Preparing for supply-chain breakdown

Preparing for supply-chain breakdown

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As the UK emerges from the COVID-19 pandemic, the domestic construction industry can look forward to a bright but challenging future. Mortgages are at record lows; housing demand remains high and the wider economy is in optimistic mood. However, businesses are experiencing challenges associated with sourcing raw materials, staff shortages and the prospect that more companies will likely fail as government business support measures tail off.

Already some of the Government’s Covid-support measures have expired (such as the suspension of liability for wrongful trading expired in June) and others will fall away shortly. At the end of September, the restrictions on the use of statutory demands and winding up petitions are due to expire and the new prohibition on using ‘ipso facto’ clauses (i.e., contractual rights that entitle suppliers to walk away from a customer that becomes insolvent) will apply to small company suppliers. Given the relaxation of the above restrictions, many are forecasting an increase in insolvencies in the coming months.

How can parties prepare?

Employers and contractors can reduce their risk by undertaking enhanced due diligence before embarking on any new relationship, looking out for any profit warnings or signs that sub-contractors are being paid late. A careful review of the latest accounts may reveal details as to their relative financial health, the status of their project finance arrangements or over-reliance on any key customers. 

Parties should continue to monitor any press reports or word of mouth warnings about an employer or contractor’s financial position. In the international context, for those using the FIDIC Contracts, there are requirements for the employer to provide reasonable evidence indicating its ability to pay the contract price, failing which the contractor is entitled to terminate. Contractors should be prepared to be more zealous in making such requests.

A sub-contractor may seek protection in the event that the contractor fails to pay. This might take the form of a parent company guarantee, or alternatively make use of a retention bond or project bank account to ring-fence funds. Alternatively, it might be possible to secure direct payments from a bank or the employer to the sub-contractor in the event of a contractor’s insolvency.

Construction contracts can also include provisions to mitigate against the risk of employer or contractor insolvency. For example, short payment periods may help to avoid a scenario where invoices do not fall due for payment until after a counterparty enters insolvency. Sub-contractors may look to use retention of title rights to ring-fence materials in the contractor’s insolvency. Enhanced termination rights may enable contractors to walk away before an employer enters formal insolvency proceedings.   

What to do if insolvencies arise?

If a contractor or employer enters insolvency, some counterparties may look to cut ties and move on. Here caution is needed as, whilst standard contracts such as those with JCT and NEC contain clauses that allow contractors or sub-contractors to terminate upon an employer’s or contractor’s insolvency, the Corporate Insolvency and Governance Act 2020 now prohibits the use of so-called ipso facto clauses. The new section renders void any clause in a contract for the supply of goods or services that provides for the contract to terminate, or entitles the supplier to do any other thing (such as changing pricing, payment terms or credit periods) because the customer enters a relevant insolvency procedure.

However, it’s worth noting, these restrictions still allow for termination with the consent of the court, the insolvency officer or the company that enters into a relevant insolvency procedure. They also seek to prevent a supplier from terminating a supply contract upon a customer’s insolvency with a view to ensuring continued supply.

In addition, section 112 of the Housing Grants, Construction and Regeneration Act 1996 (the “Construction Act”) provides a statutory right for a supplier to suspend performance upon non-payment. There remains no guidance addressing this potential conflict in the legislation, so for now if the Construction Act applies, constructors may choose to rely on the statutory right to suspend performance as opposed to any contractual right to do so.

There are also other considerations. For example, if an employer or contractor enters administration, the statutory moratorium will prevent a counterparty such as a sub-contractor from taking certain actions against the distressed business without the administrator’s consent or court’s permission.

So long as it does not involve any legal proceedings, a moratorium will not prevent a counterparty from exercising its contractual rights, such as termination or retention of title rights (although it will fetter a sub-contractor’s ability physically to repossess the goods). Sub-contractors who seek to exercise retention of title rights should tread carefully in any event, especially if the relevant materials have been fixed to the building (in which case ownership will have passed to the employer).

Administration often results in a sale of all, or part, of the business. If the business continues trading, the buyer may want to fulfil any incomplete contracts, and there may be scope for negotiation around future performance. Where there are no other interested buyers, a counterparty may consider purchasing part of the business itself to ensure the construction is completed.

If an employer or contractor enters into formal liquidation, sub-contractors are often left out of pocket, as they usually rank as unsecured creditors. One way to address this risk is to utilise set-off rights where available, with a view to setting off sums owing to the sub-contractor against any claims made against it.

Prepare for the worst

According to the Insolvency Service, the construction industry experienced the highest number of insolvencies in the 12-month period ending Q2 2021, with 1,801 insolvencies and significantly more than those in the second highest industry (accommodation and food services at 1,474 insolvencies). Whilst this reflects the larger number of active companies in construction relative to those in other industries, it also serves as a warning to act with caution when dealing with others.

This article was first published in Building, see here


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