Rising insolvencies in the construction industry

Answer

This article was originally published on 14 May 2024. 

In times of economic difficulty, insolvencies across all sectors are inevitable. But in the current financial climate, the construction industry appears to be particularly impacted by rising costs of raw materials, shifts in demand and a dwindling workforce.

In 2023, 4,370 construction companies entered into insolvency. This accounted for 17% of all UK insolvencies in that year, and this trend seems set to continue. According to the Insolvency Service, in January 2024, 16.6% of all insolvencies in England and Wales were construction-related companies. In a country where only 13.8% of registered companies are construction businesses, the industry appears disproportionally affected.

What’s causing rising insolvencies?

The construction industry is facing difficulties on several fronts. The high interest rates imposed by the Bank of England as a response to rising inflation has led to a lower consumer demand for residential housing in the form of new builds. This reduced demand for new builds has put pressure on construction firms operating in this sector, particularly civil engineering firms and sub-contractors specialising in related services. These reduced workloads have also contributed to a reduction in subcontractor charges as companies seek to provide more competitive rates for a reduced job list.

Once a contract on a development is awarded, parties must then contend with the rise in the cost of borrowing. The delay to (or outright failure to) obtain project financing can lead to longer lead times, cost overruns and amended schedules in the wider project. In addition, the increased costs for loans and other facilities utilised by the construction industry means that the margin for profit to be made on new work is limited. This is further compounded by high mortgage rates watering down consumer demand, meaning developers can’t realise the same profits that they once did.

This isn’t just limited to future contracts. Many ongoing construction projects are being undertaken on the basis of costs and rates negotiated years prior. The market has since shifted significantly, including experiencing a considerable rise in material and labour costs and increasing energy prices squeezing profitability and even viability in some cases.

The industry has also been facing a long-running concern over labour shortages. Brexit has meant the valuable source of workers from the European Union has reduced significantly, and the current UK construction workforce is ageing to the point where retirement numbers are outpacing younger generations joining the industry. Although this might be good news for the in-demand workers, this leads to higher labour costs for contractors.

What does this mean for construction firms and their lawyers?

Construction companies and their lawyers must be alive to the existing market pressures, spotting the risk of insolvency from an early stage as well as the impact of others in their respective supply chains, if entering into insolvency.

Construction firms should instruct an early review of their contracts and ensure that they’re aware of what happens in the event of an insolvency and prepare contingency plans. For new projects, it’ll be important to include clear contractual provisions as to what happens should an entity become insolvent. Some things to consider include:

• the rights of parties to terminate the contract in the event of a default or insolvency;
   
• the types of insolvency events that give rise to a right to terminate the contract – it’s important to ensure the counterparty has triggered an event of insolvency, otherwise you risk committing a repudiatory breach of the contract;
   
• the rights that the remaining parties have in the event of insolvency;
   
• steps following the insolvency such as the exchange of all relevant documents and drawings and removal of plant and equipment from the site;
   
• suspension of any payment obligations to the insolvent party until a final account can be settled; and
   
• if any ancillary contracts or warranties are dependent on the existence of the contract that involves a newly insolvent entity.

The above will provide clarity to parties in the event of an insolvency. However, other steps can be taken to help ease the pressure on the supply chain to ward off the risk of insolvency. These can include:

• ensuring a consistent and open dialogue with all members of the supply chain to keep aware of any issues that arise;
   
• requiring regular financial updates and reports;
   
• allowing for flexibility around payment obligations as to timings and value;
   
• addressing any cost or resource issues as early as possible through the life of the project; and
   
• revisiting prior cost estimates and calculations for projects that had been agreed years prior.

Rising insolvencies also create complications for dispute resolution processes. Claimants should be mindful of the different options for recovering costs. Many members of the supply chain, both upstream and downstream, might become insolvent in the years following a project, leading to a limited number of possible viable defendants. The rising costs of labour and materials, and the delays caused by longer lead times can also massively inflate claim values. This creates an element of unpredictability when considering which parties are liable to cover losses. This is particularly true for construction disputes that often involve multiple parties.

In addition, the construction industry may also see an increase in the use of the Third Parties (Rights against Insurers) Act 2010. Where an insured becomes insolvent, this act allows a third party to step into the insured's shoes, and the rights of the insured against the insurer are transferred to the third-party claimant. Although this process is limited to claims covered by the insolvent insured's policy, this provides another possible avenue of redress post-insolvency.

The construction industry may also see an increase in the number of applications for building liability orders under section 130 of the Building Act 2022 against contractors' associated companies. Building liability orders allow those pursuing contractors to "lift the corporate veil" and pursue other companies associated with the contractor if it can show that they controlled the contractor or that they were both controlled by the same company.

Where a member of the supply chain is on the cusp of insolvency, construction companies might consider using adjudication processes to secure payment quickly before the counterparty goes insolvent. Adjudications are designed to be quick and efficient dispute resolution processes specifically designed for the construction industry. These often provide a quicker resolution than the court process. However, it should be kept in mind that commencing an adjudication could unintentionally begin an insolvency procedure.  

Conclusion

The construction industry is facing many difficulties in the current financial climate. How the industry will adjust to these changing circumstances remains unclear. Construction companies and their lawyers must be alive to the impact of rising insolvencies and take action at the tender stage and throughout the lifecycle of a project to mitigate the significant risks and pitfalls that could await them.   

Lucas Johncey is a trainee solicitor at RPC.