Back to Basics: (in)security complex? Securing payment and performance on construction projects

For most in the construction industry, the recession is not yet a dim and distant memory and it has made many acutely aware of the need to ensure they are adequately protected in the event of employer or contractor insolvency. In the latest alert in our Back to Basics series, we consider the forms of payment and performance security available for construction projects.

What can you do before signing up?

Do your homework

• For both employers and contractors, the first step is to carry out due diligence as regards the other party's covenant strength during the tender process, utilising, for example, a Dun & Bradstreet report.
• Review recent press releases and shareholder announcements in order to investigate whether the other party has a history of non-performance/payment.
• For employers, consider asking tenderers to provide information about their current and future order book.
• Watch out for amendments to payment periods: longer payments periods requested by employers and shorter payment periods requested by contractors may indicate cash-flow concerns.

Who are you and where do you come from?

Do you have visibility of the other party's company structure, for example, are they a special purpose vehicle (SPV)? Are they based off-shore? Which company holds the assets? Has the company's name recently changed and if so, why?

Read the contract

Often parties who have concerns about security focus on the options for additional protection (which can be costly) without considering the protection already offered by the existing contract terms or considering if there are terms that can be added to the contract that could bolster their position.

Issues to consider:

• can payments be structured in a way that mitigates any concerns a party has about performance or payment? Are there any advance payments? If so, does an advanced payment bond need to be put in place?
• the retention is a form of security to be utilised by the employer in the event of non-performance by the contractor whilst the works are on-going, or, in some cases, for the failure to rectify defects arising during the defects period. Can the terms around the retention be amended to deal with issues around security - for example:
  • can the time period for which the retention is held for be increased or reduced?
  • can the amount of the retention be altered?
  • who will own and control the retention?
  • is the retention just cash or can all or some of it be subject to a Retention Bond? This can assist a contractor's cash-flow and also means that the part of the retention that is subject to the bond cannot be accessed by an administrator of the employer.

  It is worth noting that while retentions as a form of security are well used in the construction industry, the practice is now actively under review by the Department for Business, Innovation and Skills in the light of ongoing concerns about downstream cashflow.

• When does ownership of property, goods and materials pass and what are the implications? For example:
  • is the grant of a copyright licence subject to payment?
  • Will the employer pay for off-site materials before ownership has passed from the contractor to the employer? If so, what are the conditions of ownership passing?
• Does the contract contain terms regarding visibility over the payment terms in sub-contracts? Could payments under the main contract be subject to receiving evidence that the contactor is paying its supply chain or alternatively, allow the employer to communicate with the supply chain to verify payments are being made? Obviously, extreme caution needs to be exercised when considering the inclusion of direct payment to sub-contractors.
• Public Authorities will also want to bear in mind the prompt payment rules provided for in the Public Contracts Regulations 2015, which are covered in our alert "Getting to grips with the new public procurement rules - Issue one".
• Does the contractor have the right to suspend works for employer insolvency to supplement its right to suspend works for non-payment under section 112 of Housing Grants, Construction and Regeneration Act 1996 (as amended)?
• Do the parties have the right to terminate for the other party's insolvency and/or repeated default? Be aware that an entitlement to terminate for the other party's default may not always cover insolvency unless it is expressly listed as a default event.
• Section 113 of the Housing Grants, Construction and Regeneration Act 1996 (as amended) outlaws pay when paid clauses but this does not extend to specified employer insolvency - contractors may therefore wish to include in sub-contracts the right to withhold payment in these circumstances.
• Does the employer have the right to sell the contractor's plant? An employer is likely to have limited rights as against, for example, a contractor company in administration, with respect to the contractor’s plant, equipment and unfixed materials. Although, an employer could seek to protect itself by registering a charge over such plant etc, this is not necessarily standard practice and would need to be done at least six months before the contractor becomes insolvent

Another level

Even if your due diligence checks and the contract terms provide you with adequate comfort, it's generally wise to review third party security and the options that may be available:

• The most common forms of 'third party' security in the construction industry are performance guarantees/bonds and parent company guarantees (PCG's), both of which we covered in our alert "Back to Basics: Guarantees and Bonds". But what if such protection is not forthcoming and you have concerns about the other party's covenant strength? If only a limited performance guarantee/bond is on offer (say less than 10% of the Contract Sum) or none at all, the other party may wish to include an obligation that the value of the guarantee/bond must increase and/or a PCG is to be provided if the net worth of the other party falls to a certain level.
• Remember that collateral warranties in favour of those funding the works give the funder the right to step-in and procure the completion of the project. This provides comfort to the funder and also to the contractor, in that there is a party involved in the project that could procure completion of the project in difficult circumstances. Such rights of step-in are usually conditional upon the funder paying any sums outstanding and due to the contractor.
• If the works are being procured utilising external funding, the funder may be willing to provide a letter of comfort or allow the contractor to have sight of the funding agreement so that the contractor can ascertain for itself that the employer has an adequate funding stream. A step on from this would be an arrangement whereby payments are made directly to the contractor by the funder but this is unusual.

To escrow or not escrow?

• When considering payment security, parties to construction contracts will often seek to set up an escrow account (an account held by an independent third party on behalf of transacting parties, here the employer and the contractor) via which payments due to the contractor are made. The employer will normally open an escrow account and deposit money in the account, which is then operated in accordance with the terms of an escrow agreement. Some escrow arrangements expressly create a trust in respect of the sums held in the escrow account. Bear in mind that if no trust is created, the monies may be vulnerable in an insolvency situation and it is difficult to draft an escrow agreement to ensure that a trust will be created at that stage.
• As an alternative to an escrow account, a charge blocked account can be set up. This secures the present and future obligations and liability of an employer to make payment to a contractor. An employer will open a bank account and deposit money in the account and then charge this account to the contractor so that the contractor is able to appropriate from the account a sum of money necessary to satisfy the obligations of the employer under the building contract. A charge blocked account is safer than an escrow account for the contractor in an insolvency situation as the charge will ensure the contractor is ranked above unsecured creditors.

Top tips

To recap, when considering the issue of performance and payment security, our top tips are:

• Check out the entity you are contracting with before you sign.
• Review the contract - what protections does or could it offer?
• Consider if protections from a third party are needed and whether they are cost effective.
• Make sure any additional protections are enforceable, particularly in the event of insolvency.