Out-Law Guide | 09 Nov 2020 | 9:39 am | 10 min. read
In this note, we consider whether contracts provide any remedies, focussing on standard forms typically used in the region, and what happens when only the parent company of a contractor enters into insolvency. We also explain what an employer needs to know about insolvency of a contractor under UAE law and touch on the impact further down the supply chain. Further, we consider what happens in the alternative scenario of the employer, rather than the contractor, becoming insolvent, and also look at the potential impact of the very recent modifications that have been announced in relation to the UAE Bankruptcy Law.
The UAE Bankruptcy Law (Federal Law No.9 of 2016) (as amended) is still relatively new and remains largely untested. There have only been a small number of court-led restructurings since the law came into effect in 2016. Under the existing law, there are three insolvency procedures:
Under all three processes, creditors are obliged to provide evidence of their debts, including supporting documents, within reasonably tight timescales. Any realisations are to be paid to the court or trustee before distribution in accordance with the creditor order of priority. Other than certain preferential creditors, such as employees and certain amounts owned to government entities, secured creditors rank first in relation to realisations from the assets they have security over but secured creditors can only enforce their security with court permission.
On 21 October 2020, the UAE Cabinet approved amendments to the Bankruptcy Law in response to the financial difficulties faced by many businesses due to Covid-19. The changes will come into force when published in the Official Gazette and are designed for use during times of "emergency financial crisis". We understand that an "emergency financial crisis" will be defined as "a public condition that affects trade or investment in the state such as the outbreak of epidemic, natural or environmental disaster, war or other which cause and duration shall be determined by Cabinet resolution".
Of particular note appears to be the suspension of the requirement for a debtor to file for bankruptcy and the ability to agree a settlement plan with creditors where their financial difficulties are caused by the "emergency financial crisis" with the burden of proof as to the cause of their financial difficulties sitting with the debtor. However, as Arabtec seems to have already resolved to liquidate and the notice in circulation cites its shareholders' intention to liquidate amidst longer standing financial difficulties, it would appear that a rescue of Arabtec is not contemplated by the shareholders and that Arabtec might struggle to overcome the burden of proof that their financial distress is as a result of an "emergency financial crisis" as defined in the amendments to the Bankruptcy Law.
The gut reaction of most employers with an existing agreement with Arabtec or its subsidiaries will be to review quickly the terms of their agreements, the strength of any performance security in place and, planning for a worst case scenario, the legal bases for termination.
Whilst the Arabtec parent company has announced an intention to apply for insolvent liquidation, this does not mean that its subsidiaries, which may be the relevant counterparty in the construction context, will become insolvent. The principle of privity of contract is respected under UAE law and an employer's recourse will be against its contractual counterparty only, absent any parent company guarantees. However, the insolvency of the parent company may still have an impact and, to the extent it provides cash support to its subsidiaries, may also put their solvency in doubt.
Prior to the event of insolvency, an employer should carefully monitor the contractor's performance of the contract.
In the case of Arabtec, at this point it has been reported that it has issued a special resolution that it will apply to the competent court for "liquidation and dissolution", which we assume to mean the 'liquidation within bankruptcy' procedure under the Bankruptcy Law. This is the beginning of a long road but until Arabtec's application for liquidation is accepted by the competent court, the company continues to be in existence and its rights and obligations should be honoured.
It has also been reported that Arabtec will decide which subsidiaries within its group will be included in bankruptcy proceedings. As such, certain triggers for termination on insolvency grounds under the terms of the agreements of Arabtec and its subsidiaries may not have been met as yet, but the exact grounds for termination in agreements should be checked carefully.
When faced with contractor insolvency, the wording of the contractual terms allowing termination in the event of insolvency must be examined under the applicable law to ensure that any termination by the employer would not be wrongful.
By way of example, when faced with a contractor insolvency, Clause 15.2.1(g) of the FIDIC Red Book 2017 – the standard form of which is commonly adopted in the region – provides that an employer can give a notice of termination in the event that the contractor "becomes bankrupt or insolvent; goes into liquidation, administration, reorganisation, winding up or dissolution; becomes subject to the appointment of a liquidator, receiver, administrator, manager or trustee; enters into a composition or arrangement with the Contractor's creditors; or any act is done or any event occurs which is analogous to or has a similar effect to any of these acts or events under applicable Laws".
As a matter of UAE law, this is likely to bite at the point when the bankruptcy application in respect of the contractor, whether presented by the debtor or its creditors, is accepted and approved by the competent court.
The remedies available to the employer will then need to be considered under the suite of contracts and associated security.
The right to terminate under the FIDIC Red Book applies in relation to the insolvency of the contractor and so would not capture the insolvency of a parent company. An employer in this scenario would need to stay alert to the performance by the contractor of its obligations and any notifications that the insolvency proceedings of the parent involved the subsidiary.
Commonly in construction contracts, the employer's right to have the contract performed will be secured by a performance bond.
Under UAE law, a performance guarantee imposes a primary and binding obligation on the issuing bank to pay a specified sum to the beneficiary employer when that beneficiary makes a compliant written demand for payment following a failure by the primary obligor, the contractor, to perform the underlying contract.
Performance bonds form a separate obligation between the bank and the employer and are usually payable "on demand" such that the employer does not have to prove the contractor's breach of contract but merely inform the bank in good faith that a triggering event has occurred. The insolvency of a contractor, or its parent company, should not therefore affect the validity of the bond but the insolvency of the contractor may give grounds for a bond call.
Clause 4.2.2 of the FIDIC Red Book 2017 governs the circumstances in which calls on performance bonds can be made by the employer in relation to those agreements, including when a notice is given under Clause 15.2 – including a notice of termination for contractor insolvency.
The terms of the individual performance bond in question must be carefully examined to avoid an illegitimate call. Some will refer expressly to Clause 15.2 of the FIDIC Red Book 2017, or equivalent contractual provision, and some may define insolvency separately from the contract. A careful analysis of whether or not the contracting employer is insolvent under the terms of the contract with reference to UAE law will be required.
Whilst the issuing bank should readily release the performance bond amount to the employer without dispute following a compliant call on the bond, the bank will likely first alert the contractor.
There is a risk that the contractor may apply 'ex parte' – without notice – to the UAE court for injunctive relief in the form of a precautionary attachment over the amount of the bond to restrain the issuer from making payment on receipt of the demand. The outcome of such an application in the UAE courts is uncertain but, if successful, the contractor would then be pushed to commence formal dispute proceedings within eight days of the attachment being granted. There is therefore a risk that a bond call will result in significant escalation.
Similar concerns apply in the event that an employer applies for insolvency.
A contractor may consider making a request under Clause 2.4 of the FIDIC Red Book 2017, should it become aware of any material adverse change in the employer's financial arrangements, that the employer provide reasonable evidence that financial arrangements are in place and are being maintained to meet payments under the contract price. If such a request for reasonable evidence is not complied with, then the contractor is entitled to suspend works under Clause 16.1(b) if the failure to provide evidence constitutes a material breach of the employer's obligations under the contract.
Clause 2.4 also provides that the employer must immediately notify the contractor of any intention to make any material change to its financial arrangements affecting its ability to meet the contract price remaining, or if it has to make such change due to a change in its financial situation.
Before the employer has made an insolvency application, the contractor may consider suspension of works when specific payment obligations are not met under the terms of the agreement, such as the terms provided for under Clause 16.1 of the FIDIC Red Book 2017. In addition, it may consider calling on any security bonds in place to secure payment under the terms of the contract.
Once the conditions of insolvency have been triggered in the contract, the contractor may be entitled to terminate.
Under clause 16.2.1(i) of the FIDIC Red Book 2017, a contractor can give notice of its intention to terminate if the employer "becomes bankrupt or insolvent; goes into liquidation, administration, reorganisation, winding up or dissolution; becomes subject to the appointment of a liquidator, receiver, administrator, manager or trustee; enters into a composition or arrangement with the Employer's creditors; or any act is done or any event occurs which is analogous to or has a similar effect to any of these acts or events under applicable Laws". Clause 16.2.2 allows the contractor to terminate immediately in such circumstances.
The remedies available to the contractor will then need to be considered under the suite of contracts and associated security. Options at this stage may include the right to enforce parent company guarantees or performance bonds or simply join the ranks of other creditors proving for their debts against the assets of the employer under the relevant insolvency regime.
The insolvency of any contractual counterparty in a construction contract will send ripple effects down the supply chain. The insolvency of a main contractor is likely to result in limited cash flow, delays and diminished work quality under related sub-contracts. Should the employer terminate the contract due to the contractor's insolvency, no further payments are required to be made until the works are completed and defects certified. Such action will have a clear and direct impact on sub-contracts further down the chain relying on payments and resources from the main contractor.
The same ripple effects will be felt with the insolvency of an employer, impacting payments to contractors and the contractors' ability to pay and resource its sub-contracts.
The insolvency of a contracting entity should spur careful analysis of the contractual terms of construction contracts and the terms of related performance security through the lens of UAE law.
Whilst the insolvency of Arabtec as a parent company contractor is unlikely to directly trigger termination or suspension in contracts entered into by its subsidiaries, it provides pause for thought. Employers would be wise to assess the terms of their contracts and performance securities without further delay and be prepared to act quickly should the solvency of the contracting counterparty be called into serious doubt.
Additional research and drafting contributed by Matthew Dyson and Faisal Attia of Pinsent Masons in Dubai.