How Does Insolvency Affect Construction Projects?

Australia’s economic conditions are reportedly the toughest faced in several decades, and the likelihood of insolvency and other financial difficulties poses a substantial risk to the construction industry. Directors must then understand their obligations and manage their debts so as to proactively minimise damage to their business if a contractor or principal encounters financial difficulty. Below, we discuss how the current climate is affecting the construction industry and methods to manage insolvency if it arises during a project.

Risk Climate in the Australian Construction Industry

Today, most construction projects are delivered via a pyramid structure – the head contractor engages subcontractors who in turn sub-subcontract smaller projects to subcontractors and suppliers who perform the actual work. As a result of this structuring, those parties performing the bulk of the work do not have a direct contractual relationship with the head contractor who is receiving payments for services by the client. The end-result is a transfer of financial and project management risk downstream to subcontractors, while cash flow continues to sit upstream. This structural power imbalance means business failures higher up the chain cascade down to bottom-layer parties, increasing the risk of insolvency further down the line.

Back to Basics: What is Insolvency?

Section 95A of the Corporations Act defines insolvency as the inability to pay all debts as and when they become due and payable. Company directors have a duty to avoid insolvent trading, as set out in section 588G of the Act. In short, company directors must ensure they do not allow the company to trade while insolvent, or incur a debt that would lead the company to insolvency.

Directors that breach this duty and trade while insolvent may be subject to serious consequences, including:

• Being held personally liable for company debts incurred while insolvent;
• Being held liable for a civil penalty under the Corporations Act;
• Being convicted of a criminal offence under the Corporations Act, including potential imprisonment;
• Being banned from acting as a director; and
• Being excluded from holding a building licence under the relevant State or Territory regulator.

Managing the Risk of Insolvency

A carefully drafted contract will ensure potential insolvency risks are adequately managed and will mitigate your company’s liability should unexpected events affect a project. Consider addressing the following:

• Outlining the key roles and responsibilities of each party to the contract, and ensuring these obligations are enforceable;
• Establish ownership of materials brought to site and ensure those materials are not unlawfully removed;
• Clarify the right to terminate or suspend work in the event of insolvency or where insolvency precursors are evident; and
• In the event of termination, incorporate a clause enabling the retention of future contractual rights.

If you are the principal of a construction project, you should also consider:

• Obtaining adequate security for performance before making a payment (consider registering an interest on the Personal Property Securities Register to gain priority in the event of insolvency);
• Incorporating proof of downstream payments (to subcontractors and sub-subcontractors) as a pre-condition for progress payments; and 
• Requiring the novation of subcontractors to enable you to step into the shoes of the insolvent contractor and have its subcontractors complete their works.

For downstream service providers, the following are some basic steps that can be taken to protect your business against financial difficulty:

• Obtain personal guarantees where credit is provided;
• Obtain security over the company’s assets;
• Include retention of title clauses in your contracts to protect ownership of materials and equipment;
• Register all security interests, including any rights under retention of title clauses, on the Personal Property Securities Register so they are enforceable in the event of insolvency;
• Utilise the right to suspend work under the contract for non-payment;
• Keep regular and accurate records of all communications, including verbal;
• Take action in the event of late payments, and lodge all claims promptly; and
• Lodge a charge or notice of claim for a debt or lien (depending on the jurisdiction) to obtain priority in the event of insolvency.

Next Steps – Once a Company Becomes Insolvent

Once a company becomes insolvent, a liquidator or external administrator will be appointed to assist the insolvent party to trade out of its debts or to wind the company up, call in its debts, liquidate its assets and distribute the proceeds to its creditors. In the event a principal or head contractor becomes insolvent, you may exercise the right to terminate (subject to the terms of your contract). In addition to termination, you may be able to retain any future right to call on securities to recuperate your losses based on the rights created in the initial contract.

Instead of termination, consider exercising alternative rights within your contract such as:

• Retaining materials and equipment registered under retention of title clauses;
• Lodge any claims for registered securities, warranties or assurances of capacity to pay with the liquidator or external administrator;
• Seek advice to have the contract novated to transfer the contractual obligations on to a new, solvent principal or contractor.

Key Takeaways

The risk of insolvency in a pyramidal structure is high due to the structural imbalance of contractual relationships and top-heavy control of cash flow. Be proactive to mitigate against any risks by taking the following steps:

• Ensure any contract entered into is clear on the key roles and responsibilities of the contracting parties, provides for termination rights in the event of insolvency, clarifies ownership over assets and materials and protects future contractual rights;
• Keep clear and accurate records of all transactions and conversations, including verbal agreements and discussions; and
• Register all securities and interests to secure priority in the event a party becomes insolvent.
• Take action early:
  • Lodge all claims as soon as possible; and
  • Exercise your rights under your contract for payment, or to remove work from another party.

Importantly, in the event of insolvency, seek legal advice to ascertain the best options to obtain any monies due and limit your own liability. If your company has been affected by another party’s insolvency, or you would like further advice to on preventative actions, get in touch with our specialist construction lawyers on 1300 544 755.