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My Contractor is Insolvent, What Now?

Fasken
Reading Time 8 minute read
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Overview

The year 2020 is drawing to an end and the construction industry is gearing up for what is typically referred to as the builders break over the December holidays.  A lot of construction companies will find the 2020 builder’s break to be very different to those of previous years, due to the negative impact that the COVID-19 pandemic has had on the construction industry, and the world at large.

Construction sites across the country had to be shut down in accordance with the lockdown regulations, affecting both Contractors and Employers adversely.  The inability to continue with construction works for what was an indefinite period at some stage, resulted in construction companies finding themselves in situations where their cashflow was affected as a result of a lack of income, due to the fact that no works could progress. For some Contractors, the lack of cashflow had a knock on effect on their ability to resume operations and continue working in accordance with their contractual obligations, once the lockdown restrictions were lifted.

As a result, numerous construction companies became insolvent and had to be wound up, and this has a direct effect on the completion of a project. In this article, we will explore the effect of a Contractor’s insolvency on a project and what the Employer’s remedies are, specifically when it comes to the calling up of a performance bond, for purposes of completing the project as a result of the Contractor’s failure to continue carrying out its contractual obligations.

In terms of our law, a company can be commercially or factually insolvent. Factual insolvency occurs when a company is unable to pay its debts as and when they become due. Commercial insolvency is where a company’s liabilities exceed its assets and the effect of insolvency, whether commercial or factual, include the commencement of voluntary liquidation proceedings or winding-up of the company by the Court.  The liquidation crystallises the insolvent company’s position and creditors’ rights, in order of preference, become supreme. 

A company’s solvency will affect its ability to continue with its operations and to fulfil its contractual obligations. Some standard form construction contracts contain provisions which make insolvency a ground for termination.  An example is the FIDIC 1999 Yellow Book which provides that an Employer shall be entitled to terminate a contract if the Contractor becomes insolvent or goes into liquidation.  The NEC 3 Supply Contract enables either party to terminate the contract if, amongst others, either company has had a winding up order made against it, made arrangements with its creditors or had an administrator appointed over the whole or a substantial portion of its assets.  Furthermore, the General Conditions of Contract (“GCC”), provides that an Employer may terminate the contract if, inter alia, there is an application for sequestration against the Contractor’s estate or the Contactor presents a petition of for the acceptance of the surrender of its estate as insolvent. 

These particular standard form contracts do not necessarily refer to the event of insolvency as a breach of contract, but rather a ground for termination.  This raises the question whether the insolvency of a Contractor on its own constitutes a breach of contract, which is discussed below.

Where a contract is terminated based on a Contractor’s breach, the Employer will be entitled to complete the works with a different contractor and claim the costs expended as a result thereof from the Contractor, as allowed for in the contract.  This becomes difficult in instances where the Contractor is insolvent, and is no financial position to satisfy the claim of the Employer.  One of the options available to the Employer in such an instance will be to call up a performance bond, where provision has been made for this form of security, and in instances where the wording of the bond allows for the calling up of the bond in the event of insolvency. 

A performance bond is a form of guarantee provided by a third party, which guarantees a quantified financial benefit to the Employer, in the event of the Contractor’s non-performance.  As a general rule of thumb, the Employer is entitled to call on the bond upon the Contractor’s non performance.

The question then arises, whether a Contractor’s insolvency constitutes a breach of the contract, in terms of which the performance bond may be called up.  In answering this question, regard must be had to the wording of the bond and the contract between the parties.

In the English Law case of Ziggurat the Court considered this question.  In the said case, the bond in question had a specific provision which allowed for the bond to be called up to satisfy a damages claim, following on the Contractor’s insolvency.The Applicant, Ziggurat LLP ("Ziggurat") employed County Contractors UK Ltd ("County") to erect a building through a Joint Contracts Tribunal Standard Building Contract, 2011 (“JCT Contract”).  County’s performance was the subject of a Performance Guarantee Bond ("the Bond") provided by the Defendant, HCC International Insurance Company PLC ("HCC").  Without any fault attributable to Ziggurat, County ceased work and it later transpired that they were facing financial difficulties.  Ziggurat sent multiple notices to County and finally terminated the contract.  Ziggurat employed another contractor to complete the works, meanwhile, County became the subject of a Company Voluntary Arrangement (akin to a form of business rescue in South Africa).  Following completion of the works, Ziggurat sent it’s bill for the debt due by County, who were obviously unable to make payment, causing Ziggurat to call on the Bond by HCC, who rejected the claim. 

County alleged that Ziggurat’s termination of the contract was invalid and consequently, Ziggurat had repudiated the contract.  Additionally, County claimed that the Bond is a default bond and not a demand bond, which meant that default had to be proven first before the Bond was called.  This was the main dispute between parties.

The Court ultimately found that there was liability established under the contract which allowed for the calling up of the bond.  In assessing this issue, the Court found that a bond of this sort is an instrument of secondary liability and that the surety cannot be in a worse position as against the Employer, than the Contractor.  The Court held that insolvency would lead to a breach and thus a claim under the Bond, if the Employer had followed the provisions of the contract and established a debt due and the debt remained unpaid by the Contractor.

Further, the obligation of a surety is simply to stand behind the Contractor and not to be under any greater liability than the Contractor would have.  The Court differed with the approach of determining that the only issue between the parties is whether a breach of contract by County is always required under the Contract or whether an insolvency event is enough to trigger liability on HCC.  The Court found that the correct approach is to identify what is necessary for a successful claim under the Bond in circumstances where County is insolvent and have not paid the debt which has been ascertained and is due.

The Court further held the view that in terms of the contract, termination could occur through default and insolvency of the contractor, both events give rise to the same result, that is, calculation and identification of debt.  Thus insolvency was found to be a breach.  Further, debt can arise without a breach, which suggested that the use of the word damages in the contract was intended to have the broader meaning of loss or sums recoverable under the Bond. 

Closer to home, in Mutual & Federal Insurance Company Limited and another v KNS Construction (Pty) Limited (in liquidation) [2016] the Supreme Court of Appeal (“SCA”) had to consider whether there was a valid calling up of a performance bond by an insolvent Contractor (KNS) against its subcontractor. The subcontractor itself was not insolvent and it was found that KNS had failed to specify which breach the subcontractor was alleged to have committed, which was required for the calling up of the bond. The facts are distinguishable from those is Ziggurat. However, of importance is the SCA’s finding that the true purpose and the true intention of the parties to the guarantee has to be considered in deciding whether a bond has been properly called up. In doing so, the court will rely on the established principles of interpretation and the language used to determine the true intention of the parties. 

Parties must therefore be mindful when drafting the provisions of their contract to make provision for instances of insolvency, where this is intended.  In addition, careful regard must be had to the drafting of performance bonds to ensure that they are not loosely worded, especially in circumstances where the intention is to allow for the bond to be called up in the event of insolvency. 

Although the focus of this article is on a company’s insolvency, it is important to mention the principles as applicable to companies under business rescue. Business rescue proceedings are intended, amongst others, to restructure the affairs of a company so that the company can return to solvency. This is in contrast to liquidation proceedings which generally lead to the winding-up of the company, including the sale of the company’s assets. In principle, a Contractor in business rescue should be able to continue with its operations without the need for a performance bond to be called up, on condition the Contractor is in a financial position to do so. This can be made possible by post-commencement finance (“PCF") advanced by lenders to the Contractor. However, in instances where a Contractor under business rescue does not obtain PCF and fails to fulfil its contractual obligations and the bond is called up then the validity of the calling up will be determined by the wording of the contract as well as the performance bond.

As a alternative to obtaining PCF, or if the PCF is not enough for all projects, the Contractor may enter into commercial negotiations with Employers and agree with them that they (the Employers) will not call up their performance bonds on condition the relevant projects are completed within a specified period of time. These negotiations would depend almost entirely on existing commercial relationships between representatives of the Contractor and the Employer.

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