A building bombshell. Take cover, now!

Monday 26th January 2009

Another week, another insolvency. It certainly seems like that at the moment especially in the beleaguered construction sector. I know many contractors who have strong, well-managed businesses but who have been the victims of the credit crunch. Projects have been delayed or funding has dried up, wreaking havoc with existing order books and bombarding cashflow predictions.

Businesses who currently employ building contractors are nervous about whether their contractors might become the next victim of the credit crunch. The impact on progress of a construction project can be very serious. It can lead to delay, and huge additional cost. The employer, his professional consultants and the sub-contractors must all be careful to act rapidly to protect the project as a whole as well as their own interests.

The employer must watch out for the following things, now, before it is too late:

  • ensure that the building contract has actually been signed and dated. It contains important protection in case the builder becomes insolvent.
  • check that you have received collateral warranties from all key sub-contractors and that these include the right to step in and continue employing them directly in the event of the main contractor’s insolvency.
  • monitor very closely all of the contractor’s payment applications, to ensure that payments are properly due for works actually undertaken.
  • do whatever you can to monitor whether key sub-contractors are actually getting monies passed down to them by the main contractor. If this is not happening, that is a warning sign.
  • if you have really credible concerns about the main contractor’s stability then you may need to choose whether commercially you wish to take steps to support the contractor or whether you feel it is too late. A contractor might be prepared to renegotiate terms and allow you to pay key sub-contractors directly if he feels he is getting some support from the employer in return.

If it is too late to save the contractor and he goes into a state of insolvency, this has a number of immediate consequences. The contractor’s obligations to carry on with the work are immediately suspended, and the employer’s payment obligations cease to apply until well after the project is finished.

The employer is then free to employ anyone else to complete the works. Early in a project another main contractor may be needed; late in the project this could perhaps be avoided and the works finished off by the sub-contractors. If the employer received collateral warranties from the sub-contractors with step in rights then this is likely to assist. There can be a seamless transfer of the existing sub-contracts to the employer on the same commercial terms. In the absence of step-in rights the employer may find that he has to renegotiate and pay a premium to a sub-contractor to keep him on site. (Having said that, it is a buyer’s market at present).

If the employer takes over a sub-contractor’s employment there are some golden rules to be observed. The sub-contractor may say he has not been paid by the main contractor. The employer might be tempted to pay those arrears directly to the sub-contractor. But be careful. If the employer had already certified and paid those sums to the main contractor before he went bust then the employer will pay for the same works twice. Regrettably the sub-contractor must pursue those arrears directly from the insolvent company, if he can, along with all other unsecured creditors.

Where the employer takes over a sub-contractor’s employment, liability to make direct payments usually starts from the point of stepping in, not in respect of prior work. If a sub-contractor is heavily out of pocket the employer might have to pay a premium rate for ongoing work in order to keep that sub-contractor from walking away from the job. Provided that it is reasonable and necessary to do that, then this may be deductible from the final account ultimately to be agreed with the insolvent contractor after the project is completed.

If a project is in its early days when the contractor collapses, it is worth seeing if the building contract can be transferred (novated) to another builder. Provided that the other builder does not demand an unrealistic hike in the price, this has a long-term benefit to the employer because it keeps intact the builder’s covenants in respect of the entire works. The new builder would be required to give all the same warranties as to the design and or workmanship as the original builder. This means that if a major defect was discovered three years after the works were completed, the employer could recover damages from the new builder even if the defect was actually caused by the original builder.

The employer must remember that this security is extremely important to any external funder of the project, but even more important to anyone who will later purchase or lease an interest in the completed works, for example the purchaser of a new office block. Without the novation of the original building contract to the replacement builder, liabilities for the failures of the original builder will vanish along with that builder.

To conclude, anyone working on a major building project will understandably be nervous at present. The best strategy is to ensure that all the contract documents are in order and to hand. Before it is too late, make sure you know exactly what your contracts say. Be prepared to take the required steps under them if the need arises, so as to protect the project and your own business. There’s a bit of a wartime feeling in the air. People are bracing themselves for the next bombshell. The more prepared you are, the faster you can act, the better protected you will be.

If you would like to discuss any of the issues raised in this e-brief please contact a member of our construction team on 0113 227 0100 or email construction@gordonsllp.com