Back to basics: insolvency and construction

The construction industry has long been one of the sectors most vulnerable to insolvency. Tight margins, complex supply chains and cash flow dependencies mean that both employers and contractors can find themselves exposed when a contracting party becomes insolvent. The JCT Design and Build Contract 2024 (‘JCT DB 2024’), along with most other industry standard forms, reflect this reality and provide for insolvency scenarios. However, contractual mechanisms alone do not eliminate the commercial and operational risks. This article considers practical and contractual steps that can be taken to mitigate insolvency risk at the outset, what happens if insolvency occurs, and how employers and contractors can protect their positions.

The detail is set out below but in summary, the key focus areas when embarking on the tendering and procurement process are:

• to undertake a thorough due diligence exercise,
• to give appropriate attention to detail when drafting, negotiating, and agreeing the terms of the contract, and
• to have an awareness of the warning signs indicating that all may not be well, financially, with the contractor.

Insolvency

A company is generally considered to be insolvent when it is unable to pay its debts when they are due. However, when considering whether a contractor is or is becoming insolvent, check the definition of insolvency as set out in the contract.

Mitigating insolvency risk at contract inception

The best way to manage insolvency risk is to address it before a problem arises. Parties entering into the JCT DB 2024 should consider requiring the contractor to provide additional security and/or comfort, this can come in the form of:

• a performance bond (generally in an ABI form)
• a parent company guarantees, ideally from a subsidiary contractor’s ultimate parent company (PCGs).
• agreement for the provision of a project bank account
• direct payment agreements.

Performance bonds, typically set at 10% of the contract sum, provide an employer with a financial remedy in the event of contractor default or insolvency. They are not a cure-all – claims must meet the bond conditions – but they offer a degree of financial recourse where a bank or surety will pay out to an employer in the event of contractor insolvency.

PCGs are equally valuable where the contractor is part of a larger group; the parent may be more financially resilient than the contracting entity itself. A PCG will also guarantee the entirety of the obligations under the building contract, not just 10% of the contract sum, and create a primary obligation on the guarantor to perform the subsidiary’s obligations if it fails to do so. Once again, before accepting a guarantee, a thorough due diligence exercise should be undertaken on the guarantor to ensure that, if called upon, they have sufficient assets to satisfy any claim under the guarantee.

Project bank accounts and direct payment agreements are generally a less commonly agreed form of insolvency risk mitigation. Project bank accounts require side agreements setting out terms on which payments will be administered by a trustee and allow for direct payment of supply chain participants. Direct payment agreements, allowing the employer to pay subcontractors directly, are often rejected by contractors outright. Nevertheless, despite the administrative burden and delaying in negotiating them the employer benefits make them something which is increasingly more accepted for larger projects.

Due diligence

Just as with performing a due diligence exercise on a potential guarantor, before entering into a construction contract, you should carry out due diligence (including a credit check) to ensure there are no signs of contractor financial difficulty.

Common ‘red flags’ or warning signs of insolvency include a failure to file statutory accounts and annual returns on time, changes in the contractor’s key project team, the project not progressing at the expected rate and sub-contractors not being paid on time or at all.

Negotiating the contract

At the very outset, in order to try and mitigate the impact of a contractor’s insolvency on a project, when negotiating a construction contract you should consider:

1. amending the termination provisions to widen the definition of an insolvency type event.
2. amending the termination provisions to impose an obligation on the contractor to give you notice where their financial position deteriorates or if you reasonably believe they are about to go insolvent

It is not uncommon for a contractor to limp on for some time when in financial difficulty. In these circumstances the contractor is not meeting its contractual obligations fully, but at the same time it is also not giving the employer sufficiently clear grounds to terminate the building contract for breach. Widening the basis on which a contractor’s financial difficulties, or the practical consequences of them, can form the basis of a termination event could prevent an employer having to continue paying the contractor or inadequate or piecemeal work. This is of considerable commercial benefit to an employer when it is likely to be imminently faced with the prospect of having to lay out money to employ others to complete the works which an insolvent contractor will not finish.

Advance payments and off-site goods

The standard position under the JCT DB 2024 and other similar contracts is that a contractor does not get paid other than for “work properly executed” together with any “goods or materials delivered to site”. Nevertheless, employers often face requests for advance payments for goods not yet delivered to site. These payments are essential for the contractor to limit its exposure to a substantial negative cash flow position and to guarantee early procurement on long lead-time items (e.g. prefabricated steel, lifts etc.). Advance payments nevertheless create a risk that funds are paid out, but the goods are never delivered due to supplier or contractor insolvency.

The JCT DB 2024 allows for advance payments, but it is strongly recommended that employers seek a separate an advance payment bond. This is generally an “on demand” instrument which ensures that if the contractor becomes insolvent before delivery, the employer can recover the payment. The JCT DB 2024 has a standard form of advance payment bond including in the schedule to the contract and it’s generally acceptable to the banks and sureties who are called on to provide it.

Vesting certificates are also important—they transfer ownership of goods or materials to the employer even while stored off-site, protecting against claims by the contractor’s creditors. Identifying “listed items” in respect of which an employer is prepared to make advance payments comes subject to a contractor achieving certain conditions under the JCT DB 2024, this includes providing satisfactory evidence of transfer of title to the employer including the goods ownership being clearly marked and vesting certificate issued. If practically possible, an employer’s representative should visit the factory to make sure the conditions precedent to advance payment are met.

JCT DB 2024 insolvency provisions

The JCT DB 2024 defines insolvency at clause 8.1 and provides employers with termination rights at clause 8.5. If a contractor enters into liquidation, administration, or other insolvency processes, the employer may terminate. A critical point is to ensure termination is carried out strictly in accordance with the contract. Wrongful termination could amount to repudiatory breach, exposing the employer to claims from the contractor.

Employers may wish to negotiate additional obligations on contractors, such as early notification of financial distress. While this is not standard under JCT, bespoke drafting can provide advance warning and more time to prepare contingency plans.

If a contractor is suspected of imminently entering into insolvency legal advice should be sought urgently. It may be imperative to ensure that a pay less notice and or notice of termination are served when and where appropriate to avoid paying a contractor monies which the employer may never recover whilst operating in the knowledge that any such payment should in fact be off set against the costs of employing others to complete the insolvent contractor’s work.

Retention, monies owed and insolvency

Retention monies are often contentious in insolvency. Under JCT DB 2024, the retention is usually held until practical completion then half is repaid to the contractor with the remaining half held until the end of the defects liability period. If a contractor is insolvent, the employer must carefully consider whether and when the retention is repayable. Generally, the employer may be entitled to apply retention towards the cost of completing the works or remedying defects. However, liquidators may seek to recover sums due, and disputes often arise.

A further complication is adjudication. Following recent case law, liquidators may be entitled to bring adjudication claims to recover debts owed to an insolvent contractor. Liquidators often sell the debts owed to an insolvent contractor to factoring companies who will often vigorously pursue sums they consider are owed under a building contract to earn a return on their acquisition. Employers should be prepared for this possibility and maintain robust records of set-off claims and completion costs as well as making sure all contractual provisions, including the issuing of pay less and termination notices are, were dealt with entirely in accordance with the underlying building contract.

Securing the site and equipment

Immediately following a contractor’s insolvency, employers should act quickly to secure the site. This includes restricting access to prevent the removal of materials and protecting partially completed works.

Clause 8.7 of the JCT DB 2024 requires the employer to return tools and equipment belonging to the contractor. Care should be taken to distinguish between contractor-owned equipment and goods that have vested in the employer through vesting certificates or payment.

Insurance considerations

Insurance is another critical issue. The JCT DB 2024 contains insurance provisions at section 6. In the event of contractor insolvency, employers must ensure that works remain adequately insured including latent defects insurance for any defect in the design, workmanship or materials. Depending on the option selected (Insurance Options A, B or C), responsibility may fall on the employer to take over the cover immediately to avoid gaps in protection, for example, if the contractor’s obligation to insure falls away on termination of the contract.

Other key considerations

Insolvency also triggers wider supply chain risks. Subcontractors may walk off site or assert liens over materials. Employers and main contractors should therefore make sure when negotiating the JCT DB 2024 contract amendments that it contains an obligation on the contractor to procure collateral warranties from key subcontractors with step-in rights, allowing continuity if the main contractor fails.

It is also often helpful to contact the administrator or liquidator in certain cases to determine the ability and willingness of the contractor to perform its obligations under the contract because it may be that the contractor is in a position and / or willing to carry out the works notwithstanding the onset of insolvency which, especially if you are near completion of the works.

Employers should also engage with funders early. Lenders may have rights under direct agreements that affect how insolvency is managed. Clear communication with financiers is essential.

Conclusion

The JCT Design and Build Contract 2024 provides a clear contractual framework for dealing with insolvency, but successful management depends on proactive planning and careful execution. Employers and main contractors should focus first on risk mitigation—through bonds, guarantees, vesting certificates and clear contract drafting—before turning to the termination and site management provisions that apply once insolvency occurs. By combining contractual rights with commercial foresight, parties can minimise disruption and financial loss.

How we can help

If you would like any further advice on any issues raised in this article, or any other construction matter, please contact a member of our construction team.