When a main contractor for any construction project becomes insolvent, the repercussions can be both financially and legally painful to the owner or the Employer. Whilst there are various literatures and articles covering this subject, a good amount is written from a legal perspective dealing with issues such as the administrative procedures in respect of codified insolvency laws, retention of title provisions etc. This article however deals with the commercial perspectives of insolvency contractual provisions such as termination clauses and its effectiveness. The purpose of this article is to equip construction practitioners such as architects, engineers, commercial managers and projects managers with practical knowledge of insolvency issues. These construction practitioners interact with contractors more often than lawyers as part of regular construction management and therefore are in a unique position to deal with insolvency issues pre-emptively. Insolvency should not be addressed only after the fact but instead can be mitigated proactively. Unfortunately, most construction practitioners rightly or wrongly do not view insolvency as part of their core professional expertise. This is because insolvency appears to be a subject that involves a blend of skills such as reading financial statements as well as appreciation of business valuation and  insolvency laws.

The key to mitigating and managing any risk is by first and foremost clearly understanding the definition of the risk in hand. As it will be evident from the next section of this article, the term ‘insolvency’ is not necessarily as straightforward as it should be. This becomes problematic because typically standard forms of contract include provisions that allow the Employer to terminate the contractor’s employment under the construction contract if such contractor becomes ‘insolvent’. The ability of any Employer to issue such notice of termination is compromised if the definition of insolvency is not as clear as it should be.

Does Being Insolvent Necessarily Mean That The Contractor Is In The State of Bankruptcy?

When a contractor is said to be insolvent, the general impression is that such company is in the state of ‘bankruptcy’ or that it is unable to pay its debts. It may casually be viewed as being in “financial death” that result in the company unable to continue its operations. However if the contractor has various tangible assets such as plant, machineries, equipment and building but faces a hard time selling these assets at a reasonable market price within a reasonable time frame in order to repay its immediate debts, the contractor should not be deemed as being in “financial death”. Such contractor may at most be considered as being in financial distress but with a reasonable prospect of being rehabilitated. 

However from the perspective of an Employer with a fairly conservative risk appetite, even if its contractor is not technically in a state of financial death but merely facing financial distress, such distinction offers very limited comfort. The paramount concern remains whether the project can be completed with the contractor in issue. Even if the contractor is able to complete the project, whether it will continue to be in operation to honour any defects rectification responsibilities as well as warranties that could last years beyond the expiry of defects liability period. If the Employer continues its progress payments to the contractor in issue, will those funds be channeled to the project in hand in order to sustain its cashflow? Given these legitimate concerns, one may notice that the definition of insolvency included in most standard forms of contract that justifies the use of termination clauses is worded in a broad manner. In other words, being insolvent under most standard forms of contract may not necessarily mean that the contractor is in the state of bankruptcy. Insolvency includes various trigger events that may not necessarily lead to the liquidation or winding up of the contracting company. Ironically these preemptive clauses may end up inducing the financial death of the contracting company.

Under Singapore’s commonly used standard forms of contract such as the Singapore Institute of Architects Building Contract (SIA Form) there are provisions allowing the Employer to terminate the contractor’s employment under the contract due to insolvency. Under its November 2016 edition, Clause 32(7)(a) stipulates grounds for termination due to insolvency of contractor. Under this clause, the Employer has the right to terminate if the contractor (i) becomes bankrupt, (ii) becomes insolvent, (iii) makes a composition with creditors (iv) under a winding up order (v) a receiver or manager appointed for the contractor’s assets (vi) possession of the contractor’s assets shall have been taken by the creditors or debenture holders (vii) the contractor’s assets placed under a floating charge (viii) a judicial manager is appointed to manage its financial affairs. The public sector standard form, namely the PSSCOC has a similar provision under its Clause 31.1(2)(a) based on its July 2020 edition. Evidently, these definitions are not only broad but also diverse in that it include a variety of events with different level of financial severity. In fact, from a commercial perspective, some of these events may not strictly speaking provide a conclusive indication on whether or not the contractor is in financial distress. Therefore, if the Employer unfortunately were to terminate the contractor’s employment based on some of the defined events, it could lead to an unsatisfactory commercial outcome. There are certainly rooms for negotiations on these clauses when parties enter into an agreement based on any of these conditions.

By way of example, one of the trigger events is when the contractor’s assets are placed under a floating charge. Floating charge is quite a common way for any company to secure a loan where the lender obtains a security interest over a group of non-constant assets that change in quantity and value. These assets are typically current assets such as inventory or account receivables. Instead of offering collateral for loan based on an identifiable fixed asset such as a building or an equipment, certain loan arrangement allow for non fixed current assets as an alternative form of collateral. If such floating charge pertains to company’s inventory such as building materials, the contractor can continue to buy, sell and restock these materials without the red tape of obtaining permission from the lender for every such transaction. One may argue that where a financial institution is agreeable to offer loan to such contractor based on floating charge arrangement, it indicates that the contractor concerned has considerable financial credibility. Therefore, it may not be appropriate for a contractor to have its employment terminated due to such financing activities. Ironically some contractors may require these very financing activities due financial pressure arising from various securities required by the Employer under the construction contract such as performance bond, retention monies etc. It may not be equitable for the contractor to be terminated if the underlying event is either directly or indirectly contributed by the Employer.

Another noteworthy trigger event that allows the Employer to terminate the contractor’s employment under the contract is when the contractor is found to be ‘insolvent’. In other words, the Employer is justified to invoke the termination clause, if it is of the view that the contractor is insolvent. However, what is the test of insolvency? Is it an event that can easily, readily and objectively be determined in all circumstances? To this end, there was a case law in Singapore where the judge applied the test of insolvency. This case was Founder Group (Hong Kong) Ltd (in liquidation) v Singapore JHC Co Pte Ltd [2023] SGHC 159. In applying the statutory test of inability to pay debts, reference was made to Section 125(2) of the Insolvency, Restructuring and Dissolution Act 2018. This section states amongst others that a company is deemed to be unable to pay its debts if it is proved to the satisfaction of the court that the company is unable to pay its debts and in determining whether a company is unable to pay its debts, the court must take into account the contingent and prospective liabilities of such company. In this case, the court applied the cash flow test, where a company is insolvent if its current liabilities exceed its current assets such that it is or will, in the reasonably near future, be unable to meet all of its debts as and when they fall due. The reasonably near future for the purposes of this test is taken to be twelve months. 

Whilst this article is not meant to delve into the legal details of this case, it is clear that this issue was adjudicated before a judge with two opposing parties arguing the merits of their respective cases. It is therefore reasonable to say that an Employer may not arbitrarily decide that a contractor is insolvent and should exercise its termination rights with caution. Based on the cited case above, there are instances where the question of insolvency can be heavily contested and legal test had to be applied to make an appropriate determination. Not only the term ‘insolvency’ does not necessarily indicate a state of bankruptcy, the legal definition of insolvency can at times be contentious. Again, parties should consider negotiating a termination clause with clearer definition of insolvency that takes into consideration regular financing activities. 

Challenges In Accurately Determining Solvency of Contractor Through Its Financial Statements

As the subject of insolvency can be tricky as illustrated in the preceding section of this article, it appears that one of the more accurate ways to have an informed view is by examining the contractor’s financial statements. Financial statements generally refer to balance sheet, income statement and cashflow statement which companies are required to produce on an annual basis subject to certain exemptions provided under the law. These financial disclosures are aimed at providing the company’s stakeholders such as lenders, clients, investors, business associates etc an insight into the financial status of the company concerned to facilitate decision making.

Whilst these financial statements may offer some helpful insights, these information are usually requested during tender or procurement phase of the project. Any financial information gleaned from the review of these statements are usually used as part of the tender evaluation criteria with a modest or minor weightage assigned to these considerations. Once the procurement phase is over and the contract is awarded to the contractor, there are usually no requirements for the contractor to continuously disclose any of its financial statements. During the tender evaluation process, it is usually unclear how these financial statements are used and what specific information are identified. Balance sheet, income statement and cashflow statement provide different types of financial perspective of the company and are usually used complementary to one another. Traditionally, financial statements related information are rarely the key focus during tender evaluation unlike other more “popular” topics such as tender price, method statement, proposed team structure, exclusions and qualifications. Rightly or wrongly, there is a presumption that if certain contractor had delivered and completed a similar type of project, it is likely to be able to repeat its accomplishment without much thought given to any change in its financial wherewithal.

Even if the necessary focus is given to the financial statements, there is a question of whether the information included remains updated and relevant. It is often said that the value of financial statements expires the moment it is completed. This is because the transaction data, book keeping entries etc are retrospective in nature, i.e. it is backward looking. By way of example, if a company produces its audited financial statement in April 2024 for financial year ending in end December 2023, those statements is good for use until the next financial statement which is due in April 2025. Imagine the company participates in a construction tender in November 2024 and discloses those financial statements dated April 2024 and was awarded the contract in January 2025. The construction period is for three years i.e. from January 2025 to December 2027. If the contractor is in some form of financial distress in the middle of the project i.e. January 2026, the only financial information available to the Employer and its consultant are assembled from transactions and ledger entries that could have occurred as early as January 2023, which is three years ago. Much like most of us would not be relying on bank statements produced three years ago to determine the balance of our savings accounts especially if transactions occur frequently, it is not wise for projects to be administered in this fashion. 

The issues that arise from the analogy above is two fold. Firstly, when a contractor is possibly in some form of financial distress, there is very limited information available to the Employer and its consultant to make its own informed determination apart from financial informations that were outdated by approximately three years. Secondly, when an Employer had to decide whether to terminate its contractor’s employment it essentially is required to make a judgment call based on its future ability to continue its operation. However the data available for such future projection is basically financial statements that are backward looking. Unfortunately, the Employer and its consultants usually will end up using more primitive methods of assessment such as hearsay and market rumours. Some may even rely on casual observations such as withdrawal of equipment from site, increased staff turnover, complaints of non payment by subcontractors etc, all of which are anecdotal at best. Given that the Employer may be required make critical decisions such as to call on the contractor’s performance bond, issue its notice of termination and to make arrangements to secure the site to prevent unauthorised removal of building material and equipment, it would be preferable for these decisions to be made based on concrete, timely and objective evidence. This is to avoid the Employer being in breach of contract by virtue of abandonment due to its own actions. 

Another challenge in relying on financial statement is that its measurement metric may not be entirely relevant to certain contracting companies due to its inherent nature. In the preceding section of this article, reference was made to a case of Founder Group (Hong Kong) Ltd (in liquidation) v Singapore JHC Co Pte Ltd. One of the subject of determinations was the question of whether the company in issue was insolvent. To this end, the court applied the cash flow test, where a company is insolvent if its current liabilities exceed its current assets. The term ‘current’ refers to a period of 12 months. 

As regards current assets that can be identified on balance sheet, it typically refers to liquid assets such as cash, inventory, account receivables etc all of which are either as liquid as cash or should be able to turned into cash relatively quickly and easily. As regards inventory for a contracting firm, it may refer to building materials such as marbles, granites, ceramic tiles or other similar claddings or finishes. If the contracting firm happens to have claddings that are ‘seasonal’ in its design, they may find it difficult to sell it quickly for cash because of rapidly changing design trend. Likewise, contractors may be in possession of marble slabs that are leftover from previous projects or had been rejected by the architect due to its thick and dark marble veins that are not in line with the architectural design intent. Whilst these marbles should technically qualify as current assets in the form of inventory, whether these can be sold quickly and at a reasonable price are remained to be seen. The observations above illustrate a fairly simple point in that the devil is in the detail when it comes to asset value.

The same challenges apply to account receivables as well in terms of its classification as current assets. These form of asset refers to invoice or bills due and payable by the clients or customers. Some invoices may have payment grace of 60 days from the date of its issuance whereas other outstanding payments may be due to customers with temporary cashflow difficulties. Once again, whether these outstanding payments can actually be collected remains in question. However until that happens, it is classified as current assets, not dissimilar from actual cash. One may argue that the firm could use these account receivables to secure trade financing to convert it to cash, with certain discounts applied to the face value or par value. Whilst by doing so allows account receivables to be converted to cash, it usually comes at a cost which in turn reduces the value of current assets. 

Another difficulty in accurately valuing current assets is whether its value shall be based on the cost paid by the contracting firm or should it be based on the price it might be sold in the market? If neither approach is suitable, is there an independent valuer to appraise its value? As the current assets are typically short term in nature, there is limited or no opportunity at all to value such assets accurately.

In view of the challenges illustrated above, it is evident that the cashflow test applied to determine insolvency can have varying results depending on how the current assets or even current liabilities are derived. Consequently, whilst these tests may have the veneer of a credible approach, the outcomes of such tests are debatable at best. The subjectivity of the commercial aspect to construction insolvency is actually similar to the application of insolvency laws, where contesting parties usually would have their respective interpretations.

Conclusion

It is established quite clearly that the determination of the solvency of any contractor can be a tricky proposition for three reasons. Firstly, the process of making an objective determination of the solvency of a contractor can be subjective particularly if it involves relying on retrospective financial statements. Secondly, the definition of what constitute insolvency can also be debatable if it includes not just whether the contractor can continue as a going concern but also whether the company is in financial distress with prospect of rehabilitation. Lastly, the consequences of making the wrong determination by the Employer on the solvency of its contractor can be extremely disastrous. It not only potentially induces the Employer to be in breach of contract, but it could also be the very root cause of a self fulfilling prophecy that resulted in the financial demise of the contracting company. Therefore, it is of paramount importance to appreciate that the subject of construction insolvency is a topic that is neither “purely legal” nor “purely accounting” matter. It is an issue that requires a blend of knowledge for one to make an informed and holistic assessment.




Koon Tak Hong Consulting Private Limited