Managing insolvency risk

Just as the threat of contractor insolvency is now constant, so too should be efforts to identify and mitigate it – at every stage of the asset lifecycle.

Contractual tensions, litigious behaviours, stressed supply chains and constrained cashflow to the supply chain are all disruptive in their own way as well. Picking up on these early signs is crucial to the more disruptive threat of insolvency.

Here’s a summary of what to watch for, what to work on, and when:

Investment decision

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With inflationary and insolvency threats running in tandem and the UK economy’s outlook uncertain, clients who have yet to start procuring may wish to revisit their original decision to invest. The key question to settle is whether the project’s expected outcome is still aligned with the business’s needs.

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This process should also include scenario planning for the full lifecycle of the asset, not just the construction phase. These calculations should add empirical evidence to the hypotheticals, helping the client answer three critical questions; what is their attitude to inflation and insolvency risk, how big a cost uplift would they tolerate as a result of either, and how much will the return on investment need to rise by to justify the increased capital expenditure?

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Even at this early stage, clients should plan their project strategy at a programmatic level. Overlapping challenges are best tackled when the ‘brilliant basics’ of design, project and cost management, planning and scheduling are executed together – and programme teams are empowered to divide and conquer complex individual issues while still working towards a common goal.

Pre contract and procurement

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In the current environment, the procurement team should give equal weight to a bidding contractor’s financial stability as to their past project expertise and experience. This assessment should also consider:

  • The contractor’s current workload and whether its business is disproportionately leveraged on one client or project
  • Their existing exposure to project risk and contractual obligations, and their ability to continue if a key client or project were to get into difficulties

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Procurement teams should look beyond low cost to determine the value offered by competing bids. The prequalification process should factor in the financial security of the bidding firm, awarding bonus marks to those which can offer parent company guarantees or performance bonds. Where a prospective contractor refuses to provide a guarantee or a bond, it may indicate a lack of confidence on the part of a bank or parent company in their ability to perform the contract, and should be investigated further.

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The client must check and confirm that the contract is in place before the contractor commences work, and that the contract includes appropriate clauses to protect the employer in the event of insolvency. JCT and NEC contracts include the required provisions for termination in the event of insolvency and inadequate performance.

Projects in flight

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Pre-emption is always better than cure, and project controls should serve as both an early warning – and correction – system. Project managers must maintain accurate, real-time progress and defect reports, tracking all activities against the construction programme and documenting key milestones. In addition, project teams should carry out regular pro-active health checks, reviewing contractual procedures and confirming that contracts are fully signed and agreed, and that bonds are in place.

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Clients need to be alert to any signs of contractor distress (see red flag checklist below) while also supporting their contractors and suppliers. In practical terms, this means re-running credit checks and challenging contractors and suppliers on their ability to continue delivering, while also seeking to understand and allay their concerns.

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If a contractor does become insolvent, speed is of the essence. The site must be secured immediately to prevent the removal of plant or materials, and a full valuation of the works should be undertaken, documenting progress with photographs or videos. Records should be compiled of all additional costs incurred by the employer as a result of the insolvency – as these may later form the basis of a legal claim.

The distressed dozen: 12 red flags to watch out for

Clearly contractors are unlikely to volunteer to a client that they are struggling with cash-flow. But there are several tell-tale signs that can reveal all is not well with a supplier.

These can range from the operational – such as a fall in productivity or the contractor reporting unexplained difficulty in securing labour or materials – to the financial. Here’s a list of warning signs that may indicate a contractor is in distress:

Schedule

Financial

Slipping standards

  • Unexplained difficulty maintaining progress with the works
  • Unexplained and impractical resequencing of the works to maximise cash-flow
  • Demands by suppliers and/or subcontractors for direct payments by the employer
  • Attempts to inflate interim payments, for example by completing bulk areas of work and leaving complex finishes or final fix incomplete
  • Lack of labour, plant and subcontractor resources on site, or failure to pre-order long lead materials on time
  • Failure to pay suppliers and/or subcontractors on time
  • Unexplained removal of materials or plant from the site
  • High staff turnover
  • Attempts to negotiate more frequent valuations, shorter payment terms and early release of retention money
  • Court judgements made against the contractor
  • Warnings from suppliers, subcontractors, consultants or other clients
  • A change in the nature or frequency of correspondence, or a failure to respond to telephone calls, letters, emails etc

While the above warning signs may all suggest that a contractor is at risk of insolvency, each could have another, completely innocent explanation. Concerned clients must take care not to overreact, and nothing should be done to pre-empt an insolvency or act outside the terms of the contract.

Clients should always follow the contract provisions strictly and make detailed and evidenced assessments of sums due, to ensure no overpayments are made.

If faced with some of these warnings, clients should also consider engaging with senior leaders from their contractor or suppliers to articulate concerns.

Prevention is always better than cure

When a contractor goes bust, the impact on a construction project is always instant, sometimes severe and often long-lasting.

Their failure to complete part of the works invariably has a knock-on impact on later phases, and the sequential nature of most projects means there is typically a link between both delays and cost increases.

Contracts typically afford clients some protection from the fallout caused by a contractor becoming insolvent, and may include scope for financial redress, but their role is more palliative rather than preventative. That’s why clients and their programme teams should:

  • Work together to reduce the risk of insolvencies disrupting the project in the first place. Starting in the business case / pre-contract phase, and throughout the procurement process, care must be taken to assess each potential contractor’s insolvency risk.
  • Once the project is in-flight, put in place robust early warning systems to detect the tell-tale signs listed above. When a red flag is raised, further enquiries should establish whether the signal really is the product of contractor distress, and if so, corrective action should be taken to support the contractor and stave off insolvency.
  • Be realistic and accept that it may not always be possible to save an indebted, overleveraged contractor from failure. Nevertheless, procurement teams can, and should, take steps to avoid appointing weakened suppliers in the first place.
  • During the construction phase, clients can mitigate their insolvency risk by being alert to the early warning signs of contractor distress and engaging with their suppliers to offer practical, pragmatic help where necessary.
  • Finally, when it comes to quantifying and containing the danger of contractor failure, clients should beware of making short-term savings that incur far greater, long-term costs – both in insolvency detection and mitigation, and in the approach to net-zero and sustainability.

Seldom has the logic of ‘spend now to save in the future’ been more compelling than it is in relation to the management of insolvency risk. Clients must adopt a proactive, pre-emptive approach to mitigate the threat of contractor failure, throughout both the procurement and construction phases. Failure to do so will, in many cases, be an unacceptable risk. Far better for the client, project team and supply chain to work together, to provide a safety net rather than a stretcher.

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