Mitigating the increased risk of insolvency in the construction industry

The UK construction sector is experiencing an increasing rate of insolvency, with recent data revealing that construction firms accounted for 17.4% of all insolvencies in England and Wales in August 2024. Over the past year, the total number of construction firms becoming insolvent has increased by 2.1%. 

There are several factors which are driving the increase in construction insolvencies. One significant factor is the impact of high interest rates and increased borrowing costs which have made it more expensive for construction companies to service their debt. Likewise, inflation has led to rising costs of materials and labour, costs which can impact profit margins, especially for projects with fixed budgets. Labour and skills shortages in the industry are delaying project completion, and high global energy prices have also increased construction operational costs, making it tougher for construction companies to manage their budgets. 

What is 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 or not a member of a construction team has become insolvent it will always be important to check the actual definition of insolvency that has been included in its construction contract. For example, the JCT suite of contracts has a much narrower test for insolvency than the general test where a company becomes insolvent. Under the JCT suite of contracts a company becomes insolvent when a winding-up order is made against it, on the passing of a resolution for voluntary winding-up, it enters administration, a receiver or administrative receiver is appointed, or an arrangement is made with its creditors in satisfaction of its debts. 

Do you want to terminate the contract?

In the event of contractor insolvency, before deciding whether or not to terminate your construction contract you may want to get in touch with the administrator or liquidator to get as much information as possible as to the status of the contractor and get the insolvency practitioners view as to the ability and willingness of the contractor to perform its obligations under the contract. It may be the case that the contractor is in a position to carry out the works notwithstanding the onset of insolvency which, especially if you are nearing the end of the works may be a more favourable position.

What does the contract say? 

Once it has been determined that the contractor is insolvent, and you are considering terminating the construction contract for insolvency, it is important to review the terms of the contract, particularly the termination provisions and the method of service of notices, which are often stricter than for general notices under the contract. Wrongfully terminating a contract for insolvency may mean that the terminating party inadvertently falls into repudiatory breach of the contract and becomes liable for damages.

Often a construction contract will set out that a contractor’s obligation to carry out the works will automatically suspended on contractor insolvency and your obligation to pay the contractor is suspended until the issue of a final account, notwithstanding whether you have issued a notice of termination, but again, you should make yourself aware of any potential unintended consequences of terminating a contract before deciding whether or not to proceed with the termination. 

How to mitigate the impact of contractor insolvency 

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. 

Prior to entering into a construction contract and during the works, you should be aware of insolvency warning signs. Common indicators of contractor 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. 

To mitigate the impact of a contractor’s insolvency on your project, when negotiating a construction contract you should consider:

1. amending the termination provisions to expressly make insolvency a breach of contract, this is important as the event of insolvency is not automatically considered a breach of contract which may affect the losses that are recoverable by the employer in the event of insolvency;
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;
3. including express wording so there is no further obligation to make payment until the works are complete, whilst addressed in some industry standard form contracts, it is important to make sure such wording is included in a bespoke contract;  
4. obtaining performance bonds and parent company guarantees (if the contractor has a parent company) and including sanctions if the contractor fails to put in place a bond or a parent company guarantee for example, withholding payment until such documents are put in place;
5. placing funds in escrow or make use of a project bank account; 
6. withholding retention from a contractor’s payments (we typically see retention at 3-5% of a contract sum but any amount can be agreed commercially);
7. negotiating advance payments and off-site material bonds;
8. taking out latent defects insurance for any defect in the design, workmanship or materials; 
9. procuring collateral warranties in your favour early in the project with step-in-rights from the contractor and any sub-contractor with material design responsibility; and
10. how the treatment and ownership of on-site and off-site materials is dealt with. 

Practical Steps when a contractor becomes insolvent 

If a contractor becomes insolvent on your project, the consequences will depend on the terms of the construction contract, but generally the following practical steps can be taken which can help mitigate the effects: 

1. review the terms of the contract to assess the options available, particularly in relation to termination of the contract;
2. notify any funders (or other relevant third parties) of the contractor’s insolvency as you may require their consent to terminate the contract; 
3. prepare to secure and protect the site and materials;
4. check whether the contractor’s insurance policies remain in place and consider whether you need to take out any insurance if the contractor’s obligation to insure drops away on termination of the contract;
5. check what payment of sums will fall due to the contractor (if any);
6. consider whether you need to call on performance security and the steps required;
7. consider engaging existing sub-contractors / sub-consultants directly through exercising step-in rights under third party rights / collateral warranties;
8. keep a detailed record of any actual losses incurred as a result of termination so that they can be easily identified and therefore easier to recover; and
9. consider whether there is an ability to deduct any liquidated damages if the works are running late. 

Conclusion

Given the increased risk of contractor insolvency in the industry and that the industry continues to face economic pressures and rising costs, it is now more important than ever that employers mitigate the increased risk of contractor insolvency. To minimise the effect of contractor insolvency on a project, employers should undertake due diligence at the start of a project, consider contractor insolvency when negotiating the terms of the construction contract and be aware of the signs of contractor insolvency during the works so that they can act quickly and minimise any disruption. 

If you have any questions relating to this article, our teams can help. You can find out more by visiting our website: Real Estate - Construction and Restructuring & Insolvency

This article first appeared in AQD Winter 2024