How to avoid a construction catastrophe

The Australian construction sector has faced unprecedented challenges in recent years, with an alarming increase in the number of insolvencies. The numbers are concerning: nearly 1,400 construction businesses collapsed in the second half of the 2023 calendar year alone, accounting for over a quarter of all corporate insolvencies. The 2022-23 financial year saw 2,117 construction companies entering external administration. These figures aren’t just statistics, they represent disrupted projects, financial losses and significant stress across the industry.

For those in the construction industry, whether you're a head builder, developer or contractor, understanding the implications of insolvency is critical. Equally important is knowing how to protect your interests before problems arise and what steps might help to mitigate risk.

Insolvency creates a ripple effect. A subcontractor’s financial difficulties can impact on the entire workstream, exacerbating the impact and leaving multiple stakeholders exposed to risk.

Insolvency can wreak havoc on construction projects, often halting them entirely. This leads to substantial financial losses across the board. For customers and developers, the insolvency of a head builder or a key subcontractor can result in unfinished work and unfulfilled contractual obligations. Subcontractors and suppliers are particularly vulnerable, as they may find themselves with unpaid invoices and no clear recourse to recover debts.

For head builders, the situation is even more complex. If a subcontractor becomes insolvent, the head builder must often still fulfill its obligations to the customer, as subcontractor insolvency will not typically excuse delays or incomplete work under most standard construction contracts. The result? An urgent need to find and secure another subcontractor to step in and complete the project, incurring additional costs and residual delays.

While insolvency is a harsh reality in the construction industry, there are several practical steps that businesses can take to mitigate the associated risks and safeguard their projects. Here’s a closer look at some proactive measures:

Before engaging with any contractor, it is essential to perform comprehensive due diligence. This can include reviewing financial records, credit reports and the history/track record in the industry. This needs to be a detailed check. Try to identify whether the contractor has a history of defaults or cash flow issues.

In addition, conducting searches on the Personal Property Securities Register (PPSR) can reveal if a contractor has secured debts. A large number of secured creditors could indicate financial instability, and mean that, as an unsecured creditor, you may not be able to recover.

Contracts should be tailored to address the risk of insolvency. This involves the inclusion of key clauses designed to protect your interests. Some of the essential elements include:

• Step-in rights: This is a clause which permits the head builder to step in and take control of the project if a subcontractor becomes insolvent.
• Termination clauses: These clauses can enable a principal to terminate the contract quickly in the event a subcontractor goes into liquidation. Importantly however, these clauses may typically be unenforceable at law if a subcontractor enters administration, rather than liquidation.
• Payment security mechanisms: Secure your interests against the failure of another party by lodging an interest on the PPSR. Other options include insisting on retention funds or performance bonds to ensure funds are available.

Clear and well-drafted contracts not only provide a roadmap for resolving disputes, but they also help mitigate the financial impact of insolvency.

Avoid putting all your eggs in one basket by relying too heavily on a single contractor. Spread your risk by working with multiple contractors across different projects or engaging subcontractors from a broader pool. This strategy reduces the likelihood of your project being severely impacted if one contractor becomes insolvent.

Review your insurance policies to ensure they adequately address insolvency-related risks. Insurance products tailored for insolvency risk in the construction industry are available and should be considered as part of a broader risk management strategy. Insolvency insurance won't prevent a contractor from becoming insolvent, but it can cushion the blow by providing funds to help cover losses, particularly for head builders.

Keeping an eye on the financial health of contractors and subcontractors is a vital ongoing task. Don't just rely on initial due diligence; continue to monitor performance throughout the life of the contract. Warning signs that a contractor may be in financial difficulty include missed payments, payments in round amounts, unexplained delays and underbidding on projects. If you notice any of these red flags, act quickly. The earlier you identify and respond, the more options you will have to safeguard your project.

If a contractor becomes insolvent, there are several legal avenues that affected parties can explore. While insolvency laws aim to provide a degree of protection to creditors, it is vital to understand what options are available and how best to pursue them:

• Proof of debt: You should lodge a proof of debt as soon as possible to ensure you are in the queue for any potential recovery. At this time, it is also important provide information of any secured debts, for example, if you have lodged securities on the PPSR.
• Retention of title clauses: You may be able to rely on retention of title clauses to reclaim materials that have not yet been paid for.
• Legal claims: In some cases, it may still be possible to pursue a claim against an insolvent contractor, particularly if there has been fraudulent behaviour or breaches of statutory duties.

Seeking professional advice early is essential to ensure your business can respond effectively in the event of insolvency.

Insolvency in the construction sector is not just a theoretical risk, it’s a real and pressing concern. The good news is that proactive measures can help you mitigate this risk and protect your interests.

By conducting thorough due diligence, drafting robust contracts, diversifying contractor relationships and maintaining vigilant oversight of your subcontractor’s financial health, you can significantly reduce the impact of a subcontractor’s insolvency. In the volatile construction industry, having protective strategies in place is essential.

As the number of insolvencies continues to rise, it’s more important than ever to stay prepared. Those who fail to address these risks may find their projects derailed and their business exposed to financial ruin. On the other hand, businesses that take a proactive, informed approach will be better positioned to weather the storm and emerge with their operations, and reputation, intact.

This article provides general commentary only. It is not legal advice. Before acting on the basis of any material contained in this article, seek professional advice.

Co-author

Name: Alexander Hamam

Position: Associate

Practice: Disputes