In early March 2020, nobody could have anticipated the impact the COVID pandemic would have on the UK economy and Britain as a whole. No business or individual can fail to have been affected in some manner.
The Government has introduced a number of support mechanisms for UK businesses and, supported by the Bank of England, a number of fiscal measures to try and boost the economy.
One thing has been clear from the start - construction will be at the forefront of the recovery program. With Boris’s ‘build, build, build’ campaign, a relaxation in planning laws and the Annual Investment Allowance being maintained at £1m for 2021, the sector has a positive outlook.
Outside of these positives it is still a difficult trading environment and specialists at law firm Howes Percival and accountants Price Bailey have joined up to highlight some of the hurdles the construction sector may find along its path, and how to approach them.
4 steps to minimise the risk of contractor insolvency
In the current climate, the risk of contractor (or sub-contractor) insolvency is higher than ever. The numerous challenges posed by COVID-19 to an industry already operating on tight margins has seen a dramatic increase in the number of construction firms finding themselves in real difficulty. This is highlighted by research carried out by Price Bailey which shows a 78% increase in house builder insolvencies over the past 3 years. Whilst ultimately, the liquidity of contractors may be out of your control, there are steps you can take to try to minimise the impact.
1. Payment terms
It may sound obvious, but the longer a contractor has to wait to be paid, the greater the strain on its cash flow. Whilst it is common for contractors to make monthly applications, at least on larger projects, it may be that shorter periods between applications, e.g. fortnightly, can be considered. If a project requires significant initial outlay by the contractor, e.g. to procure materials, an advance payment may be appropriate, secured by a bond and deducted from subsequent valuations.
If payments are tied to completion of work stages/milestones, make sure the contract is suitably clear as to what those stages/milestones are, and how they are certified. Clearly a client will want to ensure that the work it is paying for has actually been carried out properly, but equally in order to manage their cash flow a contractor will want to know when it can expect to be paid.
Also consider payments down the supply chain. Problems can arise if main contractors are having to pay suppliers/sub-contractors before they have received payment under the main contract. Conversely, sub-contractors often find themselves “last in line”, at the mercy of contractors delaying payment (whether because they themselves have been paid late or otherwise), notwithstanding that “pay when paid” clauses have been unlawful for some time now. Sub-contractor insolvency can cause just as many issued on a project as main contractor insolvency.
Accordingly, there is a benefit to remaining flexible when it comes to agreeing payment terms with contractors. A request from a contractor half way through a project to reduce the period between payments could be seen as a sign that the contractor is having financial difficulties, but it may also be that by agreeing a variation, the contractor can avoid insolvency, which is in everyone’s interests.
2. Project Bank Accounts
One way to reduce insolvency risk, especially in respect of sub-contractors, is through the use of project bank accounts. Whilst these involve additional time and cost to set up and operate, so are more suitable for larger projects, they do have the benefit of providing all the parties involved with some comfort and security that payments are, to a degree, ring fenced, and that they will be paid on time.
3. Retentions
Also linked to payment terms, is the concept of retention. Principally designed to act as an incentive for the contractor to return to the project, post completion, to rectify defects, retentions are currently a hot topic in the construction industry, with a number of leading bodies calling for them to be abolished. The usual retention is 3-5% withheld from each application, with 50% being released at completion and the remainder at the end of the defects liability period (subject to the client’s right of deduction). However, retentions of 10% or even higher are not uncommon. The arguments for and against retentions could fill a whole article by themselves, but from an insolvency risk management perspective it essentially comes down to a balancing act. A higher rate retention will leave more money “in the pot” should the contractor go bust, but imposing such higher rate could be a contributing cause of them going bust. A retention bond could offer an acceptable alternative to a cash retention provided the contractor is able to source one.
4. Contractual rights/practical steps in the event of an insolvency
Whilst they may not prevent a contractor from entering into insolvency, it is vital that you are aware of the contract terms in the event that it does happen. Do not, for example, assume that the contract will automatically terminate. A JCT contract does not unless it is specifically amended and notice is required. Any actions you may take to continue the works could amount to a repudiatory breach of contract and expose you to a damages claim. Similarly you need to be aware of the contractor’s obligations upon its insolvency, e.g. to vacate and leave the site in a clean and secure state, handover any designs, drawings or other materials or assign/transfer the benefit of any supply orders and or sub-contracts.
You should also review the terms of related sub-contracts to check the effect that a main contractor insolvency has on them. If they are expressed to automatically terminate, you may want to delay serving any notices that may be required to terminate the main contract until you have agreed a way forward with the sub-contractors. If you have the benefit of collateral warranties from sub-contractors, check if these have step-in rights, as that can be a quick and effective way in which to maintain continuity in an insolvency situation.
Watch out for insolvent companies – Bresco v Lonsdale
In the final chapter of a long running legal saga, the Supreme Court has confirmed the right for an insolvent company to commence an adjudication to recover sums it may be owed. For those of you unfamiliar with the history of this case, the original dispute arose under a construction sub-contract following one of the parties, Bresco, entering into voluntary liquidation. Both parties then bought claims against the other for breach of contract resulting in Bresco serving a notice to adjudicate.
In response Lonsdale issued proceedings seeking a declaration that the adjudicator lacked jurisdiction to hear the dispute. Their argument was that the insolvency step-in rules applied, meaning all claims and cross-claims under the sub-contract were extinguished and replaced by a single claim, under the insolvency regime, for the net balance between the parties. Accordingly there no longer exists any claim(s) “under a construction contract” on which the adjudicator can decide. Lonsdale also sought an injunction restraining pursuit of the adjudication.
In the first instance the Court found in favour of Lonsdale, but subsequently the Court of Appeal agreed with Bresco on the jurisdiction point (finding that the statutory right to “adjudicate at any time” was not extinguished by operation of the insolvency rules). However the Court of Appeal retained the position regarding the injunction, stating that to continue with an adjudication brought by an insolvent company was an “exercise in futility” as it would take “exceptional circumstances” for any favourable decision to be enforced. Unfortunately, the Court of Appeal did not elaborate on what those circumstances might be, but these are explained later in this article.
Bresco and Lonsdale both raised further appeals, which brings us back to the Supreme Court. In a unanimous decision it was held that:
- An adjudicator did have jurisdiction to hear a claim from an insolvent company; and
- It is not “futile” to allow such an adjudication to proceed. It would be inappropriate for the court to interfere with a party’s statutory and contractual right to adjudicate at any time.
The Court recognised that it may still be possible that a favourable decision would not end up being enforced, however that was a matter for the appropriate Court to decide at the time of enforcement, and that possibly should not deprive a liquidator/administrator of the right to bring the adjudication in the first place.
Now, back to those “exceptional circumstances”. After the Court of Appeal decision and that of the Supreme Court, the judge in the case of Meadowside Building Developments Ltd (in liquidation) v 12-18 Hill St Management Co Ltd set out 4 factors that he considered needed to be satisfied:
- That the adjudication deals with the final net position between the parties;
- Satisfactory security is provided for both the sum awarded and for any adverse costs order that may be made against the insolvent company;
- It will be a question of fact as to what constitutes “satisfactory security” but will likely include an undertaking from the liquidator/administrator to ring fence the adjudication sum, a third party guarantee/bond and/or after the event (ATE) insurance.
- Any litigation funding agreement or security put in place is not an abuse of process.
It is these factors that the Supreme Court confirmed should be considered when deciding whether to enforce an adjudication bought by an insolvent company.
Following the outcome of the Bresco case, there have been two further reported cases that test the principles laid down by the courts. In both cases an insolvent company was seeking to enforce an adjudication, in the case of Styles & Wood Ltd (in administration) v GE CIF Trustees Ltd, the applicant succeeded, whilst in John Doyle Construction Ltd v Erith Contractors Ltd, the application was denied. Although it should be noted that the contrasting results in these cases stems primarily from their distinct facts, rather than any inconsistency in applying the principles themselves.
There is no doubting that the Supreme Court’s decision in the Bresco case has dramatically changed the landscape when it comes to construction insolvencies. It will be interesting to see how those involved adapt and whether there will be any further postscripts to this saga.
Practical considerations from an Insolvency Practitioner’s perspective
The factors that an insolvency practitioner (“IP”) will consider when taking on a new appointment do not differ greatly from the factors that company directors should themselves be thinking about at every stage of the life of a business. An IP will work through the ‘Tests of Insolvency’ and the duties owed by the directors (see further below) and the next step is to urgently consider the options available to the business.
The number of options generally correlates with the stage at which the directors’ seek advice – in an ideal world the request for help will allow sufficient time to assess and plan. However, if the warning signs have been ignored for too long, the process is often terminal.
The immediate challenge for the IP will be to ascertain how the business has got into the current difficulties; to understand the industry and environment in which it operates; and to assess its strength and ability to survive.
In every case there will be an urgent requirement for information including accountancy and legal input and asset valuations, on a going concern and forced sale bases.
There are numerous factors to be taken into consideration, including, and in no particular order:
- The extent of creditor pressure and HMRC’s position.
- Is it capable of being turned around to profitability? How, when and why will that be possible?
- Do ongoing and pipeline contracts have value and are customer and supplier relationships sufficiently strong to survive beyond the current distress position?
- What is the likelihood of achieving existing lender support; or of obtaining new 3rd party funding?
- Will a ‘rescue’ enhance value for the stakeholders including creditors?
The IP and their team will work with the business to build short and medium term cashflow forecasts, focussing initially on realising imminent income and making urgent priority payments.
Estimated Outcome Statements will also be produced, as these are fundamental in devising the strategy for the survival of the business, or otherwise.
In many situations, when advice is sought by directors at a timely stage, it is possible to continue to trade the business in order to maintain the value of its assets and goodwill and, at the same time, reduce or cancel out any sums that might be owed by the directors as a result of personal guarantees.
Contracts and the strength of business relationships will be key to the ongoing feasibility and likely realisations for stakeholders.
The Supreme Court’s decision in Bresco is welcome news in the construction industry and will provide further leverage for IP’s when attempting to realise sums correctly due to an insolvent business…but the above insights may assist in avoiding such a scenario in the first place.
Directors Duties – How to trade on during difficult circumstances
Director’s duties were first codified in the Companies Act 2006. These include duties to avoid conflicts of interest, to declare interests in proposed transactions, to promote the success of the company and to exercise reasonable care, skill and diligence. They were based on common law duties that had developed over time and which, during a company’s normal trading life, are primarily owed to the shareholders of the company.
However, where a company is in financial difficulties, there is a shift in this position and certain duties are owed to creditors rather than the shareholders of the company. The main area in which this becomes relevant is when directors consider whether to continue trading (to do so where the directors could not reasonably expect to avoid an insolvent liquidation can lead to a claim being made against them for “wrongful trading”) and, in particular, whether they should enter into transactions which involve a reduction in assets belonging to the company, including cash at bank.
One of the main issues facing directors is whether they are, in fact, in financial difficulty. The Court’s approach to this has been to use the expression “insolvent or likely to become insolvent” and more recently has defined this a being where there is “a real risk of insolvency”. That decision is currently under appeal and the Court is considering whether “probability” or “close proximity” should be used as the correct test. Directors should also be aware that the Courts will usually look at balance sheet insolvency (where liabilities exceed assets) and cash flow insolvency (where a company is unable to pay its’ debts as they fall due).
Whichever definition prevails, it is at this point that the interests of the company’s creditors become paramount and it is imperative that directors keep a full record of the decision making process, including board minutes, particularly where new debt is being incurred or any dissipation of assets is to take place.
Transactions involving the directors or persons connected to them are of particular interest to any insolvency practitioner appointed to deal with the company’s affairs, and justification for these will include demonstrating that they were entered into for the purpose of benefitting the creditors of the company. In certain circumstances, the hurdle for the directors to overcome is made higher as the Court is entitled to presume that a director intended to put the connected party in a better position than they might otherwise be in, ahead of any insolvency.
Directors should also exercise caution in relying on the temporary provisions regarding “wrongful trading” that are currently in place as part of the measures introduced by the Government in June 2020 to deal with the COVID pandemic. These provisions, which have just been extended to apply until 30 April 2021, prevent an IP from bringing a claim against directors for wrongful trading during this period.
However, although it is a well-intentioned measure designed to alleviate some of the stresses caused by the pandemic, it may provide a false sense of security. It does not remove the need for directors of insolvent companies to act reasonably and in the interest of creditors. IP’s will still have other means by which perceived wrongful transactions can seek to be undone and funds or other property recovered from the directors or third parties.
As we come out of the other side of an extremely difficult year, the advice as always is to maintain proper records, ideally in the form of board minutes, of any decisions taken during difficult times – the rules exist as the trade-off for operating with the benefit of limited lability and a lack of contemporaneous records is often the director’s downfall.
This article was written by Simon Franklin and Morris Peacock from Howes Percival and Matt Howard from Price Bailey.
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