Construction insolvencies put contracts to the test

The latest insolvency statistics published by the Building Cost Information Service (BCIS) on 1^st May, showed 18 construction company insolvencies in Scotland in March 2024, a worryingly consistent number when compared to March 2023.  It is a tough gig and the trading conditions experienced by contractors in the post-pandemic period would test even the biggest and best of corporate balance sheets.

Harper Macleod’s Major Projects and Infrastructure team has spent the last 24 months carefully considering and developing strategies intended to aid our procuring clients to manage and mitigate the financial impact of main contractor insolvency on construction projects.  Despite the very best “financial vetting” and the most robust tender processes, insolvency can happen to any contractor (no one is too big to fail remember!), so “having a plan” is a must for active buyers of construction services.

The ultimate safeguard is ensuring the availability of a robust performance bond supporting the contractor’s obligations; one that will pay out in the event insolvency arises. We will return to “bond must haves” in a future article.  Bonds are, however, increasingly difficult to obtain in the current market and, where available, do not provide an instant solution or cash injection.  Our focus has, therefore, been on trying to avoid insolvencies occurring in the first place and mitigating the additional costs the employer will incur should the worst happen and a build-out becomes necessary.

So, what to do? Here are some of our current “top tips” for clients in relation to solvency risk management:

• Pay promptly. For (literally) decades, lawyers amended clause 4.9.1 in DB/Scot 2016 Edition (and its predecessors/equivalents) to extend the final date for payment period out to 21 or even 28 days. We stopped doing this ages ago as our other mitigation measures are focused on ensuring prompt flow down of funds to the main contractor’s supply chain.  Those strategies are only effective if the employer pays promptly as well.
• Revisit the implementation of project bank accounts. Take-up remains depressingly low, despite PBAs offering important practical protections – the employer can actually “see” the flow down of funds to those supply chain members who have signed up to the PBA arrangements in real time where the “dual authentication” option is selected.  This is another theme we will come back to in a future article.
• Implement “compliant sub-contract payment terms”. Insisting that the contractor pays undisputed sums due to its supply chain promptly/with only a short “buffer” over and above the main contract payment period is an obvious requirement.  We added to this:
  • ensuring the supply chain applies for interim payments and invoices on a “works specific” basis; and
  • restricting the use of contractual set-offs at sub-contract levels – why should our client’s money be used to resolve a potential dispute arising under an unconnected project?

We have also included a “payment stop” provision in the main contract that can be applied if the main contractor is shown to be in clear breach of its prompt payment commitments.

• Change attitudes to (and priorities in) collateral warranties and secure “significant sub-contractor step-in undertakings”. For many years collateral warranties were focused on having the ability to sue people in addition to the main contractor should something go wrong with a construction project.  Our focus now is on securing step-in rights, so that the employer has contractual rights itself, or via a replacement contractor, to step-into important appointments, sub-contracts and supply agreements.  Step-in rights relate to the original contracts, meaning the employer can access the original pricing – which can be commercially important when a build-out has to be paid for.  We no longer restrict the request for step-in rights to design sub-consultants and design sub-contractors.  We actively seek undertakings from other “significant” sub-contractors, irrespective of whether they do any design.  What is important is their criticality to the delivery of the works and their importance to the overall cost.
• Include “whistleblowing” provisions in collateral warranties and step-in undertakings. The parties granting these agreements are contractually obliged to inform the employer where the main contractor is not complying with its prompt payment commitments. These provisions should offer highly effective “early warning” of possible main contractor insolvency, allowing informed and proportionate consideration by the employer of using the payment stop remedy.
• Embrace the use of “contracts of purchase”. In affordable homes/social housing projects, and other construction contracts involving MMC/off-site manufacture, the use of CoPs may offer multiple benefits  We have developed a “contract of purchase (master agreement)” format that can be used to pay for off-site goods and materials in instalments as these items are in the course of being assembled, fabricated or manufactured.  Doing so can significantly alleviate financial pressures on the contractor’s cash flow.  There is also scope for contracts of purchase to be placed by the employer directly with the subcontractor or supplier.  It is not unusual for sub-contractors and suppliers to be large companies with strong balance sheets.  This allows for cash to go to the source (mitigating the impact of any main contractor solvency and increasing security of title transfer to the employer following payment being made prior to delivery) without the employer having to assume responsibility for the performance of the subcontractor or supplier.
• Consider alternatives to performance bonds. Where bonds are not available to the Contractor or not affordable, we have avoided recommending increased “security” retention levels, as our experience is that these often result in unmanageable cash flow pressures, resulting in the Contractor seeking “waivers” from the employer. We will explore cash security deposit agreements (our preferred “bond alternate”) in a future article.

As expected, we initially received a lot of market resistance when seeking to implement these measures, but increasingly they have been accepted as “sensible” by the proactive contractors we deal with although the continued resistance to PBAs and failure to “put” collateral warranties in place quickly remains an active source of frustration. The acid test will of course come should a main contractor experience an insolvency event on one of our active projects where these measures are in place, although I will be very happy if the theory is never put to the test.