The impact of bankruptcy on the position of parties involved in construction

With some regularity, parties involved in the construction of projects go bankrupt. This may involve, for example, a client or (sub)contractor.

Bankruptcy is particularly annoying when the work has not yet been completed. Then numerous discussions arise and the question of the position of parties involved arises.

That position is determined primarily by (i) what is agreed upon in the contract entered into between the parties and (ii) how the parties subsequently act.

Starting point: in principle, bankruptcy does not affect concluded contracts

It is often thought that bankruptcy automatically terminates agreements entered into by the bankrupt. This is incorrect.

Indeed, the basic principle is that bankruptcy does not change the rights and obligations of the parties involved. This applies both to the bankruptcy of a principal and a (sub)contractor.

Obligations under contracts should, in view of the foregoing - by both the bankrupt and its contracting party - in principle be fulfilled.

However, given the bankruptcy, it is highly uncertain whether the bankrupt's trustee can comply.

The other contracting party obviously does not want this uncertainty, especially if the work has not yet been completed. What can that contracting party do then?

Request for standstill

Given the uncertainty as to whether the bankrupt's trustee will perform the contract, the contracting party may set the trustee a reasonable time within which the trustee must let the trustee know whether or not it will perform the contract.

If the trustee does default, he will have to provide security. That security is often provided by the bank that has an interest in completing the work.

If the trustee does not perform, he loses the right to demand performance and the construction can, in principle, be completed by another party. A new contract will then be concluded with that other party.

However, this does not mean that the book can be closed with respect to the agreement with the bankrupt. After all, this agreement also still exists, only the trustee can no longer claim performance of that agreement.

What if work was performed before the date of bankruptcy for which payment has not yet been made? Can the trustee then claim payment for that work performed?

Can the trustee still claim payment for work already done, even if it does not honor the contract?

Yes, in principle, the trustee can claim payment for work already done. This is especially true if installment payments are used and these installment payments are due and payable.

The trustee can rely on two grounds, namely (i) performance of the contract and/or (ii) unjust enrichment.

However, two Supreme Court rulings show that the content of the agreement can prevent this.

Supreme Court ruling regarding payment based on performance

In ECLI:NL:HR:2020:1954, the Supreme Court ruled that if an agreement provides that the obligation to pay a residual amount for work work does not arise until the additional work is completed by either the construction company or the trustee, the trustee cannot claim payment based on performance if he has not honored the agreement.

Only on the trustee fulfills its obligations as described in the agreement does the buyers' obligation to pay arise and the trustee can demand performance.

In this case, buyers had paid 25% of an additional work sum and the remainder was not due until the completion of the additional work or the next installment, with the installments always becoming due fourteen days after the date of a request for payment.

These conditions were not met, so no payment could be claimed on the grounds of performance. Thus, the contract stood in the way of this.

Supreme Court ruling regarding payment based on unjust enrichment

In ECLI:NL:HR:2016:2729, the Supreme Court ruled that, in principle, a receiver may claim payment for work already done on the grounds of unjust enrichment - even if the work is divided into installment payments and an installment is not yet due and payable - but that the agreement may exclude this possibility.

Thus, if the contract excludes such a claim or if the contract contains a justification for not having to pay compensation, that prevails and thus the trustee can no longer claim payment on the grounds of unjust enrichment.

So again, the contract may preclude compensation based on unjust enrichment.

Insolvency clauses

The rulings discussed above make clear that the content of the agreement entered into between the parties determines the legal position of those parties and, below the line, whether or not payment is due for work performed but not yet completed.

In view of the above, it may be wise to divide the work into as many installment payments as possible or, on the contrary, to include that claims based on unjust enrichment are excluded under certain circumstances. What is best for you depends on the specific situation and your position (client, contractor or subcontractor).

Often contracts contain what is known as an insolvency clause. That clause then regulates exactly what happens to the agreement in case of bankruptcy of one of the parties. This is generally wise to include.

For example, does the contract provide that the bankruptcy automatically terminates the contract or that one of the parties has the right to terminate the contract, then that is what applies (and thus contrary to the main rule that bankruptcy does not affect ongoing contracts).

In short, in any case, it is wise to think about the position of the parties in the event of an unexpected bankruptcy when drafting agreements and to anticipate this - where possible - through the agreement.

Course of action after bankruptcy also determines

Not only the content of the agreement determines the position of parties involved. Subsequent conduct can also have major consequences.

For example, if there is no insolvency clause and if the trustee does not honor it, a contracting party has the choice between (partial) rescission or claiming substitute damages.

In one situation, partial or even full dissolution may be desirable, while in another situation opting for compensatory damages may be wiser. Sometimes it can also be wise not to make a choice immediately, but to wait a while.

The wrong choice can have far-reaching consequences such as creating unwanted undoing obligations or being unable to claim or offset certain damages.

In short, it is wise to think carefully about which choice will be made, list the pros and cons of that choice and then decide if and when that choice will be made known to the trustee or other parties involved.

Conclusion: agreement and course of action determine parties' position in construction bankruptcy

Bankruptcy in the construction industry is particularly annoying if a project has not yet been completed. The question then arises as to the position of the parties involved with regard to, for example, whether or not the work has been completed, guarantees, work in progress, outstanding invoices, etc.

That position is in principle by the agreement made between the parties and their conduct after the bankruptcy is declared.

It is therefore wise to anticipate an unexpected bankruptcy of one of the parties involved when drafting a contract by including a so-called insolvency clause in the contract. Such a clause will then regulate - where possible - the consequences of bankruptcy on the contract.

Such an insolvency clause, possibly together with other actions such as invoking a lien, can prevent a lot of damage.

Even with a properly drafted insolvency clause, however, it is important to discuss how to proceed after bankruptcy. A wrong choice between full or partial dissolution or substitute damages, for example, can have far-reaching negative consequences.  

It is therefore wise to get proper advice both when drafting the agreement and how to proceed around the bankruptcy of your contracting party.