Construction firms claim their early payment schemes give them flexibility, but critics say they are unfair to subcontractors and are killing growth. So who’s right?

Rudi Klein

I often wonder what would happen if I, as a small construction business, informed my bank that I could not pay my suppliers for four months. Instead I suggest to the bank that it could pay them earlier - for a fee - and I would pay back the bank at the end of four months. The likely response I would get from the bank is a petition for the winding up of my business.

But this is exactly what some of our largest contracting firms are doing. Earlier in the year Building revealed that the net cash holdings of the UK’s top five listed contractors, by turnover, fell almost 90% between 2011 and 2012 - from £621m to £46m. This is very worrying given that these firms are letting out billions of pounds worth of contracts. One of the top five, Carillion, readily admits that its early payment facility gives it “greater flexibility in terms of managing its own working capital”.

Research carried out this year by University College London for the Department for Business Innovation and Skills concluded as follows: “Construction firms are undercapitalised, compared with firms across the rest of the UK economy … This is especially the case for tier 1 and large contractors.”

These early payment schemes are reinforcing traditional business models in the industry that are dependent on supply chain financing. This kills any prospects for industry growth

The early payment facility agreement now being touted around by Carillion (and similar arrangements being offered by other firms such as Balfour Beatty and Kier) have come in for a great deal of criticism. The Scottish government has recently carried out a review of public sector construction procurement. The reviewers state: “We do not believe that a scheme which requires subcontractors to pay a financing fee to access funds they should be receiving anyway is fundamentally fair …”

Is the criticism justified? A close analysis of Carillion’s “early payment facility agreement” suggests that it is.

Carillion’s suppliers can receive payment of approved invoices/applications in advance of the contractual due dates or final dates for payment subject to a fee charged by the Royal Bank of Scotland. All this looks innocuous until you delve a little deeper. The early payment facility is only available if the supplier is prepared to sign a deed of amendment amending the underlying contract or subcontract. The due and final dates for payment now respectively become 112 days and 120 days from the date of the application. The facility is only available in relation to applications “approved for payment”. It is not clear whether the trigger for the 112 days is the date of the original application or the date of a revised application that has had to be submitted in order to obtain approval for early payment.

Carillion also has a right to issue a pay less notice even where it has approved applications. For suppliers there is a risk in this. Carillion is unlikely to approve any subsequent applications unless they reflect withheld amounts contained in Carillion’s pay less notices. If the supplier - in order to obtain approval - reflects the sum in a pay less notice in its applications, it will not be able to then dispute the withheld amount.

But matters get worse. Carillion can terminate the facility on giving 30 days notice leaving the underlying contract in place with 120 day payments. A fee is charged in respect of each invoice or application submitted to the bank for early payment. Carillion advises that the fees “equate to an annual interest rate of 2% paid on the invoice value times the number of days the payment is taken early”. Depending on the number of invoices or applications submitted and the amounts involved, the total of fees charged could be substantial.

It is not surprising, therefore, that the take-up of Carillion’s scheme has been poor. Building recently revealed that a similar scheme operated by Kier had only received interest from 12 firms.

These early payment schemes are simply reinforcing traditional business models in the industry that are dependent on supply chain financing. This is a cancer within the industry which kills prospects for growth. A recent conversation with one construction SME revealed that £1m was owed. If this was to be repaid immediately, the firm - which is now getting busier - would be able to take on apprentices and engineers, as well as establishing a new branch office.

The government is looking at statutory options for mandating 30-day payment periods. Such legislation was introduced this year in Sweden. The Construction Contracts Act 2004 in Western Australia outlaws all payment terms longer than 50 days. A new EU procurement directive will enable public bodies to pay supply chain firms directly in the event of non-payment by a lead supplier. Such measures are now necessary if we are to propel the industry towards growth.

Professor Rudi Klein is a barrister and chief executive of the SEC Group