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Construction supply chain insolvency

This guide was updatd in January 2012

Financial difficulties in the construction sector emerged with the credit crunch and are sure to be a feature of the sector for a long time. It has been estimated that it took the construction industry a decade to recover following the recession in the 1980s.

Financial problems in the construction industry can appear in several ways: fewer orders, inflated claims and disputes, employers experiencing financial difficulties, and supply chain insolvency.

The insolvency of one of the links in a supply chain under a construction contract can be a huge area of concern for the main contractor. This guide looks at issues to consider if you are a main contractor and your supply chain is in financial difficulties.

Background

In recent years, businesses, particularly in the manufacturing sector, have shifted to an increasingly low-stock, quick-order model of supply. When economic conditions are good this can lead to greater efficiency, but in difficult trading conditions manufacturers can become increasingly exposed to risk should a major supplier fail. When there is a chain of suppliers, each dependent on the others to perform their functions, each party is exposed to risk through the weakest link in the chain.

The failure of one link can have a significant impact on each party, in several ways:

  • impact on financial and management time;
  • disruption in production lines;
  • delayed deliveries to other customers;
  • inefficiency; and
  • increased costs.

Knock-on effects can include penalties, breach of contract claims and possibly even being forced to make 'ransom payments' to the insolvent supplier or someone below him in the chain to ensure continuity of a business-critical supply. In a worst case scenario, the insolvency of one link can create a 'domino effect' of insolvencies up and down the supply chain. In turn this can have a 'ripple effect' into the wider sector.

Insolvency warning signs

There are often early warning signs that a supply chain is in financial difficulties. Contractors should be vigilant for:

  • requests from the supply chain for deposits, up-front pre-payments or reduced retentions;
  • supply chain members not delivering in accordance with agreed schedules;
  • complaints from other members of the supply chain;
  • attempts to inflate payment applications;
  • unexpected price rises or attempts to renegotiate pricing or terms, repeated invocation of variations regime;
  • failure by a member of the supply chain to file statutory accounts on time;
  • silence and evasion tactics;
  • high staff turnover; and
  • rumours and market intelligence – although these should be treated with caution, they can also provide valuable information.

Information is available through a variety of sources - formal and informal - including searches of the public registers at Companies House, at the courts or credit agencies and enquiries of fellow customers.

If you become aware of any of these issues you should inform your legal or commercial department immediately so that they can obtain financial and market information to assess how serious the situation is and plan a strategy. Open dialogue with the affected member of the supply chain may also help avoid a difficult situation turning into a crisis.

Protecting yourself – practical tips

There are various processes which can help contractors identify risks in their supply chain arrangements early. The supplier list should be regularly audited, identifying those who are critical to the business. Contractors should conduct ongoing risk assessment, perform regular credit checks and keep an eye on market intelligence throughout the supplier relationship as far as possible.

From the very start of the relationship, long before any insolvency issue arises, it is important to check what contractual terms will apply in the event of insolvency. Contractors should make sure that these are robust - particularly with regard to ownership of relevant property, payment and performance security, when payment can be withheld and when the contract can be terminated - and that there are not unclear or multiple versions of these terms in circulation.

Look at whether the project is proceeding successfully on site. If it is, consider maintaining the status quo by continuing to pay the supply chain member. If not, review the terms of the contract to see what your remedies are. Consider the options for omitting some work from the contract scope.

As a contractor, the things that you should consider when entering into and during the lifetime of the contract include:

  • bonds, letters of credit guarantees and escrows – these may provide the contractor with security in the event a supplier becomes insolvent. The contractor should obtain a guarantee from the parent company where appropriate, ensure that these can be called on effectively in the event of formal insolvency. Determine whether security for cash flow ("on demand security") or long term compensation ("default security") is required. This will determine the nature of the security and cost implications;
  • price neutrality – in major construction projects, materials are often paid for up front. If there is any risk of a supplier falling into financial difficulty, the contractor should ensure that only items which it actually owns have been paid for;
  • title retention – vesting certificates can be a useful way of passing legal ownership, or title, of offsite supplies to the contractor. However, this requires the cooperation of the supplier. Aim to have all equipment and materials brought onto the site and fixed in the works as early as possible, so that they are likely to cease to be the legal property of the supply chain member and are therefore likely to be protected from creditors.

Contractual termination

Insolvency on its own is unlikely to amount to a breach of the contract. Termination clauses should therefore be drafted carefully to ensure that you can terminate the contract immediately when an insolvency event occurs. 'Insolvency event' should be defined widely enough to catch events which occur before the insolvency process begins such as enforcement of security, winding-up petitions being issued and not dismissed within short time periods or a notice of intention to appoint administrators being filed. Always check and get evidence that the event has occurred and never rely on hearsay. Getting it wrong could result in a claim for repudiatory breach of contract against you, for a significant amount of loss and damage.

Important issues for a contractor to consider include:

  • is it commercially possible to get another contractor?
  • will an incoming contractor be willing to assume the risks associated with the parts of the project that have been completed so far (and if so will it charge appropriately)?
  • in what circumstances do you have the right to award the contract to a new supply chain member?
  • do you have the right to control or preserve relationships with other members of the supply chain, for example through collateral warranties?

If the subcontract grants you the right to terminate the contract in an insolvency situation, make sure you review the contract to check what formalities need to be followed and what effect that termination has on any other contracts up and down the supply chain. Note that any replacement strategy may need to be agreed with relevant funders, and the terms of any loan arrangements are likely to need to be reviewed.

Termination rights are construed strictly. The provisions must be followed to the letter.

Common law termination

If the contract does not contain any provisions for termination on insolvency, there are three sets of circumstances in which the contract could otherwise be terminated:

  • renunciation by a party of its liabilities under the contract – this could be a refusal to carry out a primary obligation under the contract, or a statement that the obligation will not be carried out when it becomes due. If there is no evidence of a clear refusal, the test becomes whether that party's actions would lead a reasonable person to conclude that it no longer intended to be bound by the contract;
  • impossibility to perform created by that party's own act - an example of this would be where an owner sells a particular ship it had previously agreed to charter;
  • total or partial failure of performance – this is where the party is so seriously in breach of contract that the other must conclude that it had no intention of carrying out its obligations.

If one party to a contract falls within one of these three principles, the other party can either accept that the contract has ended and claim damages for 'repudiation', or call on the other party to perform its obligations. If a repudiation is accepted, any obligations that have not yet been performed by either party under the contract are released and the obligations of the party at fault are replaced by a liability to pay damages. Determining whether a contract has been repudiated can be difficult and many issues need to be considered. Legal advice should be sought without delay if you are considering terminating a contract under any circumstances, including if there is a possibility that a repudiation may have occurred.

Issues with insolvency practitioners

If a supplier becomes insolvent an insolvency practitioner (IP) will be appointed over its business. The IP will either be a liquidator or an administrator. The first thing a contractor will have to do in this situation is to establish whether the IP will trade on and whether the contractor wishes to, or needs to, deal with him. An administrator has wide powers of trading. A liquidator is much more restricted in what he can do, and will normally seek to sell the assets on a break up basis. If trading is to continue, the IP will usually negotiate new contract terms involving speeding up the payment process or price rises. The IP may also wish to enter into 'trading agreements' or 'loss-sharing agreements', so that the contractor bears some or all of the trading costs of the insolvent supplier in exchange for continuity of supply.

As an alternative the administrator may sell the business including the rights in the contracts to another sub-contractor. The purchaser will, if it thinks your sub-contract is profitable, seek to achieve a novation of the sub-contract with you. If this occurs, you will need to consider whether this is a better alternative than termination and looking for a replacement contract. The attitude of the lower supply chain, and the existence of any bonds, will be key factors in this decision.

Conclusion

Insolvency is a fact of life in the construction supply chain. Factoring in the risk at the procurement stage is vital, as is constant and thorough monitoring of the financial position of sub-contractors. Be prepared to act swiftly and decisively if a situation arises, and seek professional advice early.

Expertise in Engineering Procurement & Construction Contracts

EPC contracts, and their related EPIC and EPCC forms, are very often highly complex in the context of technically challenging projects. Legal expertise is needed to identify and address the issues and risks arising in such contracts. Equally important, however, is the industry-focused knowledge necessary to ensure a detailed understanding of their nature. This includes familiarity with the differing emphasis placed on those negotiating and drafting EPC contracts.

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