UK: Mitigating Insolvency Effects In The Supply Chain

Last Updated: 26 July 2019
Article by Gurbinder Grewal

Key points

  • Current statistics show that insolvencies in the construction industry are on the rise
  • The liquidation of Carillion and the administration of Interserve highlight the importance of understanding the impact of a contractor's or a supplier's insolvency
  • Parties should be able to recognise the warning signs and indicators of an imminent insolvency, so steps can be taken promptly to minimise the impact
  • Adjudication proceedings are unlikely to assist where the defaulting party is in liquidation or administration

Insolvency in the construction industry is once again in the headlines. The liquidation of Carillion and the administration of Interserve (as well as several other high-profile tier 2 and 3 contractor insolvencies) have highlighted how important it is to be alert to the signs of insolvency in the supply chain on a construction project.

Cash flow can suffer greatly as a result of an insolvency in any part of the project, no matter when in the project that insolvency occurs. Each participant is reliant on the party above it in the chain to properly (and promptly) pay for work carried out. Most building contracts provide for stage payments meaning all sub-contractors will have to carry significant work in progress until they are paid. Financial difficulties suffered by just one party in the supply chain can stop the cash flowing down that chain – ultimately causing loss to many other parties involved in the project. Depending on where in the chain the financial difficulty occurs, there may be an option for further external funding or a request for shareholder equity. However, such options are unlikely to be available to the majority of the trades and businesses involved in delivering the project.

Insolvent contractor/sub-contractor 

The impact of an insolvent contractor or sub-contractor in a construction project can be far reaching. A contractor insolvency can lead to:

  • work not being completed in accordance with relevant timescales;
  • poor quality workmanship and the emergence of defects in the work as 'corners are cut';
  • a delay to the works while a new contractor is appointed (assuming the works have not been completed at the time the insolvency occurs); and
  • third parties losing the value in any collateral warranties they may have had with the insolvent contractor.

There are a number of ways that an employer could mitigate these risks or minimise its losses. For example, the employer might choose to terminate the contractor's contract, as we discuss below. Alternatively the employer could make a claim under the Third Parties (Rights Against Insurers) Act 2010 against another party's insurer directly, where the defaulting party has become insolvent. This might help a party where, for example, latent design defects have arisen after the works have completed but by which time the contractor has become insolvent and such defects are covered by the insurance policy.

Termination

To mitigate some of the effects of a contractor's insolvency set out above, the employer might consider terminating the insolvent contractor's building contract as cash flow difficulties manifest themselves and appointing a new contractor as soon as possible. Before taking this step, there are a number of issues the employer should consider. For example, if the building contract gives the employer the right to terminate the contract on contractor insolvency, the employer should check that the contractor is 'insolvent' as defined in the contract. If an employer terminates at a time when the relevant party does not satisfy the definition of insolvency (even if the party has ceased trading for all practical purposes), the employer may find itself in repudiatory breach of contract.

If there is no right to terminate for insolvency or an insolvency has not yet formally occurred, then the position is less straightforward. There may be other grounds on which the employer could terminate the employment of, or the contract with, the contractor:

  • The employer may be able to terminate on the grounds of default by the contractor (for example delay, poor workmanship or any other specified default). Again, the employer should check the wording in the contract as minor delays, defects or defaults are unlikely to be a sufficient breach of the contract to justify a termination.
  • The employer could decide to terminate 'at will' should there be a provision permitting it to do so. However, such a termination (if possible) is likely to lead to compensation being payable by the employer to the (insolvent) contractor under the contract.
  • The employer may have a common law right to terminate under the contract. For example, a repudiatory breach (a breach so fundamental that it entitles the innocent party to bring the contract to an end) may entitle the employer to terminate the contract. An insolvency leading to the contractor's effective abandonment of the project may constitute such a breach.

If the employer does decide to terminate the contract, it should ensure that any notice provisions under the contract are complied with.

Insolvent employer

Likewise, where it is the employer experiencing financial difficulties, the contractor could consider terminating its contract with the employer. As with contractor insolvency, the contractor will need to consider the most appropriate contractual and common law grounds available for terminating and ensure appropriate notices are served pursuant to the contract.

Collateral warranties and step-in rights

Collateral warranties (or third party rights) become important following the insolvency of a party to a construction project. Understanding who has the benefit of the collateral warranties will impact on the formulation of a restructuring plan or allow the build to continue despite the insolvency of a party.

In the case of an insolvent employer, an administrator may decide that, in order to achieve the best result for the creditors, the project in question should be completed. There is no need for an administrator to formally 'step in' to the employer's contract (since the company continues in existence under the control of the administrator, who effectively is the employer for all intents and purposes). However, this may not always be possible given that insolvency of the employer usually gives the main contractor a right to terminate the contract. The main contractor should bear in mind that the administrator's only interest is securing the best possible outcome for the creditors as a whole. The administrator will rarely make any promises as to its performance. In such a situation, a funder of the project may have step-in rights, which arise out of a collateral warranty with the employer and are considered to be the market norm. However, a funder is only likely to take such an option if completing the project will secure a return on its investment. There may also be (albeit less likely) a purchaser in respect of the project that has step-in rights. Should the purchaser exercise these rights, it will step in to the employer's position and ensure the project is completed.

In the case of an insolvent contractor or sub-contractor, there are usually step-in rights in favour of the employer. These arise by virtue of collateral warranties provided by the contractor to the employer. Such rights allow the employer to effectively step in to the contractor's position and 'take over' those sub-contracts in order to 'build out' the project. However, the employer should be aware that, due to the insolvency of the contractor, it may be likely that suppliers and/or sub-contractors would not have been paid for at least a month's work. In this scenario, the employer may have to consider paying the affected suppliers/sub-contractors in order to secure their continued engagement with the project. This may be despite having already paid the contractor for the same work in a previous payment cycle.

Dealing with disputes

When a contractor or an employer is in financial difficulties, it is common for payment and valuation disputes to emerge as cash flow dries up and pressures mount. The majority of these disputes are resolved via adjudication. Whether the insolvent party is in liquidation or in administration makes a difference to how that dispute is resolved. In particular:

  • Using adjudication to resolve a dispute where a party is in liquidation was considered inBresco Electrical Services Ltd v Michael J Lonsdale (Electrical) Ltd, Cannon Corporate Ltd v Primus Build Ltd [2019] EWCA Civ 27. In summary, the Court of Appeal found that: '... the adjudication process on the one hand, and the insolvency regime on the other, are incompatible. It would only be in exceptional circumstances that a company in insolvent liquidation (and facing a cross-claim) could refer a claim to adjudication, succeed in that adjudication, obtain summary judgment and avoid a stay of execution. Thus, in the ordinary case, even though the adjudicator may technically have the necessary jurisdiction, it is not a jurisdiction which can lead to a meaningful result'. An insolvent company still has the right to refer a claim to arbitration or court proceedings. However, policy reasons and the 'basic incompatibility' between the adjudication and the insolvency regimes could make it 'an exercise in futility' (and a waste of costs) for an insolvent party to refer a claim to adjudication where there is a cross-claim. In such circumstances, the court would likely order a stay on enforcement.
  • In relation to using adjudication to resolve a dispute where one party is in administration, adjudications are classed as 'proceedings' for the purposes of the moratorium in administration under para 43(6) of Sch B1 to the Insolvency Act 1986. Therefore, the consent of the administrator or the permission of the court is required to institute or continue an adjudication against a company in administration. In Straw Realisations (No 1) Ltd v Shaftsbury House (Developments) Ltd [2010] EWHC 2597 (TCC), the court held that if a party is in administration and a notice of distribution (of a dividend by the administrator) has been given, then the adjudicator's decision will not be enforced. If a notice of distribution has not been given, if the adjudicator's decision: (i) has not become final, it will not be enforced by way of summary judgment; or (ii) has become final (eg by agreement or under the terms of the contract), the decision may be enforced by way of summary judgment. Even if it is enforced, it is likely to be the subject of a stay.

Unsurprisingly and understandably, most parties view a supply chain insolvency with a degree of dread. However, prudent parties who watch out for early signs of insolvency and manage the situation proactively and in accordance with their contract should be able to mitigate (most) risks in an insolvency and ensure the project is completed.

Practical considerations

If a key sub-contractor or contractor is insolvent, the contractor or employer will need to consider the following:

  • How does this business's insolvency affect the project in terms of design, programme and materials off-site?
  • Are there key members of staff for the contractor/sub-contractor who need to be retained due to their knowledge?
  • Are there any bonds or parent company guarantees that can be called upon to soften the financial blow?
  • How is the work of the insolvent contractor/sub-contractor to be completed?
  • Have all relevant notices been issued under the contract for termination and payment?
  • Are proper records being compiled of the losses arising out of the insolvency?
  • If the contractor is insolvent, does the employer have rights to step in and take over the sub-contractor's contracts?
  • Alternatively, if an employer is insolvent, a contractor will want to consider the matters set out below:
    • Where does the employer's insolvency leave the project in practical terms? Is there an option to complete the project to realise its value? For example, could funders fund the work whilst the employer is in administration or step in to the contract?
    • Are there any bonds or parent company guarantees that can be called upon to lessen the financial blow?
    • Have all steps to bring the contract to an end for the supply chain been taken?

This article was first published by Construction Law on 2 May 2019. 

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.

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