In recent years, Israel’s real estate and infrastructure market has experienced many cases of the corporate collapse of performance contractors. Just recently, a court ordered a temporary stay of proceedings against the construction company Tal Bar Construction and Supervision. The recent interest rate hike has also made headlines, including that it might hit performance contractors particularly hard. The collapse of a construction company affects not only the company and its creditors but also the project’s developer. This is especially true when the company’s collapse has direct repercussions on the real estate developer’s conformance with the project timelines. It also has direct repercussions on the insolvent company’s ability to fulfill its obligations.
In the majority of cases, the collapse of a company results in breaches of contract. The developer has various alternatives available to it to minimize damages, such as terminating the performance contract with the current contractor and engaging with a different one. Alternatives such as confiscating the contractor’s deposits and performance guarantees are also available to the developer.
However, sometimes, due to the intricacies of the law regulating the position of insolvent construction companies, actions that appear to be legitimate and “justified” from the commercial perspective could impose liabilities on the developer and expose it to the filing of legal actions by the insolvency trustee appointed to the company.
In this article, we briefly discuss developers’ typical actions and the various ways to minimize the legal exposure that such actions provoke.
Expelling the Construction Company from the Project Site as a Consequence of Its Insolvency and Terminating the Contract
Many performance contracts include a provision that enables the developer to terminate the contract and expel the contractor from the project site if the performance contractor becomes insolvent.
However, the provisions of the Israeli Insolvency Law explicitly state that the opening of insolvency proceedings against a corporation, or the mere fact of its insolvency, does not trigger termination of contract or vest the developer a right to terminate it, even if the contract allows it. Underlying this provision is a rehabilitative rationale that serves to enable the insolvent company to continue operating and allow it to reach debt arrangements.
Furthermore, the insolvency trustee has broad discretion in deciding whether to continue or terminate the performance contract. This discretion stands regardless of whether the performance contractor upheld or breached provisions of the contract prior to the issuance of the insolvency order. Thus, the trustee can apply to the court to compel the developer to continue the contractual relationship with the performance contractor, notwithstanding the breaches of contract it committed, or, alternatively, to terminate the performance contract and prevent the performance contractor from continuing to provide services, even against the developer’s wishes.
State of Uncertainty
Therefore, when the court issues an insolvency order, the developer remains in a state of uncertainty. However, a unilateral and hasty action on its part to terminate the contract and expel the contractor could expose it to injunctions and even to claims on the part of the insolvency trustee for damages caused to the performance contractor as a result of loss of income from the project.
Instead of taking unilateral action, it is preferable for the developer to negotiate with the trustee. He should perform a swift analysis of the feasibility of the contractor continuing to provide services and attempt to receive the performance contractor’s commitment to continue carrying out the work. Since the insolvency trustee must operate the collapsing company without a cash flow deficit, it is reasonable to assume the trustee will not want to undertake such commitments. That being the case, preliminary negotiations could actually achieve swift consent to terminate the performance contractor’s work on site and to expel it with the court’s consent and approval in advance.
Using the Collapsed Performance Contractor’s Credit Balances for the Purpose of Paying Subcontractors
When the project is in its advanced stages, the developer may use collapsed company’s subcontractors to complete it. For the most part, Subcontractors, in exchange for settling debts, will agree to complete work on advanced projects. Ostensibly, the developer can pay this debt using the contractor’s credit balances it holds (as a lien or within the framework of current payment terms). However, this action could give rise to legal exposure if the insolvency trustee demands a return of the payments to the subcontractors on the grounds they constitute “unfair creditor preference.” This means the court could consider payments to the subcontractors (who are creditors of the insolvent company) as payments paid at the expense of the company’s other creditors. This would violate the principle of equality, and thus the court could invalidate the payments.
The court has the authority to retroactively invalidate an action of “creditor preference” and order the return of the payments even if made prior to the issuance of the insolvency order. This is because certain Insolvency Law provisions allow for the reversal of actions taken shortly before the issuance of the insolvency order. Although the demand to return the payments will be issued to the subcontractors whose debts were repaid, it will also be issued to the developer itself, as the holder of the performance contractors’ credit balances. This will expose the developer to legal proceedings.
The Right of Offset
The developer cannot assume in advance that it can make use of the insolvent company’s credit balances to pay debts relating to the project. This is on the grounds that it has a right of offset. It is important to keep in mind that establishing a right of offset against an insolvent company requires the developer to fulfill conditions that are more stringent than under general law. Furthermore, the court takes additional considerations into account when issuing its ruling. These considerations include maintaining equality among creditors and preventing creditors from taking independent actions. In addition to these, there are also strict formal requirements to substantiate a claim of a right of offset. This includes the issuance of a detailed notice of offset when filing a debt claim. Failure to fulfill the requirements could result in the claim being denied.
Measures to Minimize Damages in Court Rulings
The Tel Aviv District Court recently addressed the issue of minimizing a developer’s damages in a ruling in the Goren Megiddo case. Goren Megiddo is a construction company that became insolvent in 2021 while constructing a real estate project. After the appointment of the insolvency trustee, the trustee found that the developer, upon learning of the insolvency proceeding, rushed to deliver an expulsion notice to the insolvent construction company. The developer also used the credit balances it held to pay subcontractors in the project. The Court determined that the developer acted unlawfully and ordered it to return the payments it paid to the subcontractors to the trustee’s account. The court denied the developer’s claims of offset and ruled that executing the payments to the subcontractors violated the principle of equality. The court also found that the developer failed to fulfill the conditions prescribed by law.
The ruling emphasized that, for the purpose of invalidating payments, the insolvency trustee does not have to prove an intent to prioritize debt repayments to the subcontractors over other creditors, and the objective outcome is sufficient. Namely, the payments resulted in the debts to the subcontractors being repaid in excess, i.e., beyond the ratio of repayment to all other creditors during the insolvency proceeding.
The Court judge recommended developers seek legal advice on insolvency law before taking action: “Notwithstanding the natural tendency, which may be ‘justified’ from the developer’s point of view, this is an unlawful action that violates the overarching principle of equality among creditors, and the court will not allow it. Any company that finds itself in such a situation should seek in-depth legal advice from lawyers specializing in insolvency law, and it should abide by the law rather than according to its inclinations …”
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Barnea Jaffa Lande is at your service to answer any questions about dealing with a company experiencing an economic collapse and to advise you on all issues that arise during insolvency proceedings.
Adv. Idan Miller is the Head of the Insolvency practice in the firm.