Guides & Advice

Managing the risk of insolvency in your supply chain

Published: 21st April 2021
Area: Construction

The increased risk of insolvency

The combined impact of Covid-19 and Brexit means that there are significant financial pressures on companies across the construction industry. As a result, these pressures are likely to lead to an uptick in the number of insolvencies.  Of course, government have put in place measures to assist many companies, including furlough and business loans, but when those measures come to an end the wage bill and loan repayments still need paying.

Add into the melting pot an increase in the cost of materials and labour, and a decrease in productivity over the last 12 to18 months, and arguably what you have is not far off a perfect storm against the backdrop of which further insolvencies in the supply chain are inevitable.

 

Why is this relevant for housebuilders? 

Knowing that there is an increased risk of insolvency means that it is more important than ever for housebuilders to manage and monitor their supply chain.

Monitoring the supply chain can avoid or, at the very least, highlight risks early on enabling housebuilders to take appropriate mitigation measures.  Such measures usually involve keeping the channels of communication open and engaging in early discussions. The aim is to look to agree any workable solution which preserves the housebuilder’s position.

 

How do you know if a company is in financial trouble?

There are a number of warning signs of financial distress to look out for – we’ve produced a checklist of the key signs, below.

Payment-related signs:
  • A sub-contractor not paying its own workers or suppliers.
  • Requests for release of retention when retention is not yet due.
  • Requests for advance payment.
  • Premature applications for payment.
  • Contra-charge claims being made without foundation, to inflate the sums applied for.
  • Inflated applications for payment generally.
Changes in conduct:
  • Underbidding at tender stage, for example, to secure work should raise questions over the underlying reason for low tenders. If it looks too good to be true, it probably is!
  • Radio silence i.e. failures to respond to calls or emails.
  • More aggressive communications, such as the threat of proceedings if payment is not made.
Site-based changes:
  • Suspension of works on site without justification.
  • Reduction in the level of resources on site, for example:
    • A reduced number of staff/workers and/or sub-sub-contractors not turning up without explanation; and/or
    • A reduction in the amount of materials being delivered to site or indeed sub-contractors removing materials or plant equipment from site prematurely before the works are complete.
  • Unexplained or unjustified delays in completing the works by the contractual completion date.
  • A decline in the quality of the works and any associated increase in the number of defects.
Other signs:
  • It is worth keeping an ear to the ground in relation to the ‘unofficial grape vine’. It can often be a case of ‘no smoke without fire’ and it is worth listening to workers / other trades on site as they sometimes have an inside track on what may be happening, which merits further due diligence.
  • Becoming aware of any programme of redundancies or restructuring.
  • Last but not least, late filing of accounts or unsatisfied court judgments can both be clear signs of financial issues.

It is important to ensure that all your key staff (including site staff and those in the commercial and accountancy teams) are aware of what the warning signs are and, subsequently, the need to flag any concerns they have identified as soon as possible.

 

The options for managing and mitigating risks

Generally, there is no right or wrong approach.  However, keeping the channels of communication open often leads to the best outcomes.  Being upfront about whatever a workable solution could be is certainly a good first port of call, such as:

  • Increasing the frequency of payments to improve the sub-contactor’s cash flow to assist them in completing the works; or
  • Omitting elements of the works. However, you need to be careful here as any agreement should be documented so as to ensure that there is no ‘sting in the tail’ (i.e. the sub-contractor seeking to claim for loss of profit on the omitted works).

Can a sub-contract be terminated in the event of insolvency?

Ultimately, in the event of formal insolvency or failure to carry out the works, exercising the right to terminate the sub-contract might be the best option. However, there are a number of considerations before terminating.

Most housebuilders engage their sub-contract supply chain on standard sub-contracts (whether on an individual or framework basis). Therefore the first thing to check is whether the sub-contractor is actually “insolvent” as defined in the sub-contract.

If you terminate when the sub-contractor is not insolvent, as defined in the sub-contract, you can end up in a sticky situation, as this can of itself constitute a repudiatory (serious) breach of contract.

If there is no formal insolvency within the meaning of the sub-contract, it will be necessary to look carefully at the terms of the sub-contract to check if there are any other grounds on which to terminate.

Grounds for termination of sub-contracts

Contractual grounds for termination often include matters such as delay, poor workmanship or even a deterioration in the sub-contractor’s financial standing.

In our experience, sub-contracts will often include a ‘termination at will’ provision.  This means that the housebuilder can terminate the sub-contractor’s employment, even if there is no basis on which to do so.  This can be a useful tool, particularly, where the sub-contractor has not yet entered into any formal insolvency arrangement/process.

However, that said, it is worth being aware that termination at will provisions can (and often do) give rise to arguments about whether there is compensation payable to the sub-contractor as a result of depriving them of the benefit of the sub-contract, namely the carrying out of the sub-contract works for payment. As a result, it can be preferable either to look to reach an agreement to close out the sub-contractor’s involvement, or wait for the formal insolvency to occur to avoid any potential dispute on this front.

Getting termination right

In the event that you do decide to terminate the sub-contract, it is crucial that you follow any requirements in that sub-contract.  For example, such provisions might include requirements as to the form and content of the notice and / or the means by which the notice is to be served.  Strict compliance is necessary, as getting it wrong can mean place you in repudiatory (serious) breach.

We know from experience that, on occasion, sub-contractors are engaged without any formal sub-contract being put in place.  Looking to terminate in this situation is a little trickier, as it might be necessary to have regard to the common law (general) right to terminate the sub-contract.  In conclusion, it will be necessary to be able to establish a repudiatory (serious breach) of the sub-contract.  This is a breach so fundamental in nature it entitles the innocent party to bring the sub-contract to an end.

Often the position can be quite nuanced and, as such, it is worth seeking legal advice around whether a sub-contractor’s apparent breach of the terms of the sub-contract is sufficiently serious to give rise to a common law (general) right to terminate.

Keep a record of evidence

Along the way, it is important that detailed records are maintained, not only recording and evidencing the breaches on the part of the sub-contractor but also any losses arising out of those breaches.

 

Communication is key

Developing and maintaining trusted relationships with your sub-contract supply chain will go a long way to keeping an even keel. However, it isn’t always possible to avoid the risk of insolvency in the supply chain altogether. The key is to keep a close eye on any tell-tale signs and manage the risks which arise as early as possible.

 

We’re here to support you

We regularly act for housebuilders in assisting them in managing insolvency and/or disputes that arise in the sub-contract supply chain.

Read more about how we can help you manage construction disputes effectively.

If you’re concerned about the risk of insolvency in your supply chain then our specialist construction law team can guide you through your options – contact Kate Onions for advice and support.

Our construction team is ranked as a Leading Firm in the Legal 500 2021 edition.

Our updated guide to recovery and resilience covers everything you need to navigate your business out of lockdown, unlock your potential and make way for a brighter future. Further advice in relation to COVID-19 can be found on our dedicated coronavirus resource hub.

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