The construction industry has always been susceptible to cash-flow issues, and these problems were inevitably exacerbated by the COVID-19 pandemic. 

In this article, we briefly discuss some headline issues that key stakeholders in the highly inter-connected construction industry should consider in this regard as well as how they can potentially mitigate their exposure to such risks: 

INSOLVENCY OF THE OWNER

The insolvency of the Owner of the Project will inevitably cause very significant harm to the entire contractual chain. 

From a Main Contractor’s perspective, it is, therefore, important that it satisfies itself as to the adequacy of the financial arrangements that the Owner has in place in order to complete the project. 

Euan Lloyd

This is a critical point as, on account of prevailing retrospective payment mechanisms, the Main Contractor is essentially required to perform substantial components of the Works at its own cost, pending receipt of payment. Although construction contracts can allow the Main Contractor to suspend performance in the event of failures to certify as well as on account of the non-payment of certified amounts, it is not unusual for such rights of suspension to be either deleted in their entirety or made subject to lengthy trigger periods. 

This means that the Contractor may be forced to continue to perform without payment for a significant amount of time, during which time the Owner’s financial health may significantly worsen, before being contractually permitted to suspend performance and, thus, ‘stop the bleeding’.  This situation can, in part, be mitigated on the basis that various GCC region jurisdictions allow for one party to suspend performance at law in the event of a breach by the counterparty – that is, the Owner’s failure to make due payments to the Main Contractor, or to certify. However, rights at law are not prescriptive, and there is, thus, an inevitable degree of uncertainty associated with exercising should rights. 

INSOLVENCY OF THE MAIN CONTRACTOR 

The insolvency of the Main Contractor can be severely detrimental to the Owner as well as to the Main Contractor’s subcontractors and supply chain. From the outset, it is notable that a Main Contractor insolvency can, at least, partially emanate from a competitive tendering process that pressurises the Main Contractor into accepting an unrealistically low contract price. 

While this is the Main Contractor’s commercial decision whether to agree to participate and ultimately win a ‘race to the bottom’, the Owner should bear in mind that an unduly low contract price can strangle the ability of the Main Contractor to properly perform. Leaving aside the issue of the adequacy or otherwise of the contract price, it is important that the Owner conducts financial due diligence on the financial standing of the Main Contractor before executing the Construction Contract. 

Additionally, the Owner should be alert to any ‘red-flag’ signs, such as the Main Contractor’s inability to provide a performance bond, as this can indicate that the Main Contractor’s banks have lost confidence in the business, as well as industry knowledge regarding the Main Contractor. From the perspective of the Owner, the insolvency of the Main Contractor will obviously mean that it will need to engage a replacement of the Main Contractor. 

Given that an insolvent Main Contractor cannot be held responsible for the inadequate works that it may have performed, it will be the Owner’s preference that the incoming contractor agrees to assume ‘single point responsibility’ so that it is responsible for the Works performed by the insolvent Main Contractor. However, this can be a complicated and expensive proposition for various reasons, as an incoming contractor may be reluctant to take over and assume the risk of a half-completed project. It is, therefore, important that the Owner ensures that it has sufficient cash security – that is, in the form of retention and a performance bond – under the terminated construction contract to mitigate the cost and expense that will almost inevitably be incurred when engaging a replacement contractor.

A further and related point is that it is likely to be more efficient for the replacement contractor to engage some, or all, of the insolvent Main Contractor’s supply chain in order to complete the Project. However, an insolvent Main Contractor will almost certainly have outstanding payments due to the supply chain, and it is likely that the Employer will need to settle such liabilities in order to entice sub-contractors to return to the site. 

A final remark is that the insolvency of the Main Contractor will also almost certainly delay the completion of the Project and, therefore, the date upon which the Project becomes a revenue-generating asset. Amongst other things, this may have an impact on the Owner’s financing arrangement, and as such, the Owner may wish to consider the availability of insurance to address this risk as well as building flexibility into its financing documents to reflect such a delay. 

INSOLVENCY OF THE SUPPLY CHAIN 

The insolvency of a critical member of the supply chain, such as the sub-contractor responsible for a major package – that is, MEP – or the provider of a long-lead item, can cause significant delays to the Project. Further, as the Main Contractor is fully responsible for the performance of its supply chain, this can expose the Main Contractor to liability under the Main Contract, including in the form of delay damages. It is, therefore, important that the Main Contractor carefully manages and keeps a close eye on the financial standing of its supply chain and is ready to take pragmatic preventative action, if it appears that a key member of its supply chain is in financial difficulty. 

Notwithstanding the critically important role it plays, the supply chain is typically engaged under conditional payment arrangements, which provide that a sub-contractor is only entitled to payment provided that the Main Contractor has received payment for the sub-contractor’s works under the Main Contract. This can be particularly problematic if non-payment to the supply chain is caused by disagreements between the Owner and the Main Contractor that have nothing to do with the works or services performed by the supply chain. 

Payment arrangements of this nature have been prohibited by law in various jurisdictions, on account of the financial stress to which they can expose the supply chain as well as on account of their susceptibility to abuse. While it can be very difficult for conditional payment regimes to be resisted in their entirety, sub-contractors may consider seeking to negotiate mitigants to lessen the harshness of an undiluted conditional payment mechanism. 

Such mitigants may include: (i) Conferring transparency upon the sub-contractor to determine when payment from the Owner is received by the Main Contractor; (ii) Specifying that the conditional payment mechanism is not indefinite but is expressly subject to a definitive long-stop date; and (iii) Providing that the conditional payment regime is subject to prescribed thresholds.

Finally, the aforementioned points in relation to steps that the Main Contractor can take in respect of its arrangements with the Owner are generally applicable to the supply chain and should, therefore, be carefully considered by the supply chain.

Euan Lloyd, Senior Counsel, Al Tamimi & Company, writes a bi-monthly column on legal issues relating to building construction, exclusively for Climate Control Middle East. He may be contacted at E.Lloyd@tamimi.com