When to novate contracts

• Increase image
• View all images

When a contractor approaches insolvency decisions need making about its contracts. By Vicky Lee

If a contractor is heading for insolvency should he assign or novate his contracts?

What issues should the parties consider if they wish to novate the contract to a substitute contractor?

An increasing number of contractors are likely to face insolvency this year. The Equifax Report for the first quarter of 2008 shows an increase in business failures across all sectors.

The construction industry has been particularly affected, with an 11 per cent increase in businesses going bust.

Faced with insolvency, a contractor must establish the best way of realising his assets.

Such assets may include rights under his contracts, since there could be value where, for example, the contractor has completed the work and/or there is still (profitable) work in progress.

Depending on the circumstances, such contracts could be either assigned or novated to a third party for value.

Novation or assignment?

Whether you are the contractor or the client, in such circumstances, it is important to consider:

• How does novation differ from assignment; and
• What issues need to be dealt with if you intend to novate a 'profitable contract' to a substitute contractor.

How does novation differ from assignment? The key difference is that assignment only transfers the benefit of a contract from the insolvent contractor to the substitute contractor or other third party.

The obligations under that contract (e.g. the obligation to carry out the works) cannot be assigned.

Therefore, assignment would be suitable where, for example, the insolvent contractor has completed the work under a contract but has yet to be paid for such work, where retention is to be released or where the final account has yet to be settled.

Novation, on the other hand, transfers both the benefit of and the obligations under a contract.

A novation agreement is therefore like a fresh contract and a tri-partite agreement between the insolvent contractor, the substitute contractor and the client.

Novation would be more appropriate where the insolvent contractor has not yet finished the work to be performed under the contract and there is profit to be made by the substitute contractor in completing.

Novation requires the consent of the client while assignment usually doesn't.

Novation effectively brings the old contract to an end and creates a new contract.

Therefore, in addition to the usual contractual and/or legal issues, it is important that the parties consider and agree on the following:

Main points to consider

• What price will the substitute contractor pay to the insolvent contractor for the work done since the last valuation (and also what price will the client pay to the substitute contractor for the remainder of the works)?

• What work has been accepted as complete and what remains to be carried out by the substitute contractor?

• Will the original completion date be extended due to delays caused by the contractor's insolvency and, if applicable, from when will liquidated damages
be payable?

• How will responsibility for latent and/or patent defects be allocated? Is the substitute contractor willing to take responsibility for the insolvent contractor's work?

• Is there any security for performance (e.g. performance bonds and/or guarantees) and, if so, how will such security be released/discharged? Will the employer expect similar security from the substitute contractor?

• Are there any subcontractors? If so, are they willing to be novated to the substitute contractor and is he willing to accept responsibility for any subcontractor claims?

Essentially, the insolvent contractor and the client must ensure that they are released from their respective obligations under the original contract.

Insolvency may be unavoidable but, if approached pragmatically, you may be able to reduce the financial consequences.

Vicky Lee is a solicitor in the construction and engineering group of Dundas & Wilson

Keep your head above water by winning public sector work

By Jason Heath

As independent construction companies struggle with the credit crunch, public sector contracts are becoming a more trustworthy and reliable source of work for contractors and are helping to counteract the effect of big falls in the private sector.

Although public sector housing and housing association orders are down by eight per cent so far in 2008, non-housing public sector orders climbed 24 per cent in the year to April, helping to keep the construction industry afloat.

In addition, the recent lifting of the ban on assignment has made it easier for small and medium sized businesses to get involved with public sector work. The ban prohibited companies wishing to tender for a public contract from using an  intermediary such as an invoice financier to raise finance without prior permission.

But it is now possible for companies using invoice finance to compete on a level playing field for government tenders.

Invoice finance works by advancing a percentage of the value of a sales invoice, as soon as it is issued. This can provide security for construction firms as it means they can gain access to vital cash and can continue to pay staff or buy materials upfront, even if payment terms from a client are being stretched.

As well as organising finances, it is important to get a good understanding of the tendering process and how public sector contracts are awarded. This will help you to pitch your business successfully and win contracts.

There is a wealth of advice available for smaller companies wishing to take up public sector work. A great place to start is www.supply2.gov.uk which gives advice on what is required when working for the public sector and allows you to search for contract
opportunities by area. Companies can also create a business profile and put it on the supplier information database. The Government encourages public sector organisations to use suppliers accredited on the register for all construction-related contracts.

It is refreshing to see that there is help out there for construction firms. With the right attitude and well-organised finances, owners and managers can gain access to great opportunities and ride out the economic storm successfully.

Jason Heath is construction finance specialist at Bibby Financial Services