Concerns of bankruptcy in the Construction Industry

What can the Client do when Fearing Bankruptcy of the Contractor

 The Clients Path of Choice

If the client suspects that the contractor is on the brink of bankruptcy, the first question to consider is: Is it most appropriate to try to keep the contractor operational until they have completed all or part of the remaining work in the project? Or is the focus now on ensuring that payments are not made to the contractor beyond what is obligated at any given point?

Whether attempting to ensure that the contractor fulfills their obligations in the project is a viable and beneficial option must be assessed on a case-by-case basis. Construction standards are not designed for such strategic decisions, and the specific measures that are relevant and sensible must be determined on a case-by-case basis. In the following section, we will provide some examples of measures that have proven to be relevant.

Regardless of the chosen approach, it is wise to document what work is completed, and what remains.  Besides providing a basis for monitoring the contractor’s progress, such documentation is useful for evaluating whether other contractors could take over the work in the event of bankruptcy. It is not uncommon for this assessment to be conducted before it’s confirmed whether bankruptcy is imminent, as this can help minimize potential delays and other consequences of such an event.

Tailored Contract Adjustments

In challenging financial situations, a party often hesitates to disclose their condition to the contracting counterparty. This is particularly true in cases where they believe they can weather the storm. The underlying reason for this reticence is often the fear that the counterparty will take actions to mitigate their own risk, typically by assessing grounds for withholding payment, considering reasons for termination due to anticipated substantial breach, or other measures that could further pressurize an already challenging situation.

Nonetheless, our recommendation is to actively take measures to uncover the actual situation of the counterparty and evaluate whether there is a basis to modify the already concluded agreement or establish new agreements. There could be situations where an agreement to revise a payment plan, coupled with increased monetary guarantee from the counterparty’s side, that could be beneficial for both parties. In some cases, it might even be in the client’s interest to make payments beyond their contractual obligations, solely due to the fact that the contractor’s bankruptcy would be a worse alternative.

If a project is affected by a contractor struggling with payments to their subcontractors, there could be scenarios where the developer benefits from providing payment guarantees or making direct payments to the subcontractors of the contractor. However, the feasibility of this approach must be assessed on a case-by-case basis. Generally, establishing such arrangements without involving the contractor should be done with caution, as it could quickly be regarded as a breach of the general duty of loyalty in the contract to directly engage with the contractor’s subcontractors. Such actions might also deprive the contractor of the pressure to perform that comes from legitimate withholdings they apply downstream in the contract chain. Subcontractors who enter into such arrangements without the contractor’s consent could also quickly run into conflicts with their loyalty obligations in their contract with the contractor.

For developers in the public sector, it is important to consider whether revising an already executed agreement would comply with procurement regulations.

Review Paid and Unpaid Invoices

Once a decision has been made not to take actions aimed at keeping the contractor afloat, but rather to strictly adhere to the solutions outlined in the construction standards, the focus shifts to avoiding overpayment beyond the contractual obligations at any given point.

Concerns of the contractor heading towards bankruptcy, does not inherently grant the right to withhold payment for otherwise justified claims from the contractor. Nevertheless, there are several measures that can be taken which can provide the developer with grounds for a greater withholding or a lower payment than initially anticipated.

Thoroughly assessing the extent of the contract work that has been delivered, compared to what has been paid, is a measure that often provides a basis for reducing the amount of the next installment from the contractor.

Verify Compliance with Security and Insurance as per the Contract

Construction standards specify that a cumulative security of 10% of the contract amount should be provided for the fulfillment of the contractor’s contractual obligations. The coverage provided by this security encompasses both the execution of the contract work itself, for instance after bankruptcy, and liability for damages resulting from breach, such as liquidated damages.

If the contractor has not provided a guarantee in line with the contract, the developer generally will not be obligated to pay installment notes until the matter is rectified.

However, if you are well into a project and discover that security has not been provided in accordance with the contract, you should assess whether circumstances indicate that the original requirement for security stipulated in the contract might no longer apply.

Furthermore, construction standards presume that the contractor should have the construction subject matter insured and maintain liability insurance. Both insurances should be “drawn up under conditions common for the type of work that the main contractor or their subcontractors will perform (…).” In contracts based on NS 8407 or 8417, the consequence of insurance not being obtained or not being documented is essentially that the client will not be obliged to make payments until the matter is rectified.

However, the question of whether the lack of insurance coverage justifies withholding payment should be assessed on a case-by-case basis, regardless of the standard underlying the contract.

Present Counterclaims and Exercise Withholding

If liquidated damages have accrued or if the client has other claims due to the contractor’s breach of contract, the client also has the right to withhold an amount of payment that covers such specified and justified claims. Hence, it might be wise to verify if previously notified counterclaims have been considered in the financial interactions with the contractor. If this has not been done, under certain circumstances, it could provide grounds for offsetting otherwise legitimate claims from the contractor’s side.

Moreover, the client should consider whether there are claims that have not yet been raised. If other parties involved in the project or third parties have notified claims against the contractor, and if it is believed that the contractor, with its presumed poor financial situation, might be partially or fully responsible, then the client should notify the contractor of such claims and take them into account when making further payments to the contractor. If there are defects in the contractor’s work, this could also provide grounds for reducing payments in upcoming installment notes, either because, under certain circumstances, the contractor could be considered behind schedule according to the payment plan or because the right to withhold the amount as security for rectifying previous work exists.

Since the client bears the risk that its own claims and withholdings are legitimate, withholding payment for otherwise rightful claims from the contractor should not be done without prior assessment.

The consequence of unjustified withholding is, as a rule, the accrual of delay interest on the wrongfully withheld amount. If the unjustified withholding is excessive or deemed disloyal, it could, in the extreme case, lead to the contractor gaining the right to terminate the contract and subsequently claim damages.

Assess the Materials Supplied to the Construction Site

In the case of suspicion of the contractor’s bankruptcy, the developer should compile a record of the materials supplied to the construction site. Even if these materials haven’t been incorporated into the construction yet, ownership rights will transfer to the developer provided that the developer has also paid for the materials. If this is the case, the developer should take measures to ensure that the materials are not transported out of the construction site, for example, to other projects the contractor might be involved in.

What can the Contractor do when Fearing Bankruptcy of the Client

Contractor’s Options

If the contractor suspects that the client is heading towards bankruptcy, the primary objective is to avoid further resource allocation to the project. Ideally, the contractor would want to halt further work and deliveries. However, if there are no grounds for this, in some cases, the contractor may reduce resource allocation for a period, such as until it is clarified that the client is in substantial payment default or until it’s confirmed that the client will be able to settle its obligations.

Construction standards grant the contractor the right to halt work in three scenarios: 1) when the client is in substantial payment default, 2) when it’s evident that substantial payment default will occur, and 3) in certain cases where the client has not provided security as per the contract terms.

Halting Work in Case of Substantial Payment Default or Evident Impending Default

Whether a payment default is “substantial” is determined through a comprehensive assessment where multiple factors can be relevant. Key considerations usually include the amount, duration, and frequency of the payment default. In addition to the amount of the overdue payment itself, it’s also relevant whether it’s large or small compared to the value of the contract. It may also matter whether the payment default is due to an inability to pay or a lack of willingness to pay. If it’s the former, the contractor bears a higher risk of not receiving payment for completed work, which likely makes it easier to classify a payment default as substantial.

If the developer is not in substantial payment default, but it’s “evident that” such default will occur, the contractor still has the right to halt work. Legal theory suggests that this condition is only fulfilled if there is a “very high degree of probability” of a payment default.[1] Whether this condition is met, must be assessed specifically in each case, and several factors can be relevant. Examples of relevant factors may include statements from the client, such as indicating the intention not to pay further or stopping payments to other parties involved in the project.

Beyond assessing whether the condition is met, it may also be commercially reasonable to consider the risk assumed by an unjustified halt and weigh it against the resources that would be expended if the contractor chooses to wait and see if substantial payment default actually materializes. Such an evaluation is only more advisable given that the consequences of an unwarranted halt can be significant.

Once it’s determined that there is a substantial payment default or it’s evident that such default will occur, the contractor must send a notice to the counterparty informing them of the decision to halt work. The right to halt work only becomes effective 24 hours after written notice of the halt has been sent.

Once the right to halt work is established, it’s often reasonable to consider contract termination as well. Termination might be appropriate because it could allow the contractor to claim compensation for future loss of profit on the contract. The criteria for halting work and terminating the contract are similarly formulated in the standards. However, it’s assumed that the threshold for termination is higher than the threshold for halting work. Given that the consequences of an unjustified termination could be substantial, this action should not be taken without thorough prior consideration.

Right to Suspend Due to Lack of Monetary Guarantee

Based on a strict interpretation of the construction standards, the right to suspend work exists only in cases of ongoing or imminent substantial payment default. However, the construction standards also state that the contractor has the right to refrain from “commencing execution” of their work until they have received guarantee from the client.

Nevertheless, in certain situations, the contractor may also have the right to suspend ongoing work if the client has not provided a guarantee in accordance with the contract. Legal theory has also supported this stance. However, before suspending work on this basis, a careful assessment of the situation is advisable. The consequences of the contractor suspending their work can often be more detrimental for the client than if the contractor refrains from commencing work. Additionally, there is a risk that choosing to start work despite the lack of security could be construed as an acceptance that security was unnecessary.

Since the contractor is required to notify the client of the suspension in situations where the client is in substantial payment default, the question arises whether a similar requirement for a 24-hour notice applies when suspending work due to lack of security.

It is not evident that such a requirement would apply in all cases. The starting point is that the contractor was not obliged to commence work before security had been provided. On the other hand, suspending ongoing work quickly has more significant consequences for the client than a contractor not commencing work in an initial phase.

If the downside of waiting for 24 hours after sending the notice is minimal, it would likely be sensible to “invest” in such notice to avoid exposing oneself to the risk that an erroneous assessment might entail. Since the question is not definitively settled, this alone might indicate the need for such notice.

The party that suspends work bears the risk of meeting the conditions. If this is the case, the contractor is entitled to an extension of time and additional compensation in accordance with the standards’ regulations.

If a suspension is wrongful, it could trigger claims for damages and potentially constitute substantial breach of contract, providing the builder with the right to terminate the contract.

Explore the Possibility of Adjusting Planned Resource Usage

If uncertainty exists regarding the right to suspend work, but there are concerns that the client might be heading towards bankruptcy, it is advisable to consider the option of altering the allocation of resources in the project. If the immediate planned resource usage can be downscaled while still meeting an agreed-upon final or interim deadline, this could be a prudent step. If the contractor’s assumption proves correct that the builder will not overcome their financial difficulties, then further resources have been avoided, which at best might only yield partial compensation.

According to the construction standards, materials only become the builder’s property when they are incorporated into the construction or have been delivered to the construction site and have been paid for. If the contractor has the flexibility to postpone the delivery or incorporation of particularly expensive materials without causing project delays, this could also contribute to reducing the contractor’s risk in cases where a bankruptcy of the client is suspected.

[1] Henning Nordtvedt et al., NS 8407. Commentary Edition, Universitetsforlaget, 2013 p. 415.

[2] See Henning Nordtvedt et al., NS 8407. Commentary Edition, Universitetsforlaget, 2013 p. 416.