The persistent risk of insolvency in the construction industry from Clarion Solicitors

Insolvency in the construction sector is not a new phenomenon, but it has become increasingly prevalent in recent years. The UK construction industry, which encompasses a wide range of contractors and subcontractors, has witnessed a disturbing rise in insolvency cases. During the 12 months leading up to the third quarter of 2023, construction firms accounted for 18% of all insolvencies across various sectors. This alarming statistic translates to approximately 4,272 construction firms entering insolvency within that period alone.

Further exacerbating the situation, Begbies Traynor, a prominent insolvency practitioner, has reported that by the end of 2023, the number of construction businesses teetering on the brink of failure reached an unprecedented high of nearly 6,000. Notably, this wave of insolvencies is not confined to small or mid-sized enterprises; it has also affected some of the industry’s more prominent players. For instance, in 2023, companies like Toland, Henry Construction, Buckingham, Michael J Lonsdale, and the Squibb Group all succumbed to insolvency. Unfortunately, early indicators suggest that this trend is set to continue into 2024, posing ongoing risks for the industry.

In the UK, a company is deemed legally insolvent when it is “unable to pay its debts.” This situation can arise under several conditions. Firstly, a company may fail to settle an enforceable debt, such as a statutory demand. Alternatively, a court may determine that the company would be unable to pay its debts as they fall due. Finally, insolvency can also occur when a company’s liabilities, including those that may or may not become due in the future, exceed its assets.

This legal framework underscores the critical importance of maintaining financial health and stability, particularly in the construction sector, where the combination of high operational costs, complex contracts, and narrow profit margins can easily tip a company into insolvency.

Several underlying factors contribute to the high rate of insolvency among contractors in the construction industry:

1. Cash flow challenges: One of the most significant issues in the construction sector is cash flow management. Delays in receiving payments, which can extend to 90 days or more, severely strain a company’s liquidity. Bad debts further exacerbate these challenges, leaving contractors with insufficient funds to meet their obligations.
2. Low profit margins: The construction industry is highly competitive, often leading to contracts being awarded to the lowest bidder. While this may secure business, it also results in minimal profit margins. These thin margins leave little room for unexpected costs or delays, making it difficult for companies to sustain themselves financially.
3. Rising costs: The cost of materials, labour, and other overheads in the construction industry has been on the rise. Contractors may struggle to pass these costs on to clients, particularly if their contracts do not include provisions for price adjustments. As a result, profit margins are further eroded, increasing the risk of insolvency.
4. Economic downturns: The construction industry is particularly sensitive to economic fluctuations. During economic downturns or slow recoveries, the number of available projects declines, directly impacting revenue streams. Contractors that rely heavily on a steady flow of projects may find themselves in financial difficulty when the market slows.
5. The domino effect: Insolvency in the construction industry can have a cascading effect. When one party in the supply chain becomes insolvent, it can trigger a chain reaction, affecting other contractors and subcontractors who rely on timely payments to maintain their operations. This interconnectedness makes the entire industry more vulnerable to financial instability.
6. Poor financial management: Inadequate financial monitoring and management can lead to overspending, misallocation of resources, and ultimately, insolvency. Contractors who lack the necessary financial oversight may find themselves unable to manage their cash flow effectively, leading to a downward spiral of financial difficulties.

To mitigate the risk of entering into contracts with financially unstable companies, it is crucial to recognise the warning signs of potential insolvency. These signs can appear both before a contract is signed and during the execution of a project:

• Delayed filing of statutory accounts and annual returns: Companies that struggle to file their statutory accounts and annual returns on time may be experiencing financial difficulties. These delays can be an early indicator of underlying problems.
• Requests to renegotiate payment terms: If a company seeks to renegotiate payment terms, either by shortening or extending them, it may be an indication of cash flow issues. Adjustments to retentions or other financial terms can also signal distress.
• Failure to make timely payments: A company that consistently fails to make payments on time, or fails to pay altogether, is likely facing significant financial challenges. This behaviour should raise red flags for any party considering entering into a contract with such a company.
• Deterioration in the quality and progress of work: A noticeable decline in the quality of work or a slowdown in project progress can indicate that a contractor is struggling to meet its financial obligations. This may be due to a lack of funds to pay for labour or materials.
• Sudden changes in staff or personnel: An unexpected reduction in staff or a change in key personnel working on a project can be a sign that a company is in financial trouble. High turnover rates may also reflect broader issues within the organisation.
• Inability to provide contractual security: Contractors who fail to provide necessary securities, such as parent company guarantees or bonds, may be at risk of insolvency. This failure suggests that the company may not have the financial backing required to fulfil its contractual obligations.
• Inflated payment applications: Companies experiencing financial difficulties may submit inflated or unsubstantiated claims in an attempt to secure additional funds. This behaviour can be a desperate move to cover cash flow shortfalls.
• High staff turnover: Frequent changes in staff, particularly in key positions, can be a symptom of underlying financial problems. High turnover rates may indicate that the company is unable to retain employees due to financial instability.

1. Third-party security provisions: Employers should include clauses in their contracts that require contractors to procure security from third parties. This security can take the form of parent company guarantees, performance bonds, or retention bonds. Such measures ensure that there is financial recourse if the contractor becomes insolvent.
2. Project bank accounts or escrow accounts: Establishing a project bank account or escrow account can help mitigate the risk of non-payment. These accounts ensure that funds are available for the project, even if the contractor faces financial difficulties. Employers should include provisions that allow them to access these funds if the contractor defaults on its obligations.
3. Collateral warranties and third-party rights: Employers should include a requirement for the contractor to procure collateral warranties or the grant of third-party rights from key parties such as design sub-contractors and design consultants involved in the project. These rights allow the employer to step into the contractor's role in the event of insolvency, ensuring continuity of the project.
4. Step-in rights: Step-in rights are crucial for maintaining control over a project if a contractor becomes insolvent. These rights allow the employer to take over the contractor's responsibilities, keeping the project on track with minimal disruption. This can involve finding a replacement contractor or continuing the work with the existing team. The primary objective for an employer in the event of contractor insolvency is to maintain the existing project team, swiftly find a replacement contractor, and restart the work with as little disruption as possible. According to the standard form JCT subcontracts, there is a provision stating that if the contractor’s employment under the main contract is terminated, the subcontractor’s employment under the subcontract will also automatically terminate. In such a scenario, the employer is likely to step into the subcontracts using its collateral warranties or third-party rights, allowing the project to continue seamlessly. For the employer to exercise this option, it is crucial that these warranties or third-party rights are secured and in place. A key point for employers to remember is to avoid making direct payments to subcontractors before their contracts have been officially terminated. This caution is necessary due to the pari passu rule, a principle of fair treatment in insolvency situations. According to this rule, if the employer makes a direct payment to a subcontractor, they could still be liable for an equivalent payment to the main contractor, effectively resulting in double payment.
5. Rights over plant, equipment, and materials: Employers should secure rights over plant equipment and materials used in the project. This includes the right to take possession of these assets if the contractor becomes insolvent. Provisions should also be made for selling these assets to recover debts or using them to complete the project.
6. Intellectual property and document rights: Contracts should include clauses that grant the employer the right to use and demand copies of the contractor’s design documents. This ensures that the employer can complete the project if the contractor is unable to fulfil its obligations due to insolvency
7. Latent defects insurance: Latent defects insurance can provide additional protection, particularly in funded and tenanted projects. While not a substitute for a comprehensive warranty package, it offers coverage for inherent defects in design, workmanship, or materials that may become apparent after the project’s completion.

1. Escrow accounts and project bank accounts: Contractors concerned about an employer's financial stability may insist on establishing an escrow account or project bank account. These accounts ensure that funds are reserved for the project, reducing the risk of non-payment.
2. Parent company guarantees: Contractors should consider requiring the employer to provide a parent company guarantee, ideally from its ultimate parent company. This guarantee provides a safety net in case the employer encounters financial difficulties.
3. Front-loaded payment schedules: Contractors may negotiate for payments to be front-loaded, meaning that more is paid at the start of the project and less towards the end. This arrangement helps contractors cover initial costs and reduces their financial exposure as the project progresses.
4. Advance payments: In situations where significant upfront costs are necessary, contractors may request advance payments. These payments help ensure that contractors have the funds needed to purchase materials, hire labour, and secure subcontractors before the project begins. To protect the employer’s interests, an advance payment bond is typically required.
5. Direct payments from funders: Contractors can negotiate to receive payments directly from the project’s funder, bypassing the employer's bank account. This arrangement provides greater security for the contractor and ensures that funds are available to cover the project’s expenses.
6. Retention bonds: Contractors should ensure that retention monies are protected by securing a retention bond. This bond guarantees that funds held by the employer will be recoverable, even if the employer becomes insolvent.
7. Retention of title clauses: Contractors can include a retention of title clause in the contract, which reserves their rights over materials used in the project until payment is received. This clause helps protect contractors’ interests in the event of non-payment by the employer.

When signs of employer insolvency emerge, contractors must act swiftly to protect their interests. The following steps can help mitigate the impact of insolvency on the project:

• Monitor employer behaviour: Contractors should remain vigilant for signs of financial distress, such as changes in payment patterns, requests for renegotiation of contract terms, or delays in project progress.
• Adhere strictly to contract terms: Contractors must comply with all contractual obligations, including making timely claims for payment and adhering to the agreed payment schedule. This ensures that contractors can claim any outstanding amounts if the employer becomes insolvent.
• Secure plant equipment and materials: If insolvency appears imminent, contractors should take steps to secure any plant equipment and materials on-site. This is particularly important for assets that may be needed for other projects or that are on hire.
• Review payment obligations to subcontractors: Contractors may be entitled to withhold payment to subcontractors in certain situations, particularly in cases of upstream insolvency. Section 113 of the Construction Act 1996 allows for conditional payment in such cases.
• Consider adjudication: Contractors should consider starting an adjudication process before the employer goes insolvent. This can help recover outstanding payments and protect the contractor’s financial interests.
• Engage with insolvency practitioners: In the event of insolvency, contractors should engage with the appointed insolvency practitioner to discuss the possibility of completing the project under new terms. This may involve novating the original contract or entering into a new agreement.

The construction industry remains fraught with the risk of insolvency, a challenge that both contractors and employers must navigate with care. By incorporating protective measures into contracts, remaining alert to warning signs, and responding swiftly to financial distress, parties involved in construction projects can better safeguard their interests and reduce the likelihood of insolvency. As the industry continues to face economic pressures and rising costs, proactive financial management and strategic planning will be crucial for the survival and success of construction firms.