UK construction insolvency: Protecting your interests

Construction insolvency is not a new problem. With the continued presence of fixed price contracts, in an industry which has always been troubled with cash flow problems and low profit margins, coupled with persistent cost inflation and labour and materials issues affecting the supply chain, it is no surprise that we continue to see insolvencies. The question is, what can you do to protect yourself from insolvency?

In the year to June 2024, the UK Insolvency Service reported the total number of construction firms becoming insolvent was 4,303. This accounted for 17% of all insolvencies in England and Wales – a greater proportion than any other sector. This represents an increase of 33.7% on insolvencies recorded in 2019 (pre-Covid levels).

 

When is a party insolvent?

A company is considered legally insolvent in the UK when it is “unable to pay its debts”. This occurs where it has failed to pay an outstanding enforceable debt (for example a statutory demand), where a court is satisfied it would be unable to pay its debts when they fall due or where its liabilities (including those which may or may not become due in the future) exceed its assets.

Usually, the contractual definition of insolvency is a lot more restrictive. The JCT, a widely used standard form construction contract in the UK, attempts to reflect the range of insolvency procedures available in the UK in its definition of insolvency. FIDIC, which is more widely used internationally, provides for a broader definition of insolvency, in that it does not prescribe insolvency procedures, and provides a catch-all of "any event which is analogous to or has a similar effect to any of these acts or events under applicable Laws".

Whilst a company facing insolvency concerns is unlikely to admit these concerns to its contractual counterparties, there are certain warning signs which may indicate a party is facing financial difficulties.

Warning signs you should be alert to, both prior to entering into a contract, and throughout the duration of the project, include:

• failure to file statutory accounts and annual returns on time;
• requests to revisit and re-negotiate payment terms (either shortening or extending) and retentions;
• failure to pay on time, or at all;
• a notable deterioration in the quality and progress of works;
• an unexpected change or reduction in staff or personnel for the project;
• failure to provide security for the underlying contract (such as parent company guarantees and bonds);
• inflated applications for payment; and
• unsubstantiated claims.

 

Can you terminate a contract with an insolvent party?

A concern regarding a party's insolvency is insufficient. The contractual right to terminate (and the definition of insolvency initiating that right) is key. Under standard JCT and FIDIC forms of contract, insolvency is an immediate termination event.

UK insolvency legislation (specifically the Corporate Insolvency and Governance Act 2020, "CIGA") has the ability to cut across this termination right for suppliers of goods and services who are looking to terminate contracts for upstream insolvency. For example, a contractor may be able to terminate if its downstream subcontractor becomes insolvent but may be prevented from terminating if its client becomes insolvent.

CIGA prevents a supplier of services from operating a contractual termination clause (whether automatic or discretionary, and if it was existing prior to insolvency) in the event of the insolvency of the paying party (Insolvency Act 1986 section 233B(3)).

It also prohibits suppliers from doing "any other thing". This might include increasing costs or shortening payment terms. The intention behind the legislation was clear – a business experiencing short term solvency issues not of its own making should not be forced into insolvency because of supplier action – but the ongoing impact of CIGA on construction contracts is confusing.

"Any other thing" creates uncertainty as it appears to cut across construction parties' statutory right to suspend performance for non-payment under s.112 of the Housing Grants, Construction and Regeneration Act 1996 ("HGCRA"). This right being in addition to a party's contractual right, which would fall squarely in section s.233B(3).

Exercising this statutory right where the party failing to pay is insolvent may well be construed as doing "any other thing", and could be considered an attempt to make payment of pre-insolvency debts conditional on continuing supply post-insolvency (Insolvency Act 1986 s. 233B(7)). Without guidance from Parliament or the courts, it is unclear how these two pieces of legislation interact.

Termination can take place where the office holder (or the company where no office holder is appointed) consents, or where the court grants permission, where continuation would cause the supplier hardship. Where neither consent nor permission are forthcoming, suppliers should be aware that relying on an ineffective termination clause in order to cease performing their contractual obligations, is very risky.

Suppliers should monitor their client's solvency regularly and pay close attention to their contractual protections. A supplier may terminate or suspend when an insolvency appears likely, but has yet to occur. But once insolvency proceedings have begun, it cannot rely on an earlier failure to pay. Any rights accumulated prior to the insolvency cannot be exercised because of the restrictions introduced by s.233B. This means it must continue to make supplies even when owed significant sums. An affected supplier will be able exercise a right to suspend or terminate for non-payment in respect of supplies made later during the period of insolvency. 

For construction lawyers, this is puzzling. The HGCRA was introduced to give contractors and their supply chain recourse against late and non-payment, which historically has been a key cause of construction insolvencies. Whilst the courts have yet to grapple with this question, parties seeking to rely on their statutory right to suspend in these circumstances should do so with caution.

 

What can you do to protect your interests?

To alleviate the risks of insolvency during a live construction project, clients will typically request performance security. The most common forms of performance security continue to be parent company guarantees and bonds.

Guarantees and bonds

A parent company guarantee, whilst prima facie appearing the most attractive form of security, may not always be an option for some parties. This can be because the contracting party is already the parent, or the parent company is unwilling to provide a guarantee for the project. Equally, guarantees are only as good as the financial covenant of the parent. When a contracting party is insolvent, the parent is likely to face the same financial pressures. Therefore, it is also advisable to consider bonds.

There are a range of bonds that may be used in the construction industry to protect against insolvency, the most common being performance bonds, advanced payment bonds and off-site materials bonds.

There are two distinct types of bonds: on demand bonds and conditional bonds. An on demand bond is a bond to be paid immediately without the need for ascertaining the relevant party's liability. They are more common in international projects.

Conditional bonds, such as performance bonds, are more common in the UK. They only become payable once certain conditions have been fulfilled (such as insolvency or breach of contract) and financial loss has been ascertained. (Note that under English law performance bonds are typically considered to be guarantees, notwithstanding their designation.)

However, the bond market is hardening, and bonds, particularly performance bonds, are becoming uneconomical (or even unobtainable) for many projects as well as no longer providing the same comfort as they once did. One alternative, that provides performance security, is increased levels of retention. This may be unpalatable for many in the supply chain, given the additional constraints this can have on cash flow.

Warranties

One cannot mention security without touching on collateral warranties. While there is often complacency (by contractors) or reservations (from subcontractors) in putting in place warranties, they do have intrinsic benefits for clients and warranty providers where a party becomes insolvent either during the construction phase or following completion.

During the construction phase, collateral warranties that include appropriate step-in rights can be essential for both clients and subcontractors. By giving the client the opportunity to take over a subcontract in the event of the main contractor’s insolvency and contract termination, the feasibility and overall programme of a project is protected. Either the client will 'step in' to the underlying contract, or it will novate it to a newly appointed contractor.

Warranty providers also benefit, in that they will not be as adversely affected by the main contractor’s insolvency in the event the client opts to step in to the contracts – especially where payment of outstanding amounts is a condition of step-in. Note that clients should be cautious about bypassing an insolvent party and making payments direct to the supply chain without first establishing direct legal relationships with them, to avoid the risk of being forced to pay twice.

Following completion of a project, a full suite of warranties from the whole supply chain is a benefit to a client in the event a defect arises before the limitation period expires. Should a contractor become insolvent following completion, a full warranty package provides comfort to a client as it is afforded direct contractual recourse against the whole project team (including subcontractors, if appointed), rather than having to pursue the insolvent contractor. 

Warranties may also be assigned to parties taking a future interest in the completed project (such as purchasers and funders. A full suite of warranties makes it a more commercially attractive asset for those parties.

Latent defects insurance

Latent defects insurance, although rare, may be used, especially in funded and tenanted projects. This is not a replacement for a warranty package, nor a cheap option, but it can provide additional comfort to clients if an inherent defect in the design, workmanship or materials appears. This is especially important in the current market, where the potential for insolvency within the supply chain can leave liability gaps. This must be considered at an early stage, as the insurer will wish to monitor the works throughout the duration of the project.

Ownership of materials

During contract negotiation, parties should consider the treatment and ownership of on-site and off-site materials. Contracts and subcontracts should effectively deal with the passing of title of these materials, especially given increasing pre-order times for long-lead items. Vesting agreements may assist in the event of a party's insolvency by confirming title has passed to the client on payment, rather than delivery to site or incorporation into the works.

 

Conclusion

It is essential to do your due diligence from the outset of a project prior to entering into contracts and to remain vigilant for the lifetime of a project. This due diligence will ensure that safeguards are put in place, specific to the needs of the project, to protect the interests of the programme, supply chain and project in the event that insolvency does occur.

If you have any questions about how to alleviate the risks of insolvency throughout the lifecycle of a UK construction project, or when you are facing solvency issues with a counterparty in a UK project, please contact a member of the DLA Piper UK Construction team who regularly advise clients on these matters, alongside insolvency specialists.