RICS draft guidance note - Subcontracting (1st edition)

Practical considerations (Level 3 - doing/advising)

There are many practical considerations that can arise regarding subcontracting, particularly when advising on specific issues. This section cannot address all of them, but it provides specific guidance in relation to:

  • e-tendering
  • securing the subcontractor
  • overseas subcontractors
  • subcontract planning: specific issues
  • dispute resolution
  • subcontractor insolvency.

E-tendering

E-tendering involves issuing tender documentation, tracking information, and issuing and responding to tender queries, as well as receiving submitted of tenders, in an electronic format. E-tendering, RICS guidance note, contains very helpful information regarding the e-tendering process. An outline is provided here.

The key features of e-tendering are:

  • electronic communications that support workflows
  • centralised tracking of tenders and up-to-date reporting
  • the ability to change the users involved in the tender.

The perceived benefits of e-tendering are:

  • easier collaboration by the project team to collate the information required for the ITT
  • time and cost savings, mainly due to a reduction in the time spent by procurement and commercial staff in administering the tender process
  • environmental benefits: as the ITT is issued electronically, the tenderer can choose which documents to print
  • better communication, which can reduce the duration of the tender process
  • improved control over the ITT, including amendments and management of tender queries
  • improved audit trail of all communications
  • improved tender security: users have log-ins and unique tender submission areas.

Securing the subcontractor

The employer or main contractor may want to secure the subcontractor (its services, materials or plant) in advance of the main contract works commencing or the subcontract being entered into. For example, where the subcontractor has particular expertise or access to special materials or plant with long lead-in periods, arrangements can be put in place at an early stage to secure it. Examples of these arrangements are set out in this section.

An informal way of securing the subcontractor is for the employer or main contractor to rely on good business relationships. For example, the employer might be a developer and owner of a large number of properties containing lifts, which are generally installed and maintained by the same lift contractor. The employer could then rely on this good relationship to ensure its preferred lift contractor will provide services or reserve materials at the early stages of a project, before the main contractor is appointed. While this arrangement can be beneficial, its lack of legal formality has obvious drawbacks.

A more formal arrangement is for the employer or main contractor to enter into a letter of intent with the subcontractor. This also has some drawbacks, but if the letter of intent is properly drafted (and, where possible, constitutes a contract) it can be useful, for example in order for the subcontractor to carry out early design services in return for payment.

Advance orders for materials or plant

Where a specific material or item of plant that will be used in the main contract works is subject to a long lead-in period, the employer could place an advance order with a supplier. For example, if the employer knows that a particular type of barge will be required and is in short supply, it could place an advance order with the barge supplier and reserve the barge for future use. In those circumstances, the employer should ensure that it has the right to novate the order to others (e.g. the main contractor, or a subcontractor when appointed) when it is needed during the construction phase.

Framework agreement

Under a framework agreement the employer could, for example, agree with a particular cladding subcontractor that it will provide design services so the employer's design team can benefit from specialist cladding advice at an early stage of the design, including before the tender documents for the main contract works are prepared. If the employer is an organisation that has many projects, it may wish to call upon the subcontractor to provide such advice under the framework agreement from time to time as its projects begin.

Overseas subcontractors

Subcontractors who are registered outside the UK can, and do, operate in the UK construction market. This raises a number of issues.

Where an overseas company is asked to submit a tender for works in the UK, it is usual for the ITT to specify that the currency of the subcontractor's tender, and the currency applicable to the subcontract, is pounds sterling (pounds). However, the subcontractor, whose general trading is likely to be conducted in the currency of the territory in which the subcontractor is registered, might be reluctant to submit a tender in pounds, especially if the subcontractor cannot fix a foreign exchange rate for the tender.

In these circumstances, the main contractor and subcontractor can consider implementing a process along the following lines (in this example, the currency of the subcontractor's territory is the euro):

  • The subcontractor's tender sum is stated in pounds, but expressed based on a notional, agreed exchange rate of X.
  • At an appropriate time prior to entering into the subcontract, the main contractor and the subcontractor agree that the subcontractor will purchase forward contracts to buy an agreed amount of euros for pounds at an actual, agreed exchange rate (which might be different from X - call it Y).
  • Where X is different from Y, the agreement to purchase forward contracts will result in an additional or reduced cost to the subcontractor. This additional or reduced cost can be added to or deducted from the tender sum, giving a revised tender sum.
  • If the subcontract is entered into, the revised tender sum is the subcontract sum.

The benefit of this process is that at an appropriate time the tender sum becomes fixed in pounds, giving the main contractor and subcontractor a degree of certainty.

The main contractor and subcontractor will need to discuss when the foreign exchange is made, and what will happen if the subcontract is not entered into.

As an alternative, the main contractor and subcontractor can agree different arrangements to deal with fluctuations in currency exchange rates. For example, one of them could simply take the risk of fluctuations against a pre-agreed baseline exchange rate, or they could each take a share of this risk. However, these arrangements are not popular because they do not give price certainty.

Governing law and jurisdiction

A governing law clause identifies the law that will apply to the interpretation of the subcontract, and its effect if a dispute arises. It does not state how disputes will be resolved (e.g. by arbitration or legal proceedings). A jurisdiction clause is, in effect, a dispute resolution clause: it identifies the tribunal or court a dispute must be referred to. The subcontract should contain clear governing law and jurisdiction clauses. The absence of such clauses can lead to disputes over which substantive law applies to determine the rights and obligations under the subcontract, and which tribunal should determine a dispute.

In many cases, the governing law and jurisdiction that apply to the subcontract will reflect the territory in which the subcontract works are carried out. Where the main contractor and the subcontractor agree to submit disputes to the courts of a particular jurisdiction (e.g. English courts), it is conventional (but not mandatory) to agree that the law of that jurisdiction will be the governing law of the subcontract. In deciding which governing law and jurisdiction should be used, it is usual to consider the following factors:

  • Where the employer is registered. For example, the employer is a company registered in England, but the main contract works are in Scotland. The employer and main contractor could agree that the law of Scotland applies. However, due to its registration in England the employer could require the main contract to be governed by English law, so the subcontract might also be governed by English law even though the subcontract works will be carried out in Scotland.
  • The location of the subcontract works, parties, likely legal advisors and potential witnesses. For example, a main contractor that is registered in England may, as a matter of convenience and familiarity, want to refer disputes to the English courts.
  • The perception of the law and litigation system. The speed, cost and quality of the courts is important, and some systems are generally recognised as being preferable to others.
  • The language of the law and courts.
  • The enforceability of decisions made by the courts. The commercial value of a judgment in favour of the main contractor or subcontractor can depend on how easily it can be enforced.

It is also necessary to decide whether the jurisdiction clause should be exclusive or non-exclusive, and how it should apply to each party.

An exclusive jurisdiction clause limits disputes to the courts of one jurisdiction (e.g. English courts). This gives a high degree of certainty on where legal proceedings will be held.

A non-exclusive jurisdiction clause will state that disputes will be heard in a particular jurisdiction, but the main contractor or subcontractor (or both) may refer a dispute to a court of another jurisdiction if it is appropriate to do so. This has some degree of certainty (disputes will be heard in specific jurisdiction referred to in the clause), but it also has some flexibility (disputes can be heard in another jurisdiction if need be). The key risk of this clause is that proceedings could be held at the same time in different jurisdictions, which has obvious drawbacks.

In some cases, a jurisdiction clause may be drafted so that one party is subject to non-exclusive jurisdiction, whereas the other party is subject to exclusive jurisdiction. This is relatively rare in subcontracts, but can happen where one party has more bargaining power than the other.

The choice of jurisdiction clause will depend on the circumstances. For example, where the main contractor is registered in England and the subcontractor is registered in Spain (and the subcontractor has substantial assets in Spain), the main contractor could decide that a non-exclusive jurisdiction clause would be helpful to it because the clause could ensure that the English courts have jurisdiction (which would be convenient for the main contractor if it decided to commence legal proceedings against the subcontractor), but with the option to commence proceedings in Spain (which would be convenient if the main contractor required direct access to the subcontractor's assets there). Alternatively, the main contractor could decide that a jurisdiction clause in which the stated courts (e.g. the English courts) have exclusive jurisdiction, but with the right to enforce a judgment obtained there in any other jurisdiction (e.g. in Spain), would be adequate.

JCT DB Sub 2016 states that the governing law is the law of England (clause 1.10) and that the English courts have jurisdiction (article 6), although this jurisdiction is subject to any rights the parties may have to refer a dispute to adjudication or arbitration.

NEC4 ECS expects that the parties will agree the governing law and state it in Subcontract Data - Part One. Clause 12.2 gives effect to that statement. Jurisdiction is also dealt with in Subcontract Data - Part One: the parties should state the tribunal that applies (e.g. arbitration or litigation in the stated court). The dispute resolution clauses (W1 and W2) give effect to that statement.

The choice of governing law and jurisdiction can be a complicated issue, particularly where an overseas company is involved, so legal advice should be obtained.

Notices and methods of subcontract execution

If the main contractor is obliged to serve notices at the subcontractor's registered office overseas, it may be difficult to ensure the notice has been properly served. Consider drafting the subcontract so that the subcontractor appoints an agent who has an address in the territory that has jurisdiction and can receive notices for the subcontractor. Where English law applies and the subcontractor is an overseas company, special rules apply to their execution of the subcontract. Although it is not essential for an overseas company to execute the subcontract as a deed, it is preferable. The manner in which an overseas subcontractor can execute a deed is governed by The Overseas Companies (Execution of Documents and Registration of Charges) Regulations 2009 (often referred to as 'the OC Regulations'). Under Regulation 4, a subcontract can be validly executed as a deed by an overseas subcontractor under English law:

  • by affixing its common seal, or
  • in any manner permitted by the laws of the territory in which the overseas company is incorporated, or
  • by the signature of a person who, in accordance with the laws of the territory in which the overseas company is incorporated, is acting under the authority (express or implied) of the company, but in that case the subcontract must also be expressed (in whatever form of words) to be executed by the company.

The first two options can cause practical problems. Many overseas companies do not have a common seal, making the first option impossible. The second option depends on the laws of the territory in which the overseas company is incorporated, but the main contractor may not be familiar with them. In those circumstances legal advice should be obtained, which could be time consuming and costly.

Therefore, in many cases the third option would be preferred. It can be implemented using a suitable form of words (usually referred to as an 'execution block'). However, the third option can face its own difficulties: it is important to understand that whether a person who executes for the overseas subcontractor is acting under their authority, and whether execution for the subcontractor by one person or more than one person is required, is determined by the law of the subcontractor's territory. The governing law of the subcontract does not determine this authority. In some straightforward cases, a statement could be obtained from the subcontractor confirming that the person signing the subcontract has authority to do so, backed up with an extract from the subcontractor's delegated authority paperwork. That solution also has issues, however. For example, a statement from the overseas subcontractor may be insufficient because the subcontractor is not an expert in the law of the territory in which it is registered and so its statement may not be correct, or the overseas company's delegated authority paperwork might be in a language other than English, which means it will need to be translated and the translation verified. In many cases these issues are dealt with by a letter of legal opinion (see section 5.3.3).

Legal opinion

Where the subcontractor is an overseas company, the main contractor should consider obtaining, or requiring the subcontractor to provide, a legal opinion in favour of the main contractor from lawyers who are qualified in the law of the territory in which the subcontractor is incorporated. The legal opinion should cover issues that are relevant to the transaction, for example:

  • the subcontractor's capacity to enter into and be bound by the subcontract, in accordance with its terms
  • the validity of the manner of execution used by the subcontractor under the laws of the territory in which the subcontractor is incorporated
  • whether the agent signing the subcontract for the subcontractor has authority to bind the subcontractor under the laws of the territory in which the subcontractor is incorporated
  • whether there are any specific formalities that must be followed under the laws of the territory in which the subcontractor is incorporated and are necessary to enforce the subcontract in that territory (e.g. notarisation or registration of the subcontract)
  • the choice of law and the enforceability of decisions, awards and judgments relating to the subcontract.

Subcontract planning: specific issues

Subcontracts usually contain provisions that deal with specific issues that may arise with the subcontract works. This section explores some examples, and the ways the subcontract could address them.

Failure by the subcontractor to perform

If the subcontractor does not complete the subcontract works in accordance with the subcontract, it will be in breach of the subcontract and will be liable to the main contractor for damages. However, in some cases damages might not be an adequate or commercially practical solution. For example, if the subcontractor is financially weak, the damages suffered by the main contractor as a result of the subcontractor's breach might exceed the amount that the main contractor could recover from the subcontractor.

The main contractor may be able to mitigate the effect of the subcontractor's breach and reduce the damages if it has the rights and can take mitigating action. For example, if the subcontractor is not constructing the subcontract works to the required quality, or is not proceeding with the subcontract works properly and is causing delays, the main contractor may wish to make alternative arrangements for the execution of the work. This section explores examples of these rights, but they should not be exercised without sufficient grounds.

A subcontract confers on the subcontractor not only an obligation to carry out the subcontract works but a corresponding right to be able to complete them. If the main contractor takes away or varies the subcontract works, this would be an infringement of that right and a breach of the subcontract. It may also constitute an act by which the main contractor makes it clear that it does not intend to be bound by the subcontract (a 'repudiation' on the part of the main contractor), which, if accepted by the subcontractor, would entitle the subcontractor to terminate the subcontract.

Therefore, most subcontracts contain a clause that enables the main contractor to omit work from the subcontractor and requires the subcontractor to carry out additional work or make alterations. However, if the main contractor requires a right to omit work and carry out the work itself, or employ others to do so, the subcontract should contain clear wording that confers this right on the main contractor. The commercial consequences of doing so should also be addressed in the subcontract. Neither JCT DBSub 2016 nor NEC4 ECS confers this right on the main contractor.

If the main contractor is dissatisfied with the subcontractor's performance, as part of its planning the subcontract could contain a clause that confers on the main contractor the right to supplement the subcontractor's resources (e.g. with additional management, labour, materials or plant). There is some overlap here with the right to omit works, so the subcontract should contain clear wording. This right also is not included in either JCT DBSub 2016 or NEC4 ECS.

Sophisticated subcontracts confer on the main contractor a right to terminate the subcontractor's employment if the subcontractor is in breach and this is covered by a clause or provisions. The provisions often require the main contractor to give the subcontractor notice of the breach and allow a period of time to cure the breach. If the subcontractor does not do so in the specified period, the main contractor may exercise its right to terminate. Examples of issues covered by such clauses include the following.

JCT DBSub 2016:

  • before practical completion of the subcontract works, the subcontractor:
    • wholly or substantially suspends the subcontract works without reasonable cause
    • fails to proceed regularly and diligently
    • refuses or neglects to remove defects, and this refusal or neglect materially affects the main contract works.

NEC4 ECS:

  • the subcontractor:
    • has substantially failed to comply with its obligations
    • has not provided a required bond or guarantee
    • has appointed a sub-subcontractor for substantial work before the main contractor has accepted this
    • has substantially hindered the employer, contractor or others
    • has substantially broken a health and safety regulation.

Consider including the right for the main contractor to terminate the subcontractor's employment for convenience or at will. This can be exercised if the main contractor is dissatisfied with the subcontractor's performance, but the subcontractor's performance is not bad enough to permit the main contractor to terminate for breach. In such cases, a key issue for the main contractor and subcontractor to consider is the consequence of the termination, for example:

  • the extent to which the main contractor is entitled to complete the subcontract works by other means
  • the extent to which the subcontractor is entitled to payment
  • the extent of the subcontractor's liabilities after termination.

Failure by the subcontractor to complete the subcontract works on time

If the subcontractor fails to complete the subcontract works on time, it will be liable to the main contractor for damages. The types of damages that the main contractor may suffer if the subcontractor fails to complete the subcontract works on time may include:

  • time-related damages for which the main contractor is liable to the employer under the main contract (e.g. general damages or, perhaps more often, liquidated damages)
  • damages for which the main contractor is liable to third parties (e.g. general damages for delay under third-party rights or collateral warranties)
  • time-related site running/administration costs (e.g. preliminaries)
  • loss and/or expense claims from other subcontractors who are affected by the delay
  • increased costs due to inflation
  • additional time-related costs of retention being withheld under the main contract
  • time-related loss of contribution to overheads and profit
  • interest costs.

Where the subcontract states that general damages apply, the subcontractor will usually be liable for these types of loss, subject to the normal rules that apply to the assessment of damages. The burden of proof will fall on the main contractor.

Where the subcontract states that liquidated damages - a fixed/pre-agreed sum per day or week of delay - apply, there are three key issues:

  • In most cases, this will constitute the main contractor's only remedy for the subcontractor's failure to complete on time.
  • A liquidated damages clause can have real benefits for the main contractor, as it will not be obliged to prove the loss it suffered as a result of the subcontractor's failure to complete on time. Instead, the main contractor can simply implement the liquidated damages provision through action or by deduction (subject to an express right to do so).
  • Despite the convenience of a liquidated damages provision, in practice it is very difficult for the main contractor to calculate and pre-agree liquidated damages before entering into the subcontract. For example, where the subcontract works consist of suspended ceiling works in a 40-storey office block, the loss per day that the main contractor will suffer if the subcontractor fails to complete on time will vary enormously depending on the extent of the failure and the general circumstances associated with the delay. This is clear from two straightforward examples:
  • Example 1: if the subcontractor's failure to complete on time is extensive (e.g. the subcontractor has only completed ceilings for 10 floors rather than 40 floors), the loss per day suffered by the main contractor is likely to be very high, and will probably include all the types of damages mentioned above.
  • Example 2: If the subcontractor's failure to complete on time is limited (e.g. the subcontractor has completed all the subcontract works on time, except for one small storage room on the 40th floor), the loss per day suffered by the main contractor is likely to be low. In some cases, none of the types of damages above will apply, and the main contractor's loss might be nil.

The difficulty of accurately calculating liquidated damages in advance is one of the reasons why many subcontracts do not contain liquidated damages provisions:

  • DOM/1 and DOM/2: no liquidated damages provision
  • JCT subcontracts: no liquidated damages provision
  • NEC4 ECS: no liquidated damages provision by default (although Option X7, which is a liquidated damages clause, can be used by agreement).

In all cases, carefully consider whether it is appropriate for the subcontract to contain a liquidated damages provision. In many cases it will not be appropriate, and it is of course subject to negotiation.

When drafting the subcontract, consider the risk that a delay in completion of the subcontract works might be extensive. For example, if the agreed period for the subcontract works is 52 weeks and, due to events for which the subcontractor is responsible, the works are only 50% complete after 78 weeks with little prospect of the subcontractor completing them soon, the main contractor might wish to exercise a right to terminate the subcontractor's employment. This would be best achieved through an express term included in the subcontract. In drafting the term, a so-called 'longstop date' or 'longstop period' would need to be agreed and stated, and the main contractor gains the right to terminate under the clause if the subcontractor fails to complete the subcontract works by this longstop date/period.

Specific subcontract works

The scope and type of the subcontract works will generally give rise to specific considerations that should be addressed in the subcontract. For example, where the main contract works include permanent lifts, they would usually be installed by a specialist subcontractor. There may be benefits in the main contractor being able to use the permanent lifts during the construction phase; this is often known as 'beneficial use'. Direct benefits of the beneficial use of permanent lifts may include:

  • faster movement of people and goods - often much faster than temporary external hoists
  • no risk of adverse weather conditions
  • potential improvements in safety
  • potential reduction in energy costs (as the lifts may be more energy efficient than temporary external hoists)
  • temporary external hoists (if they are also used) can be removed sooner, and cladding can be installed sooner.

However, a beneficial use agreement should be dealt with expressly in the subcontract through specific drafting, and should cover all relevant issues, such as the identification of the lifts that will be subject to beneficial use; commercial aspects (e.g. entitlement to payment, rates, frequency of beneficial use); and the practical arrangements that apply before beneficial use begins (e.g. completion of the lift and protection), during beneficial use (e.g. maintenance and risk of damage) and after beneficial use ends (e.g. inspection and commissioning).

Dispute resolution

The RICS information paper An overview and comparison of dispute resolution processes in the UK and Conflict avoidance and dispute resolution in construction, RICS guidance note, include information regarding dispute resolution procedures that is relevant to subcontracts. Therefore, refer to those documents for detailed guidance on dispute resolution procedures. This section only addresses specific questions concerning drafting the subcontract.

Adjudication

If an adjudicator is named in the main contract, should the same person also be named as the adjudicator in the subcontract? It is tempting to think that the answer is yes, on the basis that if the same adjudicator is named in the main contract and subcontract (and perhaps all the subcontracts in relation to the main contract works), that person may become familiar with the project and be in a better position to decide disputes that arise. However, in most cases that temptation should be resisted. If the adjudicator is named in the main contract and subcontract, bias can become an issue as the adjudicator may need to act in a dispute between the employer and main contractor, and also in a similar dispute between the main contractor and subcontractor. It is very important to avoid an adjudication being tainted by bias (whether perceived or real). Therefore, it is usually preferable for the same person not to be named as adjudicator in the main contract and subcontract.

Arbitration

Is arbitration always incorporated into the subcontract? The answer is no. The parties must agree to refer a dispute to arbitration for resolution instead of through legal proceedings. In the absence of an agreement, there is no inherent right to refer disputes to arbitration.

JCT DBSub 2016 contains an arbitration agreement, but the agreement does not apply automatically. If the main contractor and subcontractor agree that arbitration will apply, item 2 of the Sub-Contract Particulars must be completed to state that Article 5 of the subcontract agreement applies. Article 5 states that disputes will be referred to arbitration. There are three exceptions:

  • Disputes concerning the Construction Industry Scheme will not be referred to arbitration where legislation provides another resolution method.
  • Disputes concerning VAT (again where legislation provides another resolution method).
  • Disputes concerning the enforcement of an adjudicator's decision. Article 5 states that the arbitration will be conducted in accordance with the JCT 2016 edition of the Construction Industry Model Arbitration Rules (CIMAR).

NEC4 ECS also contains an arbitration agreement, but again it is not automatic. If the main contractor and the subcontractor agree that arbitration will apply, item 1 of Subcontract Data - Part One should be completed to state that the tribunal is arbitration.

Unless the subcontract contains an arbitration agreement that overrides the jurisdiction of the courts, the courts will have jurisdiction over disputes relating to this subcontract.

JCT DBSub 2016 states in Article 6 that the English courts have jurisdiction over disputes that arise out of, or in connection with, the subcontract. This is the default position.

NEC4 ECS requires the parties to choose the tribunal by completing the relevant entry in item 1 of Subcontract Data - Part One to identify the tribunal, for example arbitration or legal proceedings. If the entry is left blank, the courts will have jurisdiction.

Dispute resolution: frequently asked questions

Should the main contract and subcontract be subject to the same dispute resolution procedure?

There is no reason why the main contract and subcontract have to be subject to the same dispute resolution procedure. For example, if the main contractor has taken on sole responsibility for the design and construction of a private hospital, the employer may decide that the likelihood of having to bring claims against more than one party is low and agree with the main contractor that arbitration should apply in the main contract.

However, the situation in the supply chain could be more complex. The main contractor may wish to bring an action against its consultants and/or various subcontractors over the same issue (e.g. a defect). Where legal proceedings apply in the supply chain, the main contractor will have the right to initiate them. Whether arbitration or legal proceedings should apply in the subcontract should be weighed up in each case, but a sensible decision cannot be made by simply adopting the position that applies in the main contract.

Are mediation and/or a dispute resolution board (DRB) relevant to subcontracting?

The main contractor and subcontractor can agree that mediation and/or a DRB are relevant to their specific subcontract, either through express terms in the subcontract or other means.

Standard form subcontracts deal with mediation and DRB in different ways. For example, clause 8.1 of JCT DBSub 2016 requires the main contractor and subcontractor to give serious consideration to any request made by the other to refer a dispute to mediation, although it does not envisage the use of a DRB. NCE4 ECS does not envisage the use of mediation or a DRB. However, clause 20 of the FIDIC Subcontract (2011) envisages disputes being referred to a 'dispute adjudication board' made up of one or three persons, which is equivalent to a DRB.

Subcontractor insolvency

Where the subcontractor becomes insolvent, the consequences for the main contractor can be very serious: delays and increased costs in completing the main contract works, financial losses and damage to reputation. Where the main contractor becomes insolvent, the employer may need to use the main contractor's subcontractors to continue the main contract works.

One of the difficulties in recognising the signs of potential subcontractor insolvency is that such signs could simply be commercial tactics or a matter of corporate management. In the end, no one sign can determine that there is a risk the subcontractor will become insolvent. Instead, consider the number of these signs in order to make an informed judgement as to the risk of the subcontractor becoming insolvent.

If the subcontractor does become insolvent, the issues to consider and the actions to take will depend on the circumstances. See the latest edition of Termination of contract, corporate recovery and insolvency, RICS guidance note, for information on post-insolvency measures for main contractors, which can also be applied to subcontractors. Further guidance regarding subcontractors is set out in Appendix 5.

The employer may want to ensure the contractual matrix provides the opportunity to use the main contractor's subcontractors to progress the main contract works if the main contractor becomes insolvent. There are five main options to achieve this.

First, the main contract could require an insolvent main contractor to assign the benefit of its subcontracts to the employer. This is a feature of JCT DB 2016 (clause 8.7.2.3) and NEC4 ECC (clause 92.2 P2). However, these provisions face two potential hurdles:

  • The assignment provisions may not work where the main contractor is insolvent because the law of insolvency requires all creditors to be treated equally (see Appendix 4 and the reference to the pari passu rule).
  • Any assignment of the benefit of the subcontract will be subject to the terms of the subcontract. If, for example, the subcontract prohibits the main contractor from assigning the benefit of the subcontract, any attempted assignment by the main contractor will be unlawful and have no effect.

The employer could deal with the latter by requiring the main contractor to include in its subcontracts the right to assign the benefit of the subcontract without the subcontractor's consent. JCT DBSub 2016 and NEC4 ECS achieve this because they do not expressly prohibit the main contractor from assigning the benefit of the subcontract.

Second, the main contract can confer on the employer the right to pay the subcontractors for materials or work executed if they have not already been paid for by the main contractor. However, even if the main contract conferred this right, the employer may face two difficulties because a direct payment by the employer to the subcontractor:

  • would not necessarily discharge the employer's obligation to pay the main contractor for that work
  • might fall foul of the pari passu rule (see Appendix 4).

The employer can mitigate these risks by:

  • including provisions in the main contract to the effect that if the employer pays a subcontractor directly, its liability to the main contractor is reduced by the corresponding amount
  • taking effective assignment of the subcontractor's right to be paid by the main contractor under the subcontract
  • including a clause in the main contract that entitles the employer to make direct payments to subcontractors at any time, not only in circumstances where the main contractor is insolvent.

The inclusion of these risk mitigation measures would be a matter of negotiation between the employer, the main contractor and, to an extent, the subcontractors. However, in most circumstances it is unlikely that all parties will accept these provisions, illustrated by the fact that it is not included in JCT DB 2016 or NEC4 ECC. Where it is included in the main contract, it would be appropriate for the subcontractor to acknowledge and give its express agreement to the provisions in the subcontract.

The first two options therefore have inherent difficulties that make them largely ineffectual if the main contractor is insolvent, which may be why they do not feature in JCT MP 2016.

The third option is for the employer to have the right to step into the subcontract in place of the main contractor, so that the subcontractor continues with the subcontract works for the employer. This is usually achieved with a collateral warranty given by the main contractor and subcontractor in favour of the employer, or through another direct agreement that grants step-in rights to the employer. In most cases, the collateral warranty or direct agreement states that the employer's right to step into the subcontract is activated when the main contractor's employment under the main contract is terminated (which would generally be the case if the main contractor had become insolvent, although this termination is not necessarily automatic). In order to secure step-in rights, in the main contract the employer can require the main contractor to:

  • procure collateral warranties or direct agreements with step-in rights from its subcontractors in a prescribed form
  • ensure that its subcontracts contain a term that requires the subcontractor to execute and deliver the collateral warranty or direct agreement in the prescribed form.

In such circumstances, the subcontract should be drafted in order to require the subcontractor to provide the collateral warranty or direct agreement in the prescribed form.

The fourth option involves the subcontract being novated from the main contractor and the subcontractor to the employer and the subcontractor. In effect, this results in the original subcontract coming to an end, and the employer and the subcontractor entering into a contract on the same terms as the subcontract.

In order to ensure that the subcontract is novated to the employer, the main contract can require the main contractor to:

  • in the event of insolvency, ensure that the subcontractor enters into a novation agreement in a prescribed form
  • ensure that its subcontracts contain a term that requires the subcontractor to enter into the novation agreement in the prescribed form.

A potential difficulty with this device is that it requires the employer, the main contractor and the subcontractor to enter into a novation agreement. However, it is possible that the main contractor's insolvency practitioner, who will be in control of the main contractor's affairs at the time, will decide not to execute a novation agreement or exercise a right it may have to disclaim the novation agreement.

Neither JCT DB Sub 2016 nor NEC4 ECS include provisions that deal with novating the subcontract. However, these provisions can be included in the subcontract through relatively straightforward amendments.

The fifth option is really a variation on the theme of the third and fourth options: instead of the employer being granted step-in rights or the right to enter into a novation agreement, a replacement main contractor is given these rights. These provisions have some commercial reality to them: it is unlikely that the employer will act as main contractor and complete the main contract works itself. In most cases, the employer will appoint a replacement main contractor to complete the main contract works and the replacement main contractor may want to step into or novate existing subcontracts.

Where the fifth option is used, the subcontract and any relevant collateral documentation should be drafted to allow the employer or replacement main contractor to exercise the right to step or enter into a novation agreement.

Termination of contract, corporate recovery and insolvency, RICS guidance note, provides helpful information on the main types of insolvency and insolvency risk mitigation measures. Further guidance on risk mitigation regarding subcontractors is set out in Appendix 4.