The majority of the building and engineering contracts that we encounter (and draft) require some form of performance security from the contractor, whether this is a parent company performance guarantee granted by the contractor's ultimate holding company, or a performance bond granted by a third party surety or a bank for a capped sum. Indeed most, if not all, standard form contracts provide for these forms of security, even if only as an option.

Previous articles have discussed the merits of these and it is pertinent to note that there is typically no express cost for a parent company guarantee, whereas the cost for a bond varies, depending on the value of the project and covenant of the contractor. The cost of the bond is usually borne by the employer as it is included within the total contract sum.

The main reason for procuring these forms of security is obvious – to provide some protection for the employer against the insolvency of the contractor. But while there have unfortunately been many contractor insolvencies over the years - it is important to remember that it is not only contractors or sub-contractors in the construction chain who can become insolvent.

Employers and funders will carry out diligence in relation to the financial position of the contractor before appointment, looking at the last few years' accounts, obtaining credit reports and considering market information. That diligence feeds into consideration of what performance security is required.

A similar level of diligence is not always undertaken by contractors around their potential employers.

We are, however, now seeing an increase in the number of contractors looking for reassurance of the employer's ability to make payments under the contract. Some of these requests may be due to the fact it is common for developers to set up a SPV (as employer) for each development which may have no other assets other than the site in question, and the site may likely be subject to a security held by a bank.

Contractors often have to order long lead items well in advance of the time when payment will be due and cancellation terms may not always be favourable. Depending on the payment terms, a contractor could have incurred potentially two months of costs in terms of work in progress and materials ordered, before payment is due.

If an employer were to become insolvent in the intervening period before payment is made, there are some protections available to the contractor in terms of requirement to make payments to sub-contractors when the employer becomes insolvent, but the contractor will clearly be significantly out of pocket and likely incur further losses.

Importantly, the new section 233B of the Insolvency Act 1986 (introduced by the Corporate Insolvency and Governance Act 2020) restricts the ability of a contractor to terminate, and also more than likely suspends their engagement under a contract, as a result of the employer's insolvency. It is therefore now more important than ever for the contractor to have security for payments due under the contract, or at least the ability to monitor the employer's financial position so that it can take preventative action prior to the insolvency of the employer, to minimise its exposure.

So what options are available to the contractor in terms of mitigating the impact of employer insolvency? This will depend on circumstances, but recent requests from contractors we have seen include:

  • A request to exhibit up to date financial information for the employer's entity (or employer group), which would include more recent information than what is available on Companies House
  • Provision of a payment guarantee (from the employer's parent company or another company in the same group as the employer)
  • A confirmation statement from the employer's bank that funds are available for the project (albeit that this is likely to be heavily caveated)
  • Provision of evidence on a regular basis or when requested that the employer has sufficient funds in its account to cover the contract sum (or at least the next couple of months' payments) with the latter being linked to an ability of the contractor to suspend works if this evidence is not provided timeously.

There is also the option of an escrow account, which is essentially set up to ringfence funds payable for the works carried out. However, our experience is that these are still not frequently used – they require substantial administration to set up, and there is a cost for operating the account and paying the escrow agent to administer. These arrangements are also complicated by the fact that depending on how they are set up, they may not provide protection for the contractor in the event of the employer becoming insolvent - unless there is a trust established in favour of the contractor.

When it comes to payment security for contractors, there is no one-size-fits-all solution, and what an employer can and will provide and what a contractor is able to accept, will depend on the circumstances of the project.

What is clear is that contractors are no longer hesitant to question the financial standing of their employers and sources of funds for projects on which they are embarking.

Contributors

Kirsteen Milne

Legal Director