Due diligence: spotting suppliers on the edge

The demise of Carillion has brought into sharp focus some deep-rooted questions for the industry. Most focus on the procurement of major projects, but it would be dangerous to assume that it affects only those major projects. 

It was quickly recognised the collapse of such a major player would have profound knock-on effects for those reliant upon the major contracts and their suppliers. But the full extent of the fall out could well be more widespread. 

In an industry dominated by low profit margins, there will inevitably be companies that cannot manage the sums they are owed. The cash flow impact of an immediate cessation of work could be catastrophic. Arrangements are being made for loans to be available to those most affected. But, by its nature, a loan can only be a short-term (and partial) fix.

So what about those companies a few steps removed from the crisis? In contractual terms, there should not be an impact for companies one step or more removed. Nevertheless, commercial pressure often runs down the supply chain to ask subcontractors to share the pain, irrespective of the lack of any contractual obligation to do so. Subcontractors reliant upon repeat business from a dominant main contractor can rarely afford to ignore such a request. They are likely to end up taking a hit. While it is easy to assume or hope that your business remains comfortably unaffected, the knock-on effects may take time to filter down. Informed preparation might help avoid or mitigate the negative impact of such problems.

Even if your own projects are unconnected to Carillion, your subcontractors or specialist suppliers may have been exposed to the fallout. How can you identify those at risk? And what are the potential consequences for your project of any specialist going bust as a direct or indirect result of Carillion’s demise?

There is no magic solution to a problem of this magnitude. However, it does highlight the importance of some standard commercial risk management considerations. 

Key considerations

Steps that you can take to avoid your project being put at risk through exposed subcontractors include:

• On existing projects, be alert to any sudden deterioration in progress by key parts of the supply chain. Look for unusual under-resourcing of the job or late delivery of materials. These indicators may ring alarm bells that their financial condition and/or credit terms have deteriorated. If so, grasping the nettle sooner rather than later by exercising contractual mechanisms will be prudent.
• Carry out due diligence. Checking the background of firms with which you are engaged or about to engage can pay dividends. This could range from a simple credit check to a more detailed search. Has there been any negative media coverage with regard to filing accounts, or any record of poor payment in the past? Has there been a marked change in staff turnover? Many of the warning signs can be easily found through an online search.
• Where things are going seriously off the rails, review your entitlement to consider exercising the termination procedures under the contract. Often this requires a two-stage “final warning” approach. Good advice will help you ensure you follow the correct procedure. If you are an unpaid subcontractor, consider your rights to suspend works. 

Either way, it is very important that the terms of the contract are carefully complied with. The potential consequences of dealing with suspension or termination in breach of the terms of the contract can be costly indeed. A recent case (Phones 4u Ltd vs EE Ltd) saw a party lose £200m as a result of following an incorrect process. 

• Review what collateral warranties you have in place. If a key member of the supply chain goes under, you may need to leapfrog past that bust entity to maintain or bring a claim. Ensure appropriate collateral warranties are in place in relation to clear and proper contracts. Take particular care where design responsibility is a feature of the contract. Note that a collateral warranty is only as good as the contract it is collateral to. 
• For new projects, ensure appropriate documentation is in place that enables the fallout of a key player going bust to be mitigated. Ensure that good due diligence is implemented to check that all appropriate insurances are in place. Do you have evidence of those insurances? If a policy exists, a claim against an insurer can generally be brought by a third party, in spite of the demise of the insured party.

However, it’s not all doom and gloom. The vast majority of projects should be unaffected. There will be an element of randomness and bad luck as to which companies that have no direct link to Carillion are nevertheless affected. But this is an opportune moment to reflect on the importance of early issue spotting and ensuring that the usual sensible risk management steps are in place.