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08/06/2022 – Managing the Risk of Builder Insolvency

In recent months, news of Probuild entering administration and Condev going into liquidation dominated the headlines in the construction industry, accompanied by the loss of a few smaller, lesser-known builders. Whether the cause was COVID lockdowns, rising construction costs, or intense competition driving margins too low to withstand unexpected pressures, the impact on the industry will be far-reaching.

It’s a good moment to recap fundamental risk management principles for consultants that come to the fore on projects where the builder runs into financial difficulty.

Advice on Progress Claims and Contract Administration

The most direct exposure for consultants is certification or advice on the builder’s progress claims. Builder insolvency during a project will inevitable cause loss, and principals may be eager to shift as much as possible onto consultants (or, as principals perceive it, onto bottomless pot of free money that is the consultants’ professional indemnity insurers!). The principal may succeed in having the consultant held liable for some of its project losses if the consultant has over-certified the builder’s payment claims, or given advice to the same effect. The same applies where a consultant in a contract administration role has failed to follow procedures set out in the construction contract, such as a requirement to obtain statutory declarations.

As a hypothetical example, a project manager is administering a construction contract that requires the builder to provide statutory declarations with each payment claim to confirm that (among other things) they have paid all amounts owing to their suppliers or sub-contractors. The project manager approves the builder’s June payment claim for $750,000, which includes $500,000 payable to suppliers or sub-contractors, but fails to obtain these declarations. When the builder enters into insolvency in July, the principal discovers the work done was worth more like $650,000. In addition, the builder is greatly behind in paying suppliers and sub-contractors, and the principal has to pay an additional amount of $500,000 directly to the suppliers and sub-contractors to keep them working on the project. That makes $600,000 of loss that the principal might not have incurred if the project manager had followed procedure and not over-certified. The project manager may face a $600,000 claim for negligent contract administration.

Certifiers generally must (and, for architects in jurisdictions where a Code of Conduct specifically requires it, always must) act fairly and impartially when certifying builder entitlements. This prevents superintendents from artificially under-certifying the builder’s fee entitlements under pressure from the principal. But the main take-away lesson is to follow payment procedures in the construction contract with care, and be very careful not to over-certify. And if you have any reason to suspect that the builder is experiencing financial difficulty – such as rumours of sub-contractors not being paid – keep the principal informed.

Avoiding over-certification also means accurately reporting any defects that are reasonably detectable. Glossing over defects in reports or certificates invites a claim for negligence once the builder is no longer around to fix the defects. If providing certificates, list all known defects in them, and take extra care at points that involve release of security such as practical completion and final completion.

Security provided by the builder can cushion the loss that is caused by insolvency. So consultants should also advise principals to seek legal advice on what forms and amounts of securities the principal should obtain in the current market. As with certifying payment claims, take particular care not to release them prematurely.

General Risks

When a builder becomes insolvent, run-of-the-mill risk management issues can turn into major disputes. The original builder may lose the ability to rectify existing defects, and any pre-existing problems may have to be resolved by a replacement builder, leading to increased costs that no one wants to pay. Informal, unwritten arrangements between consultants and insolvent builder may not be respected by the replacement builder.

Good, basic risk management from the outset of the project can minimise the pain and reduce the risk of intractable disputes, including:

  • Clear project procedures for builder-generated variations; extensions of time and requests for information (“RFIs”); consultant responses to RFIs; issuing directions to the builder; submission and review of shop drawings; and consideration of builder selections and substitutions.
  • Extra care with selection and substitution of products and materials, including checking substitutions with the same care as the original specification; requiring the builder to provide reputable certification confirming the compliance and suitability of any substitution requests; rejecting products that don’t comply with the National Construction Code and clearly reiterating what evidence the builder must provide in order to confirm compliance; and keeping a written record of information relied on to assess whether products comply (such as testing results from a NATA-approved testing body and confirmation of approval by specialists like structural or fire engineers).
  • Wherever possible, producing a good, detailed design before tender that includes carefully researched and clearly specified products, so as to allow for accurately priced tenders and minimise the issues in the previous point.
  • All-round meticulous record keeping – for instance, recording the results of observations and inspections and exactly what instructions for rectification were then given to the builder.
  • Obtaining written approval from your client before making any variations to the design or departing from the client’s brief.

It goes without saying that fees need to be set high enough to accommodate this work. For work that can’t be estimated, like the number of substitution requests generated by the builder, one option is to set up your scope of services and fees so as to charge an hourly rate. For instance, stipulating that researching and advising on substitution and selection requests by the builder is an additional service chargeable on hourly rates.

Commercial Risks

Widespread use of novation and “design and construct” procurement models in the bigger capital cities also means that, when a builder becomes insolvent, consultants engaged by or novated to that builder may lose all or some of their outstanding fees. Consultants with outstanding fees are not high-ranking creditors and may not receive much once secured creditors (like banks and other lenders) and those with special statutory rights (like employees) have been paid.

Part of the solution is a practical strategy of loading fees into earlier project stages; invoicing regularly for the full amount owing; and following up unpaid fees promptly so that outstanding amounts don’t accumulate to become a major business risk. Although more commonly used by builders, security of payment legislation also provides a mechanism for consultants to compel prompt payment of their fees, so long as the strict procedures and timeframes in the legislation are all followed. Although security of payment procedures will not override the order of creditor priority that applies after insolvency, they can help recover payment before insolvency hits.

There are also some basic contractual protections against non-payment of fees that consultants should have – although principals can be very resistant to even the most reasonable of these. The first is a clear right for the consultant to suspend or terminate services if fees are not paid. Consultants cannot work on credit indefinitely, especially if there is a suspicion that the builder may become unable to pay outstanding fees at all. Another is the consultant’s right to refuse to be novated to a builder whose financial stability is in doubt.

These strategies make for good risk management on any project. They are far from unique to projects where the builder experiences financial difficulty. But the current climate does imbue them with heightened importance.

Wendy Poulton
Risk Manager
informed by Planned Cover

This article is only general advice in respect of risk management. It is not tailored to your individual needs or those of your business, nor is it intended to be relied upon as legal or insurance advice. For such assistance you should approach your legal and/or insurance advisors.

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