June 2009

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Construction briefing

Contractor insolvency: early warning signs, practical tips and contractual safeguards

Business impact

An unfortunate but inevitable consequence of today's faltering economic climate is the upward trend of contractor insolvency.

If not properly planned for, the insolvency of a contractor can spell disaster – with projects left incomplete, major delays and cost blow-outs.

To minimise the risks associated with contractor insolvency, it is important to:

• ensure that your contract protects you; • keep alert for the early warning signs; and • if concerned, act quickly to find out the

contractor's financial position and your contractual options.

Forewarned is, as the saying goes, forearmed. Contractor insolvencies will almost certainly increase in 2009, so keeping a watchful eye out for the early warning signs of a contractor in financial difficulty will allow you to act quickly to minimise any risks or damage to your project. This briefing provides a short guide on what to look out for, what action you can take and what contractual safeguards you should consider when negotiating with a contractor at the outset.

Since most of the underlying principles will apply to any contractor or project scenario you are dealing with, the information in this briefing is general in nature and is designed to cover the insolvency of many types of contractors who operate in a wide variety of industries, from oil & gas to construction.

Early warning signs

The following are usually good indicators that a contractor is in financial trouble:

• Sub-contractors' demands: Have sub-contractors or suppliers begun to request payments directly from you? This is one of the more serious signs.

• Requests for early payment and additional funds: Is the contractor requesting advance payments to cover the cost of sub-contractors or materials? This is also a definite sign of liquidity problems.

• Scarcity of work: Is the contractor worried about a shortage of work? This may be a sign of possible cash flow issues in the future.

• Slow progress and missed deadlines: Decreasing activity? Project delays? These should cause concern.

• Staff changes: Employees' complaints about non-payment of wages and a reduced labour force are signs that not all is well.

• Disappearance of materials: Missing equipment or materials may indicate trouble.

The early warning signs should set alarm bells ringing

• Persistent rumours: Gossip can often be a useful source of information.

• Adopting a more "contractual" approach: Has the contractor changed its usual "informal" approach and started taking a more "contractual" approach to work?

• Spurious claims: Has the contractor been raising unjustified claims to increase the amount payable to it?

• Assignment: Has the contractor assigned (or asked for permission to assign) the proceeds of your contract with it to its bank or another creditor?

• Contractor's accounts: Is the contractor late in filing its accounts or does its auditors' report contain any qualifications?

• Court judgments: Does a business information report on the contractor reveal any unsatisfied court judgments against it?

• Parent company: Is the contractor's parent company (or any other companies in the contractor's group) showing any of the above warning signs?

Seeing the signs?

Not all of the above warning signs will necessarily be present and some of the indicators may be hard to spot. If you suspect that your contractor is going through some financial problems, you should not ignore it – approach the contractor about it.

However, bear in mind that sometimes rumours are unfounded and may be spread maliciously, so you should tread carefully and avoid doing or saying anything that may inflame the situation or create problems for the contractor which did not previously exist.

At this stage, your aim is just to discover what is going on and discuss with the contractor what needs to be done to make sure that your project is completed on time and within budget.

Failing contractor: practical tips

If, after you have talked with the contractor, you believe that it is in trouble, what can you do?

There are two options – either you continue to work with the contractor or you find out if you can terminate your contract with it.

First option: work with the contractor If your project is almost at completion, it may be cheaper and easier to stay with the troubled contractor and nurse it through.

This may mean making extra or accelerated payments to the contractor or agreeing to certain reductions in the scope of work. You may also want to consider making arrangements with the contractor for payments to be made directly to sub-contractors (but make sure that you obtain legal advice before doing this so you do not end up paying twice for the same thing).

Whatever you agree with the contractor during this process, you should make sure that you:

• minimise your exposure as much as possible; • keep everything well documented; • closely monitor the financial health of the

contractor going forward; • pay attention to where any of your plant,

equipment and materials are located, take steps to ensure that title to them passes to you upon payment and make sure that they are not removed by unpaid sub-contractors or other creditors of the contractor;

• maintain your own detailed records in relation to the work that the contractor is doing for you; and

• keep an eye on the contractor's own record-keeping and project reporting.

Second option: terminate Many people will want to end their relationship with a failing contractor as quickly as they can – but this approach can cause its own problems.

Firstly, in order to terminate a contract with a contractor who is failing but not yet officially insolvent, you will normally have to show either:

• an authorisation of suspension of work by the contractor; or

• a failure by the contractor to proceed regularly and diligently with the work.

Note that the latter can be hard to prove.

Secondly, the termination process will usually involve a notice period which provides the contractor with an opportunity to improve its performance. The contract can only be terminated if there is no improvement.

There are many other issues to consider if you want to go down the termination route, including the following:

• Any termination is likely to attract challenges and will result in delays and disruption.

• How are you going to get the project completed? • Have you paid more to the contractor than the

value of the works completed and how much will

you have to pay a new contractor to finish the project?

• What is the status of your agreements with third parties relating to the project and how will termination affect them?

• What if the contractor fails to co-operate with you following termination? This may cause problems with the assignment of sub-contracts and transfer of project information, data and drawings.

• Do you have "step-in" rights into the sub-contracts?

• Have all necessary collateral and sub-contract warranties been procured?

• Are all performance bonds and parent company guarantees in place? If so, you should investigate how and when you can make a claim under them and the solvency of the provider; and

• What ownership rights do you have in relation to the plant, materials and equipment which the contractor has been using for the project? How will you prevent these from "disappearing"?

Importantly, you should always seek legal advice before taking steps to terminate a contract because if you terminate without justification, you run the risk of being sued for damages on the grounds of a breach of contract.

Contract clauses: protecting yourself

How can you protect your position at the start of a project and reduce the impact of any contractor insolvency occurring?

Many would suggest that when preparing a contract, you should always assume that the contractor will fail and proceed on that premise.

The serious consequences of contractor insolvency mean that it is always advisable to obtain specific legal advice on this topic before entering into a contract. However, just to give you a brief illustration of the numerous contractual safeguards which should be considered, we have prepared a "Contractor insolvency contract checklist" below.

Importantly, though, before you even think about what should be in your contract, it is vital that you carry out financial checks to ensure that the contractor in question is in good financial standing. If, following your investigations, you have any concerns that the contractor might be on shaky ground, you should seriously re-consider whether you should be starting a contractual relationship with it.

Contractor insolvency contract checklist

The following list is not exhaustive and should only be considered as a helpful tool (as every situation will be different), but in general terms, to safeguard your position in the event of contractor insolvency, you should make sure that your contract contains:

• a wide definition of insolvency to cover as many different default and business failure scenarios as possible;

• early insolvency triggers to give you as much time as possible to consider your position if the contractor's business starts to go bad;

• no obligation to make payments to the contractor following the occurrence of any insolvency event;

• no automatic termination of the contract on the insolvency of the contractor (to provide flexibility and allow you to liaise with the contractor's insolvency practitioner);

• provisions in the main contract and sub-contracts that deal with the passing to you of title to on-site and off-site materials in the event of the contractor's insolvency;

• provisions which allow project continuation through the use of collateral warranties/third party rights from sub-contractors (which should include "step-in" rights);

• payment clauses which ensure that you pay in arrears and only pay for the value of works performed. If this is not possible (e.g. where an advance payment needs to be made for a special item), then consider securing the payment by requiring an on-demand bond (although this will involve a financial cost and the securing of a vesting certificate);

• provisions which give you the power to continue the project after termination (including the rights to use plant, equipment, materials and drawings, but be careful in situations where the contractor does not own them);

• for extra protection, it is ideal to have a clause requiring that the contractor provide you with a performance bond or a parent company guarantee (or both); in the construction industry, these are considered to be "must-haves";

• if you forgo requiring a performance bond at the start, then you should consider whether you should include a provision which specifies that the contractor must provide you with a performance bond on receipt of a written demand with a right to terminate if it is not provided by a specified deadline;

This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions. For more information please contact us at Ashurst LLP, Broadwalk House, 5 Appold Street, London EC2A 2HA T: +44 (0)20 7638 1111 F: +44 (0)20 7638 1112 www.ashurst.com Ashurst LLP and its affiliated undertakings trade under the name Ashurst. Ashurst LLP is a limited liability partnership registered in England and Wales under number OC330252. It is regulated by the Solicitors Regulation Authority of England and Wales. The term "partner" is used to refer to a member of Ashurst LLP or to an employee or consultant with equivalent standing and qualifications or to an individual with equivalent status in one of Ashurst LLP's affiliated undertakings. Further details about Ashurst LLP and its affiliated undertakings can be found at www.ashurst.com. © Ashurst LLP 2009 Ref:12978945 26 May 2009

• a provision that the contractor must ensure that any sub-contracts are "back-to-back" with the main contract so that the sub-contracts do not contain any retention of title clauses in relation to any materials being used by the contractor; and

• if you will be paying for any off-site materials: − a provision that the contractor is required to

identify clearly where any off-site materials are to be manufactured or kept;

− a provision that the contractor must ensure that the off-site materials are stored separately and clearly marked as your property;

− a requirement that the contractor will provide you with an on-demand bond before you will pay for any materials being held off-site to prevent any risk that such materials are not delivered to your site; and

− a requirement that the contractor provides a vesting certificate from the owner of the off-site materials and any intermediary owner confirming that upon payment, title will pass to you.

Conclusion

In an increasingly difficult market, it pays to be vigilant. To protect yourself against the problems of rising contractor insolvencies, you should ensure that your contract contains suitable provisions to deal with insolvency and its consequences, keep alert for early indications that your contractor may be in trouble and, if you are worried that your contractor is failing, adopt a cautious approach before deciding what steps to take in order to minimise the impact.

Contacts

Marc Hanson Partner, London T: +44 (0)20 7859 1395 E: marc.hanson@ashurst.com

Carl Dunton Partner, Singapore T: +65 6416 9508 E: carl.dunton@ashurst.com

Alex Cunliffe

Partner, London T: +44 (0)20 7859 3119 E: alex.cunliffe@ashurst.com

Tim Reid

Partner, London T: +44 (0)20 7859 1548 E: tim.reid@ashurst.com