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Contractor and sub contractor insolvency: What to look out for and action to take

Words:
Paul Cacchioli

The chancellor’s welcome measures to keep businesses afloat during the pandemic could be harbouring a problem – zombie companies that are about to fail. What can you do to spot and avert disaster?

Can you reduce the risk of contractor insolvency and site work grinding to a standstill?
Can you reduce the risk of contractor insolvency and site work grinding to a standstill? Credit: Istock

According to the latest data from the Construction Products Association, construction output in May surpassed pre-pandemic levels, with activity in 2021 and 2022 forecast to rise 13.7% and 6.3% respectively. This positive outlook is underpinned by the expected growth in key sectors, such as housebuilding and infrastructure, through the government’s commitment to invest £600 billion over the next five years as part of its Build Back Better programme.

While employers and contractors will be buoyed by the investment and forecast recovery, they will need to tackle the dual constraints of the growing skills and materials shortages if they are to meet this rising demand.

Materials shortages have been widely reported by market commentators in recent months. While it is difficult to determine the specific causes, five particular issues have been identified. Most obviously, Brexit has produced a reluctance to trade with the UK due to perceived issues with regulation, processing of imported goods and materials, customs etc, while factory closures and then new working practices, both triggered by Covid, are reducing output within the UK and internationally. On top of these problems, a shortage of shipping containers was exacerbated by the blockage of the Suez Canal, and global shortages of supply of core materials such as timber, steel and cement are beginning to bite. And alongside these supply problems, large infrastructure projects such as HS2 are monopolising available supply

As for the workforce, there has been a growing shortage in skilled labour over recent years, which has been recently accentuated by a fall in EU-born workers in the UK market, as many leave the UK.

Afloat in choppy waters

Given these market conditions, is the construction sector entering a perfect storm? It certainly has many challenges to navigate if it is to prosper.

Construction has benefited from government support for business throughout the pandemic, in the form of financial incentives and fiscal measures such as the furlough scheme, government-backed loans and tax deferrals. As reported by the British Business Bank, the construction sector was one of the biggest recipients of funds, having received the highest proportion of total Coronavirus business interruption loans and bounce back loans, with £2.5 billion and £7 billion of loans offered respectively.

In addition to these supporting incentives, on 26 June 2020 the government also introduced the Corporate Insolvency and Governance Act 2020 (CIGA) in an attempt to protect businesses in financial distress as a result of the pandemic. Although originally set to expire in November 2020, the continued impact of the pandemic saw the protective provisions been extended to 30 September this year.

The key provisions of relevance within this statute can be summarised as permanent and temporary reforms.

While employers and contractors will be buoyed by the investment and forecast recovery, they will need to tackle the dual constraints of the growing skills and materials shortages if they are to meet this rising demand

Permanent reforms consist of three strands. First is the restructuring plan, which gives a company in financial distress the opportunity to agree a restructuring arrangement with its creditors. Secondly, a moratorium is available, a ‘freeze’ which is intended to provide companies with a formal process to explore and develop a viable restructuring plan. Importantly, this also offers the company in question legal and enforcement protection. It is worth noting that, while the company remains under its own management during the moratorium (initially 20 business days but extendable by agreement or as ordered by a court), an insolvency practitioner is appointed to help protect creditors and provide some supervision. Finally, the statute seeks to limit the ability of a supplier to terminate the contract in the event that a company becomes insolvent.

Temporary reforms address statutory demands and winding-up petitions, removing the threat of winding-up petitions as a means of debt collection, and aiming to protect a distressed company as it seeks to explore other trading options.

Moreover, the government has also attempted through the Construction Playbook to reinforce the principle of prompt payment to all suppliers, and in turn their supply chain, to safeguard the delivery of public sector projects and programmes.

In support of this fundamental provision, public sector employers such as Network Rail have led the way by implementing other methods of relief for at risk businesses within their supply chains on a case-by-case basis. Such measures include immediate payment terms, advanced payments, increased frequency of payments, relaxation of relevant contractual terms and the payment of reasonably incurred additional costs arising as a direct result of Covid-19.

Recent commentary suggests that these fiscal, legal, and commercial measures have had a positive impact, citing a dramatic reduction in the insolvencies from 3,228 in 2019, to 2,042 in 2020. 

The walking dead?

While such support and protection provided by the government and enacted by public sector employers should be applauded, there is a danger that such measures have only delayed the inevitable. Are a number of these businesses unlikely to recover from the pandemic and, have they in fact, become zombie companies?

If this is the case, as we start to take tentative steps forward with the removal of Covid-19 restrictions, and as the fiscal and legal support noted above is gradually phased out, there is a risk that such companies may struggle and that insolvencies will begin to materialise in the tail end of 2021 and into 2022.

Protective measures

Consequently, it is important that businesses remain alert and monitor their supply chain to protect themselves from any failures within it. In terms of protective measures, it seems that employers and contractors alike are seeking appropriate guarantees, warranties and bonds throughout their supply chains. A greater level of financial due diligence and scrutiny is also being imposed throughout the market to validate the financial wellbeing of suppliers.

While such support and protection provided by the government and enacted by public sector employers should be applauded, there is a danger that such measures have only delayed the inevitable

Monitor for financial distress

Notwithstanding these protective measures, constant monitoring is vital. However, early signs of financial distress can be seen in a number of ways, for example: a high turnover of staff, general decrease in on-site labour, works slowing down or not achieving project timescales or milestones, poor quality workmanship and/or an increase in defects, and the removal of plant, equipment and/or materials from site.

Also, as a consequence of its financial hardship, certain actions by a company to improve its cash flow may be a cause for concern. These may include: requests from the contractor for changes to the payment mechanism, inflated applications for payment and/or unsubstantiated claims, complaints from sub-contractors regarding payment, a lack of response to correspondence, and late filing of statutory accounts and annual returns.

Any company seeing these warning signs, and a rise in the risk of insolvency, must act quickly to protect itself. It can adopt some simple ‘do’s and don’ts’ to help safeguard its position and avoid various pitfalls.

Safeguard: do’s and don’ts

Things to avoid without taking legal advice include: terminating, novating, or assigning contracts, appointing a new contractor to carry out relevant work, paying sub-contractors directly and making advance payments or paying for off-site materials.

Pre-emptive steps

There are pre-emptive steps that a company could adopt to prepare and ready itself. There are at least six such steps, for example, a company should ensure it has a complete set of contract documents (including warranties and guarantees) as these are often not conveniently stored and /or are incomplete. It should also establish a full list of the contractor’s management team, identify sub-contractors that are critical to the timely completion of the works and check whether collateral warranties are in place, and clarify its rights and obligations in the event of an insolvency, such as seeing if it has step-in rights.

Further moves would be to schedule and, if possible, safeguard any plant, equipment, and materials it has paid for, get the paperwork in place – instigate the full monitoring of progress and determine the scope and value of the work remaining (mark up drawings, take photos, and so on), and prepare a contingency plan in the event of the contractor’s insolvency (in the form of identifying other suitable suppliers, identifying critical supply chain members and materials, etc).

While it remains unclear how the construction sector will respond to the challenges of the current climate as the government support is eased, it is imperative that firms remain vigilant.

Paul Cacchioli is a chartered quantity surveyor and director of HKA Global

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