UK: You’re The Weakest Link – Goodbye!

Last Updated: 5 September 2012
Article by Scott McKinnell

Insolvency on construction projects can be fatal. Projects are based on linked contractual arrangements and as the saying goes you are only as strong as your weakest link. One party's insolvency can have knock on effects down the chain as it has an impact on the contractual performance of others. With MJN Colston, one of the industry's oldest specialist contractors recently entering administration, those in the industry need to ensure they are prepared if a member of their supply chain looks like becoming the weakest link.

Scott McKinnell considers what steps can be taken to minimise the effect of insolvency and to ensure the supply chain is as strong as the building being constructed.

It has never been more important to consider the possibility of contractor, sub-contractor or supply chain insolvency from the outset of a construction project than in today's economic climate. You want the best players on the team.  Whilst it's tempting to go with a flashy new upstart who seems to promise everything, employers appointing contractors and contractors appointing subcontractors should ensure they properly protect themselves.

First steps

It is essential to carry out financial checks on those that you will be entering into contract with beforehand. Steps should be taken to gather evidence of the contractor's financial standing through, for example, credit rating reports. Employers and main contractors should also consider obtaining parent company guarantees or requiring contractor's to take out some form of bond or subcontractor bond.

One such bond is a default performance bond. Provided by a third party and taken out by the contractor in favour of employer, these bonds require the third party to pay out a sum of money when the employer can prove that the contractor is in default of its obligations under the contract and that it has suffered loss as a result of the contractor's breach. Such bonds are only as useful as the paper they are written on, however, if they do not cover the breach complained of. Care should be taken to draft the bond to protect the employer from the contractor's insolvency which is often not classed as a "breach" by the contractor under the contract.

Alternatively, an employer or main contractor could require an on-demand or unconditional bond. Although rarer in the UK an employer can call on the bond at any time without having to prove that the contractor is in breach of its obligations. The liability of the third party bondsman in this instance is independent to the liability of the contractor.

Also consider what happens where an insolvent contractor's or supplier's work is defective? An employer will be merely an unsecured creditor for the purposes of defects. Taking out a latent defects insurance policy is one solution to this problem so long as such a policy is available and not prohibitively expensive. Indeed any premium payable by the employer might be a legitimate cost which could be set off against amounts otherwise due to the contractor or subcontractor.

If significant subcontractors or suppliers are involved in the project it is prudent for the same steps to be taken for these and for an employer to insist on collateral warranties from them. Collateral warranties should include "step in" rights which allow the employer to step into the contractor's position under the relevant subcontract. This gives the employer direct rights of recourse against the subcontractor if the contractor goes insolvent and cannot pursue the subcontractor himself.

Employers and contractors should also considering including express rights to copy and use the contractor's design documents and to require copies of such documents on demand. If a contractor goes insolvent this could help minimise delays in completing the project.

What if it all goes wrong?

When informed of a contractor's insolvency, an employer should act swiftly but not rashly. If adequate thought has been given to such a scenario from the outset an employer need only look to its contract for the best course of action to follow.

In the absence of an express term the contractor's insolvency is not automatically considered a breach of contract. It is usual, therefore, for building contracts to provide that on the contractor's insolvency, the contract is either automatically terminated or the employer has the option to terminate. Termination is not often a clear cut decision and whether or not to terminate will undoubtedly come down to commercial considerations (governed of course by the procedures of the contract) and how long, costly or possible it may be to get a replacement to perform the tasks that the insolvent contractor was doing or self deliver them.

Securing the chain

Securing and protecting the site and materials on an insolvency will also be of paramount importance. Projects can quickly fall apart where an unpaid subcontractor or supplier or other creditor seizes materials on site or in other premises in place of their debts. The employer will own all materials incorporated into or affixed to the works but if title in other materials has not passed to the employer he may find himself liable to the owner for wrongful interference or conversion if he tries to take possession of such materials.

Off-site materials can cause even greater problems for an employer. An employer or contractor may be required to pay for goods and materials in advance which are to be kept at the supplier or subcontractor's warehouse until they are used. Employers or contractors should ensure they take measures to protect their investments in such goods. Requiring a vesting certificate from a contractor on payment for such goods is one way of proving ownership of goods in the event that the contractor goes insolvent before the goods are delivered. A vesting certificate confirms that title to the materials vests unconditionally in the employer upon full payment by him and can be used to identify goods and materials as properly belonging to the employer at a later date.

However, some supply arrangements contain "retention of title" clauses which entitle the supplier to retain ownership of the materials until full payment by the contractor is received. If the employer has paid the contractor but the contractor has yet to pay the supplier, the protection of an employer's vesting certificate may be more theoretical than practical. Perhaps the most effective protection is to require an off-site material bond from the contractor. Essentially an on demand bond, an employer could call on the bond and be paid a sum equal to the value already paid for such materials. Alternatively, an employer could register a floating charge over plant, equipment and unfixed materials to avoid a contractor's insolvency practitioner having a claim over them. This should be done as soon as possible, before the warning signs of insolvency, or there is a risk that it could be avoided under insolvency law.

Is an employer still required to pay?

Under some standard form contracts, and now confirmed in statute, an employer can withhold payment of sums due to a contractor in the event of the contractor's insolvency. This is the case whether or not the employer serves a pay-less notice on the contractor but an employer should not withhold payment pre-emptively as this would amount to a repudiatory breach by the employer entitling the contractor to terminate the contract instead.

Even if not paying the contractor, an employer might want to retain subcontractors on the works to minimise delays. Employers should consider entering into direct contracts with subcontractors. Subcontractors are, however, likely to require the employer to pay any outstanding sums due for work done which the insolvent contractor is yet to pay. In this case, or indeed with any contractual right to make a direct payment to a subcontractor, employers should be wary of having a double liability to pay the contractor in addition to the subcontractor and infringing insolvency laws. Some employers might make a commercial decision in this regard and much will depend on the nature of the project and how necessary it is to do a deal to see that the works are completed. Seeking an agreement from the relevant subcontractor that he will repay any amounts paid if such payments are subsequently found to be unlawful might be a useful protection for an employer.

Conclusion

Whilst insolvency might regrettably be the end of the line for some contractors, it doesn't have to be for your construction project. Careful planning and preparation from the outset by including the necessary clauses in your contract, obtaining bonds and collateral warranties, carrying out financial checks and securing charges over off-site goods and materials will all help to minimise the repercussions of contractor insolvency. Be alert for warning signs such as a slow-down in the progression of the works, an increase in the number of defects in the work, subcontractors not being paid and plant and equipment "disappearing" from site. Don't make any arrangements with insolvency practitioners before obtaining legal advice and always consult your contract before taking action. An employer shouldn't be afraid of saying goodbye to his weakest link. The chain may well be stronger as a result.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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