Main Contractor Insolvency – Part 2: Pre-Empting the Risk– 5 Key Tips

We recently published some useful guidance on how to deal with main contractor insolvency during a live project. You can find it here.

In the current economic climate, it is critical that the risks of a live project insolvency are proactively minimised by taking steps before works begin. In this follow-up article we look at some of the steps you can take (beyond the obvious counterparty financial analysis undertaken pre-contract):

1. Use of a project bank account (PBA). PBAs are commonplace on large public sector projects (save where there's a compelling reason not to use them). There is no reason the private sector cannot use them effectively.
   
   A PBA is a ring-fenced bank account, from which payments are made directly by you as a client to all parties in the supply chain. The main benefit in the context of main contractor insolvency risk is that it provides a significant mitigation to the domino-effect of main contractor insolvency on the supply chain, potentially saving smaller businesses who often bear the devastating effects of upstream insolvency.
   
   A PBA also means money ends up where it belongs, rather than sitting with the main contractor where, without clear transparency, it can quickly be absorbed to prioritise other costs rather than remunerating the supply chain on time (as was the purpose of the payment).
   
   This may sound like a too-good-to-be-true option. There are, as always, disadvantages, such as set-up costs and negotiations, money being ringfenced which cannot be used for other projects and the reality that a PBA does not guarantee payment disputes will not occur. However, from an insolvency mitigation perspective, we see more pros than cons
   
   
2. Allow for price fluctuations. An unfortunate reality for main contractors is low profit margins. The risk of agreeing a fixed price lump sum (that only changes on the award of a relevant matter or a compensation event) in a time of price volatility is going to be a concern for any prospective main contractor, particularly on complex or long-running projects.
   
   There are three fluctuation options in JCT contracts – A, B and C. Each have different features: the Option A default allows for adjustments for changes in law, levies, and contributions a contractor must pay employees and changes to taxation and statutory duties that affect goods, materials, fuel and electricity (e.g., the recent increase in National Insurance Contributions would be captured). But in an environment where labour and materials have an unpredictable cost, Option B may be considered as it allows the contractor to be compensated for changes in actual costs. Option C allows for a formula-led adjustment to the Contract Sum, using the JCT Formula Rules published by the JCT (the Rules that apply depend on the type of work being carried out).
   
   
3. Advance payments. There is often reluctance to issue advance payments, but these can allow your contractor to secure current market prices for goods (therefore avoiding the risk of price-hiking fluctuations) and they help to ease the pain of critical cost exposure points. Any significant advance payments may be secured by an advance payment bond, depending on commercial requirements.
   
   
4. Open-book approaches and continued transparency. A hallmark of design and build procurement is that, generally speaking, the contractor does not operate on an open-book basis. But there are other ways of contracting, such as agreeing a ring-fenced profit margin for your main contractor with preliminary budgets and sub-contract costs upfront, but with an incentivisation of a pain/gain contingency in the pricing – so, if costs come in below a threshold, the contractor and the employer share the contingency.
   
   On a related topic, if you are concerned about guarding against the supply chain not being paid and being kept aware of your main contractor's liquidity, consider including provisions in your contract for transparency around actual payments made to sub-contractors (via monthly reporting as an obligation) and a requirement for the contractor to provide information as to its financial situation throughout the works.
   
   
5. Performance security. There's nothing novel about putting in place good-quality performance security (although it is not a panacea). But it's worth taking the time to assess the risks and the benefits offered by both a parent company guarantee (where available) and a performance bond. Any difficulties a tendering contractor encounters in securing a bond for a market cost, or at all, should be interrogated as this in itself might indicate weak financial covenant strength.

For more discussion of these topics, consider listening to our podcast series on construction insolvency by following this link.

You will also find a podcast with our predictions for the construction sector in 2025 by following this link.

Author: Matt Pearson, Counsel