Practical tips for dealing with contractor insolvency in the short, medium and longer term

It is important to distinguish between the period where there are signs of trouble and the period after a formal insolvency has occurred. Acting prematurely can put the employer at risk of being in breach of contract itself. In particular, an employer should not:

• lock the contractor out of the site or talk to sub-contractors directly because this could put an employer in breach of its contractual obligations. Depending on the nature of the breaches, they could entitle the contractor to extensions of time and loss and expense or to terminate the contract and recover lost profit;
• terminate the contract without clear grounds. It is almost always better to wait until after the contractor becomes insolvent and use that as a ground to terminate; and
• pay sub-contractors directly without the benefit of an agreement with both the contractor and the relevant sub-contractor which confirms that payments to a sub-contractor will reduce payments that would otherwise be due to the contractor.

However, there are various steps which employers should consider taking if the contractor is suspected to be in financial difficulty:

• reduce exposure to the contractor by ensuring that payment notices and pay less notices are served correctly and pay only what the contractor is entitled to under the contract;
• start keeping clear records about the status of the works on the site and gather programme information so you have a better understanding of any issues with the works to help with any counterclaims or deductions;
• check the contract terms, including any performance security which may respond to insolvency such as bonds and parent company guarantees;
• check the status of any materials which have been paid for but which are not yet on-site, including where such materials have been stored, whether there is a vesting certificate transferring the title in such materials to the employer and whether any contractual requirements in relation to such materials (such as insurance, labelling and storage requirements) are being complied with. This may facilitate quickly getting hold of such materials if the contractor does become insolvent;
• ask the contractor for evidence of the existence of insurances it is required to maintain under the contract, such as professional indemnity insurance;
• ask the contractor to notify its insurers of any potential claims the employer may have against it so that they are likely to be covered by the insurance; and
• finally, regularly check the London Gazette and Companies House for evidence that the contractor has entered the insolvency process.

Once there is evidence that the contractor is insolvent, it is important that a number of practical steps are taken as quickly as possible to protect the employer’s money and property:

1. Site Protection

Immediately change the locks, set up a new security contract, organise an audit of plant, equipment, goods and materials on site and set up procedures to prevent unauthorised removals from site.

2. Insurance

Where the contractor was obliged to insure the works and the site under its insurance policy, this obligation is likely to cease or not be complied with once it becomes insolvent so it is important to check how the site and any incomplete works are insured.

3. Payment

Under JCT Contracts, sums which have already become due at the point of insolvency are still payable. However, sums will not be payable if the final date for serving a pay less notice has already passed when the contractor becomes insolvent. It is particularly important, therefore, to ensure that a pay less notice is served if the insolvency occurs prior to the final date for serving a pay less notice.

Termination of the contractor’s employment after an insolvency event is not usually automatic – it will often require an election to be made by the employer.

If the employer does wish to proceed with terminating the contractor’s employment, it should:

• verify that termination for insolvency is available under the contract – insolvency is a wide-ranging term and contracts will usually include precise definitions of what types of insolvency event give rise to the right to terminate;
• ensure that the form of any termination notice complies with the stipulations of the contract; and
• ensure that the termination notice is served in the correct manner – for example, that it is sent to the right address and by the correct means of delivery.

The consequence of failing to comply precisely with the contract requirements could be that the termination is found to be invalid and to constitute a repudiatory breach of contract by the employer entitling the contractor to terminate and potentially make claims against the employer.

It is important to keep a record of how any termination notice is served (as well as a copy of the notice itself), in case there is a dispute as to its validity at a later stage. It is also usually sensible to take a conservative approach to interpreting the contract requirements in relation to service of the termination notice. If there is doubt, it is usually advisable to serve copies of the termination notice to any potentially relevant addresses and by various means (for example, by courier, recorded post and email), to ensure that at least one is served correctly.

After the contractor’s employment under the contract is terminated, many of the contractor’s obligations (for example to carry out the works) come to an end. However, the contract itself remains in place.

Dealing with sub-contractors

Subcontractors may insist that goods and materials supplied to the project are their property rather than the employer’s and that they should be returned to them. They may also refer to the tort of conversion (i.e. using wrongfully goods which are owned by others).

Whether the sub-contractors are right will be very much dependent on the facts of the case and specific advice should be taken at that point.

Many sub-contracts contain “retention of title clauses” which provide that the sub-contractors retain ownership of goods and materials in question until they are paid.

Section 25 of the Sale of Goods Act 1979 provides that if the employer has paid the contractor for goods in good faith and without notice of the supplier’s retention of title clause, ownership passes to the employer and the retention of title clause is effectively overridden. However, this provision is only relevant where the supplier is only supplying “goods”. It will not apply in circumstances where the contract also involves carrying out substantial work or performing substantial services as well.

Any payments made by the employer to sub-contractors directly will not reduce any liability the employer has to the contractor for the same work if it has been certified but not paid for. In other words, the employer risks being put in a position where it has to pay for the same work twice. This will need to be weighed against the potential need to keep the sub-contractors on board to complete the project.

Replacement contractor

A key question for the employer will be whether to engage a single replacement contractor to finish off the works, or alternatively to engage the existing sub-contractors directly (which is likely to require another contractor being engaged to assume a construction manager role, if significant work remains).

Clearly, whichever approach is taken may also need to be approved by third parties, such as funders.

It is important to keep a record of costs incurred for the final account process under the original contract with the insolvent contractor.

Final account

The contractor’s administrator/liquidator will be interested in ensuring that the final account process is properly conducted, to ensure that any payments which are due to the contractor are recovered (for example, the balance of any retention monies).

As such, even after termination, it is important that employers maintain records in relation to the project, and administer the contract in accordance with its terms. These records might include:

• photographs and documentary evidence of the status of the works at the point of the termination;
• evidence of the competitive tendering of the works to replacement contractors; and
• the costs actually incurred in procuring the completion of the works.

Employers should be aware that there is a growing industry of advisers who will pursue claims on behalf of administrators/liquidators of insolvent contractors, in some cases quite aggressively. These advisers may rely on insolvent companies’ rights to bring adjudication proceedings, as confirmed in the 2020 Supreme Court case of Bresco Electrical Services Ltd (in liquidation) v Michael J Lonsdale (Electrical) Ltd [2020] UKSC 25.

However, if an insolvent contractor does commence adjudication proceedings, the courts usually (but not always) refuse to grant enforcement of the adjudicator’s decision (or may grant a stay of enforcement). As such, there may be a difficult strategic decision for the employer as to whether or not to defend the proceedings, or how much to spend on defending them.