When a business fails, it’s a sad time for everyone concerned. But when you have a contractual relationship with the business involved, it can rapidly become a nightmare. Roland Finch lays out the steps a client can take to protect itself from contractor insolvency.
There are a number of different ways that a business can become insolvent. This may have a bearing on what precise steps need to be taken, although the end result will usually be the same: the work will stop and something will have to be done to sort it out.
For the purpose of this discussion, we will consider “contractor” insolvency and the consequences for the client; of course, there are obviously implications for a contractor if the client becomes insolvent, as well as for subcontractors because the (main) contractor is their client, but that’s for another time.
What is insolvency?
Generally speaking, insolvency occurs when someone is unable to pay their debts, or their assets are less than their liabilities. A more detailed definition is given in s.123 of the Insolvency Act 1986.
It is illegal for a company to trade while knowingly insolvent.
An organisation can become insolvent in a number of ways; this can be by application in the courts, or it can also be by voluntary agreement. It should also be recognised that there are cases where a business may be insolvent, but not beyond saving. There may be scope for an arrangement between the insolvent party and its creditors which resolves the situation without the need for further proceedings.
Alternatively, where it is deemed for example that the insolvency might be temporary, perhaps resulting from cashflow problems, the courts may appoint an administrative receiver, whose job is to assist, usually by selling off assets to meet debts, while still allowing the business to trade out of its insolvent position.
If this proves impossible, the company's assets will be liquidated, and creditors paid where practicable. The hierarchy of creditors is set out in the Insolvency Act.
Note that insolvency and bankruptcy are not the same thing. Bankruptcy only applies to an individual, not a company. Companies have several options to deal with insolvency, such as liquidation, administration or voluntary arrangements. Insolvency procedures and terminology are similar in England, Wales and Northern Ireland, but differ in Scotland.
Warning signs of insolvency
There are a number of tell-tale signs that a business is in trouble. It may delay paying bills or staff or both. Work on site may slow or grind to a halt. It may ask for additional or more frequent payment, as it has difficulty getting credit from suppliers.
For larger publicly listed companies, there may be a profit warning issued to the stock exchange and the most obvious situation is where one or more of its creditors takes legal action to enforce judgment on a debt or to commence “winding up” procedures.
The most likely outcome in the first instance is that work will stop. This doesn’t automatically mean the company is insolvent, but it’s an indication that something is not right.
Strictly speaking, a business that becomes insolvent is obliged to issue a declaration to that effect, although this may also be in the form of a court order.
What to do if your contractor becomes insolvent
Insolvency is the point at which steps need to be taken, although with a bit of foresight, the signs will have been noticed and measures will be ready.
How the insolvency comes about can have a great bearing on what is done about it, as many contracts, particularly “standard form” building contracts, differ in their approach, so it is vital to follow the correct procedure. The following are the key issues that need to be addressed.
Secure the site and materials
There are a number of short and longer term steps that need to be taken in the face of contractor insolvency but before anything it is important to secure the site. Some of the items on the site will form part of the contractor’s assets, others will not. Where materials or work have been paid for, they should be the client’s property; however, subcontractors and suppliers may not agree and their first reaction may be to repossess those items. They can be argued about later, but for now any materials should be secured, insured and protected.
Check the insurance cover
Typically, the contractor is responsible for insuring things like the site and the works, using its “all risks” cover. If it becomes insolvent, it is likely that this cover will lapse, so the client will need to take on the burden if the work has not been handed over.
Read the contract (and do what it says)
Most standard forms will contain provisions for termination on insolvency. However, the “trigger points” for beginning this process, and methods by which it will take place, can vary widely. For example, the trigger may vary from when administrators are appointed, proceedings are commenced or the insolvency order is issued.
Most contracts require notice to be served, but it is important that the notice is in the correct format, eg in writing, by recorded delivery and particularly that it goes to the correct address. This will probably be the contractor’s head office rather than the site office (which may well have disappeared by now if it is on contract hire).
Nevertheless, it’s easy to see how getting it wrong can have serious consequences.
It’s also worth pointing out that some contracts refer to termination of the “contract”, while others talk about terminating only the “contractor’s employment” under the contract. There are different schools of thought on this point — in theory, terminating the employment does not absolve the contractor of its other obligations — to ensure that the work carried out pre-termination is acceptable, for example. Although it’s difficult to envisage a situation where an insolvent contractor could be able to return and correct defects, one in administration may be able to.
Consider the measures in place to secure performance
It is probable that performance bonds, parent company guarantees, collateral warranties and suchlike remain in place. If executed successfully these bonds and guarantees should cover all of the contractor’s obligations and will be valid for the entire period of liability stated.
It is possible, however, that if a contractor is in trouble then the parent company will be as well, so care should be taken when choosing a guarantee rather than a performance bond.
It is easy to miss some of this documentation in the general rush to get started on site, although some contracts allow the client to withhold money until the relevant documents are provided.
It is important to read each one carefully and identify the trigger for calling in the bond or guarantee. Many will include insolvency but some will only cover failure by the contractor to carry out and complete the work it has done to the standard specified. Conversely, some bonds can be called in if dates are not met, without reference to the cause of the delay.
Finally, if funds are available through retention, they could be used to offset additional costs.
Make sure the contractor’s documentation is up to date
Where the contractor is responsible for obtaining things like test certificates, manufacturer and subcontractor warranties, health and safety information and record drawings, immediate checks should be made on the status of these documents. They can be expensive to reproduce, and sometimes difficult without the contractor's specialist knowledge.
Can the work be completed?
Once the contractor’s employment is terminated, the client may engage others to carry out and complete the works and to make good any defects. However, the procedure for doing this will vary depending on the contract terms. NEC contracts, for example, provide that the client may take over the insolvent contractor’s materials and equipment to complete the work; other contracts may have a different approach.
It is certainly worth discussing with existing subcontractors and suppliers whether they are prepared to continue, perhaps with a replacement main contractor; this may secure their own payment and continued employment.
Confirm who owes what
Inevitably, at some point, a financial reconciliation needs to be carried out; in many ways this is the same procedure as for the project final account, with the exception that there will undoubtedly have been additional items as a consequence of the insolvency and subsequent termination. This exercise should be done as quickly as reasonably possible, in order to identify the actual cost of completing the work and the funds available to do it, in case additional finance is needed.
Insolvency is an unpleasant experience for all concerned but its consequences can be made much easier by following a few simple steps, and observing the correct procedures. Remember that it is the job of the court-appointed administrator or receiver to raise the maximum amount possible for the assets of the failed company; they don't have to worry about securing repeat business or future relationships with potential clients, so they will be forensic in their approach and ruthless in their negotiation, in particular looking for and seizing on any errors in procedure or process.
Keep in mind
Roland Finch BSc. FRICS ACI Arb. is a Technical Author for the National Building Specification, (NBS), specialising in preliminaries. The views expressed here are those of the author and should not be taken as representing either NBS or RIBA Enterprises Ltd.
Last reviewed 17 April 2018