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Protecting projects in the event of main contractor insolvency – subcontractor collateral warranties

15 October 2021

Whilst this article has been in the pipeline for some time, the timing of its publication is somewhat apt following the administration of NMCN Plc on 4 October 2021. DWF wishes all those NMCN employees well and hope that they find alternative employment soon. We also hope that the direct and indirect consequences of the administration are not too harshly or widely felt amongst other colleagues in the industry. 

Unfortunately, main contractor insolvency is all too common and the current market conditions will no doubt be putting cash flow in the industry under significant strain. Whilst the restrictions on our daily lives have eased, the financial cost of the pandemic on the industry and the economy as a whole remains to be seen but the early indicators do not appear to be all sunshine and rainbows. 

Standard form construction contracts, in the most part, include a right of termination by the employer in the event of contractor insolvency but at what point in the insolvency process and how that termination right arises will need to be considered on a case specific basis against the relevant terms of the contract. Assuming an employer is able to bring the main contract to an end and does do so, the attention will turn to how best to complete the project. 

In these circumstances, being in the possession of a collateral warranty from each subcontractor is a real benefit to an employer. There is sometimes complacency, and sometimes even reticence, on the part of project teams in obtaining subcontractor warranties due to the time and effort it entails. 

However, we recommend that subcontractor warranties are obtained and that they each contain appropriate rights of step in for the employer which are exercisable in the event of the main contractor's insolvency. Whilst the employer may ultimately decide not to step into the subcontracts and procure completion of the project via alternative contracting arrangements, exercising rights of step-in into subcontracts could be a suitable option in protecting the project and ensuring that the supply chain is not also adversely affected by the main contractor's insolvency.

A usual condition of step-in is that outstanding payments due under the relevant subcontract are brought up to date. Indeed, almost every employer we talk to in respect of distressed projects is keen to make sure that subcontractor payments are brought up to date. However, before making any payments to subcontractors outside of the step-in arrangement, employers should bear in mind the following risks presented by the insolvency law regime:

Payments to supply chain

Some contracts include direct payment provisions which allow direct payment to be made to suppliers, by-passing the main contractor. These clauses are generally included for the benefit of the employer and supplier but are rarely used in practice due to a number of associated risks and challenges. 

The fundamental risk to an employer is that if a direct payment is made to a supplier, it may still be liable to pay an equivalent amount owed to the main contractor if the amount paid is non-deductible from the amount owed. Therefore, the employer would end up paying twice for the same subcontract works. Even if the contract contains express provisions allowing the deduction, there is a risk that such provisions contradict the anti-deprivation principle i.e. the arrangement removes an asset from an insolvent entity that would otherwise be capable of realisation for the benefit of the insolvent entity's creditors, thus the employer becomes involved in an unnecessary legal battle with the office holder.

Furthermore, the arrangement may contradict the 'pari passu principle' that all unsecured creditors in the event of insolvency must share equally any available assets of the company in proportion to the debts due to such creditors (i.e. the subcontractor has been paid in preference to other unsecured creditors).

Until the Corporate Insolvency and Governance Act (2020) (CIGA), subcontractors could somewhat help drive the process by bringing their subcontracts to an end due to the main contractors insolvency. However, the onus is now on employers to take action to protect their projects because the effect of CIGA prohibits the termination of any contract with a developer upon the developer entering into an insolvency process (sections 14 to 15 and Schedule 12 CIGA).

Effect of CIGA

The purpose of CIGA is to ensure that supplies are not cut off when a company becomes subject to an insolvency process due to a supplier relying on its ipso facto clause(s). Any such clause(s) within a contract are essentially rendered inoperable, and this applies to both new and existing contracts which were already in force at the time of the enactment of CIGA. Accordingly, a supplier cannot exercise a contractual termination right in respect of a pre-insolvency breach if the right is not exercised before the commencement of insolvency proceedings.

CIGA also places a restriction on the supplier from making the payment of pre-insolvency debt arrears a condition of continuing the supply.  Indeed, there is no mechanism to make an office holder personally guarantee the payment of ongoing charges. Any pre-insolvency debts are unsecured debts and will only be paid (pari passu) following payment of all priority insolvency expenses, and secured charge holder debts.  However, a supplier who must continue to supply its services will be paid in priority, as an expense of the insolvency process, for the services that are provided during the insolvency process.

Clearly, from the perspective of the employer or the supply chain, the position created by CIGA is far from ideal and fraught with the risk that both the employer and the supply chain will suffer even further losses arising out of the insolvency. Whilst there may be options available to the supply chain prior to the insolvency, the unfortunate reality is that it is often only when a main contractor becomes insolvent that the full extent of its financial difficulties become apparent. 

Commentary

We cannot stress enough the importance of obtaining an adequate subcontractor warranty package for any project due to the risk of main contractor insolvency. Admittedly, if the task of finalising and managing the execution of the subcontractor warranties is left to the main contractor, as is often the case, the accuracy of the document provided can be variable. Not only do the warranties provide an option to help protect the supply chain and keep a project moving, such warranties offer recourse in the event of defects in circumstances where the main contractor enters insolvency after completion.

Unfortunately, our Construction & Infrastructure and Insolvency teams are all too familiar assisting employers in dealing with contractor insolvency and restructuring the contractual arrangements to procure the completion of projects. If your project has been affected by a contractor insolvency, we are keen to help you as best as we can to help deliver your project and maintain the integrity of your supply chain.   

To find out more on the topic, please contact Adam Jason or another member of our Real Estate team.

Further Reading