Safeguarding against employer insolvency

What are the options available and mechanisms that a contractor should have in place to safeguard its interests in the event of its employer becoming insolvent? MARTIN PRESTON* of Norton Rose provides a guideline.

Under the laws of the Emirate of Dubai, employers have to comply with Law No 8 of 2007 (the “Escrow Law”).

This requires developers undertaking off-plan sales to ensure that money coming into the project as and when sales are made or as a result of property finance (excluding the developer’s own capital contribution) is ring-fenced by being paid into an escrow account.  Only certain payments are permitted to be made from this account. 
A contractor entering into a construction contract with an employer governed by the Escrow Law should ensure that payments due under the construction contract are permitted to be made from the escrow account, thereby providing the contractor with the comfort that funds coming into the project will be made available to pay the contractor.
If the Escrow Law does not apply because the project is outside Dubai or if the project is largely self-funded by the developer, how can a contractor ensure that it will be paid?
Although most standard form construction contracts (including the FIDIC forms prevalent in this region) contain provisions entitling a contractor to interest on late payment and to suspend performance of the works should the employer fail to pay sums due to it, the contractor will at this stage be out of pocket as it will have carried out the works covered by the unpaid payment certificate. 
The right to suspend does, however, give the contractor some leverage against the employer and ensure that it does not have to keep incurring costs once payments have been missed by the employer.  It does not, however, provide much protection should the employer become insolvent and unable to make payments under the contract. 
FIDIC and other forms of contract entitle a contractor to terminate the contract (or its employment thereunder) if the employer is insolvent and this enables a contractor to cease construction and the incurring of costs after the employer is insolvent (or, more correctly, after the contractor is aware that the employer is insolvent, which may be somewhat later).  However, this will not provide any comfort to the contractor in relation to costs incurred and/or payments due that the employer cannot make because of its insolvency.  Similarly, the right to terminate for non-payment – while providing the contractor with a remedy if a solvent employer fails to make payments when due – will not assist a contractor when the employer is unable to make payments because it is insolvent.
Ideally, then, a contractor will have in place mechanisms that ensure that it is paid.  The most obvious of these is an escrow account into which the employer deposits the amounts that are to become due to the contractor under the building contract.  An employer would probably be reluctant to place the entire contract price in an escrow account but an alternative would be for the employer to place an amount equal to the next anticipated payment certificate into the escrow account and for the account to be replenished after each payment has been made from it. 
The contractor will need a right to suspend performance of the works under the building contract if such funds have not been replenished so that it does not incur the costs of carrying out the works without the certainty of knowing that funds will be available to pay the next payment certificate.  In certain jurisdictions, the escrow agreement will need to be drafted with care to ensure that payments into the escrow account are not set aside on an insolvency as preferential payments to creditors or as a result of any moratorium preventing the exercise of rights on an insolvency, thereby depriving the contractor of the protection that that account is intended to provide.
Another option is for the employer to provide to the contractor a performance bond or letter of credit for a certain amount, which the contractor could draw against if payment was not made.  As with the escrow account, the contractor should have a right to suspend works under the building contract if there is a call under the performance bond or letter of credit and either it is not replenished to its full amount or the unexpired portion is less than the anticipated value of the next payment certificate.  It will be important to ensure that the performance bond is drafted so that the contractor can draw upon it when required.  This will depend on whether it is an on-demand or conditional bond and, if conditional, on the conditions that need to be satisfied before a call can be made.  Further discussion of performance bonds can be found in my article in the February 2007 edition of Gulf Construction.
If the employer has a parent company, then another option may be to seek a parent company guarantee, such that the contractor can obtain payment from the parent company if the employer fails to meet its payment obligations under the construction contract.  This option may prove more attractive to an employer as the cost is less than that of funding an escrow account or providing a bond or letter of credit, although equally the parent company may not want to be exposed to the liabilities of one of its subsidiaries in this way. 
From the contractor’s perspective, a parent company guarantee will only be of value if the parent company has the financial ability to meet any claims made against it.  The contractor will therefore have to conduct due diligence on the parent company and to ensure that it is aware if there is any deterioration in the latter’s financial standing, the parent company would be unable to meet its obligations under the guarantee. In this case, the contractor will want to ensure that alternative security for the employer’s payment obligations is put in place.

Gulf Construction