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Insolvency and construction: recovery rates remain a real issue, says expert

Out-Law Analysis | 29 Aug 2016 | 12:14 pm | 11 min. read

FOCUS: Recovery rates on insolvency remain a real issue in the construction industry, despite the increasing use of project bank accounts and supply chain finance to improve cash flow and minimise the risks.

One of the issues that insolvency practitioners (IPs) face is that the employer will invariably have the right to terminate the contract, or the contractor's employment, on the contractor's insolvency. It is unusual for the employer not to do so, and then to employ others to complete the works, subject only to the requirement that it act reasonably when incurring costs and entering into new contracts.

After two years of strong, unbroken growth in 2013 and 2014, 2015 was a more difficult year for the UK construction industry. According to figures from the Office for National Statistics (ONS), each quarter showed less growth compared with the quarter before it, with 4th quarter growth at just 0.4%. The trend continued into January 2016.

By September 2015, profit margins for the top 25 contractors in the UK had fallen by half from the year before to under 1.5%. This is a worrying trend. The construction industry is generally recognised as one that operates on high volumes and low margins, with 3% being the typical benchmark. However, even a 3% margin is currently challenging to achieve. Margins are reportedly being squeezed as supply chain prices are driven up by a combination of a surfeit of work, a shortage of skilled labour and significant increases in the price of materials.

Predictions for 2016 were more optimistic, and for the first few months of the year the data was not discouraging. However, the lead-up to the referendum on EU membership brought about the worst set of monthly figures for seven years, and it is fair to say that there is a lot of nervousness in the market about order books in the light of the Brexit vote.

Turning a profit is likely to become even more challenging. Lenders remain cautious, as they have been for several years, about lending into the sector. There are a number of reasons for this, as well as methods being used in the industry to combat the endemic issues.

Contractor's balance sheet value

Most of a contractor or sub-contractor's value consists of its receivables: debtors, retention, work in progress (WIP), claims. If a contractor becomes insolvent before completion of a project, its IP has to ensure that the contracts are completed in order to recover certified sums and WIP. It can do this either by arranging for the works to be completed, or by novating the contracts to another contractor with the employer's consent. If this does not happen, the value of certified sums and WIP is very likely to be severely or completely eroded by the value of the employer's termination claims.

It is common for the recovery value to be far less than the 'book' value in an insolvency situation, and most IPs have a working assumption of a 10% recovery rate. Statistical analysis from insolvencies in which Pinsent Masons, the law firm behind Out-Law.com was involved shows a recovery range of 5% to 69%, with an average of 19% over a 10-year period. The general average is likely to be significantly less than even that, as there will be many more 'write-off' situations where it was not economic to employ lawyers.

So why would banks ever want to lend into this sector? If a generalist contractor is being financed through a simple facility or loan agreement, it is almost certain that a lender will lose money on its demise. For construction lenders, it is therefore important to deal with well-run companies that are able to turn a profit, and to monitor very carefully any trends and any fluctuations in the company's performance.

In the current market, it is highly likely that an actual insolvency will result in the collapse, rather than the sale, of the business. As in any restructuring, early action is essential where distress is evident. The best outcome is almost always likely to arise from an orderly sale and acquisition outside of an insolvency process, or from a debt restructuring; and there are many examples of where this has happened in recent years.

The problem for IPs appointed over contractors is that their ability to achieve this goal is limited. Construction contracts almost invariably provide for termination in the event of the contractor's insolvency and an employer's instinctive reaction is to do this, particularly where it has security - for example, a performance bond. It is therefore often the case that the business will collapse, and the prospects of recovery of significant amounts to evaporate very quickly.

In the information age, it has also become increasingly difficult for IPs to hang on to what is often the firm's 'crown jewels': contact lists and details. On an insolvency occurring, a contractor's projects are easily identified by other contractors who pick off the valuable contracts and directly approach employers. In addition, in the public sector, procurement rules have an impact on the ability of purchasers to take over contracts without the projects being put out to tender once more. There are therefore very few reported examples in recent years where an administrator has been able to achieve the business sale of a contractor to an unconnected third party.

Protection of debts and cash flow

The Construction Act introduced new laws aimed at improving the lot of the construction supply chain and reducing the risk of non-payment and insolvency.

Every construction contract must now contain an 'adequate payment' mechanism, which must generally include:

  • a right to stage payments;
  • a requirement for a payment notice within a prescribed period of time of payment becoming due – failing which, the amount of the payee's application for payment will become the due amount;
  • a final date for payment; and
  • the loss of the right to set-off against the amount to be paid by the final date for payment, unless a 'pay less' notice is served a certain number of days beforehand.

There must also be a right to refer a dispute on an interim basis to adjudication. An adjudicator must be appointed within seven days of the notice of adjudication, and the adjudicator must issue their decision within 28 days of referral. Parties will be required to abide by this decision until the dispute is decided in court proceedings or arbitration, and the decision can be enforced by obtaining summary judgment from the courts.

Project bank accounts

Despite the measures introduced by the Construction Act, the industry has continued to be dogged by a reputation for slow or no payment in the supply chain.

In 2012, the Office of Government Commerce (OGC) recommended that public sector clients "progressively specify" the use of project bank accounts (PBAs) in their contracts, as part of a guide to best fair payment practices. Since then, the public sector has sought to embrace PBAs on principle; with the Highways Agency, Ministry of Justice and major projects such as Crossrail at the forefront of their introduction.

PBAs are ring-fenced bank accounts held on trust that provide a mechanism for the protection and payment of funds earmarked for specific members of the supply chain. Payment is made to all trust members at the same time. The purpose is twofold: to protect against contractor insolvency; and to speed up the payment process to the supply chain. To help embrace the OGC's encouragement of the use of PBAs, amendments have been made to the standard forms of building contract.

Money will be paid into the PBA by the employer once it authorises the payment amount – that is, the amount due to be paid on the final date for payment taking into account any pay less notice served by it. No further deductions from the money can then be made in respect of retention, withholding or set-off due to the fact that the monies are held on trust for the relevant beneficiaries once paid into the PBA. The presumption seems to be that any amounts to be deducted by the employer, contractor or sub-contractor for payments to be made should be notified before the employer pays the money into the PBA.

One of the perceived issues with PBAs is that they effectively deprive the contractor of its usual set-off rights during the several weeks that elapse between the date on which the contractor included any sub-contractor's application for payment in its own application to the employer, and eventual payment to the sub-contractor. In a normal sub-contract arrangement, payment rights will only finalise many weeks after application is made by the sub-contractor to the contractor. Until the final date by which a pay less notice can be served under the sub-contractor arises, which is usually after payment by the employer to the contractor, it remains open to the contractor to exercise rights of set-off in relation to the sub-contractor's continuing performance - or lack of it.

Should the sub-contractor become insolvent after the final date for service of a pay less notice, but before final payment is made, the right for the contractor to suspend payment continues past the final date for service of a pay less notice. Where there is no money in the PBA at the point of the sub-contractor's insolvency, and assuming no authorisation for payment has yet been signed, there should be no significant issue. However, where money is sitting in the PBA at the point of the sub-contractor's insolvency, there is the prospect that it would be available to the liquidator or administrator, notwithstanding the contractor's right under the sub-contract to immediately suspend payment, because the amount due to the sub-contractor is held on trust for it.

For this reason, contractors have been reluctant to embrace PBAs. In addition, aside from the loss of control over funds, there are a number of administrative and taxation hurdles that contractors have to overcome in order to implement them. Nevertheless, PBAs have continued to gain popularity, particularly in the public sector - in July 2014, the UK government announced that some £5.2 billion of contracts awarded by it had already embraced the use of PBAs, exceeding its target of £4bn by the end of 2014.

Supply chain finance

One of the ways that lenders commonly seek to maximise security over book debts is via factoring or invoice discounting. These services are commonly offered by specialist asset-backed lenders, as well as the clearing banks through finance arms.

Invoice discounting involves the sale of book debts by way of an assignment from the borrower to the lender, and the advance of a percentage of the invoice value before payment by the end customer. Finance of this nature is vital for many smaller businesses, as it enables them to bridge the gap between the outflow and inflow of funds.

Invoice discounting is problematic, and relatively difficult to obtain in the construction sector because of the interim nature of most payment entitlements and the potential for the value of the invoices to be eroded very considerably, particularly in the event of insolvency. Many of the leading contractors have therefore attempted to introduce a product into the lending market that enables selected sub-contractors to obtain this type of funding.

The scheme enables the supply chain to speed up receipt of funds and is intended to alleviate the late payment issues which the introduction of PBAs also sought to address. The contractor enters into a direct agreement with its bank, and the bank in turn enters into an invoice discounting agreement with the selected sub-contractors. For every interim stage payment, once performance confirmation is given by the contractor and the sub-contractor's right to payment is confirmed, the contractor must pay the bank the amount of the invoice almost no matter what.

Once this has happened, the contractor's remedies will lie directly with the sub-contractor rather than by way of deduction against the invoiced amount. This may not matter where the sub-contractor remains solvent, since a deduction for defective performance can be made against the next certified sum. However, the contractor is at more risk where sub-contractor insolvency occurs. Even liquidation set-off, which is mandatory for all mutual dealings between the parties, will not assist, since the contractor will still have a direct obligation to pay the bank the full amount.

Termination and recovery

We have seen above some of the methods the industry is employing to lessen insolvency risk and encourage lending into the construction sector. However, these measures do not lessen the risk for IPs of the employer's right to terminate the contract immediately on the contractor's insolvency.

In the standard form contracts, a termination account must then be prepared under which the employer will have the right to deduct its losses and damages, including the additional cost of completion from sums which would otherwise have been payable to the contractor for works carried out up to the date of termination. An employer is simply required to act "reasonably" when incurring costs and entering into new contracts.

A similar regime arises under the standard forms of subcontract in favour of the contractor on the sub-contractor's insolvency.

In many circumstances, the obligation to make any further payment to the contractor is suspended on the contractor's insolvency. This is obviously a critical right for the employer, and is an important catalyst in its decision to terminate. However, suspension of payments is somewhat at odds with the payment principles in the Construction Act, as set out above.

The right to suspect payments was initially unrestricted by the Construction Act, and a general right to suspend was included in most of the common forms of contract. In 2007, the House of Lords confirmed that the right to suspend was not overruled by the effect of the mandatory payment requirements, and in particular the inability to set-off in the absence of a pay less notice. In that case, the insolvency had occurred after the last date for service of such a notice but before payment was made.

In 2011, however, the Construction Act was amended to require a pay less notice to be served before an employer can suspend payment in all cases, except for when the contract provides otherwise and the payee becomes insolvent after the last date when a pay less notice could have been served. Therefore, the Construction Act principles do not give employers carte blanche rights to suspend payment regardless of when the insolvency occurred.

A Court of Appeal decision shows how difficult recovery continues to be, despite the new methods that the industry is employing to lessen insolvency risk and encourage lending into the sector. In a case between Wilson and Sharp Investments Ltd case and Harbour View Developments the court overturned a High Court judgment dismissing an application by the employer for an injunction to restrain an insolvent contractor from issuing a winding-up petition. This was despite the fact that the employer had served no 'pay less' notice; it took many months for the employer to assert its cross claims; the matter had drifted on for nearly a year since pay less notices could have been served; and, at the time of the original hearing, there was no relevant insolvency leading to suspension - although one was, by then, imminent.

The case sends a powerful message that the absence of a pay less notice will not make it easy for an insolvent party to recover money where counterclaims are subsequently raised by a paying party. 

Richard Williams is a restructuring law expert at Pinsent Masons, the law firm behind Out-Law.com.