Introduction

Currently, the construction industry accounts for 27% of all insolvencies in Australia, against only 9% of the country’s GDP [1]. While insolvency in the construction industry can often seem sudden, councils should be aware of the factors that are likely to indicate contractor insolvency and take steps both prior to and during the execution of a project to ensure they are protected. This article aims to provide some guidance to councils in respect of the actions that they can take in the negotiation of the contract, during the execution of the construction project, and in the event of insolvency, to manage their risk and protect their position. It is important that councils act at the first signs of contractor insolvency and obtain legal advice in order to take the appropriate steps to maximise the best possible outcome 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]. 

There are two tests for insolvency; the ‘cash flow’ test and the ‘balance sheet’ test. The former is generally preferred. The ‘cash flow’ test assesses the ability of a company to pay its debts as and when they become due and payable, whereas the ‘balance sheet test’ assesses the solvency of a company by reference to its total external liabilities against the total value of company assets, and determines that a company is insolvent if its liabilities exceed its assets. In Australian Securities & Investments Commission v Plymin (No 1) (Plymin),[3] the Court, citing Plowman J in Re Tweed Garages Ltd, [4] expressed a preference for the ‘cash flow’ test.

While there are specific construction industry related indicators that councils can look to for any warning signs of contractor insolvency, the Court in Plymin established the following general ‘indicators of insolvency’:

• continuing losses
• liquidity ratios below one
• overdue Commonwealth and State taxes
• poor relationship with present bank including inability to borrow further funds
• no access to alternative finance
• inability to raise further equity capital
• suppliers placing the company on COD (Cash on Demand payments) or otherwise demanding special payments before resuming supply
• creditors unpaid outside trading terms
• issuing of post-dated cheques
• dishonoured cheques
• special arrangements with selected creditors
• solicitors’ letters, summonses, judgements or warrants issued against the company
• payments to creditors of rounded sums which are not reconcilable to specific invoices
• inability to produce timey an accurate financial information to display the company’s trading performance and financial position and make relevant forecasts

Some of these indicators can be identified through regular periodic searches of the ASIC record of a contractor. However, this record is not always accurate and commonly, the question of whether a construction company is insolvent is difficult to conclusively verify until it occurs. However, appropriately drafted construction contracts can include provisions allowing a principal or owner to make inquiries of the contractor as to its solvency throughout the course of a project, creating a contractually binding obligation on the contractor to disclose some of the indicators set out above.

Negotiation phase

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

Due diligence

Councils should undertake appropriate due diligence in order to assess the financial position of contractors before appointing a contractor. Councils may be able to ascertain the financial position of a contractor through conducting an ASIC search or asking the contractor about details of similar sized projects they have previously completed, and referees for those projects.

Construction contract

Councils should propose a contract that ensures that the council’s position is protected and accounts for likely, and actual, insolvency. In particular, terms should be included in each contract relating to:

• validating that subcontractors, employees and other parties engaged by or on behalf of the contractor are paid in accordance with their trading terms
• providing rights to council to request that the contractor produce evidence that it is solvent where council suspects, but cannot immediately validate, that a contractor may be insolvent
• swift rights of termination or take-out in the event of insolvency
• 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 by council or its replacement contractor to increase the likelihood of expeditious recommencement of the works following an insolvency

Construction phase

During the construction phase, councils should be alive to any warning signs of insolvency, and undertake additional steps such as establishing an ongoing system of review of the contractor’s financial position and registering their security interests on the Personal Property Securities Act 2009 (Cth) (PPSA) register.

Warning signs of insolvency

During the execution phase, councils should look for warning signs of any impending insolvency and conduct regular reviews of the contractor’s financial position through for example, financial audits and discussions with suppliers and subcontractors. While it is not always possible to identify an at-risk contractor before it becomes insolvent, councils may be able to identify early signs of insolvency risk from contractors through the following project execution or commercial warning signs.

Project execution warnings might include:

• allocating resources to other sites
• contractors’ temporary infrastructure (e.g. portable toilets and site fencing) being removed from the site
• suspension of works by subcontractors
• contractor 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
• 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)
• delayed payment of subcontractors
• overclaimed progress payments or aggressive invoicing
• increased payment times

Establish a system of ongoing review

While councils should ensure they conduct appropriate due diligence before entering into a contract with a contractor, it is also important that they conduct ongoing review of the contractor’s position and implement systems whereby financial health issues are documented. For example, this could include looking for publicly available financial reporting by the contractor and any parent or related entities, in particular, late filing of any compulsory financial reports. Councils may also ask contractors to provide details of subcontractors or suppliers and ask staff on the ground.

Register security interests on the PPSA register

It is important that councils 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 enable councils to enforce them as a security interest in the event of an insolvency.

Other precautions

Councils can take additional precautions such as ensuring that the contractor’s insurance policies, parent company guarantees, and performance bonds are in place and have not lapsed.

What to do if a contactor is insolvent?

If councils become aware of, or suspect impending contractor insolvency, there are a number of factors that need to be considered, and it is important that legal advice is sought as soon as possible. It is important to act quickly when signs of insolvency emerge as once insolvency is formalised, the scope of actions available to councils becomes more limited.

Rights and obligations: contract and statute

As a starting point, councils need to consider their rights and obligations under contract and statute in order to assess their options. Different contracts may contain different provisions regarding what constitutes insolvency, whether the contractor has breached the contract, and councils’ rights. It important to examine the contract with the contractor 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 contractor is insolvent, the contractor and any relevant subcontractors will often stop work and councils might want to terminate the contractor as soon as possible. Councils 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 contractor becoming insolvent in certain instances of insolvency and there are serious consequences of unlawful termination [5].

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.

Councils 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.

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) [6]. 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 contractor under the SOP Act on any final basis. Accordingly, in practice, an insolvent contractor 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 council. To this end, councils must ensure that they comply with its 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 council 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.

Subcontractors

Councils should seek legal advice on their rights relating to the novation of subcontractors, whether that be either to a third party that council engages following a termination or take-out, or back to council for a temporary ‘holding’ period until a new contractor is appointed. Subcontractors must be managed carefully and with the benefit of legal advice so as to ensure that any commercial arrangements for completion of their works are appropriately documented, and do not present any issues with the administrator or liquidator of the insolvent contractor.

Insurance

If the required insurances are in place, councils 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 contractors, provided that the terms of the contract allow this. It is important that councils 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 councils 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 councils in this regard.

Unfixed goods and materials

If there are unfixed goods and materials, councils should ensure that they confirm what rights they have to them and any risks such as failing to register them on the PPSA. Councils 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 councils to pursue will be dependent on the status of the project. Therefore, in the event of contractor insolvency, councils should urgently confirm the details and status of a project in order to make future decisions. Councils 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 councils 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 councils 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, councils 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 contractor is in a formal insolvency process you generally cannot bring a claim against it without leave of the court, or unless you have consent from the administrator or liquidator appointed [7]. 

Key Takeaways

There are considerable challenges that principals face in relation to managing contractor insolvency and the significant risks that they bear if they do not turn their mind to such issues. However, principals can take numerous steps before executing a construction contract and during the construction phase of a project, to ensure that they protect their position. 

It is vitally important that councils identify factors suggesting a stressed project or contractor insolvency as soon as possible. It is equally important that councils seek legal advice as soon as possible. Taking such action will allow councils to maximise the likelihood of the best outcome for their project and financial position should the fact of insolvency of a contractor eventuate.

[6] 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] VSCA 247.
[7] Corporations Act 2001 (Cth), s 440D.