Assad Maqbool: How to head off insolvency risk

With financial instability rising once more in the industry, how should construction companies safeguard against issues of insolvency on a project? Assad Maqbool explains.

Assad Maqbool

For the first three-quarters of the year, the Insolvency Service of the Office of National Statistics reported that the second highest number of new company insolvencies in the UK was in the construction sector. In each quarter, the level of insolvencies has been higher than in the same period in the previous year.

If financial instability is growing in the industry, what steps can firms take to protect against the risk of insolvency on a project?

Part of the role of procurement is to identify and allocate risks which can be managed and budgeted. However, the risk of a party becoming insolvent is often unclear when putting together a project team. If the client has weak financial standing, it may find that its contractors request that the project costs be front-loaded or paid into an “escrow” account (where monies are effectively held on trust for the project team until such time payments are due).

In procuring contractors and subcontractors, teams will often rely on business longevity as an indicator of likely future solvency. They may also rely on the potentially blunt instruments of turnover tests or high-level company credit reports to check financial capacity.

Also, when procuring construction teams, a client may require parties to provide parent company guarantees to protect against the insolvency of subsidiary companies. They might pay for performance bonds to insure against the additional project cost that would be incurred should a company become insolvent.

Lack of scrutiny

Once initial procurement processes are completed, there is often a lack of scrutiny into the financial viability of subcontractors and suppliers brought to a project. Clients infrequently use their contractual rights to approve second and third-tier providers to check financial health and should consider this further when dealing with critical, high-value and long-lead packages.

If the worst happens, and a member of the project team does become insolvent, then the remaining parties need to work together to minimise the effect of this. Having contractual obligations to openly share information and work together might help in mitigating losses.

There are also contractual instruments that can help projects to continue in the absence of an insolvent company. For example, design appointments should make clear that the copyright and intellectual property licensing continues in the event of any insolvency and without the remaining parties needing to negotiate further payments to receivers.

Stagnant cashflow

Another example is where a supplier or manufacturer has been paid for goods which have not been delivered to site. Often, project team members will seek to enter into vesting certificates upon payment, which ensure that the relevant goods are separated out and identifiable from the general contents of a warehouse, and do not fall into the general insolvency pot shared between all creditors.

A particularly difficult scenario is where the main contractor has become insolvent after being supplied with goods by a supplier which has not received the payment. In this situation, a client may pay the supplier directly to keep the project on track.

However, this could mean the client paying twice for the same goods, and may be illegal if the supplier being paid is seen to be getting preferential treatment ahead of the main contractor’s creditors.

One way of avoiding such issues is project bank accounts. These are set up so that a payment from a client effectively goes direct to the intended ultimate recipient. This also highlights one of the major causes of insolvency in the construction sector: the stagnant cash flow that pervades the industry.

In the absence of project bank accounts, which are seldom used, project teams must consider whether they have done all they can to avoid late payment – and the risk of being affected by insolvencies.

Assad Maqbool is a partner at Trowers & Hamlins

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