Our third article on the legal implications of the downturn looks at what happens when a main contractor risks going bust and a client wants to pay its subbies directly

Two weeks ago Henry Sherman considered developers’ difficulties in mothballing or cancelling projects. But the developer who wants to complete its projects may have another headache: what to do if its contractor looks like it might go insolvent?

It is hard forcing a failing contractor to perform and equally hard to say when its delays justify terminating its employment or the contract.

The developer that waits too long may find its problems mounting. The contractor’s replacement is unlikely to accept responsibility for latent defects, insurance against which is not cheap. In addition, subcontractors will ask the developer to pay the sums the contractor owes them as a condition of continuing with the works. That means the developer may pay twice for the same work.

Foreseeing these issues, some developers act sooner. One option is to agree with the contractor that they may pay the subcontractors direct and deduct an equivalent sum from the contractor.

Here statute begins to play a part.

A court may set aside direct payment agreements reached within six months of the onset of the contractor’s insolvency if the contractor was influenced by a desire to favour the subcontractors over other creditors. This is possible where an agreement is set up for just one out of many subcontractors.

The safest course is to ensure that the contractor obtains some benefits, such as shortening valuation periods and deferring or waiving liquidated damages. The reduced risk from the agreement of the developer terminating alone may stave off administrators and liquidators, who tend to act only in clear cases.

If the developer continues paying subcontractors, it risks paying twice for the same work

An advantage of this approach is that, should the contractor go under, it is easier to appoint subcontractors to replace it or persuade them to sign up with a new contractor. If the direct payment agreement has run for a while, the subcontractors should not be owed too much.

Unfortunately, if and when the contractor enters liquidation, the law is not as supportive as developers and subcontractors might hope. It is chiefly concerned with ensuring that all the contractor’s creditors are treated equally. Although the direct payment agreement’s wording is critical, if the developer continues paying the subcontractors it risks the liquidator invalidating the direct payment agreement. If that happens, the developer is not entitled to deduct those payments from the sums otherwise payable to the contractor. That is, the developer may indeed pay twice for the same work (unless the subcontractors agree to repay the money should the liquidator invalidate the direct payment agreement – which is not a solution from their perspective).

This may not matter where the developer is an unsecured creditor (the contractor’s parent that gave a guarantee being insolvent, too). That may be the result after debiting the additional costs of completing the works that the contractor has culpably failed to complete. Then the developer may expect nothing from the contractor’s liquidation and so the loss of a deduction from any notional sum it owes the contractor is meaningless.

The developer with good security (say a bond from the contractor’s bank) is more likely to suffer should it persist with paying subcontractors. The value of its claim against the bondsman will not increase insofar as it pays the subcontractors under an invalid direct payment agreement.

As for subcontractors, when a contractor goes insolvent, payment for work done is usually at the developer’s discretion. In such circumstances, in many countries subcontractors may pursue the developer for payment or register a charge against the land.

In 1994 Sir Michael Latham recommended changing the law to permit direct payment agreements to operate after a contractor enters liquidation. However, the Construction Act 1996 said nothing and in March 2005 the government confirmed that it did not intend to change the law.

As for Latham’s recommended use of trust funds, in recent times state organs have endorsed project bank accounts, which facilitate direct payments. However, progress has been slow and it remains to be seen whether economic conditions and the government’s promises to support construction will translate into positive action on this front.