FAQs - managing insolvency and payment risks under construction contracts

Abigail Milner, 29th June, 2021

1. Before you enter into a construction contract, what steps can you take to help protect against insolvency?

It’s important to take positive steps to avoid the risks associated with an insolvency before the contract has been entered into. In many ways, taking steps before contracting with a party is the most important time.

There are a number of things you can do to avoid the risks attached to an insolvency event prior to entering into the contract:

  • It's important to check that the party you are contracting with is a safe bet. There is obviously a much greater risk of insolvency being an issue if you’re contracting with a party ‘on the brink’ of financial problems compared to one on a strong financial footing. It’s therefore important to carry out research:
  1. Do a credit check. If the company has a poor credit rating, is failing to make payments elsewhere and/or has county court judgements against it, this is a clear warning that the company is struggling. The Companies Court insolvency records also show whether an entity is subject to insolvency proceedings.
  2. Carry out internet research. Has the company recently changed its registered office, or moved to smaller offices to save cash? Are there reports of high staff turnover, or other projects going badly?
  3. Check the information available at Companies House. Does the company have a long and stable history or is it a new entity which can easily be dissolved, potentially leaving you out of pocket?
  4. If you are the contractor, check that the employer with whom you are contracting actually owns the site.
  • If the payer is to hold some form of retention, ensure that the contract requires that it be held on trust in a separate bank account. This means that if the payer becomes insolvent before completion, the cash is ringfenced rather than being swept up by other creditors.

  • Consider ensuring that security documents, such as a parent company guarantee, will be entered into at the same time as the contract. That puts a parent company on the hook for any sums which the subsidiary doesn’t pay, thus reducing the risks attached to the subsidiary's insolvency.

  • A performance bond can also be a useful tool to put in place. This is a guarantee which is normally given by a bank for the contractor’s or sub-contractor's performance of the contract. It’s usually limited to around 10% of the build cost but provides another layer of security if insolvency becomes a risk.

  • Look at incorporating a project bank account and/or escrow account into the contract. These can also provide further, alternative protection and are worth exploring, particularly if parent company guarantees or performance bonds, for example, cannot be implemented. These involve funds being paid into a safe place and being drawn down as the project progresses.

  • Does the contract have insolvency termination rights? Do they deal with all likely insolvency events? Do they deal sufficiently with payment obligations on termination? What happens to plant and materials on site?

2. Is it worth asking for collateral warranties on a project and, if so, who should these be obtained from?

Collateral warranties create a direct contractual link with third parties where a contract previously did not exist. For example, employers on a project will enter into a contract with the main contractor, but there is no contractual link with any subcontractors, architects, engineers etc appointed by the main contractor. That means that the only party that the employer could sue is the main contractor. Collateral warranties make third parties directly liable to the employer, as well as the main contractor. As a result, if the architect is at fault the employer can sue the main contractor, the architect or both. This is particularly important from an insolvency aspect; if the main contractor becomes insolvent the employer would still be able to sue the architect if it had a collateral warranty. If it did not, then it could only pursue the main contactor which might be pointless if the main contractor is insolvent.

Ultimately therefore, if there are third parties working on a project and you have not entered into a contract with them then the simple answer is yes. This is particularly relevant if there are any third parties with design responsibility, or who are carrying out high value or high-risk work.

Make sure that those warranties contain step-in rights which, based on our example above, would allow the employer to step into the main contractor’s shoes and complete the project if the main contractor becomes insolvent. These provisions can be vital and require careful drafting to have the desired effect. Please note that if there are funders on the project, they will likely require the benefit of a warranty containing step-in rights too.

3. How do you manage payment terms where they require you to make an application for payment before raising an invoice?

The issuing of VAT invoices, and how they fit into the payment process, has been an area of much recent debate. A court case in late 2020 suggested that the final date for payment of an amount due cannot be linked to an event, such as when an invoice is submitted, so payment cannot simply be “30 days from receipt of invoice”, for example. However, these comments did not provide a binding precedent, so it is difficult to give any certainty.

A payment process which requires an invoice to be submitted faces the obvious hurdle that until the deadline for a pay less notice has passed it is difficult to know the amount which should be invoiced. A contractor may apply for, say, £1,000 but that is not necessarily the amount due; if the employer serves a pay less notice for £800 then the invoice should most likely be for £800. Different contracts deal with invoices in different ways; some require that an application be submitted with an invoice, and that the contractor revise that invoice to a different amount depending on what is certified. Others make it so that the "due date" is the date of receipt of an invoice or fourteen days from an assessment date, whichever is later.

4. What are the current cash flow options for contractors to manage risks?

Construction contracts, by their very nature, give rise to cashflow issues. Work carried out on day one isn’t assessed until the later due date and then isn’t paid until the Final Date for Payment. An insolvency during that period can cause cashflow options. However, there are some things that can be done. One option is to Increase the frequency of assessments and shortening the final date for payment. This might involve some commercial negotiating, but the increased frequency of payment might be worth it if it ensures that the amount of work unpaid for is reduced. With cashflow, it’s also important to make sure that the payment cycle in your contract isn’t any worse than in any sub-contracts otherwise you’ll be paying out monies before you’ve been paid.

Escrow accounts and project bank accounts can also be useful tools for managing cash flow and ensuring that the payments are not unduly delayed as the money is already sat in a separate account waiting to be paid out. As mentioned above, they also ensure that funds are protected if the payee becomes insolvent whilst owing money to you.

5. What protection would you recommend when having to make advance payments for off-site goods or when manufactures require payment before commencing design and fabrication?

Ensuring the contract obliges the payer to make an up-front payment in respect of off-site goods to avoid you being left out of pocket is vital, particularly where goods are job specific. It’s one thing buying items which can be reused, but expensive bespoke items present huge risks.

In order to facilitate any advance payments and provide some comfort to the payer, vesting certificates are a practical and useful option which provides various assurances to the payer in exchange for payment for goods which are held off-site.

6. Are there any particular warning signs which would indicate that a company could be high risk to contract with?

There are some red flags which could suggest that a company might be high risk and we’d suggest you consider the following:

  • Are there any reports of problems online? A quick google search could bring up a whole host of useful information in this regard which might warrant you investigating further. Likewise, check at Companies House and/or the Companies Court to see if there are any insolvency issues.

  • A high turnover of staff may suggest some inside knowledge that the company is in financial difficulties.

  • A re-launch or re-brand of a company could be an attempt to turn around a failing business. Equally, it could be nothing, but this is worth exploring.

  • Inexperience in the area of work looking to be undertaken. If the company doesn’t have a solid track record of success or recommendations in the particular area of work it could be risky choosing to work with them.

Whilst any of the above red flags could be nothing, a combination might add up to a failing business. It any event, it would be prudent to investigate further.

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