Context- the risk is high  

Business Cost Information Services (BCIS) statistics from June 2024 highlighted that construction firms accounted for just under 20% of all insolvencies in England and Wales in April 2024, which is more than any other major industry. These statistics show a 7.6% increase from 2023 and a 36.8% increase from 2019.  

On the heels of construction giant ISG becoming insolvent just recently (as reported in September 2024), it is clear that the construction industry is rife with insolvency risk. From cash flow issues, non-payment, supply chain issues and increased material costs (to name but a few factors), it is clear that construction projects carry a real, ever-increasing risk of problems- not necessarily with the works themselves- but with stagnation due to contractor insolvency. 

Warning signs 

From an employer's perspective, spotting the warning signs is crucial, to manage risk and take precautionary steps before it is too late. Some of the notable signs to watch out for are: 

• Failure to file statutory accounts and annual returns at Companies House on time 
• Requests to re-negotiate payment provisions (including LADs and retention sums and periods) 
• High turnover of, or reduction in, workers onsite without warning 
• Payment issues down the chain, including sub-contractors and consultants 
• Unexpectedly high payment valuations/applications 
• Requests for extension of time or money under the contract without apparent merit 
• Substantial delay in the works, or deterioration in the quality of works being progressed 

The warning signs of contractor issues on the horizon must be taken seriously. What an employer is able to do about them, particularly if they manifest into insolvency, very much depends on the underlying legal framework between the contractor and employer. It is,therefore, crucial that as an employer you are aware of and explore all relevant protection measures before you put pen to paper on your build agreements.

Due diligence 

Financial due diligence, particularly when dealing with unfamiliar contractors, is vital for spotting and dealing with early warning signs.  

At the outset of procuring construction works employers should have a strategy in place to carry out due diligence on their prospective contractors  Some of the notable steps include: 

• Requesting management accounts for the last 3 years 
• Analysing accounts at Companies House, with an emphasis on analysing their cash flow, exceptional expenditure and any sizeable, short-term liabilities  
• Determining the group company structure for the contractor and identifying where its assets are ultimately held  
• Obtaining references from employers, sub-contractors and consultants on recent projects managed by the contractor  
• Utilising a third-party finance company to check the credit rating of your proposed contractor  
• Be clear with whom you are contracting, i.e. the parent company or its subsidiaries/SPV 

Payments 

Employers should consider opening a joint bank account (project bank account) so that payments by the contractor are monitored.  

This route tends not to be preferred by contractors due to the administration and cost burden involved with setting up and managing the account itself. However, having a project bank account in place means monies are held on trust for the contractor and any sub-contractors and consultants, and so cannot be unilaterally credited by the contractor.  

It enables oversight by the employer and ensures that sub-contractors and consultants are in turn, paid. Account holders are trustees of the account and therefore typically the employer will want to be a joint account holder with the contractorto acquire the necessary authority to authorise payments out of the account.  

Separately, employers should consider inserting monitoring obligations into their build agreements, which could include demanding receipts from and invoices for suppliers, sub-contractors and consultants to ensure payments are being made punctually by the contractor.  

A further and often useful resource to manage insolvency on the horizon is to require a contractor to provide regular management accounts on a set basis (for example, monthly or quarterly), which are then reviewed by the employer/employer’s agent to establish and significant change in circumstances of the contractor’s financial situation.  

Employers can even go one step further if they are concerned about their contractor’s long-term financial liabilities by rendering their build contract conditional upon good financial standing. The exact details vary significantly per project, however, they can be linked to any significant changes in cash flow, or in other aspects of the contractor’s management accounts. That way, as an employer you have a ground to determine the contract if the contractor’s financial situation deteriorates, without needing to rely specifically on insolvency grounds by which point the works may have already stagnated.  

Bonds 

A bond can be a handy tool to secure monies on a project; either as a reflection of monies an employer has paid up front for materials (advance payment bond), or to secure the contractor’s performance of the build contract (performance bond). They are typically provided by banks or by insurers as part of a bespoke product, whereupon the bond provider will hold monies until the point (if at all) the bond is called upon by the employer. 

Careful consideration should be given to the terms of the bond and how it interplays with the contract terms. Bonds are known to be problematic at which point the employer can claim on it, with adjudication/court decisions sometimes being required before the employer can claim any money from it. Particular attention should be paid to any unusual exclusions, or where terms such as ‘ascertained’, ‘established’, and ‘mitigated’ appear within the terms of the bond as these can muddy the waters when considering whether bond monies can be paid out and this can create a nuance between the terms of the main build contract and when bond monies are payable, which is not ideal from an employer’s perspective. 

Employers should seek extended periods for the bond’s lifetime, for example by ensuring it runs throughout the defects liability period (typically 12/24 months) post-practical completion to ensure the employer is covered if the contractor encounters monetary problems close to or soon after practical completion. In particular the bond will need to be for a specific duration to enable the development to reach practical completion if the employment of the contractor is terminated to allow the employer to ascertain its losses i.e. the cost of engaging an alternative contractor to complete the project over and above the build costs that would have been paid had the original contractor completed the development under its original employment. 

The market is becoming increasingly difficult for bonds, and they can often be considered disproportionate to the size of the project itself as an expenditure. In that case, an employer should consider an increased retention instead, by reference to the various ‘milestones’ of their project and the perceived risk profile of re-procuring the works at certain stages.  

Parent Company Guarantees (“PCG’s”) 

PCGs are used to secure a contractor’s payment obligations; typically against a member of its group entity but sometimes as a ‘corporate’ guarantee given by a third party. 

They can be useful for tying the terms of the build contract to a company with liquid assets. Due diligence is vital to the success of a PCG however, as an employer should always be seeking to receive a PCG from the ultimate asset holding entity of the contractor.  

As part of the due diligence to be conducted against the entity providing the PCG, enquiries should be made as to what other security/PCGs have been entered into by that entity. The greater the amount of PCGs entered into/security offered by that entity, the greater the risk of non-full recovery in the event the PCG is called upon. 

PCGs themselves should be drafted specifically by reference to the contractor’s obligations under the contract, and any exclusions to the guarantor’s liability should be reviewed with scepticism as they can significantly weaken the security of the PCG itself.  

An employer should consider inserting obligations for the guarantor to progress the works until instructed by the employer in the event of insolvency, as this helps to keep the project ticking along whilst the employer re-procures the works.

Collateral Warranties & Letters of Reliance 

A collateral warranty is useful on projects where third parties are providing sizeable design and/or construction input on a project, where the employer is not contractually related to them via appointment. Its purpose is to extend to the employer the obligations the consultant/sub-contractor owes the contractor.  

In the current climate, a key emphasis should be placed on step-in rights. These permit a beneficiary of an employer to essentially ‘take over’ the consultant/sub-contractor’s appointment if it is about to be terminated. Having such rights can prevent the consultant/sub-contractor from downing tools if they are not paid on time, and keep the project going with as little disturbance as possible. Be careful with step-in payment obligations in the warranty , particularly for sums due prior to step-in.  

Employers ought to consider supplementing step-in rights with the main build contract terms to record and monitor payments, to prevent a situation whereby they are stepping into an appointment and picking up a rather large bill to pay.  

Emphasis should also be given to professional indemnity provisions within collateral warranties (and indeed in your main build contract) to ensure that you are provided with regular updates in the event that insurance becomes impractical and to ensure that such insurance is being maintained.  

Employers should also consider tighter controls over the provision of warranties; once the main build contract has been entered into, it can be impossible to pin a contractor down to obtain warranties from their sub-contractors/consultants. Consider inserting provisions to withhold payment if they are not provided in a specific timescale, or render practical completion subject to all warranties being provided to ensure you are holding these before any issues arise with the main contractor (after which it really will be impossible to obtain warranties).

Title to materials 

The state, location, and monetary worth of materials can sometimes be overlooked in building contracts. However, in the event of insolvency, an administrator is always going to be concerned with which assets they can sell; materials being one of those assets. It is therefore crucial that as an employer you safeguard materials you have paid for.  

Employers should ensure that their build contract makes clear that any materials stored on site are the employer’s materials- i.e. that title passes to the employer from the contractor. 

However, that alone will not be sufficient- particularly if title in those materials never passed to the contractor from their supplier (to whom they may well owe money). Tighter payment provisions are therefore needed to make clear that any payment valuation submitted by the contractor must break down materials paid for, and that title transfers to the employer upon payment. The contractor should provide receipts to evidence that title has passed from the supplier to the contractor to ensure there’s no dispute later down the line. Employers should also consider requiring materials to be stored at specific locations, and for a regular inventory setting out the description and quantities of materials being held on site, and with a clear log of materials paid for by the employer which have now passed to the employer.  

Employers should consider entering into a vesting agreement with the contractor where they are paying large sums in advance for materials, particularly on modular building projects. Such an agreement should include inspection rights, insurance obligations for high value materials being stored off-site, and rights of access over the property in which materials are being stored.

Other drafting considerations 

Many standard construction contracts have scant provisions on insolvency events, particularly how ‘insolvency’ is defined. Consider expanding this definition so that insolvency events are triggered upon missed payments, a moratorium being entered into by the contractor (to cover the CIGA 2020 routes of insolvency), and an ‘adverse financial event’ where you are proposing reporting requirements (as discussed above).  

Does your build contract contain an obligation on the contractor to novate the agreement to a party of your choosing in the event an insolvency event is triggered?

Conclusion 

Insolvency is an inevitable risk in construction projects, and the published figures make for worrying reading. As has been discussed in this insight, employers can implement several measures from pre-contract to post-contract stages of their projects. These are useful as standalone measures or as part of a more holistic approach to protecting themselves against insolvent contractors, depending on the project's risk profile. 

How Capsticks can help 

At Capsticks, we have expertise in both contentious and non-contentious construction matters. We can provide a full-service protecting your interests before insolvency issues arise, and help you manage the legal ramifications once insolvency issues occur. To discuss how we can assist you, please contact Wilton Thomas or Spencer Vella-Sultana.