Being particularly susceptible to market fluctuations, the construction industry has seen more insolvencies in the last five years than other sectors across the UK. The collapse of construction giant Carillion in January 2018 demonstrated cashflow issues can affect businesses of all sizes.
This article considers the common reasons for construction insolvency, warning signs to be mindful of and how to protect your position if insolvency strikes.
What is insolvency in the Construction Industry?
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 valuation method 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.
Dangers of construction insolvency
In 2018, it was the hardest hit economic sector, with construction insolvencies representing 17% (3,001 from a total of 17,454). This trend continued into 2019, with provisional figures indicating construction insolvencies accounted for 18.6% (3,198 from a total of 17,197).
These statistics are regularly translated through the media as there never seems to be a month that goes by without news of contractor insolvency – from high profile industry names to historic brands to specialist contractors – no one appears to be safe.
What are the common causes of insolvency in the construction sector?
The construction industry suffers from an almost unavoidable lag between work being performed and payment being received. Contracts often provide for stage or periodic payments in arrears. This can result in the supply chain carrying significant work in progress until payment is received.
Cashflow issues can result from this payment delay if businesses have to wait up to 90 days or more for invoices to be paid, or in some cases (for various reasons) they may not be paid at all. Ultimately, late payments and bad debts are the main triggers for insolvency.
In addition, lack of profitability can also affect construction businesses. The sector is highly competitive, leading to the lowest price often winning the tender, which may in turn 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 fluctuations or rising labour costs) can wipe profit from the project.
Finally, the domino effect reflects the impact the insolvency of one party higher up the chain can have on others, such as a main contractor on a subcontractor. The failure of one business can have adverse effects for others in the chain who are reliant on the project income to fund their works.
Unprofitability in Construction Causes Insolvency
One of the most obvious causes of insolvency in the construction industry is a lack of profitability. Given a large number of firms in the construction industry, the process of winning work is highly competitive and price sensitive. In many cases, the only way to win a contract is to charge the lowest price. However, research into the capital productivity of the construction industry has shown the return on investment in construction is higher than other sectors. Over the period 1948 to 1994, capital invested in construction made a return of around 24 percent, compared to 9.5 percent and 8.3 percent for manufacturing and agriculture respectively.
So, the indicators are the bigger companies are getting a far greater return on their investment than smaller companies. You could argue the return for the larger companies is made on the backs of smaller companies whose profit is taken by the larger companies.
Domino Theory Contributes to Construction Insolvencies
Another contributory factor in the high level of insolvency in construction firms is the frequency with which suppliers and clients go out of business. Clients can go out of business with unpaid bills and main contractors can fail while owing cash to one or more smaller contractors.
Generally speaking, firms in the construction industry tend to delay payments to creditors when they are struggling. During this time more work could be done and larger debts incurred. For this reason, construction firms tend to have larger debts on insolvency than other firms.
What are the warning signs of insolvency?
Early warning signs that an employer, contractor or subcontractor could be facing financial difficulties to look out for 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
- official announcements to shareholders/the market regarding financial performance
- late filing of accounts or annual returns at Companies House
- unsatisfied court judgments, County Court Judgments or High Court Claims being issued against them
- creditors issuing winding up petitions
- suspension of work without explanation or surprising/uncommercial omissions from a project
- personnel removed from the project unexpectedly
How can I protect my business from supply chain insolvency in advance?
To reduce the impact of insolvency in a construction supply chain, when negotiating contracts and throughout the project, parties should consider:
- Obtaining references/credit checks. Auditing the other party’s financial position prior to contract negotiation by reviewing their status on The Gazette’s company profiles section can provide a good indication of their future performance.
- ‘Pay when paid’ clauses. Generally, these clauses are prohibited under the Housing Grants, Construction and Regeneration Act 1996. However, there is an exception to the prohibition in the event of ‘upstream insolvency’, so that a paying party does not have to pay downstream if its own payment is withheld upstream due to insolvency. This requires specific drafting in the contract and specialist advice.
- Retention of title (ROT) clauses. These can enable an unpaid party to retrieve goods or materials belonging to them prior to receiving full payment. However, title to goods often passes to the buyer when the goods have been incorporated into the building or attached to the land, even if the supplier is unpaid. Again, expert legal advice should be obtained in relation to the effect of such clauses.
- Suspension/termination clauses. Including a clause permitting suspension of performance or contract termination in the event of the other party’s insolvency can protect a party. Specialist drafting is needed to particularise the parties’ rights and the effect of termination on the contract, and to ensure the definition of “insolvency” is sufficiently wide to be effective.
- Collateral warranties. These create a direct contractual relationship between contractors, 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 and is another avenue for redress in the event of a party’s insolvency.
- 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 amounts due to the employer if the contractor does not complete the works. The parent company may remain financially viable and hold additional assets.
- The 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 because a claim may still be made if the defects are covered by the insurance policy.
- Communication is key. As a creditor, any debtor must consider your interests when facing cash flow issues. Arranging agreements with debtors spreading payments can help avoid insolvency occurring. Negotiating with Insolvency Practitioners to reach mutually beneficial solutions if insolvency arises can help ensure works are completed and the site is secured increasing the value of the finished project.
- Records. Maintaining proper records demonstrating the losses arising out of the insolvency, eg recording what materials and equipment are on site (especially what has been paid for), can help protect 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 with minimal prospect of a return. Obtain advice on dispute resolution options prior to impending insolvency because adjudications cannot be pursued against a company in liquidation/administration.
How can The Gazette’s data service help mitigate the effects of insolvency in the construction sector?
Insolvency can affect all businesses regardless of turnover. But getting insolvency information quickly can help businesses, contractors and project managers take steps to mitigate disruption as soon as possible.
The Gazette’s data service can help you identify up to date information relating to your supply chain partners, helping you anticipate potential problems and minimise risk exposure.
Here are the insolvency routes covered within The Gazette that you can receive through the data service:
Administration is a procedure for which a licensed insolvency practitioner is appointed to oversee and protect a business.
- Administrative receivership
Administrative receivership involves control of a company being handed over to an administrative receiver, who looks to sell the company’s assets so that the appointing lender can recover money owed to them.
- Creditors’ voluntary liquidation
Creditors’ voluntary liquidation is when the directors of a company voluntarily decide it is time to liquidate the company. A licensed insolvency practitioner is required to help them to do this.
- Members’ voluntary liquidation
Members’ voluntary liquidation is a process where the company’s shareholders have decided to wind up the company to distribute the assets after the payment of any debts, and then close the company.
- Winding up by the court
A winding up order is a court order that forces an insolvent company into compulsory liquidation – a process in which the court appoints an Official Receiver to liquidate all the company’s assets to repay creditorsThe Gazette’s data service can help you identify up to date information relating to your construction partners, helping you anticipate potential problems and minimise risk exposure.
Personal Guarantee Insurance may help Construction Directors with Financial Difficulties
A construction business may at time suffer from any one of a number of financial or trading difficulties. It is important that if any director holds personal guarantee insurance that they notify the insurance holder as soon as they become aware of any of these ‘notifiable events’.
Directors need to read their policy carefully to ensure you are aware of all such situations. Examples include:
- County Court judgements
- Inability to repay debts or creditors as they fall due
- Unexpected expenditure which cannot be met from available cash resources
About the author
Philippa Jones is a Solicitor at Womble Bond Dickinson (UK) LLP and specialises in construction and engineering dispute resolution. If you would like advice on a construction insolvency issue, contact a member of the Construction Team at WBD.