Simon Lewis: Insolvency in the construction sector
In the past five years, insolvency rates in the construction industry have increased more quickly than in other industries across the UK. Womble Bond Dickinson (WBD) lawyers Simon Lewis and Philippa Jones consider the common causes of construction insolvency and how construction firms can protect their position if insolvency occurs.
The term ‘insolvency’ indicates a company’s inability to pay debts as and when they fall due or (from a balance sheet perspective) the value of a company’s liabilities being greater than the value of its assets. Each can result in a company being placed into liquidation or administration. The aim of these processes is to recover all available assets, enabling them to be disposed of to generate proceeds which can be distributed to creditors to satisfy their debts.
Records in the 12 months to the end of September 2018 saw 2,954 construction insolvencies out of a total of 17,439 insolvencies - which represents a 12% increase on the previous year. Even large construction companies have struggled – as demonstrated by the collapse of a major contractor in 2018.
Reasons for construction insolvency
In the construction industry there is usually a delay between work being performed and payment being received. Most contracts provide for stage payments in arrears, resulting in the supply chain carrying significant work in progress until it is paid. This lag in monetary recovery can result in businesses suffering cash flow issues because they have to wait up to 90 days or more for invoices to be paid, or because in some cases (for various reasons) they may not be paid at all. Late payments and bad debts are the main triggers for insolvency.
Lack of profitability can also affect construction businesses of all sizes. The sector contributes approximately 7% of GDP meaning it is a large industry, and therefore a highly competitive industry. Tenders are often decided on a price metric meaning the lowest price often wins the work. This can result in contractors performing work with minimal margins. Any unexpected delays or increased costs in the works which the contractor has to bear (such as higher material costs, currency fluctuation risks and rising labour costs) can wipe the profit from the work. In light of the pressure to ensure a job is profitable, combined with any cash flow issues as mentioned above, disputes can emerge regarding payment and valuations – otherwise again the business can be at risk of insolvency.
Finally, the domino effect reflects the impact which one party higher up the chain becoming insolvent can have on others, such as a main contractor on a subcontractor. The failure of one business can have repercussions for others in the chain who were reliant on the income from the project to fund their works.
The Courts’ interpretation of ‘insolvency’
When determining ‘insolvency’ the Courts construe it strictly in accordance with its definition in the contract, even if the contract refers to an out of date or non-exhaustive list of insolvency processes.
At common law, insolvency by itself is not a breach of contract. However, its effect can result in a repudiatory breach of contract which means the contract could be ended regardless of whether or not the contract contains any termination provisions.
Under the Insolvency Act 1986, a company is ‘insolvent’ when it is unable to pay its debts as and when they fall due for payment. In contrast, under clause 8.1 of the JCT Standard Building Contract, a party which is a company is taken to be ‘insolvent’ for the purposes of the contract where a recognised insolvency procedure has been invoked, such as where the company has passed a winding-up resolution or the company has entered into an arrangement or compromise of its debts with its creditors. Consequently, under the JCT contract the fact that the company is unable to pay its debts as and when they fall due is insufficient for it to be ‘insolvent’ contractually, though this may ultimately lead to a formal insolvency procedure being invoked so as to make the company ‘insolvent’ for the purposes of the contract. Therefore the status of the insolvency needs to be considered, in addition to ensuring all parties follow the proper contractual formalities, to avoid any claim for wrongful termination if insolvency is relied on to terminate a contract.
The insolvency termination provisions (under the JCT Intermediate Building Contract with Contractor’s Design 2011) came under scrutiny in Wilson and Sharp Investments Ltd vs Harbour View Developments Ltd (2015).
That case considered whether the insolvency provisions applied in all situations of insolvency or just those where insolvency occurs prior to termination of the contract and the contract is terminated as a result. The issue was relevant because the contractor (Harbour View) became insolvent after termination had occurred. If such provisions did not apply where the contract had previously been terminated by the contractor, then insolvency clause allowing the employer to suspend payments to the contractor would not apply.
The case went all the way to the Court of Appeal which confirmed that the ‘insolvency’ provisions applied, regardless of whether the insolvency occurred prior to or after termination and regardless of whether termination was due to the insolvency. This decision was favourable to the employer rather than the contractor. The Court confirmed that the JCT provisions complied with the Housing Grants and Construction Regeneration Act 1996,(the Act) section 111(10) and even the JCT provisions that came under the heading “termination” applied irrespective of whether the contract was terminated or capable of termination by reason of contractor insolvency. The decision confirms if contractor insolvency occurs at any time, under the JCT the employer is not obliged to pay sums due under interim certificates. Instead, payment is delayed until the final account, regardless of whether the employer issued a pay less notice. The position is the same under the 2016 edition of the JCT.
Warning signs of insolvency
There are many early warning signs that an employer, contractor or subcontractor could be facing financial difficulties, which include:
- Cash flow issues
- Late/non-payment of supply chain invoices/employees’ wages
- Attempts to negotiate changes in payment terms such as renegotiating credit limits
- Persistent rumours within the industry about their financial position
- Late filing of accounts or annual returns at Companies House
- Unsatisfied court judgements, County Court Judgements or High Court Writs being issued against them
- Creditors issuing winding-up petitions
- Official announcements to shareholders/the market regarding financial performance
- Suspension of work without explanation or surprising/uncommercial omissions from a project
- Personnel removed from the project unexpectedly.
Protection methods in advance of insolvencies
To reduce the risk of insolvency, parties should consider the following when negotiating contracts:
- Obtaining references/credit checks. Auditing the other party’s financial status at the time of contract negotiation can be a good indicator of future performance.
- Pay when paid clauses. Generally these clauses are prohibited under the Act. However, there is an exception to the prohibition in the event of ‘upstream insolvency’, so that a paying party does not have to pay if its own payment is withheld due to insolvency. This requires specific drafting in the contract.
- Retention of title clauses. These can enable an unpaid party to get back goods/materials belonging to them prior to full payment being made. However, the clauses need to be properly drafted, and title to goods often passes to the buyer when the goods have been incorporated into the building / attached to the land even if the supplier is unpaid.
- Collateral warranties. These create a direct contractual relationship between the contractor’s, consultants or subcontractors and the employer - by which the consultant or subcontractor warrants to the employer that it has complied with its appointment/subcontract. This enables the employer to pursue them for defects despite not directly appointing them.
- Parent company guarantee (PCG). The contractor’s parent company can guarantee the performance of the contractor in the event of its insolvency. The PCG will make the parent company liable for any amounts due to the employer at any point in time if the contractor does not complete the works. The parent company may remain financially viable and hold additional assets. However, the PCG will often only pay out on completion of the building works so that the value of the claim is easily quantifiable which may limit its use. A bond can also or alternatively be used to protect the employer.
- Third Party (Rights Against Insurers) Act 2010. This legislation enables claimants to bring proceedings against the insurers of defaulting insolvent companies. This may assist an employer if latent defects arise after practical completion at a time when the contractor has become insolvent as the defects may be covered by the insurance policy.
- Suspension/termination clauses. Including a clause permitting suspension of performance or termination of the contract in the event of the other party’s insolvency can protect a party, but care needs to be taken in the drafting to detail the parties’ rights and the effect of termination on the contract, and to ensure the definition of “insolvency” is sufficiently wide.
- Communication is key. As a creditor, any debtor must consider your interests when experiencing cash flow issues. Arranging agreements with debtors that spread payments can help avoid insolvency occurring. If insolvency occurs, parties can negotiate with Insolvency Practitioners to reach mutually agreeable solutions such as ensuring works are completed, and the site is secured.
- Maintaining proper records demonstrating the losses arising out of the insolvency (such as recording what materials and equipment are on-site, especially what has been paid for) can help safeguard a party’s interests if insolvency does occur.
- Dispute Resolution. Initiating an adjudication prior to the other party becoming insolvent can mean the difference between securing payment prior to the insolvency and ending up in the queue of unsecured creditors. Always consider formal dispute resolution options prior to impending insolvency as adjudication cannot be pursued against a company in liquidation/administration.