Insolvency in construction, part 2: Downstream insolvency

Tom Duncan:

Hello and welcome to Ashurst Legal Outlook. I'm Tom Duncan, a partner in our construction disputes team in London, and you are listening to the second podcast in our series focusing on insolvency issues in the construction sector.

In the first podcast we identified construction sector is facing a series of challenges, and the last year has been particularly difficult, over 4,000 construction companies becoming insolvent. This was an increase of 7% from November 2022, and a 36% increase on the figure for 2019.

In the second podcast of the series we are going to look at issues that arise when a downstream contractor becomes insolvent. I am joined by Ben Patton, a partner in our construction team focusing on real estate development and investment, and Sadia McEvoy, who's counsel in the same team. Sadia, what is your view of the current climate and the risk of contractor insolvencies?

Sadia McEvoy:

Yes. Thanks, Tom. It's a challenging environment for sure. Aside from the number actually formally becoming insolvent, a lot of businesses are on the brink. Begbies Traynor, the insolvency practitioner, estimates that at the end of 2023 the number of construction businesses on the brink of failing was at an all time high of almost 6,000. And it's not just small operators who are suffering. Some of the most prominent failures of last year were Toland in February 2023, Henry Construction in June, Buckingham in August, Michael J Lonsdale in October, and the Squibb Group in November. And, unfortunately, the trend's looking like it's continuing into 2024 with Stewart Milne and [inaudible 00:01:45].

Tom Duncan:

Thanks, Sadia. And Ben, why do you think the construction sector and the contracting market in particular is prone to these issues?

Ben Patton:

I think it's fair to say, Tom, that the sector always sails in the tailwind of prevailing economic and political factors. I think high interest rates and consequent challenges to contractors cashflow and liquidity continues to be a major problem, as do high material prices and labor cost inflation. There is also an emerging slowdown in public project delivery, which we're starting to see come through.

Sadia McEvoy:

And added to that are factors like expensive energy, and of course the typical procurement approach in the UK of fixed price lumps sum, it leaves no wiggle room for contractors, and they may also need to deal with the bad debt left by those contractors who've gone under. I think it's also just worth mentioning the uncertainties around the Building Safety Act, like the second staircase issue, liability for remediating defective buildings, and the change in regime that's currently being enacted. They're also slowing the market down and that, of course, in turn has a knock-on effect on productivity.

Tom Duncan:

Yeah. Thanks, Sadia. Any insolvency in the supply chain has an impact on developers and funders, and I know we've been advising on a number of scenarios the last few months. Ben, could you tell us about your recent experience and what insolvency processes you're seeing, what the challenges of those processes may be?

Ben Patton:

That's right, Tom, there's been a fair bit of it. And what we're typically seeing is administrations with alarm bells ringing for developers and funders when distressed contractor files for a notice of intention to appoint administrator. That is, of course, if they haven't started ringing before, because as you know, there are a lot of ways of detecting the signs before formal processes are started. And administration is distinct from liquidation because it's designed to give a company an opportunity to rescue itself, or if that's not possible, to produce a better outcome for creditors than, say, liquidation.

It's only if rescue is not feasible that the administrator can pursue a business sale or a breakup sale, and the role of the administrator is to help get the company back on track or to realize its assets if the situation can't be salvaged. I think appointing an administrator is usually proceeded by the NOI, of course, the notice of intention to appoint, and that can be filed by the company, its directors or a floating charge holder. Typically, though, it will be the directors who initiate that process.

The NOI temporarily halts creditor action, including any legal proceedings or enforcement of security. It sets up a moratorium that protects the company and provides a breathing space in order for it to take some positive action, hopefully. Once the NOI has been filed at court, then any action by creditors has to receive court agreement. And although the moratorium period is only 10 business days initially, this often provides the space needed to try to maneuver the company away from the immediate threat of liquidation.

If the administrators are not appointed, though, within the first 10-day moratorium, but the company still has a settled intention to appoint them, it is possible to file a second NOI to extend that moratorium. However, it can't just be used on the off chance that a rescue deal will be found or used repeatedly, which would amount to an abuse of process.

Sadia McEvoy:

And then just following on from that, once the administration is formally entered into, the administrator pursues either rescuing the business or a business asset sale. And you might also have heard of what's known as a pre-pack administration. This is where the administration business sale is negotiated before the administrators are appointed, but is implemented immediately after or very soon after their appointment where the buyer is connected with the company, in other words, where some of the existing management or sponsors set up a new company to buy the business out of administration leaving the liabilities behind. This is called a connected party transaction. And if the sale is implemented by means of a pre-pack, then it's called a connected party pre-pack, and the buyer has to obtain an additional independent valuation of the proposed transaction before completion.

Tom Duncan:

Thank you both. In podcast one we discussed ipso facto and how that restricts the rights for a supplier of services to terminate when the company receiving the supply enters administration. Does this also apply for the developer if its supplier, i.e. the contractor, is the entity that goes insolvent?

Sadia McEvoy:

Ipso facto doesn't apply to downstream insolvencies. In other words, the employer under a building contract is not prohibited from terminating the employment of the building contractor or a supplier as a result of its insolvency. But the key question here is more aptly has the contractual mechanism containing the right to terminate for insolvency been triggered? Under the JCT 2016 series, for example, the contracts provide that the employer can terminate in the event that the contractor has entered administration.

In other words, it's not triggered by what Ben was talking about, the notice of intention to appoint an administrator. And this is a really important distinction and it's really important for the client to check the contract carefully to ensure that the insolvency event that has occurred does indeed give it the right to terminate. This is because if it does terminate the contract without those contractual grounds, the contractor may be able to treat the contract as repudiated by the employer at common law and claim damages from the employer in respect of its losses.

Tom Duncan:

Thanks, Sadia. Termination's always a difficult area. So, Ben, what should an employer do?

Ben Patton:

Well, what the employer won't want to do when faced with a contractor in an insolvency scenario is pay the contractor and find that the money goes into a black hole of administration as it will become an unsecured creditor with a sizable risk, it won't see that money again.

It will be preferable from the employer's point of view in this scenario to be able to terminate the contract when the NOI is filed. However, the JCT position reflects the intention of the NOI of that notice of intention to appoint. And by that, I mean the NOI period is meant to be a moratorium, so in other words, a breathing space for the contractor as opposed to a trigger for termination. An employer will be conscious also that if it doesn't pay the contractor, it will be pushing it even closer to the brink.

So you can see it both. And when we're reviewing building contracts, we do see both approaches being taken by employer clients. Sometimes we see contracts amended such that the trigger is the NOI as opposed to formally entering into administration, but sometimes the JCT position is unamended. A good example, I guess, is the recent Buckingham administration. And despite a turnover in 2021 reported to be over 600 million pounds, Buckingham was faced with a number of legacy issues on three stadium and arena contracts that it was working on and a substantial earthworks contract in Coventry.

Now it was able to sell parts of its business, its rail division to Kier before it went into administration, but it couldn't sell its remaining divisions. Though with a contractor of this size there were clearly a lot of ongoing contracts at the time of the NOI and therefore a lot of employers trying to work out what best to do.

Tom Duncan:

So, Sadia, in that scenario, how do you see employer clients dealing with it in practice?

Sadia McEvoy:

Well, Tom, matters are complicated in any construction contract by the requirements of the Construction Act. As you know, one of the primary purposes of the act is to ensure that payments are made to a construction supply chain in a timely and predictable fashion. If an employer doesn't want to pay the amount being claimed by the contractor, it has to follow the strict processes required by the act. And we've all heard of smash and grab adjudications in our sector, and this in essence allows a contractor to obtain the amount sought in its payment application through adjudication proceedings if the employer gets caught out by failing to serve those notices correctly.

Ben Patton:

That's right, Sadia. I mean the Construction Act provides that the employer can give payment notices and pay less notices in which it states that less than the amount claimed by the contractor is due. This then becomes the amount payable. And as to your point about adjudications, it's worth reminding listeners about the Bresco case. And as we know from that case, an insolvent contractor can bring adjudication proceedings, but it is unlikely to be able to enforce an adjudicator's decision in which it is awarded money. But I believe that is a topic for our next podcast, so I'll leave that one there.

Tom Duncan:

Thank you. It's clearly difficult position for the employer, slightly stuck between a rock and a hard place. Have you got any further thoughts, Sadia?

Sadia McEvoy:

Well, I agree with you. There are risks involved for an employer in stopping paying a contractor if it's in financial difficulty, unless it's clearly falling within the parameters of the contract. What both the JCT and NEC contracts provide for is that once the administration process has started, the employer has the right to terminate the contract at any time. And it's important to note here that termination doesn't occur automatically. It has to be elected by the employer. But even if the employer doesn't elect to terminate immediately, various consequences flow from the insolvency trigger.

Under the JCT contract, for example, the contractor immediately loses the right to be paid until the works are completed and defects are rectified, and its obligation to carry out and complete the works is suspended. The contractor has to also remove plant and equipment, and must assign the benefit of any supply contracts without charge to the employer.

And the employer can then employ others to complete the works and make good any defects. And it's only at this stage the final accounting stage, in other words, that the contractor potentially might be owed further monies subject to how much it's cost the employer to complete the works and finish the rectification of defect.

In reality, of course, when the final reckoning takes place, it's highly unlikely that it will have cost the employer less money to finish the job than it would've cost it if the contractor hadn't gone insolvent. Indeed, it's likely that the employer will be owed money by the contractor in relation to the expenses incurred by it as a result of the termination, which you will need to pursue like the other creditors of the contractor.

Tom Duncan:

So when the main contractor goes insolvent, what happens to its subcontractors? How does the employer make use of their expertise?

Ben Patton:

This is a good point because clearly what the employer will want to do is keep the existing team in place, find a replacement contractor and get the job restarted as soon as possible with minimal disruption. Now the extent to which you'll be able to do this might depend on keeping existing subcontractors on board. But typically, for example, under standard form JCT subcontracts, there is a clause providing that if the contractor's employment under the main contract is terminated, then the subcontractor's employment under the subcontract shall automatically terminate.

A likely scenario in this context will be that the employer will want to step in to the subcontracts through its collateral warranties or its third party rights so that the works can continue. And to ensure the employer has the option, it is essential that those warranties or third party rights are in place. But if there are sizable sums outstanding under the subcontract, employers may think twice about stepping in and becoming liable to pay them in lieu of the main contractor.

Although those step-in rights require careful drafting to ensure that the employer can step in on notice should it wish to do so. It will also need to carefully time the step-in so that it occurs before or at the same time as the contractor's employment under the building contract is terminated. Or the alternative would be to allow the automatic termination of the subcontracts to happen and then try to enter into new contracts directly with the subcontractors, but the negotiating position of the employer in this scenario is obviously much weaker and the employer can expect the subcontractors to seek to renegotiate the terms.

What's really important is for an employer not to start paying subcontractors directly before their contracts are terminated. Now, this is because of the pari passu rule, the principle of fair treatment that operates in an insolvency situation. The effect of this rule is that if a direct payment is made to a subcontractor, the employer may still be liable to pay an equivalent amount to the main contractor, i.e. might be paying it twice. And that's because paying subbies directly removes an asset from an insolvent entity that would otherwise be capable of being realized for the benefit of the insolvent entity's creditors who are all entitled to share available assets equally in proportion to the debts due to such creditors.

Tom Duncan:

Thanks, Ben, that's really helpful. So finally, both Sadia and Ben, what suggestions do you have for developer clients to mitigate the risks of contractor insolvency in the current challenging market? Sadia, perhaps you could start.

Sadia McEvoy:

Yeah, thanks. And this is a concern to our clients. But one way is to ensure that you have additional security. As listeners will know, on large construction projects it is usual to obtain a performance bond and a parent company guarantee to protect against the risks of poor performance and insolvency risk. Unfortunately, these devices can be of limited use. For example, a bond will typically only pay out a percentage, usually around 10% of the contract sum, and that of course is unlikely to cover all of the employer's losses arising from the contractor's insolvency.

The bond market's also proving increasingly difficult and expensive, and as it's ultimately the client who picks up the cost either directly or indirectly as part of the contract sum, it's definitely not the ideal or a loan solution. In contrast, a parent should be able to offer a parent company guarantee without a price tag, so without financial consequences for the employer, albeit there may be internal group accounting costs. But there is always the danger that insolvency of a main contractor affects the whole group, rendering, of course, the parent company guarantee as useless to the employer as the insolvent contractor is.

Tom Duncan:

And Ben?

Ben Patton:

Yeah, thanks Tom. Just to add to that, I mean we are seeing increasingly employers and funders requiring bonds and PCGs, again for the reasons that Sadia has outlined, and they do different things as different instruments. And as we mentioned, ensuring that the employer has warranties or third party rights and that they contain step-in rights is crucial.

Offsite goods and materials, bonds, vesting certificates, and clear controls over offsite storage of materials adequately marked as belonging to the employer are also sensible methods of mitigation. And clearly minimizing advanced payments is also a preferable position for the employer to be in to mitigate against supply chain insolvency.

Tom Duncan:

Thank you, Ben. Thank you, Sadia. Supply chain insolvency is likely to be an ongoing issue. I'm grateful to you both for providing your insights. And if listeners have any questions, Ben and Sadia will, I'm sure, be delighted to speak to you.

Sadia McEvoy:

Of course. Thanks very much, Tom.

Ben Patton:

Yeah. Thank you, Tom.

Tom Duncan:

Thank you for listening to Ashurst Legal Outlook. Our next session is the final one in the series and we'll consider adjudication and insolvency. To make sure you don't miss it, subscribe to Ashurst Legal Outlook on Apple Podcast, Spotify, or your usual podcast provider. And while you're there, feel free to leave us a rating or review. Thank you very much and goodbye.