Small firms have traditionally been subjected to commercial bullying and, despite all the legal and cultural reforms of the past 15 years, they still are.
As anybody who’s been shaved by a barber with a cut-throat razor knows, there are situations where you have to trust those with whom you enter into commercial relationships. And as every contractor in Britain knows, it takes a certain amount of faith to work for an employer whose thumbs are forever resting gently on your carotid artery …
The analogy is a close one. Money is, as Lord Denning declared, the lifeblood of the industry. And like blood, any interruption in the flow of money is a serious matter. Much of the complex legal structure that regulates the relationships within the industry is concerned with deciding who owes what and when they have to pay it. Every week, the courts produce new rulings, precedents and observations. And the major legislative development in recent history, the Housing Grants, Construction and Regeneration Act 1996, aka the Construction Act, was largely concerned with improving the circulation of cash. All of which raises an obvious question: why do so many firms still complain that the system doesn’t work? And why is the industry arguing so furiously over the upcoming review of the Construction Act?
The point of view of those towards the top of the payment chain is admirably clear. John Bradley, director of legal affairs at the Construction Confederation, had this to say about a government consultation document asking whether changes to the 1996 act were needed: “We are concerned that this document has been prepared largely on a misconceived basis. It appears to assume that payment problems are rife, whereas the opposite is true.
” The response from smaller firms further down the supply chain is equally clear: Bradley is wrong. They point to the Specialist Engineering Contractors Group’s estimate that, at any given time, about £3.2bn is being held as retentions. And if that weren’t enough, under the current mechanisms of the act, there is no legal requirement for a main contractor to clarify when it intends to pay its subcontractors, nor to provide a definite account of the amount due. It is required to issue a notice informing the payee of the amount to be paid, but there is no sanction for not doing so. In any case, the amount only becomes binding if agreed by both sides or if it is determined by a third party under the contract.
This uncertainty over when payment is due has caused misery for many smaller firms who cannot properly budget for future contracts and wage bills. Instead, they are forced to adjudicate to establish when a debt has arisen. The director of one subcontractor, who did not want to be named, said that in at least 95% of cases he did not know what payment he was going to receive until the money arrived. He said: “Unless there is a proper structure for establishing that we are owed money, the problem of payment abuse will continue, as there is nothing in the act stating what constitutes the debt and when it arises. We suffer greatly at the hand of main contractors.”
The Specialist Engineering Contractors Group has suggested that these problems could be remedied by an invoice system. This would allow subcontractors to bill contractors for the work they have carried out. The sum claimed would automatically become the amount owed, unless the main contractor challenged it by issuing a withholding-of-payment notice, along with reasons, within a short period of receiving the invoice. The move, the group says, would bring construction into line with most other industries, in which the party carrying out work is responsible for billing the client to ensure it is paid fully and on time.
Another concern is the time that a main contractor can legally wait before it has to hand over its first interim payment. The often lengthy gap between the subcontractor’s initial investment and its first interim payment, which is not due until work has commenced on site, has been exacerbated by the government-sponsored trend towards off-site construction. This can leave some firms with a huge initial outlay and a long wait before they see any return on it. Marion Rich, the legal and contractual affairs director of the British Constructional Steelwork Association, says many of her members have been hit by this wait as they attempt to engage more in prefabrication. “Steel contractors making prefabricated structures spend between 80% and 90% of their project cost before they get on site,” she says. “The impact on firms having to bear this initial cost is huge. We are calling for the law to be changed so payment starts when a contract starts.
I don’t understand why construction has such different payment terms to other industries.
There is nothing in the act stating what constitutes the debt and when it arises
Acting as the industry’s insurers
Another risk that subcontractors must bear is the chance that they will be shut out of their money if a firm north of them in the supply chain goes bust. This problem is made worse by the current legislation, as pay-when-paid clauses are perfectly legal in cases of upstream insolvency. “The act currently expects the subcontractors to act not only as insurers of main contractor insolvencies but also of employer insolvencies,” says Rudi Klein, chief executive of the Specialist Engineering Contractors Group. “We should get rid of pay-when-paid unequivocally.”
There is also concern that pay-when-certified clauses, under which a contractor is only obliged to pay its supply chain once the work on the main contract has been certified complete, are effectively being used as pay-when-paid clauses. “Pay-when-certified clauses exist solely as a means of getting round the ban on pay-when-paid conditions,” says Klein. This may or may not be true, but the problems that can arise from certification are made clear in the case of Hilton Building Services. The firm is owed £90,000 in retention money for work it completed on Hull City football stadium in 2002, as main contractor Birse Construction has not received its overall certification for the project.
Retentions death warrant
The abolition of retentions is perhaps the pre-eminent policy goal of subcontractors. Retentions enable a client to keep a proportion of the value of the contract, typically 5%, as insurance against defective workmanship. The sum is disbursed once any defects have been rectified. The Construction Confederation may argue there are no widespread payment problems in the industry, but as far back as 2003 a House of Commons trade and industry select committee acknowledged the pressure that retentions place on small firms. A report into the practice states: “The retention system is a very considerable burden upon the industry, especially the small and medium-sized companies that make up the bulk of the construction sector.”
The committee’s view is borne out by a glance at the balance sheets of specialist firms. M&E contractor Goodmarriott and Hursthouse estimates that 25% of its £4m balance sheet is tied up in retentions (see case study, above left), and there are companies operating on far smaller margins that are experiencing the same problems. One £2m turnover company claimed it has a retention account of £116,249 spread over 317 contracts. Another small contractor, who did not want to be named, says that as much as 20% of his firm’s turnover was held on retentions at any one time. “There is no other industry in the UK that places such a burden on small companies,” he says.
he risks to which small and medium-sized firms are exposed
Pay-when-certified clauses exist solely as a means of getting round the ban on pay-when-paid
as a result of retentions swiftly become apparent when a main contractor goes bust, taking with it all the payments owed to those down the supply chain. Half of the £14.9m losses sustained by trade contractors in the wake of the Ballast UK collapse in 2003 consisted of retentions. And it is understood that when roofing giant Rock Asphalte went into receivership earlier this year, one of
its suppliers took a £100,000 hit.
Retentions held by an insolvent main contractor can result in a sudden end to a company’s career. Many others are slowly brought down by a result of a gradual build-up of money owed; these
firms either call it a day or shift to less contentious business
(see Butterley Engineering case study, page 43).
Even without an upstream insolvency, firms can find it almost impossible to get their money back. The industry abounds with stories of retentions held back for a decade.
A large proportion of costs involved are accrued in chasing the payments that would have kept these firms afloat. Recent research by the Forum of Private Business found that the industry’s 51,000 small and medium-sized enterprises spend a total of 127,500 hours each week seeking payment; on average, these businesses spend 2.5 hours a week on the task.
With the industry facing its busiest period in recent history as it prepares for the Olympics, the government has a vested interest in ensuring as many firms as possible are available to carry out work. If it chooses to believe that payment problems in the industry really aren’t of concern, it does so at its peril.
The biggest problem
Stuart McDowell, managing director, Stuart McDowell Ltd
Stuart McDowell, a small contractor with a turnover of £600,000, estimates that it loses £5000 a year in bank charges as a result of payment problems. As a small company, it has frequently experienced cash flow problems caused by overdue payment, and is forced to borrow money from banks to pay its own suppliers and staff while it waits for clients to stump up. This means the firm has to pay overdraft and loan charges on the money it is forced to borrow and, even if clients eventually make their payments in full, this money cannot be reclaimed. “Retentions are the biggest problem,” says Stuart McDowell, the managing director. “I don’t think any other industry suffers retentions like we do. When contractors refuse to release our money, it has a huge effect on our profits as we’re operating on fairly small margins. We refuse to take contracts that have retentions now.”
McDowell’s stance is understandable. He is chasing a £5000 retention that he says he has been owed for three years. “We did a super job on an extension to a listed house, but the client just won’t pay up,” he says. “We’re looking for the last payment on the job that we did, but people never seem to pay the final instalment. This particular client has since gone bankrupt, and we’re having to fight with debt collectors to reclaim what we’re owed. But at the end of the day, if they don’t pay, there isn’t that much we can do.
Retentions outweigh our profit
Trevor Hursthouse, managing director, Goodmarriott and Hursthouse
The balance sheet of M&E firm Goodmarriott and Hursthouse is a clear illustration of the pressure firms can be put under as a result of retentions. As of 31 July, £950,000 of the firm’s money was withheld in retentions. Most of these retentions are not legally contentious as they are not overdue, although £350,000 worth is late.
“The fact is that almost a quarter of our balance sheet is hanging out in retentions,” says Trevor Hursthouse, the firm’s managing director. “It’s astonishing really. This isn’t because we’re slipshod when chasing our money – we review our retentions ledger monthly and progress monthly.”Hursthouse adds that the picture in his company would be even more dramatic but it has an unusually strong balance sheet for a firm of its type. “We are in good shape, but many companies of our type would have a balance sheet value of less than half of ours,” he says. “For a company with a value of £1.5m, the same retention debt would mean around 80% of its value was tied up in retentions. Effectively, that means that 80% of the company is at risk.“Whichever way you look at it, it’s crazy.”
‘We were paid £½m less than we were due’
Mel Myronko, director and general manager, Butterley Engineering
A succession of contractual complications on construction contracts, including payment issues, have led 200-year-old steel firm Butterley Engineering to halve the size of its structural division. “We are an old company with a history of involvement in bridges and structures in the UK and around the world,” says director Mel Myronko. “That side of our business used to be worth 50%, but now to go forward we have reduced it to 25%. This is because of issues over payment and other things. It isn’t a problem with markets; it’s the fact that the contract forms in the industry have become more confrontational. You spend a long time chasing payment, and seldom get a reasonable return.”
One instance where Butterley Engineering struggled to claim a “reasonable return” was on the prestigious Spinnaker Tower in Portsmouth. Butterley had a £2.7m deal for the steelwork on the scheme. “There were late payments made on that project – not spectacularly late, but enough to put us under pressure,” says Myronko. “We ended up negotiating with the main contractor in order to get paid more quickly, which meant we ended up being paid half a million pounds less than we felt we were entitled to.” Myronko says this is commonplace. “It’s always the same. If you go to court you wait for the money; if not you settle for less than your entitlement. I would say we suffer payment problems on about 80% of our contracts.”
In contractual limbo
John Ewen, divisional director, Hilton Building Services
M&E contractor Hilton Building Services has first-hand experience of the difficulties arising from completion certificates. The firm completed work on the Hull City football stadium in 2002, but is still awaiting the release of £90,000 in retention money from contractor Birse Construction.
He says: “Following the 12 months defects inspection it was noted by the client that, although the main contractor had received a Substantial Completion Certificate in December 2002, as of April 2005 it had not completed the main contractual works. Therefore the client could not issue a Making Good Defects certificate.”
Without this certificate, Birse was not obliged to release subcontractors’ retentions, even though Hull council had released £200,000 of the main contractor’s £270,000 as an act of good faith. Hilton Building Services has been one of the companies worst hit by Birse’s failure to release its money owed. The firm has a retentions account in excess of £90,000.
“The main contractor has profited thanks to the arcane retention rules,” says Ewen. “It has no financial loss as the money released in good faith has covered all its outstanding retentions. The money being held are those of subcontractors such as ourselves who have completed our work.”
Ewen says he is determined to retrieve his money, but that the need for a certificate means he has no idea when that will be possible. “As of the start of August, the main contractor has not completed the works and it is believed that it has made no move to even commence them,” he says. “If this is not sufficient reason for the abolition of retentions, then what is?”
Proposed changes to Construction Act
The government published its consultation on the review of the Construction Act in March this year. It made a series of recommendations for change, which were opened for industry consultation until the end of June. The government is expected to issue a revised draft of changes in the autumn.
The key changes relating to payment proposed by the government in March were:
Do you think the industry’s payment system is in need of legal reform – or are subcontractors protesting too much? Email us your views on firstname.lastname@example.org