How to negotiate contracts which cover your firm from insolvency

What steps can be taken during the negotiation of contracts to provide some cover in situations of insolvency, asks Richard Ward?

The negotiation of a contract for a project is understandably conducted in a climate of positive expectation and enthusiasm for that project's outcome. That climate of hope is accompanied by risk allocation either adopting a standard approach or increasingly project specific. The elephant in the room risk of insolvency is generally treated as perfectly catered for by standard provisions.

This is despite the range of issues raised by insolvency including: trigger insolvency events; practical steps on site and otherwise to be taken following insolvency; financial consequences of insolvency; dates of entitlement for payment of those financial consequences; and security for the financial compensation due.

The current climate of economic uncertainty has quite rightly focused interest on the remedies available under existing contracts in insolvency situations. Given, however, that that climate is likely to last for some time it is important to also consider the steps that should be being taken now in the negotiation of new contracts.

There is currently a fairly standard consensus on the types of insolvency event that trigger the right to determine and whether or not that is automatic or at the discretion of the other party. In respect of practical steps there is similarly general consensus on assignment of supply contracts, use of equipment and so forth.

The standard form positions are therefore generally reasonable. In respect of the financial consequences, there is less reason to rely on the standard form. When it comes to employer insolvency it is fair to say that the financial consequences for the contractor are well provided for and include:

• The value of work properly executed at termination and other amounts due under the contract.
• Direct loss and expense arising from such work.
• Reasonable costs of removal of the contractor's establishment.
• Cost of materials and goods.
• Direct loss and/or expense caused by the termination.

However, it may be that clearly setting out what is to be covered under these headings on specific projects is worthwhile. The contractor's entitlement to be paid these sums would normally arise shortly after the submission of its claim for the same.

This entitlement will be of little value unless the contractor has the benefit of some security.

Additional cost to the employer

In the case of contractor insolvency the consequences for the employer can be more far ranging and project-specific. While generally one is concerned about the additional cost to the employer of completing the works with another contractor, there are obviously other factors which need careful consideration.

These include the costs of delay and the costs of a latent defects insurance policy being required to put the employer in a position to recover the cost of defects in the work carried out by the insolvent contractor (or recover any sums payable to the substitute contractor to cover that risk).

The standard forms tend to use such phrases as "any direct loss and/or damage caused to the Employer" or "damages for delay and all other expenses properly incurred by the Employer."

There will be debates about what is covered within "properly incurred" and whether for example it would extend to premiums on latent defects. Some developers have responded to this by expressly providing for the costs of such policies to be reasonable. Similarly, while damages for delay may be recoverable, the employer would have the problem of having to establish the cost of delay unless there is agreement otherwise.

It would be of benefit to all parties to more carefully set out what it is that the employer would need to recover in the event of insolvency and when.

In terms of when the right to recover sums due following insolvency arises then the standard forms differ significantly. The JCT/ICE have the familiar approach of waiting until the works have completed and a reconciliation account before entitlement.

The NEC has an entitlement within 13 weeks of the insolvency being very often well before works are completed. That obviously has advantages in terms of cash flow timescales but considerable issues are raised in calculating entitlements at such an early stage.

In respect of security for entitlement, again there is no clear pattern established and the concerned party has to rely on a combination of retention funds, unpaid applications, work in progress and bonds and other securities. Very often, rather than a detailed assessment of the financial impact leading to an ascertainment of the required figure, security is dealt with in terms of standard practice, eg 3% on retention, 10% bonding, etc.

Similarly, is enough attention paid to when these sums are payable? Would the employer have sufficient funds available to finish the project?

A more transparent approach to the analysis of insolvency risk should enable the employer to identify what it needs to recover in the event of insolvency.

It will also allow for the costing to be identified and provided for by way of security or financial remuneration to the contractor as part of the contract price.

Richard Ward is Head of Construction at Eversheds