Insolvency: Cautious steps to save the supply chain

Peter Jansen, consultant at Maples Teesdale LLP explains why careful and decisive operation of the contract’s mechanisms to mitigate the effect of main contractor insolvency is essential when the early signs of crisis start to appear.

Recently the UK’s oldest building contractor went under after more than 400 years' trading, becoming another casualty of the current cash flow slump in construction. Main contractor insolvency has a dramatic effect on project delivery and brings an abrupt halt to the flow of cash.

The financial position of suppliers and subcontractors inexorably becomes critical if the main contractor faces insolvency or termination. There is a risk of a “domino effect” of insolvencies throughout the supply chain. 

The employer can consider taking measures that will help to avoid this and keep the project moving. These measures, which include direct payments to subcontractors, must be deployed with care because of the rules on corporate insolvency. After summarising those rules, this article looks at two situations: first, what happens when the contractor is insolvent, and secondly, the situation where that point has not been reached.

Effect of insolvency

When a company goes into liquidation, section 107 of the Insolvency Act 1986 governs the liquidator’s duties on the distribution of the company’s assets to unsecured creditors and shareholders:

“The company’s property…shall on the winding up be applied in satisfaction of the company’s liabilities pari passu and subject to that application…be distributed among the members...”.

The “company’s property” includes all debts owed to the company, at the point when it becomes insolvent, such as amounts due under interim certificates. It would include any balance stated as due to the contractor under a construction contract. The “company’s liabilities” covers all those amounts which the company is indebted to pay to unsecured creditors. That means all such creditors, comprising not just subcontractors on any one particular project but all subcontractors and suppliers on all its projects, as well as other general creditors such as utilities. The liquidator’s duty is to collect all the company’s assets, including all debts which can be settled or enforced, and to distribute this fund amongst all unsecured creditors equally. A distribution has to be in the proportion which their claim bears the total available fund.

In the case of British Eagle International Airlines v Cie Nationale Air France [1975] 1WLR 758, the House of Lords held that a company cannot “contract out” of the provision which is now section 107. An employer and a contractor cannot, for example, agree that on a termination sums which are due from the employer to the contractor at the point of the latter’s insolvency will instead be paid to certain subcontractors to whom the contractor is indebted. That would result in certain creditors receiving more following an insolvency than if all assets had been distributed equally in proportion to their claims as required by the section. Those payments could be set aside by the contractor’s liquidator. From his perspective, payments like these reduce the size of the fund available to be distributed amongst the company’s creditors as a whole and the courts will make an order for the payment to be restored to the liquidator.

Note that this principle takes account of the “mutual dealings” provision in Rule 14.25 of the Insolvency Rules 2006 which allows debts owed to a debtor to be set off against amounts due to the company so that only the balance is payable to the liquidator. In a contractor’s insolvency the employer is permitted to set off against the contractor’s debt amounts owed to the employer.

Construction contracts (in general) require an employer to pay a contract sum to the contractor for the “works”. Insofar as it has been certified and no set off is made against it, the contract sum is the employer’s debt to the contractor. “Works” includes the work and materials supplied by subcontractors, and a large component of the contract sum normally will relate to subcontract works. This part of the contract sum includes the contractor’s debt to its subcontractors. 

It may seem logical, particularly in urgent cases, for the employer to pay that debt or part of it directly to subcontractors. However such a direct payment will not discharge any part of the employer’s debt to the contractor under the contract as (unless the contract is amended) the employer remains liable to pay to the contractor the whole of the contract sum.

Moreover section 107 and the British Eagle principle could later enable the contractor’s liquidator to unwind any agreement between the contractor and the employer which permitted the employer to pay directly to subcontractors any part of amounts certified as due to the contractor. An express release of part of an employer’s debt to a contractor to enable the employer to pay an equal amount directly to subcontractors would be vulnerable to attack if the contractor was later wound up.

However section 107 refers only to property vested in a company as at date of the insolvency. It does not deal with assets which cease to belong to the company before it became insolvent (although disposals of assets can be caught by the rules on preferences). An agreement can be made for future debts to the contractor to be paid to subcontractors if these arise during, but not at the start of, the insolvency. They would not come with section 107 because they were not the company’s assets when it became insolvent. See, for example Golden Sands Marble Factory Limited v Easy Success Enterprises Limited. [1999] 2 HKC 356.

Insolvent contractor

Standard contracts address the issue of insolvency, allowing the employer to terminate the employment of the contractor. On termination all further payments to the contractor, other than amounts already certified as due, will cease until the works are completed with defects rectified. Certificates issued but unpaid as at the date of insolvency will be debts forming part of the contractor’s property for the purposes of section 107. After completion, a termination account is taken of what is due between the parties. The amount to date of all payments made to the contractor is added to the expenses incurred and the direct loss and damage caused to the employer arising as a result of the termination. In JCT contracts “expenses” expressly includes the cost of paying “other persons to carry out and complete the works.”  That sum is then set against the total amount which would have been paid to the contractor if it had completed the works.

The resulting balance is then certified as a sum due from the contractor to the employer or vice versa which will reflect the additional costs to the employer of the termination. The termination account reflects “mutual dealings” between the contractor and the employer for the purposes of Rule 14.25 of Insolvency Rules so that the amount paid by or proved in liquidation by the employer would be limited to that balance. See Michael J Lonsdale (Electrical) Ltd v Bresco Electrical Services Ltd (In liquidation). [2018] EWHC 2043 TCC.

The employment of unpaid subcontractors will either terminate automatically or be terminated by the subcontractor itself when the payment stream stops. Forms of subcontract currently in use differ on the extent of the subcontractor’s entitlement if the subcontract is terminated. However as unsecured creditors proving in the contractor’s liquidation, their recovery, if any, would be meagre. 

The employer has a duty to mitigate its loss, so the works must be completed in the most economical way. The obvious and convenient option for the employer is to re-engage existing subcontractors as “other persons”. The decision to do this must be taken without delay. The cost involved will almost invariably include unpaid amounts falling due to subcontractors before the contractor’s insolvency. If these were included in payments certified as due to the contractor before the termination, and are still debts, they will be part of the contractor’s assets at the time of the insolvency. If so, the employer cannot pay the relevant amounts to unpaid subcontractors instead. Nevertheless, if the employer makes payments to subcontractors as a cost of completing the works, it can set off these costs in the termination account when the works are completed.

Work and materials uncertified as at the date of insolvency will remain so until any part of their value is certified following the termination account on completion. Completed but uncertified subcontract work can be paid directly to subcontractors, and all of these costs again form part of the cost of completing the works by “other persons” and addressed within the termination account.

Non-insolvent Main Contractor

There are particular risks in making direct payments to subcontractors if the contractor has not gone into liquidation at the time of termination. If those payments are made without any agreement it is likely that they will relate to amounts certified to the contractor and therefore will have become assets belonging to it at the point of insolvency.

In many cases employers do not wait for the contractor actually to become insolvent. Where there are signs of financial difficulty, such as persistent late payment of subcontractors, an employer may choose proactively to step in. In contrast with insolvency, this situation is rarely covered with any clarity by the contract. The mere fact that the contractor is demonstrably in financial distress is not a legitimate basis for termination, which could be a costly risk: an employer who gets a termination wrong can face a claim in damages for repudiation.

Any termination must therefore be by agreement and would need to be commercially attractive to a financially challenged contractor. The agreement is made outside the contract but of necessity amends and replaces some of its terms. Its object, in addition to bringing the contractor’s employment to an end, is to exclude future claims. It will include a payment to the contractor as compensation for the termination and which would be a cap on the employer’s further liability. The termination agreement establishes the amount of the employer’s debt to the contractor before any insolvency occurs.

In contrast with the insolvency situation, the financial settlement under the termination agreement is achieved at the time of termination, not at completion when all costs have been ascertained. Therefore agreed estimates have to be used to calculate the settlement amount.

Main contractor termination will leave subcontractors and suppliers exposed. Their position will depend upon how the relevant subcontract is worded. For example standard JCT building subcontracts provide for the immediate termination of the subcontractor’s employment if the contractor’s employment under the main contract is terminated. But many main contractors prefer to use their own subcontract conditions.

Although by no means all contractors’ standard subcontracts provide for immediate termination in such a case, the end of the subcontractor’s employment would inevitably follow swiftly. As a last resort, the subcontractor would suspend and then terminate its own employment on the grounds of non-payment. Subcontractors whose contracts do not provide for immediate termination should plan their strategy carefully to avoid damages claims from the main contractor.

Payment is a main focus for subcontractors when the main contract is terminated. Initially the payment stream stops. Subcontractors may then be entitled to payment for the outstanding value of subcontract work carried out (including any additional cost) and materials provided up to the termination date. Entitlement will also include the subcontractor’s costs of removing plant, tools and equipment from the site. In addition, direct loss and/or damage caused to the subcontractor by the termination may be expressly covered. In practice subcontractors have little prospect of getting paid unless they press claims. The risks of becoming an unsecured creditor in the contractor’s future insolvency are high.

In common with both insolvent termination and with voluntary termination (i.e. with a termination agreement), maintaining continuity of production remains critical for the employer. It will be important for it to work rapidly to re-engage existing subcontractors with minimal disruption. But if the issue of overdue subcontractor payments is not addressed early enough, subcontractors will make alternative plans: faced with the risk of no further payments, they will bring their exposure to the project to an end as quickly as possible. 

For the employer to secure continuity of subcontract work without interruption, subcontractors need to be approached as soon as possible and before any termination is effective. If re-engaged, the new subcontract terms would be very similar, but with changes.  New pricing must be agreed taking account of amounts unpaid by the contractor, to enable subcontract work to continue as seamlessly as possible. The potential difficulty is that if and when the contractor does subsequently go in to liquidation, the employer may in effect pay twice for the same work.

If an employer has to make payments directly to subcontractors to secure continuity, the termination agreement must cover the subcontractor payments to be taken into account in the termination payment to the contractor. Changes to the main contract will need to be made so that the employer’s liability to the contractor for the value of the subcontract works is reduced and capped.

Insolvent or voluntary termination?

With less opportunity to maintain continuity and with the risk of lengthy delays, employers will want to avoid insolvent termination if at all possible. At that point at least some of the contract sum may have become unavailable to be paid to re-engaged subcontractors.

If a termination agreement is used it has to be carefully planned and drafted, so that there is no or only a limited liability to the contractor under or arising out of the contract after a termination payment is made. Importantly the agreement should present in the calculation of the termination payment a clear commercial rationale for that payment and for the allocation of funds to facilitate continuity of progress.