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Step to it: what happens to sub-contractors when the main contract is terminated?

At the end of June 2019, the TCC published the Judgment of The Honourable Mr Justice Stuart-Smith in respect of a costs hearing in the case of ABB AB HVDC -v- McLaren Construction (Midlands and North) Ltd [2019].  It was a very short judgment that concerned liability for costs of an emergency application for interim relief made by ABB AB HVDC (“ABB”).  The liability for costs is not the key point of interest here, but the underlying matter, which was discussed in some (but not full) detail by the Court is of wide relevance.

ABB had engaged McLaren Construction (Midlands and North) Ltd (“McLaren”) and they in turn had engaged a number of sub-contractors in respect of the works which were, by the time of the events which brought about the case in hand, running very much in delay. ABB purported to terminate the contract.  McLaren rejected the termination but said that by purporting to terminate, ABB were themselves in repudiatory breach which they (McLaren) then accepted. So regardless of whoever had actually terminated, it was agreed that the contract had been terminated.

In the event that ABB’s termination was valid, ABB was entitled to require McLaren to assign all of its sub-contracts across so that ABB could, effectively, step in and complete the project. Even if ABB’s termination was not valid, it seems that the assignment could not be demanded but McLaren was nonetheless required to deliver up copies of all sub-contracts to ABB. 

As a matter of law, the sub-contracts could not be assigned if they had previously been terminated. ABB therefore needed to ensure that McLaren did not terminate the sub-contracts.  Further, in order for the sub-contracts to be assigned, ABB needed to know the details of the sub-contracts and to have copies of them.

This case therefore came down to an issue of post-termination practicalities. In a situation where a commercial relationship has already broken down, what obligations are there on the parties: how are the innocent protected? 

Unsurprisingly in this case, McLaren did not have all of its paperwork fully up-to-date and in order. It is extremely common for main contractors not to have entered into formal and well documented contracts with each sub-contract.  It is worth noting, however, that depending on the wording of the main contract, this administrative failure is usually technically a breach of contract on the part of the contractor . In a market where main contractor insolvency appears to be on the increase, we recommend that employers, employer’s agents and project managers ensure that provision of documentation is a condition precedent to payment and properly enforce such terms to protect the employer in the event of contractual termination.  Whilst such administration can be frustrating when parties are chomping at the bit and focussed on work on the ground, this is definitely a situation where a stitch in time could save nine. 

At the time of writing, we were unable to find sufficient detail on the ABB -v- McLaren contractual matrix to comment on what obligations there were on the parties in the event of termination, beyond what can be inferred from the short. However, of far greater interest to you as our reader (we hope, at least) is how you can protect yourself on future contracts. 

The issue of the direct rights between the Employer and a Sub-contractor usually comes up in circumstances relating to defects and a prospective claim.  However, step-in rights can be a lifesaver for sub-contractors: just because the main contractor falls away from the job does not mean that all is lost. 

If you read the relevant parts of the JCT suite of main contracts and sub-contracts, you would think that upon termination of the main contract, the sub-contracts are automatically terminated too. So how can the relationship survive?  The answer there, and indeed here, lies in the Collateral Warranty. 

Most building contracts do oblige the main Contractor to engage on particular terms: for example the JCT suite uses section 3 to impose an obligation that sub-contractors are engaged via the relevant JCT sub-contract (clause 3.6 of the JCT ICD 2016, clause 3.9 of the JCT SBC/Q 2016 and clause 3.4 of the JCT DB 2016).  However, the JCT suite of sub-contracts then each contains a clause saying “If the Contractor’s employment under the Main Contract is terminated, the Sub-Contractor’s employment under this Sub-Contract shall thereupon terminate and the Contractor shall immediately notify the Sub-Contractor.”

How then can the Employer keep the sub-contact team engaged in the project? The answer involves step-in rights. 

Step-in rights are, of course, a familiar sight in Collateral Warranties (usually those to the funder and/or employer). Step-in clauses in such documents slow down the Sub-contractor in his attempts to terminate the sub-contract by requiring the Sub-contractor to give notice to the warranty beneficiary to give them an opportunity to step in.  Collateral Warranties may also contain clauses which state that on termination of the main contract, the Sub-contractor may not treat the sub-contract as terminated until the Beneficiary gives notice to confirm the termination.  Once a step-in notice has been served, it is then as if the sub-contract had always been between Employer and Sub-Contractor directly: so the Employer becomes obliged to pay the Sub-Contractor on the terms agreed.

If there are no step-in rights in the relevant collateral warranty (or, perhaps more likely) not collateral warranty at all, this does not prevent the employer and sub-contractor entering into a contract on the exact same terms as the existing sub-contract: freedom of contract prevails. However, in such circumstances the sub-contractor has the employer over the proverbial barrel and may seek to re-negotiate terms.  Clearly this is not a situation that any sensible employer would expose themselves to, hence the prevalence of requirement for collateral warranties with step in rights. 

So if you are an employer planning to terminate your building contract and you want to keep some or all of the sub-contract team engaged on the project, in addition to any commercial steps that you may take, we recommend you get your legal ducks in a row by ensuring that you have copies of all collateral warranties and underlying sub-contracts to hand (of course you will have made these a condition precedent to payment under the main contract and you or your PM will have a full set of documents neatly scanned into the project document drive, so this will be easy. Of course.).

If you are a sub-contractor experiencing issues with your main contractor client to the extent that you are giving serious consideration to exercising your right to terminate, do make sure you check over the warranties that you signed (which of course you scanned and saved, clearly labelled, to the project document drive. Of course.) and make sure that you give notice to beneficiaries before purporting to terminate.

Finally, something of a post script on the ranking of step in rights. Usually, both the employer and any funder will require step in rights in their collateral warranty.  If step in rights are granted to more than one beneficiary it is important to ensure that the drafting makes clear the ranking of the rights. 

 

 

These notes have been prepared for the purpose of an article only. They should not be regarded as a substitute for taking legal advice.