Currently, the construction industry accounts for 27% of all insolvencies in Australia, against only 9% of the country’s gross domestic product (GDP).[1] While insolvency in the construction industry can often seem sudden, industry participants should be aware of the factors that foreshadow insolvency and take steps both prior to and during the execution of a project to ensure they appropriately manage risks. These steps can be taken from as early as the drafting and negotiation of the contract, during the execution of the construction project, as well as following the event of insolvency. It is important that companies act at the first signs of insolvency and obtain legal advice to maximise the best possible outcomes, and mitigate any losses.

What is insolvency?

Insolvency occurs when a company is unable to pay its debts as and when they become due and payable.[2]

The question of whether a construction company is insolvent is generally practically difficult to conclusively verify, until it formally occurs. However, some indicators of insolvency can be identified through regular periodic searches of the ASIC record of a company, although these are not always accurate or complete. Ultimately, parties to a building contract can manage their risk in construction projects through appropriately drafted construction contracts, which can include provisions allowing a company to make inquiries of the other party as to its solvency throughout the course of a project, creating contractually binding obligations to disclose particular information that might indicate insolvency.

Warning signs of insolvency

While it is not always possible to identify an impending insolvency event, early signs of insolvency often materialise in the form of project execution and commercial warning signs.

Project execution warnings might include:

• Allocating resources to other sites
• Contractors’ or subcontractors’ temporary infrastructure (e.g. portable toilets and site fencing) being removed from the site
• Suspension of works by contractors or subcontractors
• Contractor or subcontractor failing to return calls or emails or delay in communication
• Slowdown in progress and performance of works, project delays, and lapsed deadlines
• Adjudication applications by subcontractors against contractors
• Drop in quality of site management
• Resignation of key personnel or loss of staff
• Increased defects and drop in quality.

Commercial warnings might include:

• Requests for direct payments in advance (that are not accounted for in the contract)
• Requests for changes to payment mechanism (e.g. timing, dollar amount)
• Overclaimed progress payments or aggressive invoicing
• Increased payment times.

Negotiation Phase

During the negotiation phase of a construction contract, industry participants can take the following steps to ensure they are protected.

Due Diligence

Principals and head contractors should undertake appropriate due diligence in order to assess the financial position of downstream parties. Companies may be able to ascertain the other party’s financial position through conducting an ASIC search or asking them about details of similar sized projects they have previously completed, and referees for those projects.

Construction Contract

Head contracts and subcontracts should be carefully drafted to account for likely, and actual, insolvency. In particular, terms should be included in each contract relating to:

• Swift rights of termination or take-out in the event of insolvency
• Validating that subcontractors, employees and other parties engaged by or on behalf of the affected party are paid in accordance with their trading terms
• Providing rights to companies to request that the other party produce evidence that it is solvent where it suspects, but cannot immediately validate, that the other party may be insolvent
• Management of ownership of unfixed plant and materials to minimise the scope for such items becoming caught up with administrators or liquidators
• Allowing for novation or re-appointment of trades and consultants to increase the likelihood of expeditious recommencement of the works following an insolvency.

Construction Phase

During the construction phase, principals and head contractors should be alive to any warning signs of counterparty insolvency, and undertake additional steps such as establishing an ongoing system of review of the counterparty’s financial position and registering their security interests on the Personal Property Securities Act 2009 (Cth) (PPSA) register. Contractors and subcontractors should also consider actions they can take to prevent insolvency, such as using specialist accountants.

Establish a system of ongoing review

While companies should ensure they conduct appropriate due diligence before entering into a construction contract, it is also important that they conduct ongoing review of the other party’s position and implement systems whereby financial health issues are documented. For example, this could include looking for publicly available financial reporting by the company and any parent or related entities, in particular, late filing of any compulsory financial reports.

Register security interests on the PPSA register

It is important that principals and head contractors register any security interests they may have under the contract under the PPSA. For example, if the contract provides for retention moneys or another form of security, this may need to be registered under the PPSA to be able to be enforced as a security interest in the event of an insolvency of an entity in the project contracting chain.

Other precautions

Companies that suspect that another party within their project contracting chain might have solvency issues can take additional precautions such as ensuring that insurance policies, parent company guarantees, and performance bonds are in place and have not lapsed.

What to do if a counterparty is insolvent

If a party becomes aware of, or suspects impending insolvency of another party within the project contracting chain, there are a number of factors that need to be considered, and it is important that legal advice is sought as soon as possible. Acting quickly when signs of insolvency emerge is of paramount importance because once insolvency is formalised, the scope of actions available to parties as creditors become more limited.

Rights and obligations: contract and statute

As a starting point and in order to assess their options, companies need to consider their rights and obligations under contract and statute. Different contracts may contain different provisions regarding what constitutes insolvency, whether the insolvent party has breached the contract, and the companies’ rights. It important to examine the contract and identify and enforce any relevant rights relating to, among other things:

• Rights of termination and take-out
• Rights of novation or assignment
• Payment claims
• Having recourse to security (timing and correct enforcement is essential when calling on security)
• Unfixed goods and materials on and off site
• Intellectual property
• Insurance.

Termination and take-out

If a downstream entity within the project contracting chain is insolvent, the contractor or any relevant subcontractors will often stop work and principals and head contractors might want to terminate them as soon as possible. Principals and head contractors should consider if they have termination for convenience rights under the contract or if there are any other grounds in the contract for termination. Generally, there is a statutory prohibition against enforcing a contractual right to terminate triggered by a party becoming insolvent in certain instances of insolvency and there are serious consequences of unlawful termination.[3] Therefore, it is prudent to obtain legal advice as to the grounds for termination as well as the appropriate format and content of notices required in order to terminate the contract.

Principals and head contractors may also need to consider rights of step in or take-out as an alternative to termination. Again, legal advice should be sought as to the merits of any such action. However, provided that the relevant contract includes the appropriate terms, this is often an option available to parties to circumvent the prohibitions that would otherwise apply to termination.

If there is a directly upstream entity that has insolvency risk, contractors or subcontractors may consider whether they can suspend works to prevent continuing work for which they might not get paid. Moreover, if there are further upstream entities companies may also consider whether they have rights to request payment directly from these entities if the principal or head contractor in the contract becomes insolvent.

Payment claims

The generally accepted position in Victoria is that companies in administration can still enforce rights under the Building and Construction Industry (Security of Payment) Act 2002 (Vic) (SOP Act).[4]

While the SOP Act is intended to operate on an interim basis, there is naturally a low likelihood of recovering money paid to an insolvent claimant under the SOP Act on any final basis. Accordingly, in practice, an insolvent party utilising the SOP Act is often a ‘last attempt’ at recovering funds under a construction contract and for this reason, must be very carefully managed by principals. To this end, principals and head contractors must ensure that they comply with their obligations under the SOP Act, for example, by serving a payment schedule within time. Legal advice should be sought immediately in managing any payment claims as principals may be able to minimise the scope for any action being taken under the SOP Act by deploying some of the actions referenced in this document.

Insurance

Contractors and subcontractors, as the case may be, should ensure they have the required insurance policies under the contract in place. On the other hand, principals should be aware of the relevant steps they need to take in order to access the policy cover, and examine whether a new or updated policy is required in the event of termination or take-out.

Security

In the event of insolvency, having recourse to security under the contract is often the best chance of recouping any outstanding amounts from an insolvent company, provided that the terms of the contract allow this. It is important that principals and head contractors are aware of the trigger that allow them to call on any security, and timing and correct enforcement is crucial. Consideration must be given to whether principals and head contractors in fact have a bona fide claim to the security, and proper administration of the project leading up to the insolvency (e.g. the notification of defects or liquidated damages as they arise rather than following the insolvency event) will assist principals and head contractors in this regard.

Unfixed goods and materials

If there are unfixed goods and materials, principals and head contractors should ensure that they confirm what rights they have to them and any risks such as failing to register them on the PPSA. Principals and head contractors should move quickly to secure possession of any off-site materials and equipment for which it has paid and title has been transferred to it.

Project status and defects

The options available to, and best course of action for companies to pursue will be dependent on the status of the project. Therefore, in the event of counterparty insolvency, principals and head contractors should urgently confirm the details and status of a project in order to make future decisions. Principals and head contractors should retain an independent, qualified building consultant to undertake a thorough review and assessment of the project, identify any known or potential defects, and assess the tasks (and the time and cost) needed to complete the project. Having this information will assist principals and head contractors in ensuring that future decisions are made with complete information and identify any relevant rights under the contract. Additionally, it is a good idea to document any evidence of defective works such as through photographs.

Future project execution

It is important that principals manage all their obligations and maintain strong relationships with all levels of project management, financiers, and suppliers. Where a contractor is insolvent, it may not have paid subcontractors for their work, and they may refuse to complete work. As it is particularly difficult to engage new subcontractors to complete unfinished work by others, it might be prudent to negotiate with these subcontractors to get them back on site. Moreover, principals might consider employing key personnel such as the contractor’s project manager or site supervisor to ensure continuity.

Bringing a claim against an insolvent company

If a company is in a formal insolvency process a creditor generally cannot bring a claim against it without leave of the court, or unless that creditor has consent from the administrator or liquidator appointed.[5]

Key Takeaways

The challenges faced by construction industry participants affected by counterparty insolvency are substantial. These effects of these challenges can be exacerbated by insufficient attention to the terms of the relevant construction contract, and steps that can be taken at the first signs of counterparty insolvency. Parties to a construction contract are not powerless and can take the steps outlined above both before executing a construction contract and during the construction phase of a project, to ensure that they improve and protect their position if an entity within the project contracting chain becomes insolvent. 

It is vitally important that industry participants identify factors suggesting a stressed project or insolvency as soon as possible. It is equally important that legal advice is sought as soon as possible, and ideally at the first sign of project issues before insolvency. Taking such actions will allow companies to maximise the likelihood of the best outcome for their project and financial position should the fact of insolvency of an entity within the project contracting chain eventuate.

Further information / assistance regarding the issues raised in this article is available from the authors, Bill Papastergiadis, Managing Partner Melbourne, Nathan Cutts, Partner, Phillip Vassiliadis, Partner, or your usual contact at Moray & Agnew.

[1] Australian Financial Review, https://www.afr.com/property/commercial/construction-insolvencies-march-towards-a-decade-high-20230418-p5d1b7.

[2] Corporations Act 2001 (Cth), s 95A.

[3] Corporations Act 2001 (Cth), s 451E.

[4] See Kennedy Civil Contracting Pty Ltd (Administrators Appointed) v Richard Crookes Construction Pty Ltd; in the matter of Kennedy Civil Contracting Pty Ltd [2023] NSWSC 99; Brodyn Pty Ltd v Dasein Constructions Pty Ltd [2004] NSWSC 1230; Façade Treatment Engineering Pty Ltd (in liq) v Brookfield Multiplex Constructions Pty Ltd (2016) 313 FLR 163.

[5] Corporations Act 2001 (Cth), s 440D.