Building contractor insolvency: Keep calm and carry on

In the twelve months before the end of March 2020 construction experienced more insolvencies than any other sector of industry in the UK. That’s according to the Government’s own Insolvency Service. Despite the emergency legislation introduced by the Government to provide some protection from insolvency during the pandemic, the pernicious effects of Covid-19 will only have magnified the industry’s endemic insolvency risk. Whether it’s a building contractor or one of its sub-contractors that fails, there are consequences for everyone involved in the project.

Insolvency - Keep calm and carry on Where typical construction procurement practice has been used, the greatest risk for an Employer is probably the insolvency of its building contractor. The same is likely to be true for other parties with interests in the project, like investors committed to future purchase agreements or funding partners providing construction finance. Where tenants are committed to occupy through agreements for lease, an insolvency can result in the whole chain of legal relationships unravelling. So, what should an interested party do if it fears the worst might be about to happen?

One of the first things to check is whether any form of performance security is available, such as a guarantee or performance bond. Usually agreed in parallel with the building contract, a well-drafted parent company guarantee would require the guarantor to underwrite and perform the contractor’s obligations if it fails, enabling the contract to continue with minimal disruption. Depending on the terms, you may also be able to recover losses and expense arising from an insolvency. However, this kind of protection is entirely dependent on the covenant strength of the guarantor and would not survive a group insolvency.

Performance bonds give a more reliable form of protection because they are, in effect, third party insurance policies allowing the Employer as beneficiary to recover losses from the bondsman, to a specified limit. The cover is usually capped at around 10% or 15% of the contract sum and may not on that account compensate for all losses. Nevertheless, a bond can help off-set the costs of salvaging a stalled project.

Bonds and guarantees aside, the main means of protection in a well configured project will probably come from a network of collateral warranties or equivalent third-party rights. These should contain step-in rights, allowing the beneficiary to step into an insolvent contractor’s shoes under the key appointments and sub-contracts and, crucially, to maintain the continuity and cohesion of the core project and construction team.

It’s important, if perhaps obvious, to bear in mind that step-in rights can only be implemented where the relevant warranties are in place. It is therefore advisable to obtain these as soon as possible, and ideally as soon as the relevant contractor, sub-contractor or consultant is appointed. The period in which to exercise step-in rights following an insolvency event is limited so it’s necessary to act swiftly to activate the rights before the warrantors can exercise their rights to terminate and walk away. This will require service of formal notices and so it’s advisable to have these drawn-up and ready if you fear impending insolvency.

It’s not unusual for a project to involve several interested parties like funders, investors, landlords and JV partners, any of whom may able to invoke step-in rights. In such cases it’s normal to have a predetermined order of step-in precedence, to prevent a disorderly and potentially confusing scramble between competing interests in the aftermath of an insolvency. The key here is good communication to ensure the order of precedence is followed. Otherwise there is a risk that someone in the chain could fail to exercise their rights in time to ensure that the project stays on the rails.

It’s common, but not essential, for the party stepping-in to engage a development manager or replacement contractor to run the project through to completion. This will inevitably entail additional cost, although this is usually a price worth paying compared with the fragmentation and unresolved liabilities that would result from an uncontrolled insolvency event.

Besides the obvious implications for the completion and delivery of a project, the loss of a building contractor can cause a significant gap in warranty coverage. The effects can be particularly acute for a design and build contract, where the building contractor would be expected to provide a single point of liability for defects in design and workmanship. It would be vanishingly rare for a replacement contractor to accept liability for any pre-existing defects and this can lead to difficulties for the onward sale and funding of the completed property, particularly for an investment-class asset. Where available, latent defects insurance may help to bridge this gap, although it’s important to check with the insurer whether any particular steps must be taken to maintain cover following the failure of the original contractor.

Having in our own work experienced some of the aftershocks that followed the high-profile failure of Carillion, the impact on developers, funders and preleasing tenants was in many cases profound. Months of delay sourcing replacement contractors, little commercial leverage in negotiating their engagement, big holes in the fabric of liability cover that’s designed to underpin confidence in the value and liquidity of investment assets, and much money and time spent resetting projects onto a footing that would allow them to resume and complete. Whilst Carillion’s failure was unusual because of its scale, Construction News reported that ninety construction businesses had fallen into administration in the first quarter of 2020. Given where we were in relation to the trajectory of the virus at that point, the risk today must be materially greater.

A building contractor insolvency will always be profoundly unwelcome and potentially disruptive, but it needn’t be a disaster because well-established self-help remedies are often available to those prepared to keep calm to carry on. The most appropriate response will inevitably be defined by the underlying contractual arrangements, which will need careful analysis. So, if you are concerned that your project may be at risk of a building contract insolvency, seek early expert guidance on your options for determining the contractor’s employment, exercising step in rights, calling on a bond or guarantee and appointing a replacement.