RICS draft guidance note - Subcontracting (1st edition)

Appendix 4: Subcontractor insolvency risk mitigation

Consider taking these steps in order to mitigate the risk of appointing a subcontractor who may become insolvent. Some of the steps require the agreement of the subcontractor and may be subject to commercial negotiation.

Prior to seeking tenders and prior to entering into the subcontract

Steps to take before seeking tenders from subcontractors and before entering into a subcontract with a specific subcontractor include:

  • Carry out (or procure independent) due diligence on the financial strength of the subcontractor, including obtaining and assessing key information concerning the financial strength of the subcontractor, for example:
    • audited accounts
    • management accounts (including the profit and loss statement, balance sheet, cash position, cash flow forecast and liquidity position)
    • a letter from the subcontractor's bank setting out the subcontractor's cash and credit position
  • Where applicable, carry out equivalent checks on the subcontractor's parent company and ultimate parent company.
  • Where applicable, consider the subcontractor's group of companies, including legal domicile, structure, ownership of assets/property etc.
  • Check that the subcontractor is able to provide adequate performance security (e.g. a parent company guarantee, a performance bond or a letter of credit).
  • Where applicable, check that the subcontractor is able to provide special forms of security (e.g. adequate bonds for any advance payment, retention or materials off site).
  • Check that the sureties proposed by the subcontractor are of adequate financial strength.

Drafting the subcontract

In drafting the subcontract, consider including the following provisions:

  • The subcontractor is required to provide performance security (e.g. parent company guarantee, performance bond or letter of credit).
  • Provision of performance security is required before payment
  • Conditions of any unusual payments, for example:
    • advance payment: provision of an advance payment bond
    • materials off site
    • release of retention prior to completion: provision of a retention bond
  • Payment is only made for work that is properly carried out.
  • The subcontractor grants to a director of the main contractor power of attorney to execute documents (e.g. collateral warranties or deeds of assignment).
  • The subcontractor agrees not to remove materials and plant from site without the prior consent of the main contractor.
  • The subcontractor is not permitted to assign the subcontract (including through debt factoring).
  • The meaning of insolvency is wide.
  • The main contractor may terminate the subcontract at will.
  • The main contractor's obligation to make payments is suspended upon termination.
  • The subcontractor must provide collateral warranties from key members of its supply chain in favour of the main contractor, including step-in rights.
  • The main contractor may make direct payments to the subcontractor's supply chain.
  • If requested to do so after insolvency or termination, the subcontractor must assign or novate its sub-subcontracts to the main contractor.
  • The subcontractor must provide financial information (e.g. management accounts, cash position, cash flow statement) to the main contractor on a regular basis.

Other forms of security

Other forms of security that may be given by the subcontractor in favour of the main contractor include director's personal indemnity, a charge on the subcontractor's property and a lien. These forms of security are uncommon and can be complex, so specialist advice should be obtained if they are required.

During the course of the subcontract works

Where during the course of the subcontract works there are signs that the subcontractor might become insolvent, the main contractor should consider mitigating the risk by:

  • supporting the subcontractor so that it is able to remain solvent and complete the subcontract works, for example by:
    • increasing the frequency of interim valuations (e.g. fortnightly instead of monthly)
    • bringing forward the final date for payment under the subcontract
    • making payments before the final date for payment
    • making payments for materials on site or off site
    • making an ex gratia payment
    • not exercising a right of set-off
    • 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), although this may require the subcontractor's agreement
  • following the terms of the subcontract carefully
  • valuing and paying for work properly, and ensuring that there is no accidental overpayment
  • having a plan in place to quickly replace the subcontractor if it becomes insolvent
  • making payments directly to sub-subcontractors (subject to the terms of the subcontract), but see comments below.

Making direct payments to a sub-subcontractor

The main contractor may perceive two key benefits in making direct payments to a sub-subcontractor:

  • They might prevent the sub-subcontractor from exercising any right to suspend performance of any or all its obligations, or terminate its employment, under the sub-subcontract for late payment or non-payment. This would allow the sub-subcontractor to continue its work, which would allow the relevant parts of the main contract works to proceed.
  • If the subcontractor's employment is terminated for insolvency, the sub-subcontractor should not claim, as a prerequisite to agreeing to continue its work, that the main contractor must pay any outstanding amounts for work done before the subcontractor became insolvent. Where direct payments are not made by the main contractor to the sub-subcontractor for work carried out, but the main contractor pays the subcontractor for that work, there can be no clear-cut guarantee that the sub-subcontractor will have been paid by the subcontractor before it became insolvent.

Although direct payments may have some potential benefits for the main contractor, they are not without risks. First, where the main contractor makes a direct payment to the sub-subcontractor for specific work, this will not necessarily discharge the main contractor's obligation to pay the subcontractor. The main contractor could end up paying for the same work twice. There are two ways that the main contractor can mitigate this risk:

  • The main contractor can include provisions in the subcontract to the effect that if the main contractor pays a sub-subcontractor directly, its liability to the subcontractor is reduced by a corresponding amount.
  • The main contractor takes effective assignment of the sub-subcontractor's right to be paid by the subcontractor under the sub-subcontract.

The second risk of direct payments comes from the pari passu rule. This rule prevents the insolvent subcontractor from favouring one unsecured creditor over another. If the main contractor makes a direct payment to the sub-subcontractor, there is a risk that the payment will be treated as a preferential payment. The insolvency practitioner might challenge the preferential payment and ask the court to set it aside. If the challenge is successful, the main contractor could be required to pay the subcontractor (or the insolvency practitioner) for the work. The main contractor can mitigate this risk by including a clause in the subcontract that entitles the main contractor to make direct payments to sub-subcontractors at any time, not just in circumstances where the subcontractor is insolvent.