Under Pressure: Struggling Supply Chains

By Matthew Friedlander and Tanya Chadha

In the construction sector solid cash flow throughout the supply chain is the lifeblood of most projects, no matter what size, and is arguably the single most important factor in ensuring that a project reaches its conclusion. However, the cumulative effect of various other factors such as Brexit, escalating global energy prices, the outlawing from 1 April 2022 of the use of the red diesel usage for construction plant, super inflation, higher material and labour costs and the end of government COVID-19 support schemes has led to increased lending costs and smaller profit margins.  As such, the construction supply chain is likely to come under ever increasing pressure in 2022.

When cash flow dries up significantly, it may become a trigger point for insolvencies in the construction sector which in turn, may cause devastation to organisations at all levels of the supply chain. It was recently reported that there has been a steady uptick in insolvencies in the construction sector from October 2021 to December 2021 and some commentators have observed that the construction sector faces a decisive 6 months [1].  In the latter part of last year, we saw several construction insolvencies including the likes of sizeable NMCN.

Where construction projects are likely to be affected by insolvency, interested parties must take all relevant and necessary steps to protect their position.   Whilst insolvency situations in the supply chain are almost always difficult, they do not necessarily have to be catastrophic for other parties involved.  There are various contractual, commercial and practical steps that parties (whether employers or contractors) might consider.

Pre-Emptive Measures

Generally speaking, the best way to reduce the impact of insolvency is to plan for the event in advance of its occurrence through contractual mechanisms.  Given the turbulence predicted for 2022, this has become all the more important. Parties may wish to consider the following pre-emptive measures at the outset of a project.

    • It may sound obvious, however, carrying out checks on the financial status of a party before entering into a contract is a good starting point.
    • Consider obtaining a parent company guarantee to guarantee performance and / or cover liabilities and losses in the event of a party’s insolvency;
    • Obtain collateral warranties from those parties with principal design or construction responsibilities to provide a contractual cause of action against those parties to ensure that multiple potential avenues for claims exist; Insurance cover may be available to protect against an insolvency event;
    • Decide up-front how insolvency events should be dealt with and include express drafting in the contract to reflect that. In particular, how and when will the account be dealt with and what happens to unpaid sums;
    • Define what an insolvency looks like. Contractual definitions of insolvency can vary from when a party enters into a formal insolvency procedure as mandated by the Insolvency Act or to something more flexible such as the failure to pay a debt that is due. Defining insolvency, should help to give certainty regarding the point at which insolvency rights and entitlements under the contract are triggered;
    • Retention of title clauses may be a way of limiting the impact of insolvency upon unpaid suppliers and in that same vein, consider the use of vesting certificates which transfer title once payment has been made;
    • Consider step-in rights in the event of insolvency;
    • Don’t ignore early warning signs that a party may be in financial distress. For example, a failure to pay sums due on time or at all, unexpected suspension of work or a reduced workforce or public statements regarding profit warnings.

Reactive Measures

Should a party in the supply chain become insolvent, it is time to consider carefully the existing rights under the contract. We consider below some the reactive measures that can be taken.

    • Be decisive and act quickly by checking the insolvency provisions in the contract. Does an insolvency give the other party the right to terminate the contract?  If so, it is imperative that notices are served properly and promptly;
    • Where does the account lie on termination? More often than not, the usual interim and final account provisions fall away and are replaced by termination account provisions.  It is important to apply the correct regime otherwise notices and certificates may be invalid;
    • Check what the contract says about making further payments to an insolvent party;
    • Review the account and ascertain whether a proof of debt should be submitted;
    • Consider whether there are any other ways to keep the project alive, for example, can fresh agreements be entered into for portions of the work?
    • What happens to un-incorporated materials that remain on site and who holds title to those?

Insolvency is not easy for any party in the supply chain. In addition to the pressures on the supply chain we identified at the outset of this article there remain many others. For example, in the years to come the construction sector will face considerable challenges around sustainability and ESG (environmental, social, and governance metrics) pressures which will create yet further budgetary concerns for projects.Where insolvency occurs it is important to be open minded and pragmatic insofar as the commercial realities of a business may allow. Nearly all businesses will face financial hardships at some point or another and whether that business will be able to trade out of that hardship is often impossible to predict. Nevertheless, provided that the strict terms of the contract are always adhered to, it is worth considering whether parties can work together and identify commercial solutions that give businesses the best possible chance of survival.  In the construction space, it is very rarely in anyone’s interest for a business to become insolvent. If the predictions for supply chain pressure in 2022 come to fruition, it may be that the best solution will be understanding and negotiation.  That said, where an insolvency is inevitable, parties must do what they can to protect their position and mitigate their own loss.

[1] Construction News, “Revealed: the 20 firms that went into administration in December”, 11 January 2022.

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The opinions expressed on this blog are those of the author and are not to be construed as legal advice.

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