One feature of the roller-coaster property cycle is that contractors survive recession, only to go bust when times are good and prices are rocketing once more.
What seems counter-intuitive at first glance is, in fact, highly predictable. The insolvency paradox is a factor not only of a highly cyclical industry, but also of the time-lag between bidding and building.
Contractors bid in the depth of a recession when costs are low and labour plentiful. If the bid was a fixed price, by the time work starts, commodities prices may have skyrocketed and skilled labour may demand much higher day rates than anticipated. In these circumstances, it is hardly surprising that contractors are just as likely to be bankrupted in a building boom as they are in a recession.
Key sub-contractors
The consequences to a developer of contractor insolvency cannot be understated – key sub-contractors can be just as critical. It is difficult to find another firm to take over a half-completed job. A company in financial difficulties might have been tempted to take shortcuts with the build, creating further complexity for the new builder.
Even if someone is willing, negotiations over liability for the insolvent contractor’s work can be contentious. The cost of labour and materials will have increased since the original tender (after all, those price rises were the trigger for
the insolvency), which will hit the developer’s margin.
Prelet agreements may have longstop dates, allowing the buyer to walk away if specified timelines are not met. And finally, holding costs of land need to be factored in throughout this process.
Contractors are just as keen to avoid insolvency. Put under too much pressure by developers, they may simply walk away from a project, as is thought to have happened to the contract negotiations at London’s One Nine Elms with Interserve and Dalian Wanda.
Reducing risks
Unsurprisingly, developers need to minimise time and cost delays. Developers and their advisers need to have a clear understanding of the risk matrix – although a risk reduction in one area can increase costs in another. For example, splitting the build contract into various phases for different contractors reduces the potential impact of a single contractor’s insolvency, but may increase the overall cost and duration of the project due to a series of handovers.
Checking the covenant strength of the relevant party is useful, but the filed accounts give a historical snapshot and cannot show whether a company has priced a bid accurately. Technology offers another potential solution: effective use of building information modelling (BIM) level 2 and beyond creates a shared database which, if properly managed and curated, will survive insolvency and assist with work integration and detection of potential defects.
Lenders’ rights
Bank financing is invariably accompanied by lenders’ step-in rights. In practice, lenders are loath to exercise these, partly because of the challenge of taking on a build halfway through, noted above; and also due to the jump in liability from being in possession of land rather than simply having security over it.
But there is no denying that step-in rights give a lender an important seat at the table in the discussions following an insolvency. In some insolvencies, there is a complex web of security interests to be balanced.
Contractor insolvency
Where insolvency of a contractor is suspected, developers need to keep alert as the project progresses. Late delivery or requests for advance payment of sub-contractors may be for price reasons, but can also be driven by concerns over payment and solvency. Can the developer withhold payment where insolvency is a concern? This may be tempting, but beware the rules regarding service of pay-less notices in order to withhold payment of sums.
If the rules are not followed, a contractor may be entitled to suspend works or refer a disputed payment to adjudication. Developers should be vigilant to the risks of adjudication, a short (28-day) rough justice process. In extreme cases, the contractor may serve a statutory demand for payment in cases where the developer does not follow the correct procedure; see COD Hyde Ltd v Space Change Management Ltd [2016] EWHC 820 (Ch) where the developer was refused relief despite the contractor being in breach itself.
Different funding
The liquidity crisis following the collapse of Lehman Brothers prompted an interest in alternative financing approaches. Joint ventures are often used where one party has expertise and the other has funds – perhaps an inward investor to the UK with a local developer, or a landowner whose interests are beyond simply selling the site but who lacks the skillset to obtain planning permission or to project manage.
The various possible structures for joint ventures are beyond the scope of this article, but afford considerable flexibility. In all cases, the agreement between the parties is critical: if you fall out over a shareholders’ agreement, the relationship is unlikely to survive the trials and tribulations of a development.
Equity investment offers similar challenges, although from a different perspective. Crowdfunding is yet to make significant inroads into the commercial property market, but this may change for some property classes in the future.
Ultimately, developers are mainly reliant on project managers and cost consultants to alert them to difficulties on site and the issues with a pricing proposal. If a bid looks too good to be true, it probably is.
Developers who adopt a collaborative approach with long-term relationships with professionals stand the best chance of avoiding insolvency from a contractor or a sub-contractor mid-build.
Suzanne Gill is a partner in the commercial property team and Helen Garthwaite is a partner in the construction team at Wedlake Bell LLP
