Legal Briefing

Insolvency issues in the construction industry

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Finance | 04 June 2011

The risk of insolvency remains a matter of increasing concern to those working in and operating within the construction industry. This article looks at the increasingly disputed area of the ownership of retention sums within the sector, considers the effect of insolvency on construction projects, and the steps that may be taken to try to limit or avoid its impact.

RETENTION SYSTEM

Retention is an important feature of the construction industry. The retention system has been part of the construction industry for over 100 years and most standard forms of building contracts provide for the deduction of retention from sums otherwise due to the main contractor or sub-contractor.

Retention is deducted first by the client who has employed the main contractor and then the deduction of retention is usually mirrored in all subsidiary contracts throughout the supply chain. Main contractors are, therefore, to a large degree the ‘middle man’ in this chain of deductions. Retentions of 3% are usual, although some contracts provide for higher retentions.

Although the retention sum has been earned by the main contractor, it is not yet payable because of other contract provisions providing for its deductions. This retention fund is intended to provide the employer (and to a lesser extent the various head contractors) with some protection against the failure by a contractor to remedy defects in the work, and it is usual practise for one half of the retention to be released on practical completion of the works and the second half following the making good of any defects, normally around one year after completion.

Failure to release the retention sums at the appropriate time can have a significant effect on the profitability and solvency of companies, and this is often particularly true in relation to small and medium enterprises (SMEs).

SMEs are the type of firms most affected by the financial implications of retention. At any period of time a significant portion of money earned and owed is held by way of retention. With low margins generally in the sector, the retention element can represent the total profit margin on a project and affect cash flow. Maintaining cash flow and certainty of payment was the prime motivation behind Part II of The Housing Grants, Construction and Regeneration Act 1996 (the 1996 Act). However, the 1996 Act does not address retention, because no consensus could be reached within the industry at the time of enactment.

The issue of who owns the retention has long caused problems for the construction industry. As the retention is money already earned most standard forms of contract provide for the retention to have trust status, although this is often negotiated or amended and in recent years certain contract forms have removed retentions completely. The importance of trust status is key to determining the status of a retention if the party holding the retention becomes insolvent.

If the retention has been segregated from other funds then it is separately identifiable as trust property and the claiming party has first call on the fund. Difficulties arise because the retention is rarely set aside into a separate fund and the clauses relating to trust status are frequently deleted or adapted. For all parties subject to retention this means that their retention is often at risk in the event of insolvency.

Additionally, certain sub-contract trades offer retention bonds as a substitute for retention but these bonds are rarely of the ‘on demand’ type. As such an attempt to call the bond will almost certainly result in resistance from the surety leading to unavoidable court action. Thus main contractors often find themselves having cash retention deducted up the contractual chain, but in certain sectors being unable to deduct cash retention down the contractual chain. Main contractors are therefore in effect financing 3% of those sub-contract works during the contract period and up until the final release of retention.

RETENTION BONDS

Contractors in the sector should try to ensure that the contractual documentation provides for retention money to be kept separately to other money, or to be expressly stated as being held on trust. An alternative is for the parties to look at using a retention bond. Such a bond simply shifts the mechanism by which the security is provided, and any bond offered in such circumstances should provide the equivalent security to ‘cash’ and therefore such bonds should be stated to be of an on demand type.

The wording of the bond itself, along with the construction contract wording, should be considered at the outset of negotiations for the construction contracts, as several bonds will only pay out if insolvency is expressed to be a breach or default under the underlying contract, and it is interesting to note that where there is no express provision for termination due to insolvency in the contract, the courts have been unlikely to imply insolvency as a ground for termination of the contract. This was noted in New Zealand in Re Premier Products Ltd (in Liquidation) [1965].

However, even the use of retention bonds may not solve the risk of insolvency and its impact on the retention sums, as in the recent financial climate companies issuing such bonds themselves have become insolvent.

While retention funds and bonds are one way of protecting against the fallout of insolvency in a construction contract there are other popular methods of protection for both the employers and contractors in a construction contract.

HOW CAN AN EMPLOYER PROTECT THEMSELVES AGAINST CONTRACTOR INSOLVENCY?

Prior to insolvency

When negotiating the construction contracts, the employer should consider the group structure of the contractor. If the contractor is part of a group of companies, a guarantee should be sought from the parent company of the group at the outset of the contract. If the contractor does not have a parent, or is the parent company itself, then the employer should consider whether a performance bond should be put in place. A performance bond will provide a sum to the employer in the event that the contractor does not complete the works, although employers should be aware that a performance bond will often only pay out on the completion of the building works, so that the value of the claim is easily quantifiable.

A further precaution that the employer should include when negotiating the contract is to oblige the contractor to obtain collateral warranties from the sub-contractors, with appropriate step in rights, to ensure the employer has the right to pursue the sub-contractors directly for any defects if the contractor becomes insolvent.

Another method of protection is the use of a separate bank account for the building project. This project account would be distinct from that of the contractor’s main account and would be used solely for the purposes of the particular project. This should assist in safeguarding the money in the account that should be allocated to the sub-contractors and suppliers of the main contractor.

Alternatively, an escrow account can be arranged that only allows the contractor to withdraw any money once they fall due. The terms of any contract that provides for such a facility should specify the events that would allow the money to be released to the employer, such as default of any of the contractor’s obligations.

The construction contract should permit the employer to employ a different contractor in the event of the original contractor’s insolvency. These provisions will provide either for the contractor to reimburse the employer for the costs of these works or allow the employer to offset these costs from the sums owed to the original contractor.

Insolvency should be defined broadly and the termination events should be drafted so as to allow termination of the contract if the contractor becomes insolvent, and preferably a review of the contract prior to that stage, by use of pre-insolvency triggers. While the majority of contracts used within the construction industry will set out a definition of insolvency, which will often include the entering into an arrangement, compromise or composition in satisfaction of debts, the passing of a resolution for the winding up of a company, the making of a winding up or bankruptcy order, or the appointment of an administrator, it is important to note that the majority of construction contracts do not terminate automatically on insolvency, but termination will take effect only on receipt of notice of termination.

Additionally the wording in the majority of Joint Contracts Tribunal precedent contracts oblige the contractor to proceed ‘regularly and diligently’ with the project. If the contractor fails to do so, the contract can be terminated. As with all such wording, there is a wealth of case law on this, with the leading one being West Faulkner Associates v London Borough of Newham [1994]. Disputed terminations are commonplace and can lead to various side disputes regarding the ownership and storage of plant and machinery owned by the insolvent contractors.

On insolvency

If the contractor becomes insolvent the employer can terminate the contract. The termination events should be clearly set out in the contract. If the employer is planning to withhold any payments due under the contract, for example, in the event of the contractor’s insolvency, the employer must give notice under s111(1) of the 1996 Act which provides that:

‘A party to a construction contract may not withhold payment after the final date of payment of a sum due under the contract unless he has given an effective notice of intention to withhold payment.’

The contract should provide that, in the event of a contractor’s insolvency, if there are any outstanding interim payments due to the contractor they would not be payable unless there is a balance due on completion. This would take into account payments to new contractors to complete the works.

In the event that the employer discovers that the contractor is insolvent, before giving notice to terminate the contract the employer should consider discussing the various options available with the contractor’s insolvency practitioner. This may enable the two parties to agree a mutually beneficial way in which the works can be completed rather than having to terminate the contract.

As an immediate precaution, on notice of the contractor’s insolvency the employer should secure the building site so as to prevent the contractor, its creditors or its sub-contractors from removing any materials from the site that remain unpaid. The employer should ensure that the contracts between the contractor and the sub-contractors are on the same terms of the contract between employer and contractor. This provision should make sure that none of the contracts contain retention of title clauses. The best protection that can be afforded to the employer to provide for its ownership of the on-site and even off-site materials, is by including a provision in the contract and sub-contracts dealing with the passing of title of the on-site and off-site materials to the employer in the event of the contractor’s insolvency.

HOW CAN A CONTRACTOR PROTECT THEMSELVES AGAINST EMPLOYER INSOLVENCY?

Pre-insolvency

Contractors are best advised to ensure they have a valid retention of title clause in the building contract. This will allow the contractor to retain title to the goods on site in the event of the employer’s insolvency. A valid retention of title clause avoids an insolvent employer, or an appointed insolvency practitioner, from taking ownership of the goods on site until full payment has been made. To make certain that the clause takes effect, the goods should be readily identifiable. However, such a retention of title clause will not extend to goods that have been attached to or form part of the land.

Sub-contractors should check whether there is a pay-when-paid clause written in the contract between the employer and contractor. This type of clause is valid only to the extent that it applies in the case of insolvency up the chain. Such a clause would make the contractor’s payments to the sub-contractor subject to the contractor being paid by the employer. Main contractors should try and negotiate the inclusion of such a clause in the contract with any sub-contractor, so that it does not remain obliged to pay the sub-contractor for work done for which it has not been paid itself.

The best protection available to a contractor would be in the form of a guarantee from an employer, or any parent company of such an employer. While a parent company guarantee will provide protection to a contractor it may be that the whole group of companies goes insolvent. To avert this risk, the safest protection is with a bank guarantee from a reputable bank.

On insolvency

Much as the employer can terminate the contract if the contractor becomes insolvent so can the contractor terminate the contract in the event of the employer’s insolvency. Whether a contractor terminates the contract or not, from the date on which the employer becomes insolvent, the contract should be drafted so that all obligations under the contract to carry out and complete works are suspended.

Once the contractor is sure that the employer has become insolvent the contractor should secure the plant machinery and materials. Then check whether there are provisions in contracts with the contractor’s suppliers and sub-contractors to delay or withhold payments in the event of the employer’s insolvency. This would be in the form of a pay-when-paid clause, and the contract should be clear in its definitions of insolvency, a danger highlighted by William Hare Ltd v Shepherd Construction Ltd [2010].

A contractor who becomes aware of the employer’s insolvency should speak to the insolvency practitioner dealing with the employer’s affairs before terminating the contract as completion of the job may be possible on mutually agreeable terms.

CONCLUSION

In summary, the key elements in seeking to protect against insolvency are to make sure that before starting a project a full review is held to ensure that the construction contracts set down the potential for insolvency and cover the issues of termination and payments on insolvency. To ensure that steps are put in place for ‘ring fencing’ money, whether by way of a trust arrangement for retention money, by way of a retention bond or setting aside funds, or the use of project or escrow bank accounts. The parties should ensure that there are appropriate collateral warranties and that the contacts contain step-in rights to enable those to be enforced.

On a practical level, credit checks should be carried out on the parties and counterparties, prior to entering into the contracts, and during projects parties should monitor for signs of impending insolvency, ensure adherence to the contract terms, with regular invoicing and credit control, and consider making adjudication proceedings prior to insolvency taking effect in the event of breaches.

If insolvency strikes, then parties should open negotiations with any appointed insolvency practitioners as quickly as possible, to see if a mutually agreeable solution can be found to enable the works to be completed, take steps to secure the site and any assets, and carry out a review of payment obligations for any consultants or sub-contractors.