We are often asked by clients what contractual provisions or other mechanisms we consider effective to balance the risk of awarding construction contracts to SME firms where such firms may offer better value for money, but where they do not hold a particularly strong financial covenant or backing of a strong corporate group (unlike some household name contractors in the UK).
This is becoming increasingly important as one of the ways to protect against contractor insolvency is for clients to award multiple packages to different contractors so as to spread the risk across different contractors. With this approach, it consequently means packages are being let for smaller values than would otherwise have been the case, such that smaller contractors are sometimes the most appropriate company to undertake the work (from a cost perspective but also willingness to tender perspective).
In our view, the starting point when engaging any contractor is to carry out the necessary financial due diligence checks on the company to ensure that the client is satisfied with the company's financial health and its capability and capacity to perform the works in question (including having regard to other projects underway and in the pipeline, its bond exposure, cashflow and liabilities/debts).
Where the contractor passes this first test and the decision is made to engage that contractor, then there are a few contractual regimes to consider which provide some comfort around the contractor's ongoing financial standing and potential insolvency risks.
1. Performance bonds and parent company guarantees
When the contractor is a SME firm, we consider it unlikely that performance bonds will be readily available to such a company in the current market (or are available but will likely be cost prohibitive). However, performance bonds should always be considered as they provide third party protection (typically for 10% of the contract sum until practical completion or end of defects liability period) in the event of default or contractor insolvency.
Similarly to performance bonds, when the contractor is a SME firm, it is unlikely that such a company will be part of a larger group and so will not have a parent company that it would be valuable obtaining a guarantee from. Again, this should always be considered on a case-by-case basis as the benefit to obtaining one is that the client would have the comfort of the ultimate parent company standing behind the contractor's performance for the duration of the contractor's liability.
2. Subcontractor collateral warranties and step-in rights
Where the contractor subcontracts any part of the design or works, it would be beneficial to obtain subcontractor collateral warranties from those subcontractors. These collateral warranties would be granted in the client's favour and would include step-in rights in the event that the subcontractor became entitled to terminate the subcontract (eg where the contractor failed to pay the subcontractor) or where the client otherwise elected to step-in.
This would provide the client with direct recourse to these subcontractors in the event of a contractor insolvency (or for any other reason that recovery against the contractor was not possible or sufficient). Additionally, it would entitle the client to step-in to the subcontract and employ those subcontractors directly in the event of contractor insolvency.
Additionally, depending on the extent of subcontracting, the client could also consider sub-subcontractor collateral warranties where the client would seek greater comfort over the wider supply chain.
Were subcontractors or sub-subcontractors resistant to agreeing to grant collateral warranties, we have also seen step-in undertakings granted whereby the step-in rights would be granted without the other benefits of a collateral warranty.
3. Trade contracting / splitting works packages
An alternate or additional way of reducing risk in awarding work to a SME firm is to split the works packages into numerous packages and let them to different contractors. This means that the risk is spread amongst different contractors rather than relying on one single contractor to deliver the works. A trade contracting procurement strategy could be used to achieve this (which would include the appointment of a construction manager to manage each of the trade packages). We are seeing this approach of splitting packages grow in popularity in the current market (particularly on some residential and industrial projects) and when managed well, this procurement route can offer good value for money.
4. Retention
A consideration in any building contract is whether to apply retention (and if so, the level of retention to be withheld). We sometimes see employers utilising SMEs apply a larger retention upfront which then ramps down over the course of the works as the risk reduces.
5. Financial distress regimes
Coupled with the initial due diligence that will be carried out prior to contract signature, some contracts include regular financial reporting requirements and/or financial distress regimes which require ongoing monitoring, disclosure and corrective action plans. Failure to comply with these requirements (or breach of any financial solvency requirements) often results in a termination right arising (which while it is often a last resort, can be used at an early enough stage to mitigate losses and allow the works to be re-tendered).
Given the ever-present risk of contractor insolvency, we are increasingly seeing a focus on contractual provisions that do offer greater financial protection to a client and so it is not uncommon to see a mix (or all) of the ideas above used, particularly when SMEs are appointed.
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