Insolvency is something we are seeing a lot of at the moment but most contracts don’t deal with the void between being insolvent and being declared insolvent

In the wake of the recession, one situation that continues to crop up frequently is that of outstanding payments due at the point of contractor insolvency.

Most standard form contracts do not cover the common situation where a contractor is, to all intents and purposes, insolvent but has not yet entered an official state of liquidation or administration. What happens on site during the weeks running up to such an event causes employers real headaches in terms of payments due, unless specific amendments have been made to the contract to address this risk.

Under the Construction act, once a sum is certified, payment must be made, unless a withholding notice is issued: there is no workable defence. But an employer will be reluctant to pay a contractor that has gone under, for obvious reasons. What will have to be spent getting a project back on track with a replacement contractor will far outweigh anything currently owed.

Construction law practitioners will be familiar with the case of Melville Dundas Ltd (in receivership) vs George Wimpey Ltd. The House of Lords decided that there was nothing in the Construction Act that prevented parties to a construction contract from agreeing that, in certain circumstances, an installment payment can cease to be payable.

The contractor may look insolvent but may not actually be ’insolvent’ within the definition in the contract

The clause in question was clause of the 1998 JCT WCD which provides that in the case of termination due to insolvency of the contractor, requirements for “any further payment … shall not apply”.

Armed with such a clause, you can terminate immediately and make no further payment, even if a withholding notice has not been served.

The problem is, matters are rarely this straightforward on site. Rumours may have been circling for some time amid warning signs of corner-cutting and cash-flow problems. In this context, news of a winding-up petition being served on the contractor (and this can happen some weeks before a court decides whether to order a company to be wound-up) can give its entire workforce, along with its subcontractors, very real concerns about getting paid themselves. Often they will simply abandon site, taking their unused materials with them.

The contractor at this stage may well look insolvent, and even smell insolvent, but may not actually be “insolvent” within the definition in the contract. The JCT suites define insolvency as entering into an arrangement with creditors, or having a winding-up order made, or appointing an administrator. All are definite acts or states of insolvency.

What normally follows a walk-out is a hiatus of some weeks while the contractor negotiates with its shareholders/funders/creditors. More often that not, this is followed by an event of official insolvency.

Meanwhile, the employer has to make a decision. If it waits for “official” insolvency it can terminate the contract and make no further payments. But if the final date
for payment has passed, the employer will be in breach itself for non-payment. This is especially an issue if the employer had been intending to call on a performance bond or similar as employer breach may invalidate a bond.

When the changes to the Construction Act come into force in October, section 111(10) commits to statute the principle, derived from Melville Dundas, that parties can create a contractual exception to payment obligations in cases of insolvency. However, this will only assist if the insolvency occurs between the date a counter notice should have been given and the final date for payment. This change is undoubtedly an improvement, creating certainty around the exemption to payment obligations. But it does not address situations of insolvency limbo where neither party is clear of its rights and obligations.

Specific clauses or amendments can be included in contracts in order to address the risk of this situation. One way this can be done is by widening the definition of insolvency to include situations where there is evidence that the contractor’s solvency will jeopardise completion of the project.

With recent reports predicting that 2012 will be yet another tough year for the construction industry, this situation will continue to crop up for some time to come.

Rebecca Shorter is an associate solicitor at Maxwell Winward

This article was originally published under the headline ’You say tomato’