Insolvency in Construction Contracts

Commercial Management and Dispute Resolution - Insolvency

Understanding Breach of Contract

A breach of contract, including subcontracts, occurs when a party fails to comply with an obligation set forth in the contract terms. While most contracts address breaches, not all breaches lead to termination. A material breach is a serious event that allows the aggrieved party to consider terminating the contract, citing specific contractual obligations. In contrast, a non-material breach allows the contract to continue, with the issue being rectified under its existing terms.

In construction contracts, contractor breaches often involve defective work. For example, a party might complete all required tasks, but the work contains defects. Such defects can be deemed a failure to carry out contractual obligations. In these cases, the defective work might be covered by a bond, or the additional cost of completing the works could include rectifying these defects. Further guidance on this can be found in the RICS guidance note Construction security and performance documents.

Repudiation (Non-Contractual Termination)

Repudiation occurs when a party commits a breach so serious that it entitles the other party to treat the contract as immediately terminated and to claim damages for loss and/or expense. Whether a breach is deemed material or non-material in this context depends on its severity, effect, and whether it pertains to a core contractual obligation.

Clear instances of repudiation include:

• Abandonment of the site or removal of plant by the contractor.

• Refusal by a party to carry out work.

• Employment of other contractors to perform the same work.

• Denial of access by an employer to the site.

Some breaches may not be explicitly defined as repudiatory and are open to interpretation. If a party wrongly treats a non-repudiatory breach as repudiatory, that party will have committed wrongful termination and will itself be in breach of contract. In such ambiguous situations, it is often advisable to exercise a clear contractual right to terminate rather than claiming repudiation, as this might result in a lower level of damages.

Termination of Construction Contracts

Termination of a construction contract can happen when one party breaches the contract terms. Termination can be either voluntary or involuntary. Voluntary termination occurs when parties mutually agree to end the contract, or when one party unilaterally ends the agreement. Involuntary termination can be caused by insolvency, where a party lacks sufficient assets to cover its debts or cannot pay them when due.

In all termination scenarios, contract clauses must be followed diligently. Incorrect termination can lead to repudiation, where the terminating party is found to be in breach.

Contractual Rights for Termination

If a contract lacks specific termination provisions, parties must rely on common law, which allows termination only for a material breach.

• Contractor's Rights: Contractors are typically granted the right to terminate or suspend work if the employer fails to pay undisputed amounts after receiving notice and an opportunity to remedy the situation. If the amount is disputed, expert advice may be needed for a secure position. Contractors may also have a contractual right to suspend obligations for other material breaches by the employer.

• Employer's Rights: Employers usually reserve the right to terminate the contract for material breach, insolvency, or for convenience.

The Process of Termination

Contracts should clearly outline the requirements for serving notice, detailing the default(s) and the relevant clauses being relied upon. Before initiating termination, it is crucial to seek legal advice. The Contract Administrator (CA) can advise the client on relevant clauses, gather necessary information about a breach, and prepare the correct notice. The termination process can be emotional, frustrating, and disruptive, making strict adherence to contractual procedures vital. For any termination (voluntary or involuntary), the reasons must be clearly stated in the termination notice. If no notice is contractually required (which is unusual), it is still advisable to describe the breach(es) with as much detail as possible.

Express Provisions in Contracts

Express provisions within the contract or subcontract typically grant a party the right to terminate. Following a breach, the CA must strictly follow these established procedures. A common procedure involves writing and dispatching a formal notice. If the breach is not rectified, the party who issued the notice then issues a financial statement detailing the financial situation and the sum due. The other party may contest this notice and statement if they believe the breach claim is incorrect. Associated tasks include document preparation, final account information, site security, and considering alternative contractor tenders.

If a contract termination is deemed incorrect (a breach of the termination provisions), the other party may be entitled to claim for loss and/or expense. For instance, a material breach like non-payment of an interim application might occur, even if the contract isn't specific on this point. In such situations, and generally when considering termination, legal advice is essential.

Upon insolvency, a contractor will likely be unable to continue works, effectively suspending their obligation. However, termination of the contract should not occur prior to a formal insolvency declaration, as this could expose the terminating party to a charge of breach of contract.

Avoiding Termination

Preventing contract termination through good management and proactive problem-solving saves time, cost, and the expertise required for appointing a new party. As CAs, we can suggest actions to avert termination. This requires thorough familiarity with the contract terms, both parties' obligations regarding termination, and the subsequent consequences.

Contract Frustration

Contract frustration occurs when neither party has defaulted, but unforeseen circumstances prevent the contract from being performed as originally intended. It implies that further performance is impossible, illegal, or so fundamentally different from what the parties contemplated at the contract's formation that it renders the contract void. When a frustration event occurs, the contract automatically ends, releasing parties from future obligations. However, any accrued liabilities (e.g., defects from work already undertaken and their remaining defects period) remain in place. A frustration event must be central to the contract and entirely outside what was envisaged by the parties.

Difference Between Termination and Frustration

What is Insolvency of a Party in a Construction Contract?

A company or party is deemed insolvent when it possesses insufficient assets to cover its debts or is unable to pay its debts as they fall due. Common indicators of potential insolvency include consistently late payments to creditors or the initiation of legal action by a creditor to recover an unpaid sum. The New Zealand government provides resources at https://www.insolvency.govt.nz/business-debt.

Company Insolvency Options in NZ

• Receivership: A receiver is appointed by a secured creditor to manage secured assets. A company can be under receivership concurrently with liquidation or voluntary administration.

• Voluntary Administration: An administrator is appointed to review and restructure a business with the objective of avoiding liquidation.

• Liquidation: A liquidator is appointed to investigate and deal with all business assets. This can occur through a court order (Creditor Liquidation) following an application by creditors to the High Court, or by a special resolution passed by shareholders (Voluntary Liquidation). Liquidators are typically chartered accountants or insolvency experts.

Solvent and Insolvent Liquidations (NZ)

There are two main types of standard liquidation:

• Solvent Liquidation: Occurs when there is enough money to pay all creditors, with a surplus returned to shareholders.

• Insolvent Liquidation: Occurs when there is insufficient money to pay all creditors.

Voluntary Liquidation

Voluntary liquidation can be initiated even when a company is still solvent. This typically involves members (directors) passing a resolution because the company's liabilities are deemed too substantial to allow continued trading, possibly due to an unmanageable debt. In this process, a liquidator is appointed by resolution to realize and distribute the company's assets, leading the company to cease trading.

The Effect of Liquidation on a Company (NZ)

When a company enters liquidation, a liquidator is appointed who assumes control of all the company’s unsecured assets. These assets are then sold to repay creditors. Trading companies are usually closed down, though they may continue operations for a short period to facilitate the sale of the business. Once the liquidation is complete, the company is removed from the Companies Office Register.

The Effect of Liquidation on Directors (NZ)

Directors are required to complete a Statement of Affairs form, providing information such as a brief description of the company’s history, trading details, the cause of failure, all company assets and liabilities, shareholder information, and any legal claims by or against the company. Directors must assist the liquidator in locating business records and assets and answer questions about the company. Destroying, hiding, or removing property, records, or documents is an offense punishable by fines and imprisonment. The liquidator will also investigate if directors or shareholders owe money to the company or if any offenses have been committed. Should a surplus remain after all assets are dealt with and debts and liquidation expenses are paid, it is distributed to the shareholders. The Statement of Affairs can be submitted online via Business Connect or manually.

Personal Guarantees and Effects on Employees (NZ)

• Personal Guarantees: A guarantor agrees to repay a company’s or individual’s debt if they default. If the company liquidates or an individual enters personal insolvency (e.g., bankruptcy), the guarantor must repay the creditor. Company directors frequently guarantee their company's debts and thus become responsible if the company liquidates.

• Effect on Employees: The liquidator decides if the business should continue trading for sale as a going concern. If the business closes, employment ends. Employees who lose their jobs can file a claim in the liquidation for owed salary, wages, holiday pay, or redundancy. Such claims may be considered preferential, meaning they are paid before unsecured creditors if funds are available.

The Effect of Liquidation on Creditors (NZ)

• Unsecured Creditors: Cannot initiate legal action against a company in liquidation or deal with its property without permission from the Court or the Liquidator.

• Secured Creditors: Can deal with the company's secured assets. They may choose to appoint a receiver if one hasn't already been appointed. For any shortfall, they can claim as an unsecured creditor. Any surplus remaining after secured assets are valued or sold is paid to the liquidator.

According to the Companies Act 1993, if the liquidator recovers money, the priority of payments is as follows:

1. Liquidator fees, expenses, and remuneration.

2. Costs awarded by the court to the applicant creditor.

3. Costs and claims of a creditor who assisted the official assignee in asset recovery.

4. Actual 'out-of-pocket' expenses of any liquidation committee.

5. Wages owed to employees for the four-month period prior to liquidation, and all holiday pay and redundancy payments up to a specified maximum amount.

6. Preferential taxes collected for Inland Revenue, including GST, PAYE, employee deductions for child support, and other taxes.

7. All other unsecured creditors.

Bankruptcy

An individual is declared bankrupt when a court issues a bankruptcy order against them. This order can be initiated by the individual, one or more creditors, or the supervisor of an individual voluntary arrangement. A bankruptcy order indicates the person's inability to pay debts and, with some exceptions, deprives them of their property, which is then sold to pay creditors.

Progress Reports (NZ)

The liquidator must send a report to all creditors outlining the company’s financial position at the date of liquidation. This report is due within 25 working days from the date of liquidation (or within 5 working days for a voluntary liquidation). It explains how the liquidator plans to manage and complete the liquidation. If a dividend is likely, six-monthly update reports are also required. A final report is issued at the conclusion of the liquidation. If the Official Assignee is the liquidator, creditors can access regular updates via the Insolvency and Trustee Service website after the initial report.

Appointment of a Liquidator

There are no strict requirements to become a liquidator, but several prohibitions exist. Prohibited individuals include:

• Anyone who has, in the two preceding years (2 years), served as a shareholder, director, auditor, or receiver of the company or a related company.

• Anyone who has had a continuing business relationship with the company.

• The majority shareholder, directors, or secured creditors are also prohibited from acting, unless the directors resolve prior to their appointment that the company will be able to pay its debts.

Commercial Awareness and Practical Solutions to Insolvency

Corporate Recovery

Corporate recovery is a global term for the processes and actions taken to restore an ailing company to full health. This often involves financial, restructuring, accounting, and legal advice from qualified professionals, potentially including the appointment of an insolvency practitioner. The RICS has published an insolvency information sheet offering advice on regulation and recommended actions for chartered surveyors or companies (primarily UK-focused).

Signs of Financial Problems

For contractors or subcontractors, potential signs of financial distress include:

• Work on site lacking progress or slowing without clear reasons.

• Applications for payment being grossly overvalued, or requests for account payments beyond contractual provisions.

• Unexpected claims for additional payment.

• Materials or plant not ordered/delivered as expected, or frequent changes in suppliers.

• Insufficient labor resources, or frequent changes in the labor force, suggesting non-payment or delayed payment to operatives.

• Word-of-mouth evidence or legal judgments against the party.

Pre-Insolvency Actions by the CA

• Complete Credit Check: Uncover financial difficulties, recent changes in directorships, or judgments against the company.

• Investigate Verbal Evidence: Follow up on word-of-mouth concerns with inquiries, offering assistance or expert support.

• Relaxation of Payment Terms: With agreement, consider temporarily easing payment conditions to reduce insolvency risk, provided the risk remains acceptable to all parties.

• Reletting Work to Others: Suggest that the client or contractor relet some work to other parties, subject to agreement, if it mitigates insolvency risk.

• Keeping Detailed Records: Maintain comprehensive records of transactions and events. Regular, minuted meetings with parties can formalize discussions.

• Direct Payment: Suggest direct payments to a third party, with all parties' agreement, if it reduces insolvency risk.

• Termination: If a party is in breach, consider terminating the contract. This may involve suspending the next payment. It is advisable to inform the company directors of such actions and strictly follow contractual procedures.

Claims and Valuations

Claims often follow insolvency, making strict adherence to contractual procedures crucial. This includes correctly dispatching contractual notices, with particular attention to timing and delivery method. The contract should specify notice terms; if not, advice should be sought. The CA must ensure that any set-off, contract charges, or withheld sums are properly deducted in accordance with contract terms and notice requirements.

Interim payment valuations must be fair and reasonable, not overstated. Overvaluing and paying interim amounts, only for the party to become insolvent, risks the overvalued element being unrecoverable or recoverable only after significant time and expense.

Role of Third Parties

Third parties are frequently used as a surety, meaning they guarantee to make good on a bond claim in case of default. Most construction contracts include protection mechanisms against insolvency, such as performance bonds, guarantees, and retention funds. Relevant details are in the RICS guidance note Construction security and performance documents.

Step-in Rights: A collateral warranty may include 'step-in rights', allowing a named beneficiary (e.g., a funder) to assume the role of another party. For example, if a developer becomes insolvent, the funder (as beneficiary of a collateral warranty) can step in, honor payments to the contractor and consultants, and take the project to completion. These rights are commonly invoked upon employer insolvency. It is vital to confirm their enforceability, and surveyors should seek advice if inexperienced. Similarly, collateral warranties may allow beneficiaries to step in if a main contractor or even a construction consultant becomes insolvent or commits a material breach. Beneficiaries must also be informed if the employer becomes insolvent.

If Employer Becomes Insolvent

If an employer becomes insolvent, the contractor must strictly follow contract terms and terminate if provisions allow. A new contract may be negotiated to complete the works. The contractor must decide whether to secure the site or withdraw, ensuring the site is safe until its future is determined. Subcontractors may be informed to remove their materials, assuming they haven't been invoiced and paid by the contractor, preventing trespass implications. The CA will need to issue a valuation statement to the nominated insolvency practitioner, comprising a final account and any claims (e.g., loss and expense). This statement must be accurate, detailing any retention, outstanding claims, and the effect of liquidated and ascertained damages (LADs) if applicable. This process may show a sum due to the contractor, or, less commonly, to the employer (e.g., if extensive defects are uncovered).

If Contractor Becomes Insolvent

If a contractor can no longer continue, the CA must issue the required notices, follow contractual processes and timelines, and terminate the contract. Failure to follow precise procedures could lead to a claim from the employer. The CA should issue a valuation statement detailing the current status of the works, outlining all risks, liabilities, and claims. If outstanding works remain, a tender process might be necessary to complete the project with an alternative contractor, or the services of an alternative contractor could be novated.

If Subcontractor Becomes Insolvent

Typically, the contractor or subcontractor will send the necessary notice(s) to the insolvent party, assuming preventive measures like relaxing payment terms or holding discussions have already been attempted. The contractor or subcontractor usually has the right to terminate if the insolvent party fails to perform under the contract, including design, goods, or services, or fails to perform regularly and diligently. An insolvent party often falls into one or both of these failure categories.

Managing the Process: Timing and Termination

Effective management in insolvency situations involves:

• Advising on options for project completion.

• Advising on claim options, such as bonds, guarantees, collateral warranties, loss and/or expense, prolongation, disruption, overvaluing of works, professional indemnity claims for consultants, extensions of time, and liquidated and ascertained damages.

• Obtaining and collating design information, specifications, and drawings, and any technical advice or reports on installed work.

• Advising on the creation of a schedule of defects at the date of termination, which may involve intrusive investigation if work quality is suspected.

• Sending inquiries and obtaining competitive quotations for defect rectification.

• Liaising with the insolvency practitioner.

• Advising on the maintenance or risk of lapsing professional indemnity insurance.

• Writing and issuing a notional final account and a completion final account.

• Completing general project administration, including financial monitoring and re-tendering.

Managing the Process: Preparation of Reports

The CA may need to prepare various reports in an insolvency situation. This includes an account that assesses the party’s liability to the insolvent company and details the contract's implications. The notional final account, which recognizes costs incurred at the time of insolvency and builds upon that to show the cost to complete, may be higher than the anticipated final account before insolvency. The difference between this amount and the original contracted sum to complete is typically a debt due to the additional costs associated with appointing a new party.

The completion final account is, in effect, the contract's final account. Its difference from the notional final account depends on the project's nature and arising issues. It includes claims such as loss and/or expense, disruption, prolongation, and acceleration, making its timing critical. Issuing the final account after practical completion can trigger specific timing issues outlined in contract provisions, which must be complied with. It is essential to ensure the final account is complete and fully substantiated.

Managing the Process: Progress Report

A progress report should accurately record progress against the construction program. This includes:

• Commencement and completion dates, key milestones, partial handovers, and anticipated handovers.

• Procurement, monitoring, and subletting of subcontracts for work and material supply.

• Claims compilation, submission, and likely outcome.

• Extension of time (EOT) claims granted or pending to establish any deficit.

• Preliminaries, site setup, and scaffolding.

• Health and safety, identifying areas needing detailed records.

• Progress on design, drawings, specifications, and relevant documentation.

• Record keeping, including labor, site diaries, plant and materials on and off site.

Managing the Process: Defects Report

A defects report is necessary if, upon contractor insolvency, visual or physical (intrusive) checks reveal that workmanship or materials failed to meet specified contract obligations. This could involve significant deviations from specifications or drawings.