Preparing for the worst as insolvencies rise
More and more construction firms are going bust
According to recent figures from the Insolvency Service, construction firms accounted for 17.3% of all insolvencies in England and Wales in April 2024, with 399 registered construction businesses becoming insolvent. This is in line with the latest statistics published on 18 June 2024, showing a trend over the last 12 months whereby a total of 4,401 of insolvencies were in the construction sector, accounting for 18% of insolvencies.
It is every client's worst nightmare: a main contract which goes bust partway through a project, or a major defect presents itself shortly after completion only to find that the main contractor has gone into liquidation. As more and more companies struggle with the challenges of inflation and higher interest rates and as insolvencies rise, it is increasingly important for clients to protect their position by ensuring their construction contracts are fit for purpose at the outset of a project. Cesare McArdle (Partner) and Jake Gatley (Senior Solicitor), explain the potential options with construction contracts and what action should be taken.
Retentions
A retention is a percentage value (typically 3% or 5%) of the overall payment for construction works which is held back, under a construction contract.
The purpose of the retention is to act as security that the works will be completed by the sub-contractor and that any defects which may subsequently develop are remedied. If the sub-contractor does not remedy a defect, the contractor may use the retention to remedy the defect itself and notify the sub-contractor that they have used the retention money for this purpose. A well drafted contract will permit the client to retain the retention should the main contractor become insolvent (which results in project milestones not being achieved).
Parent company and personal guarantees
A main contractor may belong to a group of companies, including a parent company with an interest in the main contractor winning work from the client. Typically, a parent company will be willing to provide the client with a guarantee. Under the guarantee the parent company will promise that the main contractor will perform its contractual obligations to the client under the contract, and provide recourse for the client against the parent company in the event of the main contractor becoming insolvent. It is also not uncommon for company directors to be asked to provide personal guarantees. This is where they agree to guarantee a number of contractual obligations, whether it be completing certain elements of the project or accepting liability for any breach of performance by the contractor company.
Performance Bonds
Another option is to purchase a performance bond, which is a type of financial product. A performance bond contains a written promise from the bond provider to pay the client in the event of a breach of the building contract by the main contractor or the main contractor going bust. Typically, a Performance Bond is capped at 10% of the main contract value. This compensation is intended to contribute towards the additional cost to the client of the main contractor becoming insolvent partway through the project, with the result that the client has to find a new contractor to finish the project.
Collateral warranties and Third Party Rights
It is normal for a main contractor to sub-contract large portions of works to a number of sub-contractors under various sub-contracts. Should this happen, the client should consider negotiating either a set of collateral warranties and or Third Party Rights (TPRs) obligations from all the key sub-contractors.
Collateral warranties sit alongside the various sub-contracts and are used to create direct collateral links between the client and each sub-contractor. Sub-contractor collateral warranties will typically contain step-in clauses. This allows the client to take over the sub-contract in the event of the main contractor's insolvency if drafted correctly. In addition, if a defect arises in the works in circumstances where the main contractor is insolvent, the collateral warranties will give the client direct contractual recourse against the sub-contractors responsible for the defective work (where applicable). If there is not a collateral warranty the client would then need to rely on a non-contractual claim against the sub-contractor using the law of tort. This is far from ideal because the client would need to pursue a negligence claim against the sub-contractor, and the difference between tortious damages and contractual damages can be considerable.
TPRs perform a similar function to collateral warranties. Although most clients prefer the certainty of a physical collateral warranty, TPRs are popular because rights can be conferred on the client using a simple notice. Unlike a collateral warranty nothing needs to be signed by the sub-contractor. However, attention needs to be given to ensure TPRs are properly drafted in sub-contracts, and that the notice has been properly drafted and served on the sub-contractor. Similar to collateral warranties, TPRs provide the client with a direct contractual claim against sub-contractors for defects in the sub-contract works. However, unlike collateral warranties, it can be difficult securing step-in rights into the sub-contracts using TPRs.
Insurance
An alternative is to acquire some form of insurance, such as latent defects insurance (LDI) to provide protection against defects. We suggest discussing any available insurance options with a broker, as an appropriate insurance policy could help should there be defects and a contractor becomes insolvent.
Escrow accounts
Another option is to put in place suitable escrow arrangements. Holding money 'in escrow' would oblige a developer to pay all or a percentage of the total/remaining build cost into a separate escrow bank account. The purpose of the escrow is to provide a fund on which the contractor may draw in the event of an incoming developer's default in making future payments (certified as) due under its building contract. This is preferable to making advance payments, which should be avoided where possible.
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.