The number of construction companies going bust should be a salutary warning for employers to get their construction contracts in order

Recent figures from the Office for National Statistics revealed that the number of construction companies going bust in England and Wales in 2023 reached a 30 year high with over 25,000 company insolvencies registered.  Data suggests that 2024 will be another tough year for the sector.

A nightmare scenario for any client is a main contractor going bust partway through its project, or a major defect arising in the months or years after completion only to find that the main contractor is no longer solvent.

Thankfully, clients can take steps to minimise their exposure to main contractor insolvency by getting their construction contracts in good order at the outset of their project.

Collateral warranties

It is commonplace for a main contractor to sub-contract large portions of works to a whole host of sub-contractors under various sub-contracts.  The client should obtain a set of collateral warranties from all the key sub-contractors.  The collateral warranties sit alongside the various sub-contracts and are used to create direct collateral links between the client and each sub-contractor.  Sub-contractor collateral warranties will usually contain step-in clauses which allow the client to take over the sub-contract in the event of the main contractor’s insolvency.  Moreover, if a defect arises in the works in circumstances where the main contractor is bust, the collateral warranties will give the client direct contractual recourse against the sub-contractors responsible for the defective work.  In the absence of a collateral warranty the client would need to rely on a non-contractual claim against the sub-contractor using the law of tort.  This can be problematic because the client would need to demonstrate that the sub-contractor has been negligent, and because the difference between tortious damages and contractual damages can be very significant.

Third Party Rights

Third party rights (TPRs) perform a similar function to collateral warranties, and although most clients prefer the certainty of a physical collateral warranty, TPRs are popular because rights can be conferred on the client using a simple notice, and unlike a collateral warranty nothing needs to be signed by the sub-contractor.  However, great care needs to be taken to ensure that TPRs are properly drafted in the sub-contracts, and that the notice has been properly drafted and properly served on the sub-contractor.  Like collateral warranties, TPRs provide the client with a direct contractual claim against sub-contractors for defects in the sub-contract works.  However, unlike collateral warranties, it can be problematic securing step-in rights into the sub-contracts using TPRs.

Latent defects insurance

Latent defects insurance (LDI) is an alternative way of providing protection against defects in the works.  Like collateral warranties and TPRs, LDI policies provide cover in the event of defects becoming apparent after completion, typically for a 10 or 12 year period.  The LDI policy will typically cover the cost of remedying defects, but unlike collateral warranties and TPRs, the policy won’t usually respond to claims for economic losses arising from the defect, and claims may be subject to a maximum sum insured.

Parent company guarantees

Sometimes the main contractor will belong to a group of companies, including a parent company with an interest in the main contractor winning work from the client.  It is often the case that the parent company will be willing to provide the client with a guarantee.  Under the guarantee the parent company will provide a contractual promise that the main contractor will perform its obligations to the client under the contract and provide recourse for the client against the parent company in the event of the main contractor going bust.

Performance Bonds

A performance bond is a financial product that can be purchased.  A performance bond contains a written promise from the bond provider (typically an insurance company) to pay the client in the event of a breach of the building contract by the main contractor or the main contractor going bust.  Performance Bonds are typically capped at 10% of the main contract value.  This compensation is intended to contribute towards the additional cost to the client of the main contractor going bust partway through the project, with the result that the client has to find a new contractor to finish the project.

Retentions

A retention is a percentage (typically 3% or 5%) that is held back from interim payments to the main contractor.  Half of the retention amount is released at practical completion, and the remaining half of the retention amount is released at the end of the rectification period (otherwise known as the defects liability period) which is typically 12 months after practical completion.  The main purpose of the retention is to ensure that main contractor properly completes the works and achieves practical completion, and thereafter the making good of any defects arising during the rectification period.  A well drafted main contract will permit the client to retain the retention in the event that the main contractor goes bust (resulting in project milestones not being achieved).  Main contractors assert that the widespread use of retentions is one of the reasons why so many companies are going to the wall because they create cash flow problems on top of very tight profit margins.

Speak to our specialist Construction and Engineering lawyers

Paul Brampton is the Head of Construction and Engineering at IBB Law LLP and has a degree in Civil and Structural Engineering.

If you have any questions about this blog, please speak to one of our construction team on 03456 381381 or email construction@ibblaw.co.uk.

Alternatively, contact Paul Brampton on 01895207276 or paul.brampton@ibblaw.co.uk.