendering those who cause loss liable only for the portion of the plaintiff's loss which that party itself caused. This contrasts with the prior legal position under which a wrongdoer responsible for any portion of the plaintiff's loss could be sued successfully for the entire loss suffered by the plaintiff, even where that loss was contributed to by the acts or omissions of others.
Any wrongdoer sued and found liable for the entire loss must then pursue each concurrent wrongdoer for its respective contribution. Where a concurrent wrongdoer is dead, unable to be located or insolvent, the risk of non recovery is placed on the party sued.
The proportionate liability provisions of the Civil Liability Act place the risk of a dead, absent or insolvent defendant upon the plaintiff. Contracting out of the proportionate liability provisions of the Civil Liability Act essentially reverses the position back to the pre 2004 'joint and several' liability position.
In an economic environment where insolvency appears to be increasing, any party faced with a request that it contract out of its apportionment rights under the Civil Liability Act must consider carefully the risk that it may be left bearing the liability of an insolvent concurrent wrongdoer against whom it is unable to recover payment.
As this article emphasises, the best time to militate against the risk of insolvency of a contract counterparty is when the contract is being negotiated. Much can be done at the contract negotiation stage to ensure that the effects of insolvency are minimised.
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This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.