Stopping the dominos

So far, the construction industry has led a charmed life. It is more than 10 years since an FTSE 100 company became insolvent (Polly Peck in 1990). However, the recent collapse of Enron and the dramatic fall in the share price of Marconi and other large companies suggest that the next major domestic insolvency may not be far off. Accordingly, it's a good time to look at how companies can best protect themselves against the "domino effect" of the insolvency of other parties in the contractual chain.

Parent company guarantees: Any party entering into contract with a subsidiary of another company can seek a guarantee of that subsidiary's payment obligations from its parent company. Although this is useful if the client is a special purpose vehicle established for a particular development or project, it will be of little use if the client's group of companies, including the parent, were to become insolvent. In practice it is extremely rare for a parent to survive the insolvency of a major subsidiary.

Performance bonds and bank guarantees: Performance bonds are a popular way of guarding against contractor insolvency. The purpose of a performance bond is to provide the beneficiary with access to immediate funds should the party procuring the bond be in default under its contract, primarily to pay the costs of engaging a replacement contractor in the event of the original contractor's insolvency. Unfortunately, it is necessarily the case that the less creditworthy the contractor, the more expensive the bond. There are two types of performance bond: on-demand and proven default. On-demand bonds are essentially letters of credit, which means that the party calling the bond does not have to prove that the contractor is in default or that he has suffered a loss (as is the case with proven default bonds). As a result, proven default bonds are unpopular as the party calling the bond may have to go to court before a call can be made. However, proven default bonds are usual in UK developments and care must be taken to ensure that insolvency is expressed to be a ground for calling the bond.

Direct payments and trust funds: Specialist subcontractors' lobby groups have long sought to protect their members against the insolvency of main contractors by including a clause in standard form main contracts that would allow the employer to pay subcontractors directly in the event of the insolvency of the main contractor. However, in light of the British Eagle¹ case, such clauses may be ineffective. That is because a direct payment by the client to a subcontractor in the event of the main contractor's insolvency could result in the client also having to pay the liquidator. One of Sir Michael Latham's recommendations on insolvency was that the Insolvency Act 1986 should be amended to solve this problem.

However, the government considered that the use of trust funds, Latham's alternative recommendation, should be adopted. A client may be required to set up a trust fund. At the beginning of each payment period the client would pay the anticipated amount due at the end of the period into the fund. In the event of the client's insolvency, the trustees would then pay the main contractor. In the event of the insolvency of the main contractor, the trustees would then pay subcontractors directly for work done and materials supplied. However, the government refused to introduce trust funds without further consultation, and has yet to do anything about it.

Insurance: Bad debt insurance is available to companies. However, insurance is unlikely to be an adequate solution to the risk of insolvency given that: it is not something that has been widely used in the construction industry, the additional costs of such insurance to main contractors and subcontractors could result in their tenders becoming uncompetitive and the scope of such cover is often very restricted.

While bonds, guarantees, step-in clauses and insurance give some degree of protection, trust funds and permitting direct payments are better solutions. However, in the absence of action by the government, parties will continue to have some degree of insolvency risk.

¹ British Eagle vs Air France [1975]