Mitigating Insolvency Risk on Construction Projects (Part 1) - The Employer’s Perspective
Financial Services Focus
The construction sector in the Middle East is widely considered to be one of the key construction growth markets globally.
Law Update: Issue 365 - Financial Services Focus
Leith Al Ali Senior Counsel,Construction & Infrastructure
Rashed Abdel HadiParalegalConstruction & Infrastructure
The construction sector in the Middle East is widely considered to be one of the key construction growth markets globally. Countries including the United Arab Emirates and Saudi Arabia are at the epicenter of expansive construction projects in the region. Such projects are however inherently volatile and susceptible to various challenges and risks. One such challenge is safeguarding against the risk that the contracting counterparty does not possess the necessary liquidity and financing required to satisfy its obligations (including fiscal commitments) both during and post-completion of a construction project.
In this, the first of our two-part series examining the mitigation of insolvency risk on a construction project, we will briefly examine some of the key considerations and strategies Employers can deploy in order to mitigate against the risk and impact of a Contractor insolvency with a view to better safeguarding their legal and commercial position.
There are various steps an Employer can take in order to mitigate against the risk of Contractor insolvency on a construction project. One such important measure can be implemented during the procurement process and thus well before the parties have even entered into a construction contract.
Whilst it is recognized that financial issues will often arise during the project construction phase, where an Employer is procuring works by way of a formal tender, bidding process or indeed by way of single source procurement, the procurement process should be carefully managed in order to help the Employer effectively determine the extent to which a bidding Contractor has the financial capacity to execute and complete the project and satisfy its contractual commitments well beyond handover. Accordingly the relevant Request for Proposal, Instructions to Tenderers and general procurement documents/process should be carefully drafted and managed to provide for (amongst other things) a detailed suite of requirements (including information and documents needed) to enable the Employer to perform in-depth financial due diligence on the Contractor to determine its financial standing, prior to awarding the project. This should include requiring the Contractor to provide the following:
at least 3 to 5 years of the most recent audited financial statements. Such statements can provide the Employer with a more detailed insight into the Contractor’s financial solvency in the years leading up to a proposed project;
a company structure chart with details of the overall holding company structure so that the Employer can undertake market research and examine the extent to which affiliates (including its parent entity and other subsidiaries) may have previously been involved in any form of company restructuring or experienced solvency issues;
an overview of all recently completed and current construction projects as well as their completion status with a view to helping the Employer identify any delays or cost overruns that might have arisen due to the bidding Contractor’s weak liquidity and cashflow. This should be supplemented by the Employer making its own enquiries (whether by contacting referees and/or engaging with industry contacts) in order to gage the bidding Contractor’s reputation in the market; and
details of all previously settled, ongoing and threatened claims and disputes that have arisen. This can help provide the Employer with insight into previous, current and potential future financial issues including any that might have arisen from payment disputes with subcontractors and suppliers.
Inevitably however, one of the most prudent and effective ways in which an Employer can protect itself and mitigate against the risk of Contractor insolvency is by ensuring the construction contract that is negotiated and agreed between the parties contains a robust, comprehensive suite of rights and obligations which limit and mitigate against the Employer’s exposure in this regard. Therefore some of the key contractual measures that can be implemented are further examined below.
Depending on the nature, value and complexity of a project, the Contractor can be required to procure, in favour of the Employer, a performance security (also known as a performance bond or performance bank guarantee). This is a separate legal instrument, usually in the form of an unconditional, irrevocable and on-demand bank guarantee issued by an independent third party bank or other surety, which can be encashed at any time by the Employer, if (by way of example) it considers the Contractor has committed a significant breach of the construction contract and/or where the Employer has incurred or might incur losses and/or damages (which might otherwise be unrecoverable) as a result of the Contractor’s failure to execute the construction contract and complete the project in accordance with its terms due to the Contractor’s insolvency. A separate but related point to note is that where an advance payment is being made by the Employer, it should ensure this is secured against an unconditional, irrevocable and on-demand advance payment bond or bank guarantee that is equivalent in value to the advance payment, which can be encashed if the advance payment is not fully repaid.
A Parent Company Guarantee (PCG) is an additional form of performance security that can be procured from a Contractor’s parent or ultimate holding company, as a further precautionary measure in order to protect the Employer against Contractor default due to the Contractor’s insolvency. Although it serves a similar purpose to a Performance Security, it is procured from and issued by the Contractor’s parent or holding entity and subject to a distinct set of terms and conditions, by which (as the name suggests) the guarantor parent or holding entity effectively guarantees the performance of the Contractor’s obligations under the construction contract.
A PCG may often be required (in addition to a Performance Security) on higher value, more complex projects and/or where there is any doubt about a Contractor’s solvency, such that the Contractor’s parent or holding entity will be required to underwrite the Contractor’s obligations and the risks it is assuming under the construction contract. The PCG may however prove to be of limited value where the wider corporate group is impacted by the insolvency.
The Employer should ensure it has a contractual right to retain a retention amount from each interim payment. This is usually withheld and repaid in two tranches, the first after issue of the taking-over certificate and the second no sooner that after expiry of the defects notification period. The retention can therefore be used as an additional form of security to offset any costs or expenses incurred by the Employer as a result of the Contractor’s insolvency, including for the purposes of completing the works. A retention bond may also occasionally be obtained in lieu of the retention amount.
An Employer should insist on the provision of collateral warranties from key subcontractors engaged by the Contractor on a project. The collateral warranty will essentially create a direct contractual right of recourse for the Employer with those third parties with which it has no direct contractual relationship, pursuant to which the relevant warranting subcontractor can be pursued for any breach or default to the extent relevant or applicable to the scope of the warranty.
Although by no means a silver bullet given that subcontractors can be equally susceptible to insolvency issues, it can potentially be effective where the Contractor can no longer be pursued as a result of its insolvency such that the subcontractor can be called upon to cure the relevant breach. In addition, the collateral warranties should be drafted to include step-in rights which allow the Employer a clear right to step-in to the subcontract, if the Contractor is terminated, thereby minimizing scope for disruption and ensuring the Employer is able to maintain some continuity in progressing the relevant component of the works.
The Employer should ensure it has a clear, express contractual right to directly pay subcontractors in circumstances where the Contractor fails to do so, and moreover a right to set-off and deduct any such direct payments made from the Contractor’s payment entitlements under the construction contract. This can help mitigate the disruption caused due to the Contractor’s insolvency by helping ensure subcontracted works continue on site, mitigating the risk of disruption and work stoppages by subcontractors due to non-payment.
The Employer should have a clear right to immediately terminate the construction contract and take possession of the site if the Contractor becomes insolvent. This termination right may also be drafted to extend to not only the Contractor, but also its parent and holding company, so that it is triggered in the event that the wider corporate group are at financial risk or have become insolvent given that solvency issues can (in the early stages of a group insolvency) stem from issues higher up the corporate group ladder. In addition, the consequences of termination should be clearly defined such that, after termination, the Employer is entitled to withhold all further payments to the Contractor until the costs of executing, completing, remedying defects, damages and other costs incurred by the Employer have been fully established and properly quantified with any additional costs incurred recovered as a debt due from and payable by the Contractor.
Throughout the duration of the project and particularly on termination the Contractor should be required to provide the Employer with originals of all relevant project documents (including designs prepared by or on behalf of the Contractor the title to which should be expressed as vesting in the Employer upon creation, as well as permits and third party approvals procured). This will ensure these documents are readily available and can be used when procuring a replacement contactor to complete any outstanding works.
The Employer should also consider procuring insurance that will respond to and address certain Contractor obligations if it becomes insolvent. This should include latent defect insurance which can be procured to indemnify the Employer for damage arising from construction defects, often for a period of 10 years post-handover, thereby ensuring that should the Contractor become insolvent after completion, it has an additional remedy which can be invoked to further limit the costs it could incur for the rectification of defects that otherwise would have been remedied by the insolvent Contractor.
Finally, the Employer should not underestimate the importance of implementing effective contract management and administration strategies, including through engaging a reputable, experienced contract manager to administer the project. A good contract manager should be well versed in recognizing some of the key red flags and early warning signs associated with a Contractor experiencing financial difficulties and a potential insolvency. Some of these warning signs can include poor quality work, reduced personnel on site, late payments to subcontractors and suppliers, an inability to provide securities, bonds and other guarantees required under the contract, slow progress of works and spurious, unsubstantiated Contractor claims for additional time and/or costs.
The GCC construction market is not immune from the fiscal challenges that have historically plagued the global construction industry.
Contractor solvency issues arguably still present one of the key risks that an Employer can encounter on a construction project. Employers must therefore ensure they are well placed to navigate insolvency risk with proactive, strategic legal and financial planning as well as procurement and contracting strategies that aims to mitigate its impact well before the Contractor has even mobilized to site. This will be crucial to ensuring Employers legal and commercial interests are protected and that they are better placed to respond to this issue, if or when it arises.
For further information,please contact Leith Al Ali and Rashed Abdel Hadi.
Published in February 2024
