Building with confidence: insolvency-related considerations for principals in building contracts
At the start of 2023 we looked back at the 2022 challenges facing the real estate sector, including the construction and project development practice. Such challenges are driven by economic and environmental factors as well as (plans for) legislative and regulatory changes. Also in 2023, these much-discussed challenges – such as the increased construction and interest costs, the nitrogen crisis and tax law changes as well as the uncertainty about, and feared consequences of, the plans for further regulation of the Dutch residential rental market – give rise to discussions between (contracting) parties to construction projects.
Challenges for construction and development practice
In this ‘turbulent’ market, it is especially important for principals to mitigate risks and stipulate solid arrangements from their contractors. It is essential to take into account the possibility that the contractor does not fulfill its obligations (for example) due to bankruptcy or other insolvency-related issues. What contractual tools does a principal have at its disposal to limit damages and ensure, as much as possible, the completion of the project? In this blog, we briefly discuss some of these contractual tools.
The security package to be provided by the contractor will certainly come up at the negotiation table. There are different types and forms of securities; for example, a bank guarantee or performance bond, a corporate guarantee, surety bonds, a so-called 403 statement, deposits, retention or a third-party guarantee (such as SWK or Woningborg). Each type of security offers different advantages (and disadvantages) to the principal and perhaps also to his buyer, and requires specific (legal) points of attention that must be taken into account.
Foremost, it is essential that a security is structured in such a way that its validity is not affected if the contractor becomes insolvent. In addition, careful consideration must be given to the composition of the various securities that constitute a specific security package: through selection of securities – each offering different benefits and risk coverage – principals can negotiate a balanced security package to optimize protection against insolvency risks.
Other contractual instruments
In addition to an appropriate security package, there are other tools a principal can use to minimize the consequences of a potential insolvency of the contractor as much as possible.
Naturally, it is desirable that the contract price is paid in instalments afterwards 'in line with the progress of the work'. In addition, it is customary to agree that the last instalment, or part of it, will be retained on completion, allowing the principal to keep a reserve for rectifying handover defects and any defects that may emerge later.
It is also crucial to make proper arrangements regarding the insurance to be taken out for the project. In the context of the CAR insurance, it is advisable to include a beneficiary clause – this clause ensures that insurance proceeds are paid to the principal or held in escrow and cannot end up in the estate of a bankrupt contractor.
The specific risk that the contractor becomes insolvent during construction can be covered by a completion (and repair) guarantee from, for example, SWK or Woningborg. The choice of one of the aforementioned insurance instruments will be determined by the varying coverage these products offer and, of course, the cost considerations.
It is also important that the building contract stipulates certain "principal rights”. For example, one provision that is typically included is the principal's right to dissolve the building contract in the event of insolvency on the part of the contractor. Another instrument that may be available to the principal in such a situation is a so-called 'step in right' that the contractor – for the benefit of his principal – must stipulate from his subcontractors. This step-in right is legally structured in such a way that, in case of insolvency of the (main) contractor, the subcontractors (on the basis of the subcontracting agreements) can be directly addressed by the principal to complete the project. It is also advisable to stipulate a so-called waiver of the contractor's statutory retention right, or at least a market-based variant of such a clause. In addition, we recommend to ensure that (intellectual) property rights in respect of the (design of the) project are properly, insofar as permitted by law, transferred to the principal.
The type of project and the structure of the related transactions are also relevant for determining which contractual tools a principal wants to have at his disposal. With modular construction, for example, a principal will want to ensure that prefabricated (‘prefab’) components, which it has already paid for, do not end up in the bankrupt estate if they are still stored in a warehouse at the moment the contractor or his subcontractor or supplier goes bankrupt. In that case, it is advisable to arrange the transfer of ownership in such a way that prefab components become the property of the principal immediately upon payment of the relevant instalment. For the legal considerations in this respect, please refer to our recent blog on the (contractual) challenges in modular construction.
The bottom line is that the current market conditions may prompt extra attention to insolvency-related safeguards in contracts with (sub)contractors, so that you, as the principal can nevertheless continue building with confidence.
If you would like more information or a conversation on this topic, please do not hesitate to reach out to us or our Loyens & Loeff colleagues. We are happy to assist you.