Can construction hold back the insolvency tide?

Ben Harwood is Head of Asset Recovery at the national surveyors and property consultants Naismiths, here he gives us his opinion on how the COVID-19 pandemic is affecting the construction industry.

In ordinary times, insolvencies ebb and flow in tandem with the economic cycle.

As a sector that has seen more than its fair share of boom and bust, construction has also endured big tides of insolvency over the years.

The most recent official data shows that in the 12 months before the Covid-19 pandemic hit, nearly 3,100 construction firms went bust in England and Wales – a higher casualty rate than any other industrial sector.

That’s not a good place to be at any time. And it’s a terrible starting point from which to enter what may be the sharpest recession in a century.

Output collapsed in April as the lockdown forced many construction sites to close and disrupted the supply of both labour and materials.

The Construction Purchasing Managers’ Index for the month showed that activity crashed to a fraction of what it was even in the darkest days of 2009.

All this bodes very ill. And as the example of King Canute’s wet feet shows, no one player in the industry – not even the Government – can prevent the tide of insolvency from coming in.

Tide rather than tsunami

Nevertheless there are a few crumbs of comfort. In May the Government revealed that its vast furlough scheme is paying the wages of 7.5 million employees – a quarter of the private sector workforce – across 935,000 companies.

This unprecedented Government subsidy, which is due to last until the end of October, is easing the cashflow pressure on thousands of construction firms.

Together with the raft of other support packages made available, it should greatly reduce the casualty rate – meaning we are likely to see a steadily rising tide of business failures rather than a sudden tidal wave.

There is modest cause for optimism on the demand side too. New orders grew by 11.8% in the first three months of the year, meaning pipelines are technically fairly healthy, for now at least.

The question now is how effectively that work can be done. ONS data shows that output across the industry shrank by 5.9% in March, and April’s figure – the first full month after the lockdown was declared – is likely to be even worse.

Fortunately, with some work continuing even during the height of the lockdown, and construction being among the first sectors to see restrictions eased on 13^th May, thousands of firms – including Britain’s biggest housebuilders – are now back on site.

As a result, the most likely flashpoints as projects try to get back on track in the coming weeks will be contract disputes as clients and contractors face up to delays and cost overruns.

Contract crunch

While many construction projects are underpinned by standardised contracts – those published by JCT and NCE are the most common – the question of liability for any breach of contract, or what compensation must be paid for a delay, is likely to hinge on who ordered work to cease.

While it’s essential that everyone in the supply chain reviews their contracts and complies with any conditions requiring them to give notice of changes to the delivery schedule, they should be wary of assuming that simply pleading force majeure will exempt them from their contractual obligations.

For a contractor to declare a force majeure event, there must be a specific clause in the contract detailing what constitutes force majeure. Typically this will include dramatic and unforeseen events such as war or earthquake, but there’s no guarantee that disease or epidemic will be included.

It’s a similar picture with insurance policies. Standard business insurance typically only covers standard risks and is therefore unlikely to pay out for extraordinary risks such as the Covid-19 pandemic. Even ‘business interruption’ policies, which protect against more unusual events, tend to list the diseases they cover against. If Coronavirus is not listed, it’s not likely such a policy will cover the current reduction in trade.

Building defences

Wherever businesses are in distress – whether from non-payment by clients or a failure by suppliers to deliver – contract disputes and claims are likely. For now, some pragmatic players in the construction industry are showing forbearance with creditors and suppliers, driven by the knowledge that we’re all in this together.

But such truces are unlikely to hold for long if business confidence remains at its current rock-bottom level. With many construction firms in a precarious position even before the crisis hit, some will be driven to take drastic action in an effort to turn around loss-making projects.

In such cases, companies, their advisors and their accountants should assess, act and adapt to this unprecedented situation, as follows:

1. Act early and decisively: by engaging with suppliers and clients, and appointing specialist help where necessary.

2. Be honest and transparent: by providing up-to-date, accurate and concise information to clients about the impact on project delivery. Contractors should also communicate regularly with their lenders, as banking and debt covenants may be breached – and it’s essential that funders are kept onside.

3. Understand their rights and obligations: by reviewing all contracts and establishing whether they allow for extra time, or additional costs to be charged, to complete the work.

4. Feel the force: if a contractor is using a force majeure clause to defend against a legal challenge from a client, they will need to convince the court that the event was beyond their control and has hindered their performance of the contract. Above all, they must show they have taken all reasonable steps to comply with their obligations.

5. Build your way out of the crisis: have a plan for bringing furloughed staff back on stream gradually, and ensure self-employed subcontractors are paid promptly for their work to help them stave off insolvency.

Clearly, any contractor under pressure should make full use of the emergency support being offered by the Government.

Away from the headline-grabbing support measures, there are some equally valuable changes to tax rules that companies should investigate.

While the automatic deferrals of VAT payments are useful, care should be exercised as VAT liabilities will still be accrued while the can is kicked down the road. The changes to wrongful trading regulations have already given struggling companies a freer hand to act, and proposed further reforms to insolvency legislation – which would offer firms a moratorium while they consider their options and prevent suppliers from cancelling contracts – could all prove invaluable tools for turnaround specialists.

Ultimately the casualty rate will be reduced if all players – from clients to main contractors and subcontractors – are pragmatic with each other. Better to collaborate, renegotiating contracts or retendering where appropriate, than taking the nuclear option of a legal challenge.

While the pandemic will inevitably drive some contractors into the abyss and will force a painful recalibration of property values, construction companies and their accountants who are willing to think calmly and rationally – and take expert advice – will be better placed to rise with the tide rather than be swamped by it.

www.naismiths.com