From red flags to rate rises – a developer’s survival guide to contractor fragility

Few industries are more reliant on sentiment than construction. Long timeframes and high upfront costs force developers to bet on future demand, and confidence is invariably a key factor in any investment decision. So it’s ironic then, that developers – so well versed in reading the runes of the market when building their business cases – can sometimes be unaware of changes in sentiment once construction is under way. Clearly such lack of information can have disastrous results if a contractor goes bust halfway through a project.

Such a prospect may seem unthinkable during the tender process, when bidding contractors have their game faces on and everyone is excited about the challenge ahead. But the blunt truth is that construction has the second-highest new company insolvency rate of any corporate sector. In the 12 months to the end of Q2 this year, more than 2,600 construction firms went to the wall.

Companies with debts will be placed under growing pressure in coming months

While the rise in the Bank of England base rate has yet to significantly increase the cost of borrowing for contractor firms, those with debts will be placed under growing pressure in coming months.

It can be agreed therefore that developers’ due diligence of their supply chain shouldn’t end with the tender process. Clients need to remain alert to changes in their contractors’ performance, not just because of the immediate impact it can have on the project, but because such changes can be a warning of deeper problems below the surface.

But what to look out for? Here is a helpful list we put together of 10 question to ask, with answers that provide red flags to indicate if a contractor is in financial trouble:

1) Have the main contractor’s direct employees not turned up for work, or is there a decrease in labour on site?

2) Is building work slowing down substantially or have plant, equipment and materials “disappeared” from site?

3) Have subcontractors such as electricians, carpenters and plasterers not been paid?

4) Is completed work increasingly defective or of a sub-standard quality?

5) Has the contractor attempted to negotiate further payments, release retentions or seek changes in payment patterns?

6) Did it make spurious or unjustified claims or contra-charges to hike up the contract cost?

7) Has it assigned, or attempted to assign, the proceeds of the building contract to a bank or other creditor?

8) Is it late filing accounts or annual returns at Companies House?

9) Does the contractor have unsatisfied court judgments or is there anecdotal evidence about its financial position

10) Has the contractor’s parent company, or other companies in the same group, displayed the warning signs listed above?

While some of these telltale signs will be immediately obvious on site, others will require the client to carry out some investigation into the contractor’s finances, and those of the guarantor (should it have one).

Whether this is done through background research, or by putting the contractor on the spot and asking some direct questions, it’s essential that any developer who suspects their contractor is in financial trouble acts fast.

Clearly the first thing to check is how much has been paid to the contractor so far, and if they have been overpaid. Developers should also conduct an audit to ensure all on-site plant, equipment and materials cannot be removed.

The initial contract should include a retention clause – a sum, typically 5% of the total cost, that the client need not pay to the contractor until the project’s certification. But it’s worth checking there is also an abatement in place. This is the common law right to reduce the price or value of work if the work delivered is defective or incomplete.

If the worst happens and the lead contractor goes bust, the developer may need to make direct payments to subcontractors, suppliers or professional consultants, so it’s important to check what the legal implications of this might be.

It is also prudent to check all insurance obligations have been met, as well as who has rights over designs. Developers should obtain copies of any design files or documents, including those from subcontractors and consultants.

While litigation should be seen as a last resort, worried developers should immediately scrutinise all collateral warranties and seek legal advice on whether the contract can be terminated – and what the rights of third parties are in such an event.

Cynical as it might sound, if a contractor is in distress, the best way for a developer to limit their risk is “ABC” – assume nothing, believe nobody and check everything.

 

Gareth Belsham is a director at Naismiths