When Ewan McArthur won a job worth more than $100,000 on a state government project for demolition and asbestos removal work as part of an upgrade to a public housing estate in North Melbourne, he understandably presumed that he would in fact be paid for the job as per his contract.

As noted in The Age, however, that was not to be. Reed Constructions, the company contracted by the Victorian Government to undertake the upgrade, famously collapsed in 2012 owing $89.2 million to unsecured creditors, including $85.6 million to subcontractors – many of whom had been engaged (mostly in New South Wales) to work on major public-sector road, housing and education projects.

Reed is not the only case of a builder going belly up. All up, 1,481 companies within the construction sector entered some form of external administration over the 12 months to March this year according to data from the Australian Securities and Investments Commission. Of these, 1,112 were liquidated – a situation which usually sees subcontractors and suppliers recover little if any of what is owing to them.

That raises questions about what subcontractors and suppliers need to be aware of when parties up the chain become insolvent and what decisions and actions they need to undertake. Further issues surround strategies they can employ upstream to reduce any exposure they may have to financial difficulties of other parties.

For answers, Sourceable spoke with insolvency practitioner and BRI Ferrier principal Costa Nicodemou and construction industry lawyer and Holding Redlich partner Troy Lewis regarding the more straightforward case of a head contractor becoming insolvent in the case of a principal/head contractor/sub-contractor or supplier type arrangement.

Essentially, companies are placed into external administration when they are unable to pay their debts as and when they fall due and thus become insolvent. Common types of external administration include voluntary administration, receivership and liquidation.

Voluntary administration involves control of the company being taken from its directors and placed into the hands of an independent external administrator. That administrator’s role is to investigate the company’s circumstances and report to creditors as to what should happen next. Options to consider include returning control of the company back to its directors, entering into a deed of company arrangement (DOCA) under which the company repays all or part of its debts owing and is then free of those debts, or placing the company into liquidation.

For subcontractors and suppliers, the prospect of a DOCA means compromising part of the amount owing to them prior to the administration, albeit typically at a higher rate than in a liquidation scenario.

A second form of external administration is known as receivership. This involves a secured creditor (such as a bank) or a court appointing an independent receiver to take control of some or all of the company’s assets and collect or sell enough of these assets to pay money owed to the creditor in question.

However, the most common form of external administration within the building and construction sector is liquidation. Where this happens, a liquidator assumes control of the company so that it can be wound up in an orderly fashion.

Typically, where a liquidation occurs, subcontractors will recover little if any of the amounts they are owed. This is because they are usually unsecured creditors and therefore rank below liquidators themselves, secured creditors (those such as banks who have a mortgage or charge over some or all of the company’s assets) and employees in terms of who gets paid first.

When a head contractor enters external administration, Nicodemou and Lewis say arrangements with regard to projects which are in progress essentially ground to a halt and one of two things takes place:

First and least likely, the project goes on and the administrator tries to complete the job under the head contractor’s existing arrangements with the principal and subcontractors.

Where this happens, subcontractors generally have two options. First, they can continue working and complete their contract under existing arrangements. Before agreeing to this, they may choose to demand that most or all of any existing amounts owing be paid. They may also seek guarantees of payment for future work from the administrator.

As an alternative, many contracts include provisions which enable the subcontractor in a head contractor insolvency event to cease work, terminate the contract and attempt to recover monies outstanding. This is an attractive option where continuing would mean outlaying more funds which may not be recovered.

More commonly, however, work on the project ceases and the principal appoints another contractor to complete the work. This is common because most contracts between the principal and the head contractor afford the former a right to terminate the agreement in the event of insolvency of the latter. Invariably, principals exercise this right so as to avoid delivery of their project being subject to the vagaries of a head contractor insolvency process.

Where this happens, the contract ceases and the subcontractor in most cases is simply an unsecured creditor.

Beyond ceasing work, Nicodemou and Lewis say subcontractors and suppliers may have other rights. These may include removing any materials and equipment which they own from the site, withholding any intellectual property such as documentation or certifications, and claiming any amounts owing under trade insurance policies. Should they wish to do so, there is also nothing to stop them contracting with the new builder to continue working on the project.

In addition, Nicodemou points out, whilst subcontractors are unsecured creditors from a legal sense, those who are integral to the success of the project may be in a position from a practical viewpoint to secure a reasonable outcome for themselves. This would include, for example, plumbing or electrical contractors whose certification was critical to the principal or any contractors who hold expertise which is specifically needed on the project. In one recent case, he said a façade supplier who had designed a very specific façade was able to secure a good portion of the amounts owing along with guarantees in respect of payments for the remaining portion of the work.

Prior to any insolvency events happening, however, both Lewis and Nicodemou say there are steps which suppliers and subcontractors can take upstream in order to protect themselves.

Before signing any contract, Nicodemou says it is important to obtain a clear picture about the head contractor. This includes who they are, their financial position and the type of things that impact their business and cash flow.

In addition, he says it is important for subcontractors to avoid becoming overly reliant upon a single builder in terms of generating work – a situation he says can lead not only to their own business following suit where the builder goes under but also to them being hesitant in respect of following up outstanding payments.

During the contract, Nicodemou and Lewis say it is important to remain on top of amounts owing and to take prompt action in respect of late payments.

When trouble does emerge in the form of late payments, Lewis says it is important to act.

First, outstanding amounts owing should be followed up and recouped where possible. Whilst security of payment legislation is useful, Lewis cautions that in the event of liquidation, adjudication decisions made under SOP law do not confer any special rights in respect of payment priority. Thus he says it is important to ensure these amounts are paid and received prior to the head contractor going into administration.

In Queensland and New South Wales, subcontractors are also able to lodge either a subcontractor’s charge under the Subcontractor Charges Act in the case of Queensland or a payment withholding request under the Security of Payment Act in New South Wales. These notices prevent the principal from paying any money to the head contractor up to the amount owed and instead require them to pay this to the court – at which time the subcontractor will have a claim upon the money in question.

The effect of this is to enable subcontractors to obtain payment for amounts owed directly from the principal rather than going through the struggling head contractor. The notices must be served to the principal (with the head contractor being advised of what has happened) and are followed by court proceedings which must be lodged within a month.

In addition, Lewis says those who are integral to completion of the project could approach the principal directly and negotiate with them to either apply pressure upon the head contractor to follow up any outstanding payments or to pay the subcontractor directly and seek reimbursement from the head contractor.

To ensure they avoid paying double in respect of work performed (paying the subcontractor directly and then paying the head contractor in respect of that same work), Lewis says principals will only agree to the latter type of arrangement with the express agreement from the head contractor as part of a three-way agreement.

In addition, principals will generally be willing to enter into such agreements only in respect of fixed amounts already owing. Thus, whilst these arrangements can be used to recover amounts already outstanding, Lewis says subcontractors are unlikely to be able to use them to secure ongoing payment for work going forward.

Finally, Lewis said it is important for those not being paid to consider any contractual rights they may hold to suspend work. On this note, he says it is important before signing any contract to ensure that the agreement enables the suspension of work in the case of non-payment.

Nicodemou says it is important to understand where the contractor is at from a financial perspective as much as possible. As well as asking questions of the contractor themselves, this includes speaking to other subcontractors and finding out who else is not being paid, he says.

Where problems are widespread, Nicodemou agrees with Lewis about considering ceasing work and approaching the principal with respect to being paid directly. He also advises subcontractors to take inventory of any ‘cards’ they may hold in the event of external administration and to get any documentation in respect of this ready. This may include critical certifications and project documentation.

Finally, he advises parties to engage in open dialogue. Too often, he says, solutions are held back because people are afraid to raise concerns.

“Often subcontractors are scared and you have the financier or principal who is concerned and running around asking questions but the contractor has spooked all of the subcontractors from talking to anyone,” he said.

“The sooner that everybody is on the same page, the easier it is to identify a solution. Even if something has gone wrong and there is a shortfall, if the principal and the financier know what is going on and can quantify what the issues are, then they can make decisions. If there is a short-term issue with cash flow, everyone can sit down and work out a solution.

“If instead they are kept in the dark, the problem progresses further because payments start to get slow, money is outstanding and more subcontractors start to get concerned. That delays work even further and some subcontractors cease work – it is a house of cards waiting to collapse.

In many situations, head contractor insolvencies are bad news for subcontractors.

By adopting simple strategies, subcontractors can position themselves to obtain the least-worst outcome.