Experts offer guidance on navigating construction industry's insolvency storms as 11 companies enter a formal insolvency process each day

In figures released on Friday 28 July 2023 from the Insolvency Service, the total number of registered company insolvencies in England and Wales during Q2 2023 was 6,342, the highest since Q2 2009 and up by 9% compared to Q1 2023. The construction industry was again the hardest hit (a trend going back over a decade). Whilst more construction companies went into administration during Q2 compared to Q1, significantly higher numbers went quietly into liquidation during the same period, at an average rate of around 11 per day.

Construction and Insolvency experts from law firm Womble Bond Dickinson have come together to offer guidance to businesses on navigating the construction industry’s insolvency storms to support companies to protect their businesses, finish their at-risk projects, and mitigate their losses.

A guide to insolvency terminology

Each week we are seeing stories in the news about construction companies becoming "insolvent", going into "liquidation" or having "administrators" appointed. But what do these terms mean? Insolvency is a complex area of law with its own terminology, so we've broken down what all the terms mean below.

What is insolvency and what happens to a company when it is insolvent?

The main piece of legislation that governs insolvency in the UK – the Insolvency Act 1986 – does not actually define insolvency. From a legal perspective, companies are legal persons. They're effectively born (when they're "incorporated") and they also cease to exist (when they're "dissolved"). Somewhere in this legal life, they may experience financial distress and become unable to pay their debts. This, in a nutshell, is the concept of insolvency from a corporate perspective: an ability to pay one's debts, it's essentially a state of being.

When a company is unable to pay its debts, it is very likely that it will enter a form of insolvency procedure under the Insolvency Act. For construction companies, the main procedures here could include administration, creditors’ voluntary liquidation and compulsory liquidation. 

What does it mean when a company goes into administration?

Many construction companies that are insolvent go into administration. In short, administration is a procedure where a company may be reorganised or its assets realised without fear of those who are owed money by the company ("creditors") taking action against it (known as a "statutory moratorium"). 

An administrator is appointed over the company, who takes control of the company's business and assets from its directors, and whose job it is to implement the strategy for the company's rescue or asset realisation. At the end of the administration, the business may have survived and the company been rescued, or the business and the company's assets may have been sold by the administrator. The administration ends with the company either being dissolved or the company going into liquidation.

There are various ways in which a company may be put into administration: by the court or by an out-of-court procedure available to the company itself, its directors, or a holder of a qualified floating charge (a person who has a security over the company's assets).

What does it mean if a company places itself into creditors' voluntary liquidation (aka "CVL")?

CVL is a procedure that an insolvency company places itself into voluntarily on the recommendation of its directors and the agreement of its shareholders (hence the 'V').

A liquidator is appointed, who the company's creditors have the opportunity to choose (hence the 'C' and the 'L'), whose job it is to collect in and sell the company's assets and distribute the proceeds to the company's creditors. At the end of liquidation the company is dissolved. Liquidation is therefore also referred to as 'winding up' or the company being 'wound up'.

What is compulsory liquidation?

This is the other form of insolvent liquidation, this time instigated by a "winding up petition" (typically presented and forced upon the company by one of its creditors) and resulting in a "winding up order" being made against the company by the court (hence the 'compulsory').

When a winding up order is made, the Official Receiver is appointed as liquidator (effectively a 'state liquidator'), who again collects in and realises the company's assets and shares out any proceeds with the company's creditors.

In both forms of insolvent liquidation (CVL and compulsory) the powers of the company's directors automatically cease (and in the case of compulsory liquidation, they're also automatically dismissed from office). The liquidator's powers in both cases also include continuing or bringing legal proceedings in the name of the company.

Why is construction so vulnerable to insolvency?

Whilst on average around one construction company has been going into administration every other a day over the last few months, liquidation has been the far more prevalent insolvency procedure to darken the industry's door in this period. In fact, the Insolvency Services' quarterly statistics show that, of the 1,049 total company insolvencies within the construction sector during Q1 2023 (which includes other corporate insolvency processes), only around 4.5% were administrations, whereas 94.6% were liquidations. Of these, the overwhelming majority were CVLs (82%).

Why is it then that are more construction companies going into liquidation? There will be no one, single answer, but (as a general rule) companies with an underlying business and assets (which are capable of being saved) tend to go into administration - whereas construction companies may often own limited assets (such as plant and machinery) themselves and their construction projects may have already ground to a halt, with unpaid subcontractors and suppliers walking off site and ceasing to provide (or even taking back) materials.

So, hopefully the next time you see something in the press about insolvency in the construction industry, you will now have a deeper insight into what process the company has gone into, and will be able to read between the lines on why that may be the case.”

How to spot a business on the cusp of insolvency

Those involved in construction projects need to remain vigilant against the risk of someone in their project becoming insolvent, or experiencing operational distress in the lead up to a formal insolvency. 

That said, it's unlikely that another party in a project would tell you about the state of their solvency or their concerns about their business (or at least in sufficient time). Equally, the people in a business who you work with day-to-day may have no idea what their wider organisation is grappling with in terms of slow cashflows, dwindling profit margins or unexpected financial impacts.

So, what could or should you look out for if you have concerns about another party's solvency?

Scanning for danger

Being alive to possible indicators that an employer, contractor or subcontractor could be facing financial difficulties to the point that they may be about to enter an insolvency process is vital. It's not an exact science but there are some things you can keep an eye out for, including them:

• Having or seeming to have cash flow issues
• Paying supply chain invoices or employees’ wages late, or even not paying them at all
• Revisiting payment terms and trying to re-negotiate them
• Being the subject of persistent industry rumours that focus on their financial position and stability
• Making official announcements to shareholders or the market about their financial performance
• Stopping or suspending work without giving any explanation
• Making changes to the project by scaling back or omitting some of the works, where these changes are uncommercial and surprising
• Unexpectedly removing their staff or personnel from the project or site
• Filing their accounts or annual returns at Companies House late (these have to be filed within 9 months of a company's financial year-end)
• Having court claims issued or judgments entered against them.

The above are all common precursors to a company entering administration or liquidation. Whilst you may get some (albeit limited) notice of a company entering a formal insolvency event itself, for example that one of its creditors has presented a petition to wind up the company, its financial plight will inevitably be terminal at this point. In other cases, you may only find out after the event, such as when a notice is filed of administrators having already been appointed over the company.

Alarm bells ringing? Act now!

As they say, forewarned is forearmed, so if you're on alert and have spotted an early warning sign there are a few things that you can do to get ahead of the curve. From there, you can work out what your options are and next steps should be.

These all essentially involve taking pro-active steps, rather that passively reacting to events as they happen. For example, you could:

• Keep an eye on Companies House online, which allows you to 'follow' companies that are causing you concern for free. For example, an alert will be sent out if and when a company files their accounts. Whilst Companies House is only as good as what a company has filed, a search would also show the lack of filings
• Search the Gazette, a UK official public record, where notices relating to company insolvencies (such as the presentation of a winding up petition) have to be advertised. You can also subscribe for the Gazette's data service
• Search the Central Registry of winding up petitions, which not only records the presentation of a winding up petition but also shows whether a notice of the appointment of administrators over a company has been filed at Court. A search will reveal these in real time, whereas notices published in the Gazette typically only appear after the event
• Search the Register of Judgments, Orders and Fines for County Court Judgements, which would reveal any Court judgments against a company
• Obtain a credit report for the company, which often helpfully package up publicly available information, including from the above sources, in one place
• Engage a specialist business data intelligence / creditor services provider, who offer bespoke products, have access to more data and can give a better insight into a company's financial position.

The results of your investigations may not reveal anything if the party you are looking into is at an early stage of its financial difficulties. Alternatively, when the information is pieced together, it may reveal a concerning outlook for that party, and therefore also for you.

Either way, you need to consider what do to next with the information that you have.

It is important for companies to act swiftly if they consider that a business in their supply chain may be in financial difficulty. Taking advice at an early stage as to the options available will help you to make the right decisions to protect your business and your construction project. We're living in a data age, so it's not unsurprising how much information is in the public domain, relating to the financial health (or ill health) of a counterparty, which companies can be monitoring and harnessing to their benefit.

How to protect your business, construction projects and supply chain from insolvencies before you’re on-site

It is important to consider insolvency from an early stage (before you sign your construction contracts on the dotted line), and then keep an eye out for warning signs and act on them.

The terms in your contract

When negotiating your construction contracts, think about suspension and termination clauses. Whether you are an employer, contractor, or subcontractor, including a clause that allows you to suspend your work or terminate the contract if the other party becomes insolvent can protect you. Thoughtful drafting is needed, for example to spell out what "insolvency" means, the parties’ rights, and the effect of the suspension or termination including on others who are not party to the contract, like funders. 

It’s also worth paying special attention to retention of title clauses. If you are a contractor, subcontractor or supplier, these clauses can help you retrieve your goods or materials if they aren't fully paid for (although ownership of goods often passes to the buyer, even if they haven’t fully paid, once the goods have been incorporated into the building or attached to the land). Again, you'll need careful drafting to allow you to retrieve items, otherwise e.g. you might be guilty of trespassing in trying to get your goods back. Bear in mind that even with a well-drafted clause, retrieving your items may not always be possible in practice.

Look out for "pay when paid" clauses. These clauses are prohibited under the Housing Grants, Construction and Regeneration Act 1996 – but there's an exception to this rule where there's an "upstream insolvency". This means a party doesn't have to make a downstream payment if its own payment is withheld upstream because of insolvency. So, if you are a contractor and your employer doesn't pay you due to their insolvency, you would not have to pay your subcontractor - while this is obviously not a great position for the subcontractor, it can avoid pushing you into your own cashflow issues. If you want this right though, you will need specific wording in your contract.

Other "ancillary" contracts

Before the project starts, there may also be other contracts worth considering which could help bolster your position in the event of insolvency:

• Collateral warranties and third party rights: If you are an employer, these agreements create a direct contractual relationship with other parties you would not otherwise directly contract with, like subcontractors. The benefit of these is that if the contractor becomes insolvent you still have the relationship with the subcontractors – you might be able to step into the subcontracts they had with the insolvent contractor to complete the project (if the collateral warranty or third party right wording allows, and if this is practically possible), and you can still hold them to account if they have not carried out their subcontract works properly. While it will not help you with the rest of the works, at this point, something may be better than nothing, and having the option may prove valuable
• Parent company guarantee: the contractor’s parent company may provide this to the employer, to guarantee the contractor's performance and cover the contractor's liability for breach or (if the drafting is clear enough) insolvency. In practice though, it may be that if the contractor is in financial difficulty, its parent may be too depending on its other assets
• Performance bonds: a bond can guarantee the contractor’s performance, allowing the employer to recoup some of its losses – but the drafting has to be clear to cover insolvency, and the bondholder has to be paid upfront (a cost which the contractor may be expected to cover, but which is likely to find its way back to the employer in some way in the tender price)
• Project bank accounts: the contractor may want to try to protect itself by requiring the employer to ringfence the money for the project in a specific account so that if the employer gets into financial difficulty, the money for the project is protected and the contractor can be paid. In practice, though this is rare, and there may be a cost for running this account.

Other pre-contract practical steps

There are other steps you could take, including running a credit check on the other party before you contact with them, checking the company's filings at Companies House, and obtaining a business data intelligence report on the company.

What to do when insolvency looms on-site

Once the project is underway, you can protect yourself, for example, by keeping good records to help you evidence any losses that may arise out of an insolvency, whether you are an employer, contractor or subcontractor. For example, this could include recording what materials and equipment are on site and what has been paid for. If an insolvency then occurs, you will already have this information to hand and can act quickly to protect your interests.

Once the project is underway, and it becomes apparent to you that the other party is struggling financially, consider the following:

• Review your contracts promptly: check what your contract says and whether it includes any of the clauses, and whether you have any of the ancillary contracts, that we've referred to that could help you. Once you know what your options are, you can decide the best course of action
• Seek expert advice: get advice promptly from whichever insolvency experts you choose to use, as this can help you keep your options open, for example there may be circumstances in which you wish to institute insolvency proceedings, rather and wait for someone else or the company to do so itself
• Dispute resolution strategy: adjudicating before the other party becomes insolvent could mean the difference between securing payment before the insolvency as opposed to ending up in the queue of unsecured creditors with low prospects of payment or repayment. However this process of itself could force the other party into an insolvency process
• The Third Party (Rights Against Insurers) Act 2010: These laws help a party to bring a claim against the insurers of defaulting insolvent companies. For employers, if latent defects arise after practical completion and the contractor has become insolvent, a claim may still be possible if the defects are covered by the insurance policy.

What next?

Bear in mind the above when negotiating contracts and carrying out projects. Also consider whether other protective options are available depending on, for example, the specific nature of your project, your commercial bargaining power, your project or company structures and more.

Insolvency up and downstream is inevitable in periods of economic uncertainty. It is important that businesses look to protect themselves not only via their contractual processes but also by ensuring that the financial issues with contracting parties are dealt with swiftly.