Practical Tips to Limit Risks of Subcontractor Insolvency

Life is becoming increasingly difficult for subcontractors and we are seeing time and time again how these difficulties are impacting on the successful delivery of projects across the Middle East.

The rising costs of construction caused by inflation and supply chain disruptions has led to a squeeze on subcontractor margins. This, coupled with liquidity constraints due to difficulties in obtaining payment, and the interest rates that subcontractors are likely facing on their financing arrangements, means that subcontractors are at a higher risk of insolvency now, than since the financial crisis of 2008.

There are some  practical steps that Contractors and Employers alike, can consider to try to limit projects from the risks of subcontractor insolvency.

1. Due Diligence

Where possible, the financial strength of a subcontractor should be investigated.

Management account information (such as profit and loss statements, cash position statements, cash flow forecasts) should be sought to investigate the liquidity of the subcontractor.

In order to obtain this, consideration should be given to requesting specific disclosure of up to date financial information in any request for a proposal that is sent out.

Where a subcontractor is operating as a foreign branch, or as a subsidiary of a larger group of companies, the structure, domicile and ownership arrangements, and assets of the group should be considered and similarly requested.

If operating in a jurisdiction in which information in relation to ongoing litigation is freely accessible, the number of claims brought against the subcontractor should be requested taken into consideration.

2. Drafting of the Subcontract

Unreasonably burdensome subcontracts lead to more disputes which can be difficult, costly, and time consuming to resolve. Ultimately it serves both parties if there is a fair and reasonable allocation of risk but if insolvency is a concern, we recommend care is taken to ensure that the subcontract includes, amongst other things:

• (a) A requirement to provide various forms of security (e.g. parent company guarantee, performance bond, advance payment bond or letter of credit) as preconditions to an entitlement to payment;
• (b) Reasonable payment terms for works completed, with payment to be made subject to receipt of funds from the Employer (in respect of the subcontractors claims);
• (c) Rights to ownership of materials (even if materials are off site);
• (d) The application of a retention against amounts invoiced;
• (e) The right to terminate without cause and without the need for a court order;
• (f) A requirement to accelerate subject to a written instruction;
• (g) A right to omit any portion or section of the Works;
• (h) Obligation to provide collateral warranties for works performed and from key suppliers and sub-subcontractors;
• (i) Step in rights with key suppliers and sub-subcontractors;
• (j) A discretionary right to the appointment of key suppliers and sub-subcontractors
• (k) Discretionary right to make direct payment to sub-subcontractors and suppliers; and
• (l) A requirement to provide evidence of payments made to sub-subcontractors and suppliers.

3. Performance Securities

The subcontractor should be able to provide any necessary securities from a reputable bank with a strong financial rating. If the subcontractor is unable to facilitate a security from a facility with a strong reputation, consideration should be given as to why that is not possible.

We recommend that securities received are kept in safe custody and a register is completed noting when the security was received, and when the security expires, so as notice can be sent out as necessary requesting a renewal if required.

4. During the Subcontract Works

To put the project in the most reasonable position for success, it is important to support the supply chain where reasonable to do so.

Therefore, care should be taken to ensure that the payment terms of the subcontract are followed carefully and money flows to the subcontractor as intended.

If there are concerns surrounding the liquidity of the subcontractor, it may make sense to support the subcontractor so that it is able to remain solvent and complete the subcontract works. The liquidity risk can be managed by:

• (a) increasing the frequency of interim valuations (e.g. fortnightly instead of monthly);
• (b) promptly assessing claims for variations and extensions to the time for completion;
• (c) making payments on account;
• (d) not unreasonably exercising a right of set-off;
• (e) omitting parts of the subcontract works to reduce the subcontractor’s workload and financial stress (e.g. for works that require advance payments for materials);
• (f) making payments directly to sub-subcontractors (subject to the terms of the subcontract); and
• (g) releasing performance security at the conclusion of the subcontractor’s scope of works and not withholding the security for longer than necessary.

Taking time to make informed decisions in relation to the subcontractors you engage, and the terms on which you engage them, may mitigate some of the risk of insolvency which may ultimately save you time and money.