Effective communication between a borrower, its lender and the lender's project monitor is crucial in ensuring that any actual or potential issues relating to the professional team are promptly addressed. However, it is equally important for a lender to actively monitor the project and be vigilant for early warning signs of distress. We would encourage lenders to exercise their rights to attend site meetings periodically alongside their project monitors.

Some early signs of distress in a contractor which a lender should be alive to include:

• slow progress on site, including a failure to meet key milestones
• non-delivery of materials or equipment
• frequent Requests for Information (RFIs) (such as documents, drawings and specifications) and numerous Change Orders (COs) being requested, indicating the contractor may not have undertaken full due diligence before commencing the project
• reduced labour and personnel on site or a high turnover of onsite staff and/or sub-contractors
• delayed or failed payments to the contractor's supply chain
• inflated applications for payment from the contractor against the actual work visible on site
• failure to rectify breaches of contract or address construction deficiencies

The insolvency of the main contractor typically constitutes an event of default under the loan agreement, giving the lender the right to refuse to provide further funds, demand loan repayment and enforce its security. However, in cases where the loan is otherwise performing, lenders often opt to collaborate with the borrower to ensure a replacement contractor is found quickly, as this is often the best way to preserve the project's value.

Has an event of default occurred?

Whatever its intentions upon the occurrence of a contractor insolvency, a lender should check the loan agreement to determine whether an event of default has occurred. If an event of default has indeed taken place, action should be taken to preserve the lender's enforcement rights, as it may need to rely on them in the future if a replacement contractor cannot be found. This should take the form of a reservation of rights letter citing the breach, which should be issued to the borrower in accordance with the notice provisions in the loan agreement.

Note that the loan agreement may provide a timeframe for the borrower to replace a contractor following such contractor's insolvency before an event of default occurs (see further below).

If the contractor is experiencing financial distress but has not yet entered a formal insolvency process such as an administration, an event of default may not have occurred. The contractor insolvency events of default in the LMA REF development facility are often negotiated to occur later in the financial decline curve or when the contractor is unable to pay its debts as they become due, which may be difficult to demonstrate in the absence of a formal insolvency process. In such cases, a lender should consult with its project monitor and the borrower to assess the extent of the distress and the borrower's intentions regarding the continuation of the building contract. As noted above, the lender generally has rights under the loan agreement to attend site meetings alongside its project monitor, which can be exercised in these circumstances.

What is the process for replacement of the insolvent contractor under the loan agreement?

A well-advised borrower may have negotiated a specific timeframe within which an insolvent contractor can be replaced before triggering an event of default. The length of this window may vary, but even in cases where a new contractor is identified relatively quickly, the replacement process can take several months to finalise and document.

The loan agreement will outline the lender's approval rights concerning the replacement contractor. Typically, both the identity of the replacement contractor and the terms of its appointment require lender consent. The loan agreement will also generally give the lender a right to require the borrower to terminate the building contract on the contractor's insolvency.

Prior to an insolvency being confirmed

The building contract will typically give the borrower the right to terminate in the event of the contractor's insolvency, usually when formal insolvency proceedings have actually commenced (note that a notice of intention to appoint an administrator may not be sufficient).  

If the contractor is not yet insolvent but is clearly in distress, a lender can expect its borrower to:

• assess applications for payment and serve "pay less" notices where required to ensure undue sums are not being paid to the contractor (which are unlikely to be recoverable on an insolvency)
• attend all site meetings and inspections with the contractor and professional team to assess the current status of works in comparison to the agreed programme
• monitor the arrival of materials at the site and secure the transfer of ownership to the borrower
• ensure vesting certificates are in place for materials stored off site to ensure ownership is transferred to the borrower once payment is made

Following insolvency

Whether a contractor has entered a formal insolvency process can be confirmed by a check of Companies House or the Law Society Gazette, although these records are often only updated several days following the appointment of an insolvency practitioner. For a more up-to-date insolvency check, lawyers can be instructed to search court records for any insolvency notices or applications filed by the contractor or its creditors.

Once the borrower's right to terminate the building contract has arisen, the borrower should take the following preliminary steps prior to exercising that right:

• arrange for replacement security, including hoardings/fencing and on-site security and assess all materials on site to prevent removal
• arrange insurance cover for the works and site
• review collateral warranties and the right for the borrower to "step-in" (i.e. assume the contractor's obligations under the underlying appointments and contracts)
• engage in commercial discussions with the professional team to determine any outstanding payments owed by the contractor and the current status of their works (commercial settlements with such parties are often a part of any step-in process)
• place the guarantor under any performance bond and/or parent company guarantee on notice of the insolvency event

There are certain commercial, practical and legal steps which a borrower can take to minimise project disruption as a result of contractor insolvency for itself and its lender. These include:

• Implementing a robust document management process: This ensures the timely execution and receipt of warranties, bonds and notices for payment under the contract, allowing for a smoother transition to any replacement contractor
• Obtaining performance bonds and parent company guarantees: Securing a performance bond (preferably operating on an on-demand basis) and/or a parent company guarantee can help to mitigate the financial risks associated with contractor insolvency
• Including a wide termination right for insolvency in the building contract: This allows for early termination in the event of contractor insolvency enabling swift action to be taken to minimise the impact on the project
• Allowing for direct payments to sub-contractors in the building contract: This allows for early intervention to preserve the remainder of the professional team in the event of their non-payment by the contractor

A lender's lawyers should confirm the presence of any legal protections as part of the due diligence process undertaken when the loan is put in place.