Mitigating Insolvency Risk on Construction Projects (Part 2) - The Contractor’s Perspective
Construction and Infrastructure / UAE
Solvency and liquidity issues on a construction project can have a detrimental, far-reaching impact on Contractors as well as their supply chain.
Law Update: Issue 366 - Transport & Insurance
Leith Al AliSenior Counsel,Construction and Infrastructure
Rashed Abdel HadiParalegal,Construction and Infrastructure
Solvency and liquidity issues on a construction project can have a detrimental, far-reaching impact on Contractors as well as their supply chain. It is therefore important for Contractors (as well as Employers) to be aware of some of the key considerations and strategies that can be implemented in order to mitigate against the risk and the wider impact of an Employer insolvency.
In this article, the second in our two-part series examining the mitigation of insolvency risk on a construction project, we delve further into some of the key issues Contractors should be mindful of in order to mitigate their risk exposure to an Employer insolvency, if and when such an event occurs on a construction project.
The insolvency of an Employer can have significant, far-reaching consequences for not just the project, but also the Contractors and indeed the wider supply chain. Contractors must therefore be mindful of the possibility that the Employer may become insolvent during the course of a construction project. In doing so, it is therefore important for Contractors to be aware of the tools and strategies that can be deployed to mitigate against the risk of Employer insolvency with a view to trying to maintain some degree of financial stability for the business and their wider portfolio of projects. Some of the key measures that can be implemented are discussed further below.
The Employer can be required to provide a Letter of Credit, which essentially is a contractually binding promise from the Employer's bank to pay the Contractor, thus providing an assurance that its financial obligations will be fulfilled. Although not uncommon in the Middle East construction market, such a requirement will likely be met with some resistance from the Employer such that the Contractor may need to concede that it is procured at the Contractor’s cost.
A common feature in the FIDIC Rainbow Suite of contracts (albeit one that is often also resisted by Employers and therefore deleted from the General Conditions) entails requiring the Employer to submit reasonable evidence that financial arrangements have been made and are being maintained to enable it to fund the works, with any material change in its financial arrangements giving rise to a requirement for the Employer to notify the Contractor with particulars of the change. This can provide the Contractor with some comfort as to the Employer’s financial arrangements for the project and thus may allow it to take pre-emptive action to mitigate its financial exposure, where the Contractor is notified of a change in the Employer’s financial position, well before the Employer has undergone formal insolvency.
The contractual payment terms should be carefully negotiated and where possible regular interim payment terms agreed based on works performed. This will help reduce, to a minimum, the period between payments. This can also help facilitate regular cash flow thereby helping to minimize the Contractor’s financial exposure between payments and the extent to which it is required to self-fund the project.
The Contractor should negotiate the inclusion of clear rights to suspend and where necessary terminate due to non-payment. Whilst some Middle East jurisdictions such as the UAE, afford the payee a codified statutory right to suspend at law in such circumstances, it can be subject to dispute. It is therefore recommended that this right to suspend is expressly captured in the construction contract with terms which also clearly specify when and to what extent non-payment actually triggers suspension or termination, in order to avoid allegations that the Contractor has acted prematurely or in a disproportionate manner.
In addition, the consequences of suspension and termination, specifically the Contractor’s payment entitlement in this regard, should be clearly defined. In doing so, the Contractor should seek to minimize the often-lengthy notice periods Employers try to impose prior to suspension or termination becoming effective, given the Contractor will be required to continue performing works during this interim period which risks further exasperating its precarious financial position. Moreover the construction contract should state that following suspension or termination, the Contractor has a right to be paid for all works performed up to the date of suspension or termination (as applicable) including (in the case of termination) all demobilization and other costs incurred, noting however that loss of profits and other special, indirect or consequential losses are usually carved out from a Contractor’s payment entitlement and thus may not be recoverable.
The Contractor should (in addition to the right to terminate for non-payment) also look to retain an express right to immediately terminate the construction contract if the Employer becomes insolvent (or indeed is reasonably considered to be at risk of insolvency), the terms of which should mirror the equivalent termination right that has likely been afforded to the Employer under the construction contract.
It is finally worth noting in the construction contract that title to goods, plant and materials procured by the Contractor and its subcontractors in connection with the project only pass to the Employer upon payment and not on delivery to site (as is commonly the case). This will ensure that if the Employer becomes insolvent prior to it having fully paid for these procured items, the unpaid goods, plant and materials remain under the Contractor’s ownership and can (if necessary) be resold by the Contractor, with the income generated used to offset the costs incurred (such as in order to pay subcontractors) or alternatively may be used by the Contractor on other projects.
Unpredictable global as well as regional, political and economic developments will continue to expose Contractors (as well as other project stakeholders) to varying project risks, a number of which may have a detrimental impact on the Employer and Contractor’s financial standing including project pricing, liquidity, cash flow and profit margins.
As the construction industry in the region continues to evolve at an exponential rate, it is important that Contractors ensure they clearly understand and are able to leverage the contractual tools and legal strategies available to mitigate against this risk well before it occurs.
For further information,please contact Leith Al Ali and Rashed Abdel Hadi.
Published in March 2024
