INSOLVENCY

What is insolvency?

This is when an individual or a company is unable to meet its liabilities as and when they
become due, it therefore does not mean that the debtor has virtually no assets nor does it mean
that the creditors will not receive payment in full.

According to- section 132 of the Insolvency Act of 1986. Insolvency occurs when a corporate
entity is unable to pay its debts

There are tests to check for insolvency:

 The cash-flow test (whereby the company is judged to be insolvent if it cannot pay debts
as they become due)
 Balance sheet test (this examines the value of company’s assets in relation to the
amounts of its liabilities, then the company will be deemed insolvent)

A person is insolvent if his or her liabilities (debts) are greater than his or her assets. For legal
purposes, a person whose liabilities are greater than his or her assets will only be treated as
insolvent once his or her estate (in other words his or her collection of assets and liabilities) has
been sequestrated by the court. A sequestration order is a formal declaration that the debtor is
insolvent. The debtor him- or herself can apply to court for a sequestration order (voluntary
sequestration). Alternatively, the debtor's creditors, (persons to whom the debtor owes money)
can apply to court to sequestrate the debtor (compulsory sequestration).

Voluntary sequestration

This is when the debtor him or herself apply to court for the acceptance of the "surrender of his
estate". A court can accept the surrender of a debtor's estate and grant the sequestration order
only if it is satisfied that - the debtor's estate is in fact insolvent (in other words liabilities exceed
assets), the debtor's estate will be able to pay for the costs of sequestrating the estate, and
sequestration will be to the advantage of creditors.

There are also some formalities which have to be followed. Even if the court is satisfied that the
requirements set out above have been met and that the formalities have been followed, the court
may still refuse to give the sequestration order. Factors which may influence a court to refuse an
application include

 That the debtor's aim in applying to have his or her estate sequestrated is to avoid paying
a particular creditor or to prejudice the rights of a particular creditor
  That creditor are not in a rush for payment and are prepared to give the debtor time to
pay or are willing to accept payment in installments.

Compulsory sequestration

This is when the debtor's creditors, (persons to whom the debtor owes money) can apply to court
to sequestrate the debtor. An application for compulsory sequestration is made by one or more
of a debtor's creditors. A court may grant an application for the sequestration of a debtor's estate
if it is satisfied that:

 The applicant (i.e. the creditor) has established a claim against the debtor;

 The debtor has committed an act of insolvency or is insolvent;

 There is reason to believe that it will be to the advantage of creditors of the debtor if his
estate is sequestrated.

The law of insolvency

The law and procedure for insolvency is different, but the main statute covering insolvency law
is the Insolvency Acts 1986 and 2000. The Act improved insolvency practice by controlling
persons entitled to act as insolvency practitioners and by introducing new procedures. The aim of
the law of insolvency is to protect the creditors of the debtor, not the debtor him or herself.

If one is insolvent the court will sequestrate the debtor's estate only if sequestration will be to the
advantage of the creditors. If the insolvent debtor does not have enough assets to pay all his or
her creditors everything they are owed, a sequestration order is made such that whatever assets
the debtor does have are shared among the creditors in an orderly and fair way.

The Insolvency Act sets out the order in which creditors of a person who is under a sequestration
order are to be paid. Once a sequestration order is granted by the court, an independent person is
appointed to act as the insolvent's trustee. The trustee takes charge of all the assets of the
insolvent and has the job of working out who the insolvent's creditors are and in what order they
are to be paid. The insolvent is not allowed to increase the debts of the sequestrated estate.

The effects of insolvency are mainly governed by the provisions of the insolvency act, which are
set as follows

 When a company is unable to pay its debts the provisions of the law relating to
insolvency shall in so far as they are applicable, to be applied “mutatis mutandis”
(mutatis mutandis) in respect of any matter not specifically provided for by that act.
  In terms of the law of insolvency, the insolvent part to a contract does not as a rule
automatically terminate the contract the trustee has the right to decide whether to
abide by the contract or not

Insolvency in construction industry

Causes of insolvency

Construction projects are typically high risk with high value contracts, modestly capitalized
contractors and relatively small margins – projects and contractors rely heavily on positive cash-
flow to fund projects. On the other side reduction of construction workload resulting in
competitive tender prices, costs continue to increase worsening cash-flow that inevitably leads to
construction insolvencies, probably at an increasing rate.

The nature of construction means that insolvency of one ‘link’ can potentially have an impact on
the whole supply chain as well as the employer and consultants.

CONTRACTOR’S INSOLVENCY

Common rights of the employer when the contractor becomes insolvent

i) Right to terminate the contract
ii) Right to use materials and plant on site
iii) Right to acquire ownership of plant and materials

The employer is under no duty to pay the trustee or liquidator any monies due to be certified
at the date of determination until such time as the cost of completing the works by the other
person has been ascertained the employer is entitled to set off an extra cost incurred in
completing the works as compared with the cost of works under the contract under which the
contractor’s employment has been determined, against any monies due to the contractor at the
date of such determination

However the employer must honor any certificate prepared by the architect prior to
determination but yet not paid. An architect certificate is a liquid document and the employer
has no choice but to pay if he is to avoid being in default himself

Any additional cost in completing the works aforementioned may be deducted from the
monies due to the contractor in the form of retention payment of uncertified works or if these
are not sufficient, it may be set off against other monies due to the contractor.

Whatever the cause of insolvency, Q.S should be equipped to deal with incidence of contractor
and sub contractor insolvency
Damages resulting from insolvency can be wide spread , the cost , quality and duration of a
construction project can all be detrimentally affected as a consequence.

Looking at the hierarchy within the construction industry, the insolvency of the contractor can
affect the subcontractor and the suppliers for example, the failure of a large British contracting
company organization during the 1980 recession resulted in large chain of insolvencies of the
developer.

It is most important for surveyors to ensure that the contractors engaged on projects are
financially stable and are likely to remain stable for the duration of the contract.

A surveyor can achieve this through formal and informal checks prior to contract formation or
even prior to tender

In the event of the contractor insolvency during the course of the projects surveyors must advise
and act to protect the interest of their clients.

On insolvency the contractor’s obligation to carry out & complete the works is usually
suspended. The contractor is required to give notice of insolvency.

Typical warning signs of contractor insolvency

 Rumours – usually from suppliers/subcontractors
 Unexplained difficulties in securing labour and/or materials, etc
 Unexplained reductions in productivity
 Supplier/sub-contractor payment defaults
 Attempts to negotiate early valuations and payments and release of retention

It is critical to act only in the event of insolvency and not to ‘jump the gun’ with regard to the
particular matters and actions noted
It is important not to ‘contribute’ to the likelihood of insolvency by delaying or under estimating
valuations or certificates, which will serve to worsen any cash-flow difficulties.

Actions taken on contractor’s insolvency

It is important to act quickly following the announcement of the contractor’s insolvency the
consultant team should:
- Advise the client on contractual position as well as recommending action and advice on
his liabilities
- Advice on securing the site for 24hrs and consider hiring a security firm
- Prepare a detailed valuation of the completed works and inventory of the materials and
equipment on site
- Stop the process of any payment to the contractor
 - Check on available securities and where appropriate follow the prescribed procedures
- Keep a record of the time spent and cost incurred in dealing with and advising on the
insolvency. It is normal for additional fees to be charged in this respect.
- Preparing a schedule of defects at the date of termination as well as estimating the cost
and obtaining quotations for making good defects
- Formalizing extension of time/liquidated damages and direct loss/expense position at date
of insolvency
- The option to terminate and options for completion of the project should be considered
- The need for expert legal & technical advice should be considered
- Liaising with insolvency practitioner administering completion of the project
- Preparing the notional & completion contract final accounts

Termination

The contractor’s employment under the contract, does not usually automatically terminate on
insolvency, but may be terminated at the option of the employer
Notice in the proper form is required to avoid expensive adverse complications for the employer
and contract administrator/ architect

Payment of Contractor

The provisions requiring the employer to make further payments including releasing retention
also cease to apply from the date of insolvency until accounts have been made up after the
project has been completed or abandoned and the loss/ damage caused to the client as a result of
the contractor’s insolvency is known, identifying the balance, if any, due to the contractor.

Completion Options

The employer should consider the options in consultation with the existing project team and
additional specialist i.e. legal, accounting & technical experts.
Completion by:
1. Contractor, usually in the person of the insolvency practitioner (someone in charge of
your assets when you become insolvent), but a liquidator may disclaim. The employer’s
contractual termination rights are waived. Probably only practical where little work
remains to be done and a payment to contractor will result otherwise not attractive to an
insolvency practitioner. Future defects liability remaining with an insolvent contractor are
a risk.
2. Guarantor e.g. where an effective parent company guarantee exists with a ‘see to it’
obligation.
 3. Bondsman e.g. under performance bond usual position is that a payment is made under
the bond either ‘on-demand’ or the after works are completed and proper procedure
followed.
4. Novation to a 3rd party – an agreement between the employer, the insolvency
practitioner, the insolvent contractor and the new (3rd party) contractor – that transfers all
rights and obligations (past &future) to the new contractor. These agreements need
careful drafting to be effective in transferring pre-existing obligations especially where
design is involved. Novation is attractive to an insolvency practitioner as it achieves a
‘clean break’ but the new contractor may want a premium to take on the risk of latent
defects, etc.
5. A new contractor selected after tender/ negotiation but:
 Delay may result
 Liability for pre-existing defects, delay
 Additional cost in excess of available retention and withheld payments remains with
original (insolvent) contractor

6. Sub-contractor(s) under direct agreement(s). This is safest where original agreements

contain step-in rights and provisions/ indemnities with regard to pre-existing and future
payments otherwise employer may have to pay a premium and find such payments are held
to be void under the Insolvency Rules. The employer is then left as an unsecured creditor
having effectively paid twice. For the same reasons, care should be taken not to compromise
legitimate withholding or set-off between the contractor and suppliers/ sub-contractors

7. The employer may decide to complete the works himself.

Materials on site

Once incorporated into or affixed to the works these become the property of the employer. The
position with unfixed materials should be clarified as the general principle that the employer has
a lien over or that title vests in the employer on inclusion in a certificate or on payment may be
displaced by retention of title clauses in supply/sub-contract terms

Dawber Williamson v Humberside (1979)

If title has not transferred to the employer the owner may repossess good/materials and in the
event of wrongful use or interference a claim against the employer in tort for conversion may
result.

Materials off site

If materials off site are eligible for inclusion in certificates care must be taken to ensure that all
the contract requirements are complied with to effectively vest or transfer ownership to the
employer. Advance payment bonds should be considered. In the event of insolvency, steps
should be taken to ensure that these are safeguarded.

Contractors’ plant

The contract provides that the employer may use all temporary buildings, plant, tools &
equipment to complete the works and the contractor removes from site only when instructed to
do so.

However 3rd party ownership and/or vesting issues may arise where plant, etc is hired requiring
delivery up of plant or direct hire agreements.

Latent defects insurance

As an employer would be merely an unsecured creditor with regard to latent defects, the
availability & cost of latent defects insurance should be considered; the premium for which could
be a legitimate cost to the employer that could be set off against amounts otherwise due to the
contractor.

Accounts

Within a reasonable time after completion of the works and making good defects, accounts are to
be taken of:
1. Amount of expenses properly incurred by the employer completing the works
2. Amount of payments made to insolvent contractor
3. Amount which would have been certified if insolvent contractor had completed the
works
If the total of 1 and 2 is greater than 3 then this will be the balance/debt due to the employer
against which the employer may set-off withheld payments & retention. If there is a shortfall this
becomes a claim in the insolvency so the employer should register as a potential creditor early in
the insolvency.

The employer has a duty to mitigate loss by.

 Intelligent Procurement
 Contract Drafting
 Contract Risk Management
 Claims Management

N.B The difference between sequestration and liquidation is that sequestration is used for
personal insolvency and liquidation is used for business insolvency
EMPLOYER’S INSOLVENCY

In the event of Employer insolvency, a contractor is empowered, under clause 24, to terminate
his employment under the contract.
The consequences of termination of contract are set out and they require:
(a) The contractor to remove (and ensure that sub-contractors remove) temporary buildings,
plant, materials, etc., from the site;
(b) Where there is a contractor design portion, the contractor is to provide the Employer with 2
copies of the design documentation identified as far as it has been prepared by the contractor at
the date of termination;
(c) The contractor to prepare an account detailing:
(i) The total value of work completed and any other sums due
(ii) Sums in respect of direct loss and/or expense payable
(iii)The cost of removing temporary buildings, plant, materials, etc., from the site;
(iv) Direct loss and damage caused by the termination;
(v) The cost of materials and goods ordered and either paid for by the contractor or which
the contractor is legally bound to pay for; ownership of these materials will pass to the
Employer on payment by the Employer
(d) The difference between the account and the amounts paid to the contractor is to be paid by
the Employer within 28 days of presentation of account (no Retention is to be deducted). In
practice, termination following insolvency may make this payment unlikely. In such
circumstances the contractor will become an unsecured creditor of the Employer. An Employer’s
interest in Retention is as a trustee for the contractor.

In the JCT 05 clause 4.18.3 requires the Employer (local authorities are not bound by this
condition) to place retention monies in a separate bank account (designated to identify the
amount as Retention held by the Employer on trust) if so requested by the contractor. In the
event of Employer insolvency, the separate bank account will ensure the trust status of Retention
and should therefore protect a contractor’s right to the Retention. In the absence of a separate
account, case law suggests that a contractor may lose this right. It is, therefore, strongly
recommended that, as a matter of course for all contracts, contractors should request that
Retention be held in a separate identified bank account