Payment Charter: bad timing for main contractors, good timing for change?

Trevor Drury asks whether the new supply chain charter could indirectly reform the industry.

The construction industry, or certainly parts of it, has been talking about changing payment practices for years. But is that not what statutory adjudication was supposed to do – prevent those that sit higher in the supply chain holding on to money due to those that reside further down the supply chain pecking order?

Well, to a degree adjudication has brought about positive changes. For example, a main contractor will have to inform a subcontractor within five days of a payment due date of the amount that the subcontractor will receive. Also, within seven days of the final date for payment, if the main contractor intends to pay a lesser sum than it has previously notified, then it will have to issue a notice to pay less.

However, within the contract, the parties are free to agree payment terms that could be as much as 60, 90 or even 120 days from the due date to finally receiving the cash. This is all well and good if both parties have equal financial status and therefore equal negotiating power. The reality is that the subcontractor or supplier has to accept the payment terms on offer to them from the main contractor if they want the work, particularly in recessionary times. 

Or, if they want payment earlier, they can always enter the main contractor’s supply chain finance initiative, where for a discount, they can receive their money earlier and nearer what many would consider a fair period of time. So is it any wonder that  those sitting at Tier 2 or below in the supply chain have been lobbying for change?

The new payment charter drafted by the joint industry/government Construction Leadership Council seeks to commit signatories to paying within 30 days by 2018. There we have the first of a couple of major problems.

It is voluntary – it is not mandatory and so the large contractors or indeed clients do not have to sign up to such practices. Only eight companies have signed up so far: Barratt Developments; Berkeley Group; British Land; Imtech UK; Laing O’Rourke; Skanska; Stanford Industrial Concrete Flooring; and Stepnell.

2018 is three and a half years away… no urgency then? The charter says that 60 days should apply for contracts starting from January 2015 and 45 days for those starting by June 2015.

In addition, the intention is that retention, ie that percentage kept back from main contractors’ and subcontractors’ payments until the end of the defects rectification period, will be less frequent or eliminated altogether. A further drive is also for project bank accounts, which will be encouraged on public sector contracts.

Whilst abandoning retention helps main contractors, subcontractors and suppliers alike in terms of cash flow, having to operate on projects with project bank accounts is going to affect main contractors’ cash flow and reduce working capital.

Historically, main contractors have used positive cash flow to fund their speculative property development and also to make further money on the over-night money markets in the period between receiving the cash from the client and paying subcontractors and suppliers. This apparently allows them to keep the profit margins charged to clients for building, construction and maintenance low.

If main contractors have to work with project bank accounts, this will mean that subcontractors’ money gets paid direct from the project bank account and therefore does not touch the bank account of the main contractor, so the subcontractors get paid on time – ie within 30 days. 

Also, the main contractor will receive what is due to it when it is due, ie its preliminaries, any work that it has undertaken and not subcontracted, and overhead and profit.

The main contractor also gets paid on time, so everyone is a winner. But for main contractors the whole turnover of the project does not go through their accounts, so turnover on the balance sheet reduces and they do not have the subcontractors’ money for 30-120 days to use to fund their businesses. In other words, they lose working capital.

In the current climate, this is quite significant for main contractors as, coming out of recession, they will need more cash to fund expansion and the rising cost of completing projects won in the recession. Main contractors earn such low profit margins that without using subcontractors’ and suppliers’ money, they have little in reserve if they have to use project bank accounts or pay within 30 days as per the charter.

The construction industry cannot continue to operate in the way that it has for decades by passing the financial pain down the supply chain to smaller organisations that effectively fund the main contractors. The model is unsustainable.

No other industry operates with such low profit margins and high risk. Another criticism of the construction industry is the amount spent on research and development, or the lack of it compared to other industries. Other industries have to innovate and design products that we want to buy, develop, manufacture, market, distribute and sell those products with a significant upfront investment before they receive payment. However, their margins are higher to fund such a process. Perhaps the construction industry needs to operate along similar lines which will require a structural change?

Profit is not a dirty word and is necessary in order to pay a dividend to shareholders and to stay in business. Given the risks involved and in the majority of cases, superb buildings or structures, produced by the construction industry, profits need to increase throughout the supply chain to allow investment in research and development, to improve working capital and so that all in the supply chain get paid promptly. 

Clients will moan but in response, the industry must add value to the client experience and work more innovatively and drive out unnecessary costs, which all help profitability. Could we be at the point where we recognise the need for an alternative business model? 

Trevor Drury FRICS FCIOB MCIArb is managing director of commercial, management and construction law at consultant Morecroft Drury