REUTERS | Arnd Wiegmann

Three tips for addressing the risk of contractor insolvency

These are tough times for contractors. A recent Construction News survey of price prediction data revealed that tender prices are dropping, with an expected average reduction of 3.7% during 2010. In a market where contractors are battling to survive, here are my top three tips for addressing the risk of contractor insolvency.

Cost Control

Cost control for an employer on any project is critical. This is particularly so where the construction tender price is very low and the employer is concerned that the contractor may have tendered at a loss. Employers should adopt a rigorous and disciplined approach to cost control.

One area where claims for additional costs can spiral out of control is in relation to variations. The best way of avoiding this is by using a robust change control processes.

A more productive way for some clients to target cost reduction may be to adopt a target cost contract with a gain share mechanism and incentives to save costs, rather than beating down the initial contract sum or accepting a low tender price. One popular example of this approach is the NEC ECC Option C.

Performance Security

Regardless of covenant strength of the intended contractor, most employers insist on some form of performance security from their contractor, as this provides some protection if the worst happens.

A parent company guarantee is the most comprehensive form of performance security, providing protection in respect of all of the subsidiary’s liabilities for the entire liability period under the contract. However, the guarantee is only as good as the parent company giving it. If a contractor is in financial difficulty, this may be a reflection of wider difficulties throughout the corporate group.

A performance bond provided by a third party bank or insurance company, which responds in circumstances where the contractor becomes insolvent, will remove the group insolvency risks inherent in a parent company guarantee. However, on-demand bonds are unusual in the domestic market, and recovery under default type bonds can be difficult and time-consuming, depending on the “conditions” to recovery. It is critical that the terms of the bond are drafted appropriately. A bond that only pays out on a favourable court decision does not provide adequate security in these circumstances.

In addition, the solvency of the bondsman itself cannot be taken for granted in the current market.

Supply Chain

Employers should be aware of the impact of falling tender prices on the supply chain. Speaking to various contractors about this issue, it appears that price reductions have only been possible through efficient management of the supply chain and squeezing sub-contractor margins. However, the general view is that sub-contractor margins are now very tight and cannot be squeezed any more.

Some contractors are seeking to rationalise their supply chain by reducing the number of suppliers, standardising the procurement of certain products and services, and streamlining administrative procedures (such as invoicing) to try and introduce efficiencies and cost savings into the supply chain. Employers should take note. Ultimately, there is little benefit from squeezing margins in the supply chain if you make no gains in efficiency.

Too good to be true?

If a discounted tender price seems too good to be true, it probably is too good to be true. An unprofitable construction contract is unlikely to have a happy outcome for any party involved.

One thought on “Three tips for addressing the risk of contractor insolvency

  1. Surely if the contractor has completed a pre qualification questionnaire and the client has taken this into account during the tendering process, this should significantly reduce any risk of contractor insolvency?

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