Risks related to insolvencies in the UK construction industry

How can contractors manage the risks related to insolvencies in the UK construction industry?

Robert Rawdon Senior Consultant Contact

Current insolvency trends

Traditionally, contractors operating in the UK construction industry have been susceptible to supplier insolvencies. However, there has been a demonstrable increase in the quantity of insolvencies in recent years. BCIS reportedⁱ that to September 2023, there were 4,287 insolvencies in the industry, which represented a 8.3% increase on 3,958 recorded in 2022 and 33.2% increase on 3,218 recorded in 2019.

The impact of the Covid-19 pandemic and its legacy has been an influential factor leading to increased insolvencies, but a plethora of issues have continued to arise increasing the occurrence of insolvency. These issues include significant inflation, high energy costs, increasing interest rates, insufficient labour supply to meet demand and exposure to the contract cycle. These factors are likely to exist for the foreseeable future, and the increased instances of insolvency therefore represents a key challenge for contractors. This article explores how contractors can manage the risks throughout its supply chain related to insolvencies.

Monitoring the status of the supply chain

Contractors need to be proactive through engagement with its supply chain, and flag any signs that indicate a supplier may be at risk of insolvency. Through assertive action, a contractor can be alert to quickly ascertain if a supplier has become insolvent.

The following outlines essential steps
required to proactively monitor the status of the supply chain and outlines risk associated with a potential insolvency:

• Maintaining a clear line of regular communication is beneficial in enabling any insolvency issue to be identified before it arises.
• Awareness of the increased likelihood of a supplier becoming insolvent enables a contractor to assess strategy and implement measures to mitigate the risks.
• Through early engagement, an agreement can be made between the contractor and the supplier, which enables the contractor to support the supplier, whilst exploring the procurement an eventual replacement supplier.
• A contractor can review the option of making payment direct to onward suppliers for materials and providing labour direct. A decision for a contractor to take such steps needs to be balanced against the risks associated with the supplier becoming insolvent; and,
• If the supplier is a key subcontractor, then its demise and replacement could cause critical delay to the project works, thus exposing the contractor to extensive claims from the employer to liquidated damages.

Taking stock of the supplier’s account

It is essential that contractors maintain awareness of when a supplier is likely to, and formally enters insolvency. This is because through the contract payment cycle, the contractor can opt to withhold further payments due in accordance with its statutory rightsⁱⁱ. This right enables the contractor to withhold any sum due, even after the prescribed period has elapsed for the issuance of a noticeⁱⁱⁱ to inform otherwise. However, care must be taken in that this legislation only assists where the supplier’s insolvency precedes the last date for giving a pay less notice. Rationale suggests this is because the contractor can protect its position in that situation through the issuance of a payless notice.

The cessation of payment to the supplier can be temporary until the contractor has been able to undertake a comprehensive review of the supplier account. The benefit of this pause in payment enables the contractor to reduce the risk of over payment, but, also facilitates the production of an accurate assessment of the supplier account. This can avoid the risk of further disputes if an agreement can be amicably reached with the insolvent party relating to the status of its account.

Responding to agents acting on behalf of an insolvent party

It is customary that insolvency professionals will act as agents on behalf of the insolvent party who will aim to conclude agreement of the accounts of the insolvent company. Contractors should not disregard these professionals and should proactively engage to expedite agreement of the accounts in the best interests of all parties. If a contractor undertakes a thorough assessment in accordance with the conditions of contract, then this will reduce the risk of dispute. A fair assessment of the account should reduce the risk of the dispute escalating to formal dispute resolution.

Escalation of disputes to adjudication

Historically an insolvent party could not rely on adjudication as a method of dispute resolution. However, in Bresco Electrical Services Ltd v Michael J Lonsdale (Electrical) Ltd^iv , the Supreme Court affirmed its willingness to allow insolvent parties to enforce an adjudicator’s decision. This was a notable decision, because it demonstrated an insolvent party could refer a dispute to adjudication, obtain a decision and seek to enforce it (although it acknowledged obstacles remained at enforcement stage).

The salient obstacles include determining whether the adjudication has addressed all outstanding matters between the parties and whether the insolvent party can provide sufficient security. The latter focuses upon whether adequate provision is made for the paying party to recover the sums paid including legal costs, should the adjudicator’s decision be challenged.

The provision of security was assessed in John Doyle Construction Ltd (In Liquidation) v Erith Contractors Ltd^v, and Coulson LJ stated “…any undertakings or security being offered by a claimant company in liquidation need to be clear, evidenced and unequivocal”. Although this shifts the burden upon the insolvent party to evidence, it indicates that should the claimant satisfy the evidential burden, then they will be able to enforce the decision.

Contractors on the receiving end of a referral from an insolvent party need to assess the funding status of the insolvent party. If faced with a well-funded opponent, then the contractor will need to rigorously defend the adjudication. This follows from the previous steps, which place emphasis on the contractor undertaking a fair assessment of the insolvent supplier’s account. The production of a comprehensive assessment, including contemporaneous records, will assist the contractor in providing a robust defence to its position.

Implications of the corporate insolvency and governance act 2020

This legislation continues to impact contractors, restricting the ability to terminatevi the contract for the supply of goods and services when the employer (party upstream) has entered into an insolvency procedure. Commonly used forms of contract in the UK include the NEC and JCT, which contain clauses allowing contractors to terminate for employer insolvency. Exceptions may exist, but generally, the contractor will no longer be able to use the clause to terminate. To avoid the implications of this legislation, a contractor would have to persuade either an appointed administrator, receiver or liquidator to agree to termination or persuade the courts to grant permission that continuation of the contract would cause hardship. The latter introduces additional risk, because ‘hardship’ is not defined and creates uncertainty when mounting a challenge.

A contractor could seek to reduce its risk through the following:

• Exercise its right to suspend the works for non- payment. This termination right would only be available before insolvency. Therefore, it is paramount that the contractor administers the contract carefully, and scrutinises any signs that indicate the employer could be on the verge of insolvency;
• Negotiate reduced payment periods under the terms of the contract to improve cashflow and reduce the amount of payment outstanding at one particular time;
• Negotiate improved payment security through the use of payment guarantees, project bank account and / or an escrow arrangement;
  Negotiate further rights to enable termination before a formal insolvency procedure is entered, thus providing the right to terminate before the legislation applies; and,
• Obtain additional insurance for the outstanding debt applicable to the risk of non-payment.

Termination following insolvency in the supply chain

It is imperative that the contractor obtains bonafide evidence that the supplier has entered insolvency before exercising its contractual right to terminate.

The contractor may then exercise its post termination rights, which could comprise, inter alia, of the following:

• Engage another supplier to complete the works;
• Take possession of the site;
• Utilise or dispose of all temporary buildings, materials, plant and equipment left on site;
• Purchase additional goods and materials required to complete the works and make good defects;
• Require the supplier to provide without charge copies of all the supplier’s design documents;
• Cease payment of any sums payable to the supplier under the termination account following the making good of defects and completion of the works. This would be on the proviso that a pay less notice has been issued or the insolvency event occurred after the last date a notice could be issued;
• Recover all expense properly incurred by and any direct loss and/or damage caused to the contractor as a result of the termination; and,
• Set off such expense and loss against sums otherwise due to the supplier.

DGA often provides advice to contractors and employers leading up to, and following, insolvency, and is able to provide independent opinion on the proper valuation of an insolvent party’s account and/or the impact on the programme.

 

References

i BCIS, Why are contractors in the construction industry vulnerable to insolvencies? 05 December 2023.
ii Section 144 (10) of the Local Democracy, Economic Development and Construction Act 2009 (LDEDCA).
iii Section 144 (110) (b) LDEDCA.
iv [2020] UKSC 25.
v [2021] EWCA Civ 1452 (CA) p8
vi Section 233B, Insolvency Act 1986.