Construction contracts: dealing with a contractor’s insolvency – a Nigerian law perspective

June 2017 | EXPERT BRIEFING | BANKRUPTCY & RESTRUCTURING

financierworldwide.com

Nigeria’s construction sector is a vital economic growth driver. The construction sector provides physical infrastructure in relation to power, roads, rail, bridges and real estate – industries which drive industrialisation and economic growth. The Nigerian Institute of Building claims that Nigeria’s construction industry is worth about $69bn and employs about 5 percent of Nigeria’s estimated 180 million people. The Nigerian Bureau of Statistics, in its last released Labour Productivity Report, i.e., Q3 of 2016, estimates that Nigeria’s workforce stands at 80,669,196 people. This means that the workforce in the construction sector constitutes about 11.65 percent of Nigeria’s total workforce.

According to the Lagos Chamber of Commerce and Industry, Nigeria currently has an infrastructure deficit of $300bn. The Integrated Infrastructure Master Plan (NIIMP), a 30-year blueprint for infrastructure development launched in 2014, projects that Nigeria will require roughly $3 trillion for infrastructure development over a period of 30 years to close the infrastructure gap. The foregoing highlights the importance of a stable construction sector and timely project delivery.

A contractor’s insolvency will adversely affect a range of parties including the employer, subcontractors and suppliers, tenants and lessees, landlords and lenders, etc. The insolvent contractor may be compelled by its impecuniosity to compromise quality, allocating insufficient resources to the project with the aim of cutting costs. This may result in underperformance, increase in defects, drop in quality of work, substantial time and cost overruns, defaults in subcontracts and obligations to funders and the possibility of discontinuance of the project. An employer’s remedies and buffer against contractor insolvency will depend partly on the terms of the contract and the principles of contract and insolvency law. This article examines these remedies and buffers through which employers may mitigate losses arising from the insolvency of contractors.

Employer’s payment obligations

Payment provisions are very vital in construction contracts. Payment arrangements are usually agreed by the parties and may be influenced by the nature of the project. Payment may be made in advance, conditioned on completion of work, based on the amount of work done, contingent upon milestones and based on submission of pay applications. An employer will understandably be concerned where a contractor that has received advance payment becomes insolvent. Such employer faces the risk of becoming an unsecured creditor, in relation to the sum, with very little hope of receiving dividends in the insolvency proceedings.

Advance payments to contractors may be secured by parent company guarantees (PCGs) and performance bonds. At the negotiation stage, an employer may require an undertaking from a parent or affiliate of the contractor to guarantee the performance obligations of the contractor. Upon the contractor’s insolvency, the employer must be careful not to act in any manner which may discharge the guarantor of its obligations. Depending on the terms of the PCG, such acts may include employment of a new contractor, variation of the contract without required notices or consents and termination of the contract.

An employer making advance payment could also require the contractor to provide a performance security. A typical performance or advance payment bond will provide for payment of the employer by the bond issuer (a bank or an insurer) of up to an agreed amount (usually 10 percent of the contract sum) if the contractor becomes insolvent. Bonds provide an additional layer of security considering that they are usually provided by third parties (as opposed to the contractor’s affiliates) which would not be affected by the contractor’s insolvency.

An employer may also include a retention fund clause in the contract. The clause would typically require the employer to retain a percentage of each progress payment as a buffer against insolvency resulting in non-completion. A retention fund is a purely personal monetary obligation which does not constitute a trust. The employer merely holds back money as opposed to setting it aside (MacJordan Construction Ltd v Brookmount Erostin Ltd (1992)). Accordingly, a retention fund may not provide foolproof protection to an employer upon the contractor’s insolvency. The funds may be regarded as having already been earned by the employer and hence ought to be turned over to the liquidator. Retention may thus constitute fraudulent preference or breach the pari passu distribution scheme.

Payment of subcontractors

An employer’s ability to retain the services of an insolvent contractor’s subcontractors may be crucial in avoiding time and cost overruns. There are a number of ways in which an employer may reduce the risk of an insolvent contractor’s indebtedness to subcontractors. First, an employer may require contractors to include a ‘pay-when-paid’ clause in vital subcontracts. The provision will require a subcontractor to be paid within a specified period after the contractor has received payment. This will ensure prompt payment to subcontractors and reduce the chances of monies being unreasonably held up by contractors with the risk of being trapped in subsequent insolvency proceedings.

Second, an employer may insert a direct payment clause in the construction contracts which will authorise the employer to make direct payments to unpaid subcontractors where the contractor defaults. A direct payment clause converts an employer’s duty to pay contractors into a right to pay subcontractors directly and set-off the equivalent amount against sums due to the contractor. Instructively, direct payments made three months prior to commencement of the contractor’s insolvency proceedings may constitute fraudulent preference (section 495 of Companies and Allied Matters Act, 2004 (CAMA) and section 46 of the Bankruptcy Act, 1979). Direct payments made after the commencement of proceedings will violate the pari passu rule and may also be void pursuant to section 413 of CAMA (Merchantile Bank of Nigeria v Nwobodo (2000)). The English cases of Re Tout and Finch Ltd (1954) and Re Wilkinson (1905) where direct payment clauses at insolvency were held to be valid are not good law in this regard. Against this background, an employer making direct payments to subcontractors should obtain an undertaking by the subcontractors to indemnify the employer against any liability the employer may have to pay a similar amount to a liquidator.

Third, a viable alternative to direct payment clauses is the creation of a trust in favour of subcontractors. Accordingly, monies advanced by the employer to the contractor for the specific purpose of paying subcontractors but which has not been paid to them at the time the contractor goes into liquidation would be held on a resulting trust in favour of the employer (Barclays Bank v Quitclose Investment (1970)). The money will not fall into the insolvent contractor’s estate and a liquidator will have to pay back the money to the employer (Canary Wharf Contractors Ltd v Niagara Mechanical Services Int’l Ltd (2000)).

Fourth, an employer may negotiate for collateral warranties from the contractor. The collateral warranties which include ‘step-in’ rights will entitle the employer to step into the contract between the contractor and subcontractors on termination of the contract. The step-in rights will minimise time and cost overruns by enabling the employer to work on the same terms the contractor agreed with subcontractors.

Plants and materials on site

Provisions vesting ownership of equipment on site on the employer are usually inserted in construction contracts to secure the equipment, use equipment as security for performance and ensure uninterrupted continuation of the project if a contractor is replaced. Vesting clauses may provide that ownership of materials and plants shall transfer to the employer once they are brought on site (Hart v Porthgain Harbour Co Ltd (1903)). Care must be taken to ensure that a vesting clause is not recharacterised as a charge. Whether the vesting clause transfers ownership is a question of construction of the clause (In re Cosslett (Contractors) Ltd (1998)).

Instructively, where the clause provides for transfer of ownership upon the contractor’s liquidation, it may be void for breaching the anti-deprivation rule (In re Harrison (1880)). The anti-deprivation rule invalidates contractual provisions designed to remove assets from the estate of an insolvent on winding up (Belmont Park Investments Pty Ltd & Ors v BNY Corporate Trustee Services Ltd & Anor (2012)).

Where there are retention of title clauses in favour of the contractor, a liquidator will have a rightful claim to the plants and materials. However, where the materials have been incorporated into the project or affixed to land, they become assets of the employer. The equitable principle encapsulated in the latin maxim Quicquid plantatur solo solo cedit (meaning whatever is affixed to the soil belongs to the soil) will apply (Orianwo v Okene (2002)). Whether an asset remains a chattel or becomes part and parcel of the land depends on the degree of annexation to the land and the object of the annexation (Elitestone Ltd v Morris & Anor (1997)).

Termination

Under common law, insolvency is not a fundamental breach of contract which entitles an employer to a right to terminate. A liquidator may opt to perform the contract as was the case in In Re Toward (1884). However, it is common practice for insolvency to be made an event of default in construction contracts, entitling the solvent party to terminate the contract. An example of this can be found in the Multilateral Development Bank’s harmonised edition of ‘General Conditions made in collaboration with the International Federation of Consulting Engineers’ (June 2010). Further, the contract may also authorise the employer, upon the contractor entering formal insolvency, to withhold all monies until the works have been completed, all defects liability period has expired and all defects have been rectified.

An employer may also terminate the contract for repudiatory breach by the insolvent contractor. Insolvency in itself does not constitute repudiatory breach given that the liquidator may opt to continue and complete the contract. A repudiatory breach is a fundamental breach that entitles the injured party to terminate the contract and sue for damages (Saka v Ijuh (2010)). Repudiatory breach may either be due to inability or unwillingness of the contractor (through its liquidator) to perform its contractual obligations. For instance, where the contract provides that the contractor shall proceed with work regularly and diligently or where time is stated to be of essence, failure of the contractor may entitle the employer to treat the contract as at an end.

Conclusion

Numerous contractual safeguards are available to employers whose contractors become insolvent in the course of construction projects. Most of these safeguards must be incorporated into the contract from the outset. However, some of these safeguards may not provide employers with foolproof protection as they may be invalidated if found to be in breach of any principle of insolvency law.

Dr Kubi Udofia is a senior associate and head of the corporate and commercial law practice group at Fidelis Oditah & Co. He can be contacted on +234 81 0289 1800 or by email: kudofia@oditah.com.

Dr Kubi Udofia

Fidelis Oditah & Co.