Recent high-profile contractor collapses have made many acutely aware of the need to ensure they are adequately protected in the event of employer or contractor insolvency. This increase in insolvencies has also placed significant stress on the construction bond market. Contractor insolvencies put pressure on surety bond providers, which in turn can lead to increased rates and more stringent criteria being imposed on contractors seeking bonds. There is now an even greater squeeze on available bond capacity as a number of large surety bond providers have exited the construction bond market in recent weeks and months.
We outline below some steps and measures that can be put in place at the pre-contract stage to safeguard against the risk of insolvency in circumstances where the most common forms of 'third party' security, i.e. performance guarantees / bonds, are not available.
Do your homework
- For both employers and contractors, carry out due diligence as regards the other party's covenant strength during the tender process (talk to your finance or legal team as they will be able to advise on the types of checks/reports that can be done).
- Review recent press releases and shareholder announcements in order to investigate whether the other party has a history of non-performance/payment.
- For employers, consider asking tenderers to provide information about their current and future order book.
- For contractors, consider asking about employers' funding arrangements.
- Watch out for amendments to payment periods: longer payments periods requested by employers and shorter payment periods requested by contractors may indicate cash-flow concerns.
- Consider whether you have visibility of the other party's company structure, for example, are they a special purpose vehicle (SPV)? Are they based off-shore? Which company holds the assets? Has the company's name recently changed and if so, why?
Consider contractual safeguards that can be put in place (with your legal team)
Often parties who have concerns about security focus on the options for additional protection (which can be costly) without considering the protection already offered by the existing contract terms or considering if there are terms that can be added to the contract that could bolster their position. Issues to consider include:
- Can payments be structured in a way that mitigates any concerns a party has about performance or payment? Are there any advance payments? If so, does an advanced payment bond need to be put in place?
- The retention is a form of security to be
utilised by the employer in the event of non-performance by the
contractor whilst the works are on-going, or, in some cases, for
the failure to rectify defects arising during the defects period.
Can the terms around the retention be amended to deal with issues
around security - for example:
- Can the time period for which the retention is held for be increased or reduced?
- Can the amount of the retention be altered?
- Who will own and control the retention?
- Is the retention just cash or can all or some of it be subject to a Retention Bond? This can assist a contractor's cash-flow and also means that the part of the retention that is subject to the bond cannot be accessed by an administrator of the employer.
It is worth noting that while retentions as a form of security are well used in the construction industry, the practice continues to spark debate. It has been subject to a review by the Department for Business, Innovation and Skills. More recently, following a joint Construction Leadership Council (CLC) / NEC guidance note in 2022 calling for retentions to be abolished, there have been further calls from the CLC for government intervention. Watch this space to see if the new Labour Government will take action in this regard....
- When does ownership of property, goods and materials pass and what are the implications? For example, will the employer pay for off-site materials before ownership has passed from the contractor to the employer? If so, what are the conditions of ownership passing?
- Does the contract contain terms regarding visibility over the payment terms in sub-contracts? Could payments under the main contract be subject to receiving evidence that the contactor is paying its supply chain or alternatively, allow the employer to communicate with the supply chain to verify payments are being made? Obviously, extreme caution needs to be exercised when considering the inclusion of direct payment to sub-contractors.
- Public Authorities will also want to bear in mind the prompt payment rules provided for in the Public Contracts Regulations 2015 and (from 28 October 2024) the Procurement Act 2023, which will continue to impose stringent requirements for payment of suppliers within 30 days of a valid, undisputed invoice. Under the new Act, similar prompt payment requirements will be required from suppliers to their subcontractors. For more detail, see our insight on the Procurement Act 2023 and contract performance.
- Does the contractor have the right to suspend works for employer insolvency to supplement its right to suspend works for non-payment under section 112 of Housing Grants, Construction and Regeneration Act 1996 (as amended)?
- Do the parties have the right to terminate for the other party's insolvency and/or repeated default? Be aware that an entitlement to terminate for the other party's default may not always cover insolvency unless it is expressly listed as a default event.
- Section 113 of the Housing Grants, Construction and Regeneration Act 1996 (as amended) outlaws pay when paid clauses but this does not extend to specified employer insolvency - contractors may therefore wish to include in sub-contracts the right to withhold payment in these circumstances.
- In limited circumstances, where the contract is for the supply of goods or services, the Corporate Insolvency and Governance Act 2020 has extinguished a contractor's ability to terminate if their employer becomes insolvent. However, this does not apply if it is the supplier that has entered into insolvency proceedings.
- Does the employer have the right to sell the contractor's plant? An employer is likely to have limited rights as against, for example, a contractor company in administration, with respect to the contractor's plant, equipment and unfixed materials. Although, an employer could seek to protect itself by registering a charge over such plant etc, this is not necessarily standard practice and would need to be done at least six months before the contractor becomes insolvent.
Consider a project bank account
A project bank account is a ring-fenced bank account from which payments are made directly and simultaneously to all members of a supply chain. This may safeguard funds meant for the contractor's subcontractors and suppliers which would otherwise be swallowed up in the contractor's bank accounts. Whilst it costs money to set up and increases the administrative burden, it may be particularly advantageous in circumstances where the employer needs the subcontractors' and suppliers' co-operation to complete the works. Appropriate advice should be sought to check that the project bank account arrangement offers appropriate protection in an insolvency situation; charged blocked accounts maybe a viable alternative in certain circumstances.
We explored the public sector Construction Playbook and its private sector counterpart (which we commented on upon its launch in November 2022), both of which endorse the use of project bank accounts. This forms part of their focus on careful resolution planning – to be put in place when projects commence – to help mitigate the risks of potential insolvency down the line.
Performance security
Even if your due diligence checks and the contract terms provide you with adequate comfort, it's generally wise to review third party security and the options that may be available.
As noted above, protection in the form of a performance bond / guarantee may be costly, or unavailable. If only a limited performance guarantee/bond is on offer (say less than 10% of the Contract Sum) or none at all, the other party may wish to include an obligation that the value of the guarantee/bond must increase and/or a parent company guarantee (PCG) is to be provided if the net worth of the other party falls to a certain level.
In most cases, PCGs are supplied at no cost to the employer. However, if a contractor is suffering financial difficulties, the parent or group company may also be affected, leaving the guarantee worthless. The financial standing of a parent company will therefore need to be considered.
Collateral warranties / third party rights – supply chain considerations
Check that all collateral warranties from subcontractors and subconsultants have been procured in accordance with the terms of the contract. If not, take steps to obtain any missing collateral warranties (together with the underlying contracts). Contractor insolvency may mean that the employer is left without an enforceable remedy for future defects. Therefore, the employer should insist on collateral warranties (together with a copy of the underlying contract) from the contractor's material and/or design subcontractors and subconsultants so that it has right of recourse against a solvent counterparty.
If third party rights are being granted instead of collateral warranties, check that all notices granting third party rights have been issued.
Top tips
To recap, when considering the issue of performance and payment security, our top tips are:
- Check out the entity you are contracting with before you sign.
- Consider the contractual provisions carefully with your legal and finance.
- Consider what third party security is available and whether it is cost effective.
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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.