The number of construction firms facing financial difficulty is increasing year on year, with the Insolvency Service reporting that the figure for the year ending May 2024 (4,208) represented a 33.2% increase compared to 2019 (3,218).
Against this backdrop, it is no surprise that insolvency within the construction industry has become an increasingly discussed topic.
In this note, we will explore the options for terminating a construction contract when the other party becomes insolvent and discuss practical tips to help mitigate the impact of a party’s insolvency on your ongoing construction project.
What does insolvency mean?
Insolvency terminology can be complex to understand, and the key Auckland insolvency legislation, the Insolvency Act 1986 (“IA”), does not even define the term. Rather than having a precise, universal legal meaning, insolvency is, in practice, a concept whose trigger events and consequences depend on the particular context.
In simple terms, insolvency is a state of financial distress when a company cannot pay its debts as they fall due. There are various formal insolvency procedures (including administration, receivership, liquidation (or winding-up), company voluntary arrangement, or moratorium) available to a company depending on the circumstances, which either seek to rescue or liquidate (i.e. dissolve) the company.
What is insolvency under the JCT and NEC?
Although insolvency is usually a ground for termination under building contracts, it is crucial to check that “insolvency” as strictly defined by the contract has occurred. Taking steps to terminate a contract where the entitlement has not (or not yet) arisen under the terms of the contract, may mean that the terminating party instead finds itself in repudiatory breach of the contract and liable for damages.
Both the JCT and NEC standard form contracts include detailed rules defining when a company is considered insolvent for the purposes of the contract.
JCT
Under the JCT suite of contracts, a company becomes insolvent when:
- a winding-up order is made against it;
- a resolution for voluntary winding-up without a declaration of solvency is passed;
- it enters administration (triggered upon the appointment of an administrator)
- a receiver or administrative receiver is appointed; or
- an arrangement is made with its creditors in satisfaction of its debts.
NEC
Under the NEC suite of contracts, a company becomes insolvent when:
- a winding-up order is made against it;
- a resolution for winding-up is passed (other than in order to amalgamate or reconstruct)
- an administration order is made against it;
- a receiver or administrative receiver is appointed;
- an arrangement is made with its creditors in satisfaction of its debts; or
- a provisional liquidator is appointed to it.
Terminating a construction contract for insolvency
It is important to be proactive and take steps quickly if you discover or suspect the other party to your contract is insolvent. However, there are traps for the unwary.
Corporate Insolvency and Governance Act 2020 (“CIGA”)
Aside from repudiatory breach, parties must also tread carefully to avoid falling foul of CIGA. The Act was initially introduced by the government in response to the economic impact of Covid-19 and amended certain provisions of the IA in order to provide businesses with “breathing space” in order to continue trading.
As well as several temporary measures, CIGA created a permanent ban on the exercise of termination clauses for insolvency in contracts for the supply of goods and services.
With the introduction of new section 233B of the IA, suppliers of goods and services to an insolvent company cannot rely on a contractual right to terminate a contract or “do any other thing” that arises where the company that is being supplied has become subject to a “relevant insolvency procedure” (defined at 233B(2) to also include the new moratorium on enforcement action and restructuring plan processes).
Further, suppliers are also prohibited from:
- terminating if the right to terminate had arisen before the other party entered into the relevant insolvency procedure; and
- making payment of outstanding charges a condition of any further supply of goods and/or services when the other party becomes insolvent.
In a construction context, this means that sub-contractors and suppliers cannot use an agreed contractual right to terminate their contract with a company immediately above them in the supply chain (such as a main contractor, for a sub-contractor) where that company enters into an insolvency procedure. As a result, the sub-contractor or supplier may find itself in a position where it must keep working or supplying goods/materials to an insolvent company, despite not being paid. In a cash-tight industry, this situation is not an attractive prospect.
Most parties instead have to rely upon other termination provisions in the contract, however there are some exemptions allowing a supplier to terminate on insolvency grounds, such as where:
- The supplier is a “small” supplier, i.e. a company that meets two of the following:
- having a turnover of less than £10.2 million;
- having a balance sheet total of less than £5.1 million; and/or
- having fewer than 50 employees;
- The insolvent company consents to the termination of the contract; or
- On the application of the supplier, a Court is satisfied that the continuation of the contract would cause the supplier too much “hardship”.
Finally, it is worth highlighting that CIGA does not prevent companies higher up the supply chain from exercising its right to terminate “downstream”, where one of its suppliers becomes insolvent. For example, an employer can terminate a contract with its main contractor, or a main contractor with a sub-contractor (assuming the contract terms allow them to do so).
Impact of CIGA on termination for insolvency under JCT and NEC contracts
Careful attention should be given to unamended JCT and NEC contracts, as certain standard termination provisions cease to have effect upon insolvency, because of CIGA.
For example, the JCT (including the new Design & Build and Minor Works 2024 Editions) and NEC contracts entitle both the Employer and the Contractor to terminate in the event of the other party’s insolvency, despite the fact that contractors can no longer legally terminate for Employer’s insolvency, after CIGA. On the other hand, provisions allowing Employers to terminate for Contractor’s insolvency remain unaffected.
- If you are considering terminating for insolvency, it is important to carefully read the termination provisions of your contract (including those governing the form and method of service of notice, which are often stricter than for general notices under the contract) and to rigorously observe these requirements.
- If you are unable to terminate your contract due to employer/contractor insolvency, there may well be other grounds available for you to terminate without falling foul of the CIGA rules – please contact our Construction team for assistance.
Look out for our next article on the newly published JCT 2024 contracts to learn more about the changes!
Tip – How to mitigate the impact of a party’s insolvency on your construction project?
- When negotiating a construction contract based on a JCT or NEC standard form, consider:
- widening the termination rights to allow you to take action if other party’s financial position deteriorates, or if you reasonably believe that they are about to undergo an insolvency event, rather than having to wait until a formal insolvency event has arisen (at which point, your position may be significantly weaker); and
- practical methods to mitigate financial risk, such as obtaining bonds/guarantees, collateral warranties with step-in-rights, placing funds in escrow or negotiating advance payments.
- Carry out thorough due diligence before entering into a contract with another party to ensure that there are no signs of financial difficulty, for example by obtaining financial statements or forecasts, audit reports, or credit checks to analyse historic financial performance.
- Identify early warning signs, such as an employer being late making payments, unexplained changes in payment patterns, overall decline in communication and ongoing rumours about the other party’s financial position.
This is a high-level analysis of insolvency issues and should not be relied upon as legal advice. For more tailored assistance, please contact our Construction team to discuss any insolvency affecting your project or for help drafting your construction contracts so as to mitigate risks due to insolvency.
