Mitigating supply chain insolvency risk

Careful contract negotiation can limit the potential damage from insolvency in a construction firm’s supply chain. 

The construction industry suffered the highest number of company insolvencies in the first half of 2022, with 2,083 firms entering an insolvency process. This represents a failure rate of just under 1% of total construction companies in the first half of 2022 alone, and 20% of total insolvencies in the same period. According to a recent ONS Business Insights and Conditions Survey, the primary concern for building firms this year was accelerated inflation of goods and services, as the industry relies heavily on raw materials such as cement, brick and steel, the costs of which are influenced by energy prices.

Interest rates are at their highest since 2008, pushing up mortgage costs and putting pressure on the housing market and the value of work in progress and investments made by construction businesses. In addition, many construction companies will be experiencing supply chain breakdown due to increasing costs. Given the pressure-cooker environment in which businesses are now operating, and the ongoing political uncertainties, it seems inevitable that many projects will suffer delays, postponement or cancellations, leading to a rise in contractual disputes.

So, why do disputes arise in times of financial difficulty, and how can construction companies best protect themselves from the effects of insolvency in their supply chain?

The predicted increase in claims

The pandemic may be over, but the after-effects of Covid are still casting a long shadow over the industry, amplified by global economic and political issues. Where construction contracts are commonly fixed-price, the delay and disruption to projects, combined with the increased materials, labour and energy costs, seriously impacts on the bottom line – especially with margins historically already very tight. When contracts become underpriced and the pipeline for future projects is uncertain, parties will seek ways to maximise recovery, through claims for variations or additional loss and expense, for example. 

Despite the protection of the Construction Act, the nature of the payment process in construction contracts (with stage or periodic payments in arrears) means that there is often a significant lag between costs being incurred and payment being made. This makes the supply chain particularly vulnerable if one of the parties becomes insolvent, further delaying payment and potentially triggering a domino effect.

In times of financial difficulty, where cash flow becomes even more crucial for survival, parties are more likely to take an adversarial approach and proceed earlier to formal dispute resolution, with adjudication in particular offering the potential for a quick victory and a welcome cash injection.

In the current climate it has never been more important for parties to proactively manage risk. This includes:

• Carefully reviewing contractual terms (and technical specifications) and the allocation of risk before entering into contracts, to limit exposure to price increases and delays. Where the programming of projects is arguably more unpredictable, the level of liquidated and ascertain damages, for example, could be the difference between making a profit or a loss.
• Ensuring those managing the projects are fully aware of contractual obligations and the correct operation of the contract – any overpayment may not be easily recovered.
• Keeping accurate records to evidence entitlement or to defend against a claim.

Mitigating the risk of insolvency

Increased due diligence is the first step to identifying potential warning signs before embarking on any new relationship, including looking out for any profit warnings or signs that subcontractors are being paid late through the press or word of mouth. The latest filed accounts may provide some key indicators as to their financial health, albeit publicly available information on Companies House is historic in nature.

In the international context, contractors using the FIDIC contracts can request that employers provide reasonable evidence of their ability to pay the contract price, failing which the contractor is entitled to terminate. Contractors should use this tool wherever concerns arise.

Parent company guarantees, or the use of a retention bond or project bank account, will also provide protection in the event that a contractor fails to pay. Alternatively, it might be possible to secure direct payments from a bank or the employer to the subcontractor in the event of a contractor’s insolvency.

When negotiating construction contracts, short payment periods will help avoid a scenario where invoices do not fall due for payment until after a counterparty enters insolvency. Rigorous debt collection will also be key to avoid debts remaining unpaid for long periods.

Subcontractors may look to use retention of title rights in their contract to ring-fence materials in the contractor’s insolvency: any insolvency officeholder should be alerted to these rights as soon as possible on their appointment.

Enhanced termination rights may also enable contractors to walk away from a contract before an employer enters formal insolvency proceedings, which is increasingly important given the prohibition on termination for insolvency, introduced by the Corporate Insolvency and Governance Act 2020.

While it is not possible to avoid counterparty insolvency altogether, by being aware of the market, negotiating contracts carefully and utilising the tools mentioned above, construction companies can significantly limit the damage resulting from any such occurrence.

This article was first published in Building Magazine and can be accessed here.