Protection against contractor insolvency

To safeguard their interests, employers should carefully word their bonds and underlying contracts to ensure that they have the protection they need in the event that the contractor does become or is likely to become insolvent, writes Martin Preston.

Are difficult times ahead? Employer-clients have begun asking how they can protect themselves against the risk of insolvency of a contractor that they have engaged on a particular project.

FIDIC and most other standard forms of contract provide for termination of the contract (or the contractor’s employment thereunder) in the event of the contractor’s insolvency whereupon the employer is relieved from making further payments to the contractor until completion of the works and the contractor is required to pay to the employer any excess costs incurred by the employer over and above the contract price due to the contractor’s insolvency. This is the position under FIDIC Red Book which remains widely used in the region. However, while these provisions enable the employer to avoid making payments to an insolvent contractor who will not be able to complete the job, it is clear that an insolvent contractor will not be able to meet any excess costs occasioned by such insolvency.
How then can an employer best protect itself to ensure that it does not have to bear such costs?
If the contractor is a subsidiary, the most obvious (and cheapest) route will be to seek a parent company guarantee from the contractor’s parent company, which enables the employer to require the parent company to carry out (or procure the carrying out) of the outstanding works or to meet any excess costs over and above the original contract price incurred by the employer in doing so. Whether the parent company is required physically to carry out the works or simply to make payment when the excess costs are known, will depend on the exact wording of the parent company guarantee.
It may suit both parties for the parent company to be required to complete the works as the parent company may be able to have these works carried out “in house” by itself or another subsidiary. This may mean that the cost of completion (and the parent company’s liability) is less than may otherwise be the case (because the parent company or its subsidiary may forego all or part of its usual profit margin) and the employer is not required to find additional funds to pay another contractor before it is able to recover such funds under the parent company guarantee.
Withholding money from amounts otherwise due to the contractor by way of retention is another way in which the employer may seek to protect, in part, against the contractor’s insolvency. Typically, retention will be 10 per cent of the amount that would otherwise be due to a contractor with 5 per cent being paid to the contractor on handover of the works and the remainder being released on completion of the defects liability period. To preserve his cash flow, a contractor will often ask that he be entitled to provide a retention bond rather than a physical retention, and this is usually acceptable provided that the proposed form of bond is on demand.
In addition to the possibilities mentioned above, it is customary for a contractor to be required to provide a performance bond of between 10 and 20 per cent of the contract price. Clearly, it will be important from the employer’s perspective for the bond to be callable on insolvency. This will not be a problem with an on demand bond which, as its name suggests, requires only a demand in the form prescribed by the bond to trigger payment. However, with a proven default bond (where proof of contractor breach is required before a claim can be made under the bond), it is important that the employer ensures that the bond will respond when the employer expects it to should the contractor become insolvent.
There is a potential pitfall for the unwary employer if a proven default breach requires proof of breach, and does not specifically address insolvency, as under the vast majority of standard forms of contract (including the FIDIC forms), insolvency triggers termination but does not constitute a breach of contract. Breach by the contractor will therefore only occur after the employer has paid to complete the works and the insolvent contractor has failed to pay any excess amount over the contract price incurred by the employer in completing the works. This means that the employer will not be able to access the bonded sum when it is required on the insolvency of the contractor but will have to fund the excess itself before claiming it under the bond. If this is the case, then the wording of the bond should be amended to provide for a call to be made in the event of the contractor’s insolvency as well as when a breach of contract has occurred. Further discussion of bonds can be found in my article in the February 2007 edition of Gulf Construction.
Obviously, a parent company guarantee will only be available if the contractor is a subsidiary and will only be worth seeking if the parent company itself is (and is likely to remain) a creditworthy entity. Retention and/or retention bonds and performance bonds are requirements of most construction contracts in the region, but employers should check carefully the wording of their bonds and the underlying contracts to ensure that they have the protection that they believe they have in the event that the contractor does become or is likely to become insolvent.

Gulf construction