The rising problem of contractor insolvency
Construction remains one of the worst-hit sectors for insolvencies, with construction firms in significant distress rising by 14% over the last year and employment in the sector at a near two-decade low. A number of ongoing factors have contributed to this including soaring costs, tighter margins, labour and raw material shortages and economic uncertainty.
The high rate of construction company insolvencies presents a threat to borrowers who risk defaulting on their loans due to delays to or incomplete developments and to lenders who seek timely and full repayment of borrowed money. A recent example includes the collapse of ISG in September 2024, one of the UK's largest construction companies which held over £1 billion worth of Government contracts, marking the biggest collapse post Carillion in 2018. Contractor insolvency should therefore be in the minds of the finance parties from initial negotiation stages to completion of the project, and the finance documents involved in a development facility should be drafted to address potential contractor insolvency and to provide workable options for lenders.
What is development finance?
Development finance involves a party borrowing money to finance both the purchase of a property and the subsequent construction or redevelopment of it. On completion of the development, the property will either be sold or used as an income-generating asset. In exchange for lending money to the developer to fund the project, the lender typically seeks security over the property itself and the developer's rights during the construction phase. In terms of drafting, there are key differences between development facility agreements and investment facility agreements, including the structuring of drawdowns, the reference points for financial covenants and the inclusion of specific undertakings as to the meeting of milestones, build-out completion dates and any overrun costs.
Identifying an insolvent contractor
In the current climate borrowers should proactively monitor contractor financial health and look out for early warning signs of insolvency. Identifying these early can be invaluable, allowing the parties to take preventative steps, put in place a contingency plan or, if unavoidable, try to minimise the impact of an insolvency. Insiders at ISG reported 'legacy issues' arising from contracts secured between 2018 and 2020 which were running at significant losses. Given that construction runs on very thin profit margins (around 2%) it can take just one other delayed project to cause serious cashflow issues. Practical on-site indicators of financial distress include reduced workers, materials or equipment on site, failure to meet milestones or an increase in building defects. Parties should also look out for financial and legal red flags including requests from contractors for early or irregular payments, assignment of contract proceeds to creditors, late filings at Companies House or complaints of non-payment from subcontractors.
To find out if a contractor has entered formal insolvency proceedings, Companies House or the Law Society Gazette can be checked. For the most up-to-date checks, lawyers should be instructed to search court records for insolvency filings by the contractor or its creditors.
An insolvent contractor will be subject to the provisions within the Insolvency Act 1986 (IA 1986); the Insolvency Rules 2016, SI 2016/1024; and the Corporate Insolvency and Governance Act 2020 (CIGA 2020) and may find itself in one of the following procedures: administration; receivership; liquidation; a company voluntary arrangement (CVA); or a moratorium.
Practical steps for borrowers
Where a borrower is faced with an imminent contractor insolvency, there are a number of practical steps that borrower can take. While the appropriate steps are highly fact-specific and must be carefully considered in all the circumstances, potential steps could include the following:
- in advance of an insolvency:
(i) maintaining adequate records
(ii) procuring appropriate insurance
(iii) reviewing warranties (as discussed further below)
(iv) procuring financial protections (such as performance bonds or parent company guarantees)
(v) completing due diligence on the contractor's position
(vi) completing site audits
(vii) monitoring payments and
(viii) ensuring any pay less notices are issued correctly;
- immediately following an insolvency:
(i) considering any available 'step-in' rights under warranties
(ii) making appropriate notifications under insurance policies before they are cancelled
(iii) securing site materials and preparing detailed valuations of works
(iv) considering termination of the contract (and any related notices) and the appointment of a replacement contractor and
(v) ensuring an appropriate dialogue with administrators.
It should be noted that these are not exhaustive lists but serve as an indication of potential measures that may be taken by a borrower in these scenarios.
Remedies available within the finance documents
In addition to such practical steps that may be taken by the borrower, throughout the project, related finance and facility agreements should be checked by both borrower and lender to identify the contractual effect and both parties' rights in the event of a contractor's insolvency. Typically, the finance documents will be drafted to include a suite of provisions which address contractor insolvency, and which are discussed further below. Once the lender has identified the rights available to it, the route preferred will depend on the factual circumstances involved. However, in less stable economic climates and property markets, lenders tend to be more likely to renegotiate terms, offer covenant waivers or amend covenants. This allows a lender to avoid calling defaults to find solutions with borrowers to avoid further financial distress.
Has there been an Event of Default?
The primary concern for the parties is whether the contractor insolvency constitutes an 'Event of Default' under the facility agreement (Event of Default). In development finance, the inability of a main contractor to pay its debts as they fall due, its insolvency or formal administration proceedings each do usually constitute an Event of Default and will generally be tied to a material company such as the contractor, rather than solely the 'Transaction Obligors' or the sponsor. If an Event of Default has occurred, the lender can exercise its rights under the acceleration provision and choose to refuse further funds, demand repayment and/or enforce security. However, the commercial reality is that a lender will not usually want to enforce its security over an incomplete development as an incomplete development does not benefit any party.
If the contractor has become insolvent but the loan is otherwise performing or the contractor has not yet entered formal insolvency proceedings, an Event of Default may not yet have occurred. In these cases, the best option may be the lender working with the borrower to find a replacement contractor, assisting in completion of the development, and preservation of value. Where the contractor is to be replaced, the lender should check the facility agreement to confirm the borrower's timeframe for replacing the contractor before an Event of Default is triggered. The lender should also remind itself of its rights of approval. If no cure rights apply (see below), the lender should preserve its enforcement rights by way of a reservation of rights letter which cites the breach(es) and is served on the borrower in accordance with the notice provisions in the facility agreement.
However the parties decide to proceed, they should communicate clearly to plan the next steps to be taken which may include completing the work or engaging alternative contractors or subcontractors. It is important to note that the lender will need to provide its consent to any new or varied contracts.
Cure rights and workout strategy
Facility agreements often contain 'cure rights'. These enable the borrower to either prepay the loan, for example by reducing the loan-to-value (LTV) ratio below the level of the relevant covenant or to grant further security to remedy the breach. There will usually be a time limit and a maximum number of times across the loan that the borrower can exercise its cure rights. If cure rights do not apply, a lender can use the acceleration option.
Alternatively, the lender may take a 'workout strategy'. This may allow the borrower to:
- repay part of the loan early to reduce the outstanding balance of the loan and therefore lower the LTV ratio
- agree that the borrower will pay an increased rate of interest throughout the period of default
- require the borrower to grant further security or
- renegotiate the terms of the facility through an amendment.
Rights under security documents
The lender may choose to use its rights under the suite of security documents to safeguard its interests (eg performance bonds, advance payment bonds, and parent company guarantees). These rights may be exercised alongside the lender's rights under the facility agreement itself.
Remedies available within the construction documents
Right to terminate
The borrower should check the building contract for termination clauses and ensure the definition of 'insolvency' under the contract is met. If the definition is not met, the borrower itself could be in breach of contract by terminating the agreement. Alternatively, the borrower may consider if it has any other grounds on which to terminate the contract (noting that this is often a high-bar). Common law rights of termination for repudiatory breach may also apply.
If the borrower's right to terminate the building contract has arisen, the borrower should look to:
- check notice provisions in the contract
- hire site security
- arrange insurance to cover the works and site and
- review its collateral warranties and step-in rights which would allow it to assume the contractor's obligations.
If the contractor is insolvent but the borrower does not exercise any rights of termination, the borrower may need to novate or assign building contracts to the insolvent company's administrator.
It is important to note that CIGA 2020, s 14, inserted section 233B into the IA 1986, which is relevant to any contract termination by sub-contractors. The provisions of this section apply where the main contractor under a contract for the supply of goods or services becomes subject to a relevant insolvency procedure (IA 1986, s 233B(1)). This means that the sub-contractor cannot terminate the contract unless the insolvent contractor either consents to the termination or the sub-contractor can satisfy a court that continuing the contract would cause it 'hardship'.
Collateral warranties and step-in rights
It is a general principle of contract law that only a person who is party to a contract can bring a claim under that contract (excluding situations arising under the Contracts (Rights of Third Parties) Act 1999). In contract law, the employer of a contractor (ie the developer/borrower) can bring a claim against that contractor under the relevant building contract. However, once a development has been completed, the developer will likely have transferred its interest in the property to a purchaser or tenant. If a defect arises after this transfer, that purchaser or tenant is not party to the contract so would have no cause of action in contract against the party at fault. Collateral warranties seek to address this contractual gap: they sit alongside the primary contract and give the third party a direct way to bring an action against the warranting party. Lenders will therefore require a warranty so that they can make a claim against the construction parties in the event of defects or defaults and to recover the borrowed money by selling the development.
Step-in rights give the beneficiary of the collateral warranty the ability to step into the shoes of another party, who is party to the underlying contract in specific circumstances including where the right to terminate or a default has occurred. They prohibit a construction party from terminating its employment contract with the borrower without notice to the beneficiary of the step-in rights and once notified, have 20 or 28 days in which to decide whether they intend to step-in and replace the defaulting party.
Other remedies available
Aside the remedies available under the finance and construction documents, other steps may be taken by the parties involved in a construction project to safeguard their interests. These measures may include:
- applying funds held in a project bank account, which are held on trust and ringfenced from the estate of the insolvent company, to pay sub-contractors, encouraging completion of work
- making use of statutory rights such as the Third Parties (Rights Against Insurers) Acts which may assist a party to a construction contract to make a claim against another party's insurer directly where the defaulting party has become insolvent. For example, where latent defects have arisen after the works are completed but by which time the contractor has become insolvent and such defects are covered by the insurance policy.
Concluding thoughts
Construction insolvencies are on the rise posing risks for borrowers and lenders. Various provisions within the finance and construction documents and generally at law can help the parties to mitigate the impact of contractor insolvency. In the unfortunate event that it does happen, the parties should review the terms of their construction and finance documents as to their respective rights, notice and replacement periods and, if necessary, seek legal advice. One anticipated development which may assist with addressing the issue of such insolvencies is the Government's proposed legislation to tackle the issue of late payments. The legislation aims to do the following: prevent parties from being able to force suppliers to agree to longer than the private-sector 60-day payment cap, with a potential reduction to 45 days; enforce the 8% interest payable on late payments; introduce a 30-day deadline for disputing invoices; and either ban retention clauses (which could give rise to retentions by other names) or require withheld sums to be protected in trust or in surety bonds (which would ringfence funds in cases of insolvency). It will be interesting to see if such legislation, if and when implemented, assists the construction industry, in particular SMEs and in turn assists lenders in the real estate development market.
Find out more
To discuss the issues raised in this article in more detail, please contact a member of our Banking and Finance or Construction team in London.
