The consequences of contractor insolvency can have far-reaching implications beyond the parties to a construction contract. Insolvency inevitably results in increased costs, project delays and third parties losing the benefit of collateral warranties. It is, therefore, important for an employer to protect its position at the outset of a project and understand the steps that are open to it when contractor insolvency occurs.
Most standard forms of building contracts do not include an express right to terminate a contractor unless included during the negotiation process. Ideally, the employer should seek to include an express right to terminate the building contract by notice, at the employer's option, in the event of contractor insolvency. The inclusion of a notice period provides the parties with an opportunity to engage in meaningful discussions with a view to completing the works, rather than an automatic termination which has far-reaching implications throughout the supply chain.
It is important to define insolvency events as widely as possible in order to capture the full range of proceedings that are open to insolvency practitioners today.
Performance bond and parent company guarantees
No amount of background checks can adequately protect the employer against the risk of contractor insolvency. The employer should always consider the forms of protection available to it at the outset of a project.
A parent company guarantee is desirable because it guarantees all of the contractor's obligations under the contract. However, the employer should also consider other forms of protection given the potential for insolvency to spread to other group companies, including the ultimate parent. A performance bond, given by a third party provider is commonly sought by employers, usually capped at 10% of the contract sum. The employer should ensure the bond contains an entitlement to call on the bond on the occurrence of an insolvency event.
Another issue is the employer's entitlement to have the works completed to their original specification and warranted in accordance with the original contract. In order to ensure direct rights of recourse against the relevant sub-contractors, the employer should seek collateral warranties from material sub-contractors which contain step-in rights. These enable the employer to step into the contractor's position before the sub-contractor can exercise its termination rights on contractor insolvency.
Practical steps for employers to take in event of contractor insolvency
When there is a risk of contractor insolvency, it is important to take early action to minimise the consequences of the fallout. An employer should:
- Closely monitor the contractor's performance on site and check financial standing
- Ensure a performance bond and/or a parent company guarantee has been obtained
- Check all relevant third party warranties have been provided and any outstanding warranties are obtained without delay
- Check that all insurances are in place under the building contract
- Check the insolvency provisions under the building contract and the consequences of terminating the contract on the occurrence of an insolvency event
- Check the provisions of the building contract dealing with direct payments to sub-contractors and retention and payments in title to off-site materials
- Conduct a comprehensive audit of all on-site plant and materials
- Seek legal advice at the earliest opportunity and in any event before any right to terminate under the building contract is exercised
Conducting financial due diligence on the contractor at the outset of a project and seeking comprehensive financial security are key tools that can help employers to safeguard their position on the occurrence of an insolvency event. Given the ambiguous nature of the construction industry generally, particularly in Ireland, where boom and bust cycles are commonplace, it is fundamental that employers understand their rights and know the steps to take when faced with a contractor's insolvency.
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.