Contractor insolvency - planning and prevention
Those in the construction industry, in particular those with contractors or subcontractors engaged, should be watching for warning signs of counterparties who are potentially at risk of insolvency and implement forward planning and mitigation steps in relation this risk.
Current trends and challenges
Inputs in terms of timber, steel and concrete have risen significantly. An increase of approximately 12% across the board on construction materials on a year-on-year basis has been observed. Contractors who are locked into existing fixed price contracts will unfortunately bear the brunt of those cost impacts. There is also pressure from increases in the price of fuel and energy. Domestically, we have seen the recent impacts to the electricity and gas markets, and internationally, factors such as the war in Ukraine and the embargo on Russian exports means that anyone who is using diesel operated equipment or generators is facing significant costs increases. The ongoing supply chain issues and labour shortages also continue to cause significant challenges.
There is an increasing nervousness around continuing to progress large scale residential developments. The continued impact of interest rate rises is looming, which has a twofold effect on the construction industry. This increases the cost of debt for construction firms and the cost of capital. It also impacts on the costs of those feasibilities for the developers. Many operators, particularly in the construction industry, may lack the ability in these more stressful times to manage and stress test their cashflow forecasting.
There are several warning signs that businesses should be on the lookout for from the contractors and other businesses they engage with, including:
- a slowdown in performance of works, project delays, or lapsed deadlines without any discernible basis for that happening, all of which could be representative of cashflow restraints;
- delayed payment of subcontractors or others within the supply chain; and
- a sudden drop in the level of performance of the work from a quality and programme perspective, which could indicate there are concerns about delivery of the works by the counterparty.
In the event a counterparty is insolvent
In the event a counterparty becomes insolvent, it must be decided how the works they were performing are going to be completed. The written contract will most likely set out the rights of the principal in the event of insolvency. Generally however, there are realistically three options:
- they may continue operating (for example, by way of restructure);
- step in rights may need to be exercised on a temporary basis; or
- the contract may be terminated.
It is important to consider the terms of the contract and understand the available rights, subject to any impacts that either the ipso facto regime or the Personal Property Securities Act 2009 have upon them. It is critical to understand the degree of access to materials, plant, and equipment and consider the insurance suite and understand what impacts, if any, the counterparty’s insolvency will have on these factors. If bank guarantees are held, then close attention will need to be paid to:
- whether certain rights are able to be exercised and called against; and
- when, if at all, the time constraints are to exercise those rights.
To protect businesses from the challenges of dealing with an insolvent third party, certain contingency planning can be carried out. In this process, key questions to ask could include:
- whether there is someone accountable for cash flow forecasting;
- whether those cash flow models are being updated on a regular basis;
- whether the data is reliable;
- whether the cash flow models are being stress tested; and
- whether there is a reporting framework within the business to appropriately test and consider the cash flow model and what it is predicting.
Obtaining an independent review of the contract that is being performed can remove any bias that the business might have as to the profitability, cash flow, or rights and considerations around those contracts. Engaging an independent party to stress test that analysis can be a helpful tool when dealing with periods of challenge.
Likewise, counterparty financial due diligence is important. Obtaining information from the construction firm in relation to their financials and qualitative information is useful. A financial capacity analysis can then be undertaken for both quantitative and qualitative aspects to stress test the financial integrity of that business.
Finally, businesses can get on the front foot of some of these potential risks at the tendering stage. In relation to tenders for future works, there is often scope for more rigour around requests for financial information during this process. Further, parties could require the introduction of reporting obligations into contracts in respect of finances on an ongoing basis to ensure an adequate level of rigour for future contracts.
This article provides general commentary only. It is not legal advice. Before acting on the basis of any material contained in this article, seek professional advice.
Author: George Panayotopoulos, lawyer in our transactions practice