Strategy for mitigating effect of contractor insolvency - Step 3: get the right bond in place

This is my final perspective on HM’s three-step strategy for purchasers of construction and engineering services to manage and mitigate the effect of contractor insolvency risk.  Step 1 involves paying contractors promptly and not extending standard form payment periods.  Step 2 is including contractual mechanisms to ensure the contractor passes down to its supply chain payments received from the employer quickly.  The final step recognises that, despite prudent management, insolvency events may still occur and that the purchaser will have no option but to appoint a replacement contractor build-out the works where the original contractor does go bust.

The occurrence of an insolvency event is the decisive test for the effectiveness of the performance security package for the works negotiated with the contractor.  Availability of a performance bond granted by a financially stable provider, which compensates the employer for additional costs incurred in undertaking a build-out, is enforceable quickly, and at an affordable cost is of paramount importance. This is why HM always advises clients undertaking construction or engineering projects to include a bond as part of the security package (in lieu of a parent company guarantee if necessary) and we also advocate seeking changes to the model form of bond issued by the ABI.  Securing a robust performance bond will have a price tag, but it will prove to be money well spent if the worst should happen and the original contractor enters insolvency.

The first “challenge” to be met in relation to performance bond drafting is to ensure the bond provider is required to compensate the employer in respect of additional costs incurred in building-out following the original contractor’s insolvency.  ABI standard bond wording states, “in the event of a breach of the Contract by the Contractor the Guarantor shall … satisfy and discharge the damages sustained by the Employer”.  Under most standard form construction and engineering contracts, the original contractor entering into insolvency will not give rise to a breach of contract, meaning costs incurred by the employer in building out may not be recoverable under a standard ABI bond.  It is critical to amend the form of bond proposed by the contractor to permit recovery of costs incurred by the employer post insolvency.

The second key challenge with ABI standard bond wording is lack of “liquidity”, i.e. the time required to recover sums due under the bond from the bond provider.  The standard wording refers to recovery of damages sustained by the employer “as established and ascertained pursuant to and in accordance with the provisions of … the Contract”.  This text allows the bond provider to defer making payments until the employer establishes recoverability of damages claimed via court processes (potentially including appeals).  The employer is already likely to have to finance build-out costs itself before seeking to recover these under the bond.  The cash flow implications are even worse if the employer then has to spend a significant amount of time and money pursuing recovery of those costs from the bond provider through the courts.  The best solution would be to obtain an on demand bond securing the contractor’s obligations, but such bonds are very difficult to secure and may be very expensive.  Our practical recommendation is for the employer to insist on obtaining an “adjudication” bond, i.e. a bond under which the provider is required to pay out based on receipt of the decision of an adjudicator awarding a payment to the employer.  Adjudication is a fast track form of dispute resolution and a lower cost option compared to litigation.  We extend this principle to allow enforcement of the bond directly against the bond provider by way of an adjudication following occurrence of an insolvency event in respect of the contractor.

Other key factors to consider in relation to bonding include:

• Ensuring the bond provider is a financially robust organisation that is demonstrably capable of standing behind the guarantee obligations undertaken (i.e. that it has an “investment” grade credit rating).
• Checking that the bond provider is domiciled or has a substantial trading presence within the UK, making it practical to seek recovery of amounts due under the bond without having to enforce decisions of adjudicator’s and/or UK courts in foreign jurisdictions.
• Considering adequacy of the bond amount.  This is typically 10% of the original contract sum and is the maximum amount recoverable from the bond provider.  A 10% bond may be insufficient to cover all costs incurred by the employer in undertaking a build-out, which is why adopting the measures recommended in step 2 of HM’s strategy is so important.  If the employer makes the contractor pass on payments to its supply chain quickly, and enters into step-in undertakings with significant subcontractors, this should significantly reduce the level of build-out costs, making it more likely that a 10% bond will be sufficient to compensate the employer for additional costs incurred following occurrence of an insolvency event.
• Finally, action is likely to be required re the bond expiry date.  Most bonds state this as being the date of practical completion of the works.  This does not work well in the context of enforcing bonds following occurrence of an insolvency event in relation to the original contractor.  Employers should amend bonds to provide for a (much) longer expiry date in the event of insolvency.  Normal practice is to state this as a period after occurrence of the insolvency event and this must be long enough to cover possible build-out periods and time to agree final account with the replacement contractor.  18 to 24 months is the recommended period.

If you want to hear more about HM strategies to manage contractor insolvency risks, I will be presenting on the topic at HM’s Housing Law Update. The event is free to attend and registration is via this link https://mailchi.mp/7923a24dffa8/housing-law-update-october-2021