12 October, 2020

In today’s febrile climate insolvency risk looms large on many risk registers. Stalled projects, late  payment or broken supply chains all threaten cash flow and available financial resources.

Third quarter data from the UK Insolvency Service shows that construction is one of three industries most affected by Covid. Government support and emergency protection for businesses is making a difference but the cost to the public purse will make it unsustainable in the long term.

Knowing where to look is a challenge itself. In addition to a building contractor, any sizeable development project involves an array of sub-contractors and professional consultants each of whom has an important role to play. The insolvency of any of these parties may have profound consequences for the health, progress and cost of the project.

And yet the methods of assessing the financial standing of key suppliers are, at best, unsophisticated. They commonly rely heavily on the use of business credit reports which derive from filed company accounts together with other indicators like county court judgments.  While this might offer a quick snapshot of a company’s financial status it is, by nature, retrospective and has a limited shelf-life, especially in volatile conditions, like a pandemic for example.   

Although it is possible to carry out more sophisticated financial due diligence, this relies heavily on the co-operation of the supplier. Moreover, the cost and time implications of this deeper analysis are likely to be prohibitive on all but very large schemes.  So, although thorough financial due diligence is always essential and does give some indication of a company’s financial resilience, key aspects of inherent commercial risk remain largely unascertainable.  These include market shock, group company failure, litigation risk and the potential indirect effects of an insolvency event anywhere along extended supply chains to name but a few.

This systemic uncertainly, amplified at present by the pandemic, reinforces the need to monitor the financial health of key suppliers, not only at procurement stage when it is most commonly undertaken, but throughout the project. Time is usually at a premium and the ability to spot the warning signs early can mean the difference between triggering a planned mitigation strategy or facing a disorderly insolvency event.

With a long-running project, obtaining fresh credit reports for key parties needs to be a regular task. While recognising the limitations of this information, it nonetheless provides an important level of objectivity and may highlight any change in circumstances that warrants further investigation.

Construction_insolvency_risk_1078x564
It’s important at the same time to be attuned to more immediate warning signs. An unexplained failure to meet service performance requirements or milestones, disengagement, poor responsiveness and lack of communication could all signify possible underlying issues. Equally, aggressive or irregular invoicing including duplication of accounts or inappropriate pursuit of payment, even approaches from sub-contractors for direct payment could both indicate cashflow difficulties.  At head office level, high staff turnover, particularly in key managerial or delivery roles or unexplained friction with other parties are also signs that all may not be well .

With a well-run project, the main contractor should actively monitor and manage its subcontract supply chain. From an Employer’s viewpoint the greatest level of risk is therefore likely to arise from a main contractor insolvency, especially where the building work is being procured using a traditional building, as distinct from a construction management approach. The same focus is likely to be true for a development investor or a funder.

Responses to a main contract insolvency will inevitably be defined largely by the underlying contractual arrangements. These will require careful analysis and legal advice will be necessary in planning and implementing any response. It always pays to be well prepared however and vigilance will pay dividends  by detecting risks as early as possible.

In a world of imperfect information and innate uncertainty it is impossible to exclude insolvency risk. However, it is possible to anticipate and mitigate the consequences of an insolvency event. The tools for doing this already exist within most building contracts and development agreements. Although there is no such thing as a pain-free insolvency event, key to a successful recovery is to keep the risks under review, understand the contractual procedures, prepare the ground and be ready to act decisively when needed.