How to manage distress in UK construction supply chains

While insolvency events may appear to arise suddenly, there are often warning signs or "red flags" of distress well in advance. While these do not necessarily demonstrate actual insolvency, they can indicate liquidity and solvency risks to the supply chain.

In our earlier infographic we explored how to manage the risks arising from distressed supply chains. When considering the construction industry in particular, warning signs of distress in a construction supply chain may include the following:

• Slowdown in performance of the works, project delays or missed deadlines.
• Delayed payment of subcontractors or others within the supply chain, requests for direct payments down the chain, or increased use of practices like reverse factoring.
• Quality issues.
• Subcontractors and employees refusing to attend site.
• Aggressive invoicing, becoming increasingly litigious or seeking early payments.
• Lots of sudden claims across all of the entity’s/group’s projects.
• Sudden refinancing or engagement of restructuring or financial advisers.
• Chasing new contracts to win and potentially under-bidding to get cashflow started or to boost balance sheets.
• Resignation of key personnel or significant loss of staff and evidence of low morale.
• Increased financial oversight by head management or third party advisers.
• Lack of communication or a delay in responding to questions.
• For listed companies, profits warnings, short-selling by the market, or suspension of trading.
• Late public filings, declining credit ratings, withdrawal of credit insurance.
• Market rumour or speculation in the press/social media (albeit treat with caution)

What to do if you recognise early warning signs in your project

If you suspect distress within your supply chains, taking early action to protect your position is critical. It is also crucial that you fully understand your options, considering both your contractual and non-contractual rights and obligations. There are usually a number of practical steps and commercial implications of exercising those rights, some of which are explored in this Insight.

Taking early professional advice to ensure that you are cognisant of all of the available options (and the potential consequences of exercising those options) can be invaluable.

Suspension and termination

It is critical not to terminate the relationship without first considering the overall position and the potential implications of termination on the project and wider supply chain. Termination may require lender consent or may be unavailable from a certain point.

Where there are entities in distress directly upstream, businesses should consider whether they can suspend work/services to avoid incurring cost for which they are unlikely to get paid. If there are entities that are higher up the chain, consider whether there are rights to request payment directly.

If a downstream counterparty (for example, a subcontractor) appears to be in distress, make sure you understand your termination for convenience rights or if there are any other relevant grounds for termination.

Early planning is invaluable. You may want to identify alternative contractors as potential replacements in the event of termination or insolvency. Make sure these communications make it clear that no termination has occurred and do not appoint the new contractor until termination has been effected.

Payment and set-off

It is important to make sure that any payment claims have been properly made and, in the event of non-payment, to consider prompt debt recovery action, as recovery can be increasingly difficult as distress grows.

When making payments, only pay amounts that are contractually due and consider utilising any set-off rights to avoid or limit exposure.

Security and off-site goods and materials

At the outset of the relationship and on an ongoing basis, consider whether obtaining security or guarantees is necessary. In the event of insolvency, secured creditors benefit from greater priority and have a better chance of recouping an enhanced proportion of amounts owing. Make sure you are aware of the triggers allowing you to enforce and consider whether any third party security provides enhanced rights.

If you are holding a guarantee from an entity in the same group as the distressed entity, consider the extent to which the distress might be prevalent throughout the group, affecting the prospect of recovery.

If there are off-site goods and materials, consider whether title has passed. Also consider any practical issues in enforcing those rights; for example if the goods are located overseas or stored in a third party location, or if they are impacted by third party security.

Collateral warranties and step-in

It is not uncommon for some collateral warranties that are deliverable in relation to a particular project not to have been provided. If an entity is obligated to provide collateral warranties or similar instruments from all of its subcontractors, ensure that you hold a properly executed copy of each document. Without that direct contractual remedy against subcontractors, it will be much harder to have recourse against subcontractors in the event of contractor insolvency.

Ensure that you also have a copy of the underlying subcontract (including schedules and specifications) because otherwise enforcement can be very difficult.

Insurance

Check that all the required insurances are in place, the level of cover, exclusions, and be aware of the steps you need to make a claim. In the event that insolvency in the supply chain causes you loss, having an insurance policy which responds is likely to be the easiest way to recover.

Adjudication

You should also consider whether you should be commencing adjudication steps to crystallise amounts due before any insolvency event, in case there are options to consider under the Third Parties (Rights against Insurers) Act 2010. Remember to make formal claims in writing, and ask the contractor/consultant to notify its insurers, especially if it has professional indemnity insurance and design obligations.

Other possible steps to consider

Employers that are worried about a distressed head contractor should make sure that they can secure the site, make it safe, and cover up the works as appropriate.

Where the distressed entity has control of the plant, equipment and other materials on a site that it owns or for which it is responsible, it is advisable to conduct audits and closely monitor where they are located.

It is important to obtain up-to-date records (including photographic evidence) of works done, defective works and materials procured for the project. If there is any concern of financial health for a relevant party, procure a detailed survey of the project. Also obtain copies of documents relating to the project from the contractor/consultant, consider any claims under bonds or guarantees, and review what retention is held (if any) under the contract.

If there are joint ventures (JVs) in your supply chain, check what happens if the JV or just one JV party becomes insolvent. This will depend on if and how the JV is incorporated, the terms of the JV agreement, and the terms of any agreements that you have with the JV.

Osborne Clarke comment

As the construction industry (and the wider UK economy) continues to experience difficult trading conditions, the ability to identify early warning signs of supply chain insolvencies is crucial in order to best protect ongoing projects and the financial positions of parties involved in a project.

It can add enormous value to understand the full range of both practical and legal steps that are available in the event of potential supply chain insolvencies. Getting in touch with your legal advisers as soon as you spot potential red flags in your supply chain can help to secure the best outcome for you and your project.