Contractors' insolvency: Clean break

Work on your site has slowed to a trickle and subcontractors are complaining that they haven’t been paid for weeks. It looks like your contractor is on the verge of insolvency (if not already there).

What do you do? You might decide to cut your losses by removing it and finishing the work either by employing subcontractors directly or bringing in another contractor. However, terminating a contractor’s engagement is not always straightforward. In this article we look at some of the traps for the unwary and how you might avoid them.

Most contracts entitle one party to terminate the other’s engagement if the other is insolvent, but it is essential to check that the particular circumstances in which your contractor finds itself constitute insolvency as defined in your contract. For example, insolvency of the contractor’s group but not the contractor itself may not count.

Once you have established that your contractor is indeed insolvent and that you want to terminate its engagement, check the notice provisions in your contract and make sure you serve the termination notice in the correct manner.

Failure to take these steps may mean either that you terminate the contract when you are not entitled to or do so incorrectly.

Assuming you have followed the termination procedures correctly, what happens to your relationship with your contractor?

JCT contracts make it clear that it is the contractor’s employment under the contract that is terminated, not the contract itself. As a result the contract continues to bind the parties, and indeed the JCT forms set out in some detail what happens afterwards.

Up to a point, NEC3 is similar, as it refers to terminating the contractor’s “obligation to provide the works”.

In contrast, NEC2 simply refers to “termination”. This is likely to mean that the contract as a whole has been terminated and not just the contractor’s engagement under it. Parties have argued that this means all obligations under the contract fall away. This is not so. If it is clear that the survival of a particular obligation is what the parties had in mind then they must continue to comply with that obligation. NEC2 contains provisions that are clearly intended to deal with the consequences of termination and must therefore fall into this category.

Regardless of this issue, the parties’ rights to claim against each other for breaches occurring before termination are automatically preserved.

Difficult issues can, however, arise regarding what payments are due after termination. You may recall the House of Lords’ decision in Melville Dundas vs George Wimpey. This case considered the termination provisions of the JCT 1998 with contractor’s design form. Clause 27.6.5.1 provides that no further payments are due after termination, and the House of Lords held that this clause meant that the contractor could not claim payment for an amount that had already fallen due, despite the fact the final date for payment had passed and no withholding notice had been served. The JCT provisions were deemed to have trumped the requirements of the Construction Act in this respect. This clause has been carried forward to the JCT2005 forms (with slightly different wording) so the principle will continue to apply.

There are of course amendments to the act under consideration at the moment that will affect notice requirements. One proposal would enshrine the Melville Dundas decision in statute in a limited form. It provides that the requirement to pay a sum due by the final date for payment does not apply if the contract says the payer need not pay if the payee has become insolvent after the last date for serving a withholding notice.

Under NEC2, given that it is the contract that is terminated, the payment obligations cease to apply, except to the extent preserved by clauses that apply post-termination. Quite what happens under NEC3 remains to be seen.

Another difficulty under the NEC forms is how payments on termination are calculated. These provide that the amount is to be certified within 13 weeks of the termination based on the forecast cost of completion. This may be difficult to estimate and is likely to differ from actual costs. The employer is therefore left with a risk of shortfall.