Insolvency in construction, part 1: Challenges for UK contractors supplying services to companies that enter insolvency

Tom Duncan:

Hello, and welcome to Ashurst Legal Outlook. I am Tom Duncan, a partner in our Construction Disputes team in London, and you're listening to the first of three podcasts from Ashurst on current insolvency issues facing the construction sector in the UK.

The construction sector has faced a series of challenges over the past five years, caused by a combination of Brexit, the war in Ukraine and COVID. The inflation of labour and material costs, and the impact this has had both on current projects and on the willingness to invest in new projects, has been well documented.

Insolvencies of companies in the UK and now higher than they were after the 2007-2008 global financial crisis. Almost 20% of these insolvencies are in the construction sector. And last year, over 4,000 construction companies went insolvent. This is a 36% increase from 2019.

Over the three podcasts, we will look at a number of the issues that may arise in an insolvency scenario or construction companies. Today, we will cover some of the challenges that construction contractors are encountering and the companies to which they're supplying services into insolvency.

I am joined by my colleagues Ru-Woei Foong and Inga West, Partner and Counsel in our London Restructuring and Special Situations practice to discuss this challenge. This includes a discussion about the ipso facto regime and its impact and insolvency situations. And we also discuss how the liabilities created or extended by the Building Safety Act interact with insolvency.

So turning to Ru-Woei first, it's rare now that we use Latin phrases, but what is “Ipso Facto”, and what does it mean an insolvency context?

Ru-Woei Foong:

I'm glad you asked that question – everyone always does. So “ipso facto” is actually Latin for “by that very fact”. But what it means typically in a legal context is a clause that permits or provides for the termination of a contract upon the occurrence of an insolvency event. Or in other words, by the very fact that the company has become insolvent. And it's relevant in the context of construction companies because, in 2020, the UK Government brought in some new legislation which restricts a supplier of goods or services to an insolvent company from terminating supply when the company goes into insolvency.

So the idea being effectively to preserve that supply in order to aid the company's rescue. This legislation does capture the supply of construction services. So obviously, it's going to be relevant for a lot of the clients that we're speaking to today. And while there is an exception, where continuing to supply would cause hardship to the supplier, this actually appears to be a pretty high bar, and so is unlikely to offer much assistance to large construction companies which are well capitalised.

Tom Duncan:

So is there anything that a construction company can do to avoid ipso facto? Surely a construction contractor could not be expected to continue to supply to an insolvent company without being paid

Ru-Woei Foong:

Well, there isn't anything which can be done in the sense of the legislation applies automatically, and would even capture termination of a contract triggered by other non-insolvency events to the extent that they would result in a termination of supply. So you can't contract out of the legislation. But what you can do is protect your position by engaging with the insolvency practitioner early on, either to get permission to terminate your contract because they take the view that it's no longer required, or if the insolvency practitioner won't consent to that and in fact does want to preserve that supply, then to get confirmation that your fees and any costs and expenses incurred in respect of post insolvency supply will be paid in full and on a priority basis. And the other thing to note is that if a new right to terminate arises post-insolvency, for example, if there was failure to make such payment after it had been agreed with the insolvency practitioner, then you would be able to terminate your contract off the back of that.

Tom Duncan:

So it may often be the case that a contractor – who has been providing services up to the point of insolvency – hasn’t been paid. So what about those sums? Can you make it a condition of continued supply that any outstanding sum owed under the contract in relation to supply pre insolvency or paid in full?

Ru-Woei Foong:

Yeah, so unfortunately the legislation explicitly restricts the supplier from doing that. I think precisely because they didn't want suppliers to be able to hold insolvent companies to ransom. So those amounts would remain unsecured claims against the insolvent estate.

Tom Duncan:

So there's clearly a bit of a tension between this ipso facto regime and the Construction Act statutory right to suspend work pending settlement of outstanding payments.

Ru-Woei Foong:

Yeah, you're right. There is that conflict there between the two different kinds of statute. Unfortunately, there is very little case law and ipso facto, at the moment, that hasn't been very much in the courts that has been able to clarify how the regime works and how it should operate in practice, let alone case law on how it interacts with that specific statutory provision that you have mentioned.

In reality, I guess what would happen is likely to be driven by the commercial position. So in particular how essential the supply is, and how much it is worth to the insolvency practitioner to keep the same construction company on board for the relevant project. And that's why it'll be so important to start the conversation early with the insolvency practitioners and get as much clarity on the situation from them as soon as possible to minimise the amount of risk in terms of further exposure to the contractor.

Tom Duncan:

Thanks. Definitely food for thought. Inga, if we could turn to the Building Safety Act, which is and remains a very hot topic in the industry, specifically how it interacts with the insolvency related issues. I'm sure listeners now will be all too familiar with what claims under the Building Safety Act are and the corporate provisions that exist, which make associate companies potentially liable. But I wanted to focus on the aspect of this potential liability in relation to developers and their holding structures. What should they be thinking about?

Inga West:

The impact of this new potential liability for developers and their holding structures may actually depend upon what is the risk and the content of these claims, as well as what stage the investment is at. The problem, I think is particularly acute for older or more mature developments for two reasons.

Firstly, the building will perhaps have been constructed under older regulations, and maybe that gives rise to a greater scope for defects to arise.

And secondly, the developer holding structure may now be left holding very few assets and other than the potential defects, planes, minimal external liability. So the directors will need to address the situation that the company may actually be unable to pay the defects should they crystallise and that potentially renders the company insolvent.

And I realise I'm saying “potentially” and “potential” quite a lot here. But the potential risks do need to be factored in.

And insolvency or potential insolvency does bring about a new set of onerous directors’ duties that the board needs to comply with. Such as, for example, they need to take into account creditors’ interests and think about wrongful trading duty. Getting these duties wrong can result in personal liability for directors. So it is critical that they take advice to protect their position.

And of course, if the developer and holding structure turn out to be insolvent, the defects claimant may well look further up the tree for deeper pockets to claim against. And this brings into focus the corporate veil provisions you mentioned. Sponsors will need to review not just the shareholders and their voting rights, but also any special control provisions in the Constitution or shareholders agreements that might put them in scope the regime.

Tom Duncan:

And are you seeing Building Safety Act related issues in other insolvency contexts?

Inga West:

Yes, in fact, there was a recent example of a homebuilder which was running a public M&A process. And even though they had substantial development assets on their balance sheet, before the BSA would be expected to generate significant interest – nevertheless, the shadow of the potential BSA claims meant that they couldn't find a buyer. The homebuilder ultimately went into administration. So we can see that the BSA is having a real impact in this area.

Tom Duncan:

Thank you. The implications of the BSA obviously continue to stretch far and wide. It's putting significant pressure on the industry. This, together with the financial pressures I discussed at the start of the podcast, means that construction companies will benefit from having access to insolvency expertise than early stage. So it's been great to have Ru-Woei and Inga to join us today. If you have any questions, they would be delighted to speak with listeners.

Ru-Woei Foong:

Absolutely. And you'll find our contact details on our Ashurst website or on the LinkedIn posts relating to this podcast episode. Please feel free to call or email Inga or myself or any other member of the Restructuring and Special Situations team here at Ashurst.

Tom Duncan:

Thank you both.

Inga West:

Thanks, Tom. It was great to be here.

Tom Duncan:

Thank you for listening to Ashurst Legal Outlook. Our next episode will cover things to consider relating to the insolvency of a contractor or subcontractor, and we look forward to that discussion.

To make sure you don't miss future podcasts in this mini-series, please subscribe to Ashurst Legal Outlook on Apple podcasts, Spotify, or wherever you get your podcasts. And while you're there, feel free to leave us a rating or review.

Thank you for listening and goodbye.

Host:

If you enjoy Ashurst Legal Outlook, why not check out our other two podcast series as well. Ashurst Business Agenda tackles the big strategic issues that business leaders face. And ESG Matters @ Ashurst reveals how business leaders are rising to mounting environmental, social and governance challenges. You can listen and subscribe to Business Agenda and ESG Matters wherever you get your podcasts.