Managing Sub-Contractor Insolvency In The Construction Industry

 

In the recent financial climate, the UK construction industry has suffered numerous Sub-Contractor insolvencies. Various components have caused this, however one of the main sensitivities is the multiple levels of contracting which cash has to cascade through successfully, to ensure the liquidity of each of the contracting parties.

Below I wish to look at ways in which Contractors can avoid, identify, de-risk, avoid and if all else fails; manage the crisis that can occur if a Sub-Contractor befalls financial failure during a contract.

The following is by no means an exhaustive list or a magic panacea to avoid the potential issues that insolvency can cause; all it seeks to do is identify adequate procedures to minimise the risk and mitigate the impact.

Avoidance and preventative measures

It is possible to live too much by maxims; however, in the field of Sub-Contractor insolvency, prevention is undeniably much better than cure.

A package risk review should be undertaken prior to procurement of the works identifying the key high-risk packages with factors such as; long lead-in works, single sourced systems, critical path dependent activities etc. Once these are identified, a risk mitigation review and strategy should be ascertained depending on the severity, risk and individual company.

When formulating the specific strategy for each package the following are some key checks and points to consider.

  • Credit reports – Most companies undertake credit checks, however too often these are reviewed only at the beginning of a project and forgotten about. Credit reference agencies generally update their records monthly and it only takes another Contractor to default on a sizeable payment during this time to send your Sub-Contractor into turmoil. These checks are vital and need to be carried out regularly.       Credit reports are useful, but are not infallible.
  • Enquires and references – Even with Sub-Contractors with whom you have a long trading history, it can be very beneficial to obtain references from fellow Contractors and even better their Suppliers, especially if you have not engaged them for a while. Suppliers are normally the first to feel the pinch if a Sub-Contractor is struggling financially and act as a great barometer. However caution must always be exercised and to never rely solely on word of mouth. Nothing can damage a Sub-Contractor’s solvency quicker than a rumour being spread that they are in fact insolvent!
  • Payment terms – There is always a balance to be maintained with regard to the payment terms we contract upon. Naturally we wish to ensure that we maximise our own cash flow wherever possible, but at what cost? Contracting on overly onerous payment terms can be a false economy. The disruption and costs associated with Sub-Contractor failure can heavily outweigh the gains from additional cash in our coffers for a short period.       A reasonable payment schedule should always be agreed with a Sub-Contractor and run through fully to ensure it is fully understood (especially with the smaller and less commercially perceptive members of our supply chain). While this all well and good, we need to be mindful that once this process is done, the golden rule is we must stick to the agreed payment date! It is crucial that payments are made on time and we must be cautious to never overvalue the works position.
  • Vesting – The mind-set of traditional contracting is that the risk of products and materials lays solely with the Sub-Contractor until the works are fully installed or handed over. There are compelling reasons for this and it is many Contractor’s natural instinct to transfer risk down the supply chain in this manner. However, we must be sensible that we do not actually encumber ourselves with additional perils in the process through Sub-Contractor’s being overly committed with off-site manufacturing and material costs with no route for recovery long periods. Quite often, a far better solution is the use of bonded storage or better still secure storage on site (if we have the luxury of space).
  • Contract terms – It is imperative that the Sub-Contract defines insolvency broadly, uses pre-insolvency triggers and contains provisions to;
    • End payments to the insolvent Sub-Contractor.
    • Allow an alternative Sub-Contractor to complete the works and set-off costs.
    • Allow the direct employment and payment to Sub-Sub-Contractors.
    • Pass titles for on and off-site materials.
  • Performance Bonds and Parent Company Guarantees – Consider the group structure and stability. If the Sub-Contractor is part of a larger and fiscally sound organisation then a PCG may be considered. If the company does not have a parent (or is the parent) then consider whether a Performance Bond is more suitable.       If in doubt, the safest form of security is (usually) a guarantee from a reputable bank.
  • Collaterals Warranties – In the event of failure there are often difficulties bringing a tortious claim against second level Sub-Contractors and Sub-Consultants because of the restrictions in place of recovering pure economic loss and establishing a linked duty of care to a distant employer. Although some may argue that The Contracts (Rights of Third Parties) Act 1999 should be making this arduous paper chase obsolete, it has yet to be significantly tested. With that in mind seriously consider whether it is better to have these than not.
  • Early Engagement – Sometimes this is easier said than done, however a key principal is to ensure we have early engagement with the Supply chain in the event of any problems. Personally, I have held open workshops with key players regarding insolvency to open an honest dialogue if a problem arises.
  • Do not package all your eggs in one basket.       – There is a philosophy within Design and Build Contracting to Sub-Contract large work packages to reduce interfaces and the inherent interface risk between the smaller work items. The risk balance needs to be reviewed between having a single point of responsibility for failure verses the control and adaptability of having multiple smaller packages. In the event of failure, it is typically easier to replace one small cog such as a sprinkler contractor rather than a wholesale turnkey M&E package.
  • Take into account Plan B – When dealing with bespoke products such as cladding it is a common occurrence to end up single tracking / negotiating with one individual company. Make sure the risk of this is fully evaluated within your risk review and consider your contingency plan. Gaining access to an overseas manufacturing and storage facility not governed by English law can be chalenging.

Warning Signs and detection

Okay! So our Subbie has passed all the vetting checks, we are in contract and they have hit site. Now the risk becomes tangible so we must be vigilant.

Use the whole team – Monitoring the risk of Sub-Contractors cannot be done in isolation by Commercial / Project Managers. Quite often, those members of our team who are closer to the action have access to the key information first. With that in mind it is surprising how rarely we engage our Site Managers, Foreman and direct labour with this critical task by briefing them on what to look out for, such as:

  • Staff complaints about not being paid appropriately.
  • Large churn of direct staff / Sub-Subcontractors.
  • Plant and materials removed at the wrong time.
  • Very slow progress on site for no obvious reason.
  • Resource numbers dropping dramatically out of line with programme.
  • Operatives repetitively not turning up without good reason.
  • Rumours and market intelligence. This should be treated with caution although it can also provide valuable information.
  • Silence and evasion tactics.

One of the first signs Quantity Surveyors or Accounts Payable will notice, is overly aggressively chasing in of cash. This is not to be confused with diligently checking that the payment is forecast on time. If you can hear desperation or aggression in the tone and the payment is not even not due, this is a sure sign your Subbie is in trouble!

Other signs for Quantity Surveyors to look for are:

  • Requests for advanced payments for materials etc.
  • Numerous claims for additional money without any substance.
  • Attempts to renegotiate pricing or terms. –       Once the correct process of explaining and agreeing the terms with your Sub-Contractor up front there should be no reason for them to try to renegotiate terms. Generally, Sub-Contractors will only do this if they are worried about something greater than the potential reputational damage.
  • Failure to file statutory accounts on time.
  • Sub-Contractor seeking to assign the proceeds of the building contract to a bank or other creditor.

Mitigation if imminent

If an honest and open dialogue is established with the Sub-Contractor and they have expressed that they are having cash-flow difficulties, it may be prudent to support them (so long as it does not place ourselves at risk):

  • Direct procurement of materials – When Sub-Contractors are suffering from financial constraints, having large material orders can tie up their available funds. Consider setting up an order direct with the suppliers to ensure availability of materials and help free up the Sub-Contractors cash flow. Be mindful not to be burdened with any liability for overdue accounts the Sub-Contractor may already have with them.
  • Directly employ subcontract labour – As with large material orders it is worth exploring the direct employment of any specialist Sub-Sub Contractors to free up the company to focus on its own direct works and gain greater control.
  • Escrow Account – The use of an escrow account to ensure any monies paid through our contract go to the right people and not to pay off other debts.

Immediately Following Failure

So all our endeavours have been fruitless and the Sub-Contractor has become insolvent.

  • Secure the site! – As a precaution it is always advised that the site be further secured on suspicion of insolvency to prevent any creditors of the Sub-Contractor from removing plant, machinery and materials from the project, which may not have been paid properly paid for.
  • Secure off-site – In line with the provisions mentioned previously ensure all off-site plant, equipment and materials are secured.
  • Balance the accounts – Ascertain the precise payment already made to the contractor and providing the adequate provisions are in place check whether you can avoid making any further payments to the Sub-Contractor through abatement. The Insolvency Rules allows any creditor who owes a debt to an insolvent company to set-off that debt in full as security against his own liquidated cross-claims in the insolvency.
  • Engage with insolvency practitioners – Before giving notice to terminate the Sub-Contract, consider discussing the options available with the Insolvency Practitioner (IP).       Depending whether the IP is a liquidator or an administrator it is normally quite straightforward to determine whether they are intending to continue trading.

Some may consider it mutually beneficial to complete the works, although this is generally only practical when little work remains, as future defects liability remaining with an insolvent contractor are a risk. Also, exercise caution when reaching any settlement with IPs as pre-insolvency and post-insolvency debts cannot be set off against each other.

  • Termination of contract – Ensure the correct notices are issued dutifully in line with the contract terms. Also ensure you have a comprehensive and fully documented a schedule of defects and outstanding works at the date of termination.
  • Call Bonds – Calls should be made on any bonds available prior to the date on which the right to call expires.

Conclusion

Insolvency is an unfortunate and unpleasant fact within the construction industry.

Putting adequate mechanisms in place for assessing, reviewing and managing the risks early is essential, together with constant monitoring throughout the lifetime of the project if we are to act swiftly and decisively.

 

Ian Graham

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