UK: Insolvency In Construction: What Is Insolvency?

Insolvency is high on the agenda in the construction industry.

In the first of this mini series, we take a look at the meaning of insolvency and summarise the main insolvency processes that can typically affect parties involved in construction projects. The series will also address contract issues and minimising risk, so keep an eye out for our future articles on this topic.

Those working in the construction sector will be now familiar with the overall concept of insolvency, particularly following Carillion's collapse into liquidation in January. The construction industry has never been a stranger to insolvency though.

Whilst the impact of insolvency can be mitigated to some extent, in order to do so successfully, parties involved in construction projects need to have a good understanding of what 'insolvency' actually is, so that they can spot the warning signs and plan ahead.

What is insolvency?

There isn't actually a legal definition of 'insolvency'. However, if:

  1. from a cash-flow perspective, a company can't pay its debts when due; or
  2. from a balance sheet perspective, the value of a company's liabilities is greater than the value of its assets (factoring in any future and contingent liabilities),

then a company is technically 'insolvent'.

That's because in both circumstances, a company is deemed to be unable to pay its debts, which in turn allows a creditor, certain other parties or indeed the insolvent company itself (or its directors) to ask an English court to make an order to wind the company up and ultimately, put it out of business (often referred to as 'compulsory liquidation').

Difficulties in mitigation planning

One of the key problems with mitigation planning in construction projects is having access to real-time information on the financial health of a construction counterparty. Publicly available information is typically out of date (for example, filed accounts at Companies House represent a company's historic accounting position for its latest statutory accounting period), so up front due diligence and frequent monitoring of performance under construction contracts are vital in assessing insolvency risk.

Unfortunately once cash-flow or balance sheet pressures actually arise, it can be too late to save a construction project. So, when negotiating any construction contract, it's important to consider what events might directly or indirectly evidence pressure on a counterparty's cash-flow and balance sheet. Exit/termination rights can then be planned around them. This also has the advantage of identifying counterparty insolvency risk before it crystallises; in turn allowing the possibility for practical discussions between parties before things take a turn for the worse. (The next article in this mini-series will look at exit/termination rights in more detail).

Is insolvency just a matter of cash-flow and balance sheet?

The short answer to this question is no.

Whilst a company's cash-flow or balance sheet are key indicators of a company's financial health, it's important for parties to construction projects to be aware that insolvency processes can arise regardless of whether a company is insolvent, which may in turn lead to a company being wound up.

Understanding how insolvency processes arise and who can trigger them can help parties build protections into construction related contracts (including mechanics that prevent or put a standstill around other creditors from exercising insolvency rights unless certain conditions are met).

What are the main insolvency processes that might affect parties to construction related contracts?

1. Liquidation/Winding-up

The overall commercial effect of liquidation is to wind a company's business up (selling any remaining assets in the process) so that a cash distribution can be made to the company's creditors in the final settlement of any outstanding claims.

Where construction projects are financed, lenders will typically take security over construction contracts, which may leave little in the winding-up pot for unsecured creditors once secured creditors are paid off. Construction parties should bear this in mind in their exit strategy at the outset of any project. Taking guarantees and security, where available, may mitigate against the ultimate risk of there not being enough money to go around all creditors if a company fails.

If a construction contract counterparty is wound up, a new counterparty may need to be found to complete a project that otherwise remains viable. Anticipating the possibility of circumstances that could lead to liquidation can be key to getting construction projects back on track if one of the parties fails.

In addition to compulsory liquidation procedures, creditors' voluntary liquidation offers another route to liquidation, although this process requires buy in from a company's shareholders, which may not always be forthcoming. In a creditors' voluntary liquidation, the company's board and shareholders will resolve to place the company into creditors' voluntary liquidation, while the final say over who is appointed liquidator will be reserved to a vote of the creditors.

Where a liquidator has been appointed, it is possible for the court to appoint in addition one or more special managers, to manage the business and property of the company in liquidation. The powers of those special managers will be set out in the court order; that order might commonly include all powers usually exercisable by a liquidator but it is possible that it might be scoped more narrowly. In practice, special managers would most often be appointed where the role of liquidator itself is being taken on by the Official Receiver, as has been the case with the Carillion companies.

2. Administration

Administration is an insolvency process that is often in the news as it can typically lead to job losses in an attempt to save a company as a going concern.

From a construction perspective, it's important to note that whilst administration can lead to liquidation, that isn't always the case. In an administration, when an insolvency practitioner (the administrator) is appointed, his/her principal objective is to seek to rescue the company, so that it can continue to trade as a going concern. If that's not possible, an administrator will look to try and achieve a better result for the company's creditors as a whole than liquidation would achieve. Finally, if neither of the preceding objectives can be achieved, the insolvency practitioner may look to realise property in order to make a distribution to one or more secured or preferential creditors.

There are two potential ways into administration which typically arise in a construction context:

  1. a creditor, liquidator, supervisor of a company voluntary arrangement, or the company (or its directors) may look to apply for administration via the courts if the company is insolvent (or likely to become insolvent); or
  2. a security holder holding a 'qualifying floating charge' (essentially security over all or most of the company's assets) or the company (or its directors) may appoint an administrator by lodging specified documents at court if it has valid powers under the security document evidencing its charge (often referred to as the 'out of court route').

In practice, given that a lot of construction work requires bank funding and security, in using the out of court route, the choice of insolvency practitioner appointed will often be controlled by lenders whether the actual appointment itself is made by the security holder or the company.

Of key importance to construction contract counterparties here is that for a security holder looking to appoint via the out of court route, the company in question does not necessarily need to be insolvent where a default has occurred under the lending documents. In particular, lenders' powers tend to be wide ranging and circumstances such as a breach of bank financial covenants or other material defaults may be enough for a lender to look to the exit door. That's because left unchecked, any further deterioration in the company could jeopardise the value of a lender's security and leave it unable to recover shortfalls in repayment.

Administration can leave parties to construction projects in a difficult position, particularly as one effect of administration is to freeze a creditor's ability to bring legal proceedings against the company. Understanding how administration may arise can therefore help parties to plan their options if a company enters into a potentially distressed situation.

3. Administrative receivership

Since 15 September 2003, the ability to create a power to appoint an administrative receiver under a floating charge has been limited to a number of exceptions. It's worth discussing in this article however, as those exceptions include public/private partnerships, utility projects, urban regeneration projects and project financings.

Administrative receivership is a process that allows a secured creditor holding floating charge security over all (or substantially all) of a company's assets to appoint an 'administrative receiver'. In a construction context, this will typically be a lender financing a construction project, who can appoint under powers in its security document.

As with administration, the company doesn't necessarily have to be insolvent in order for the security holder to be able to appoint and the power to appoint will again be linked to events of default under the lender's finance documents.

In contrast to an administration, where appointed, an administrative receiver's main duties are to the secured creditor who made the appointment and typically, an administrative receiver will look to satisfy any outstanding indebtedness owed to the secured creditor, by running the company's business and/or disposing of assets.

Whilst administrative receivership may not necessarily achieve any better outcome than an administration, for other creditors on construction projects, the fate of a project where a secured creditor has the power to appoint an administrative receiver, may ultimately be at the mercy of that secured creditor.

4. Receivership

Whilst floating charge security may provide a route to administration or administrative receivership, it is also common in construction projects for secured creditors to take additional 'fixed charge' security (for example: over land, buildings, equipment and other materially important assets).

This provides flexibility and different options for security holders, because a fixed charge holder usually has the power to appoint a 'fixed charge' receiver if an event of default occurs under a loan agreement. As with administration and administrative receivership, a company does not necessarily need to be insolvent for the power to become exercisable.

Ultimately, the commercial effect of receivership is to facilitate a sale of the asset(s) subject to the fixed charge security, in order to raise sufficient proceeds to repay the secured creditor.

More so than the other procedures set out in this article, receivership may not necessarily be fatal to a construction project. However, it could ultimately change the ownership of key assets and contracts, which may affect the viability of that project.

5. Company Voluntary Arrangement (CVA)

In addition to the processes mentioned above, an administrator or liquidator may propose a CVA. (A company in financial difficulties (or its directors) may also look to propose a CVA to its shareholders and creditors if it is not in liquidation or administration).

A CVA is a statutory process where a compromise or arrangement is made by the company with its unsecured creditors. That can typically include varying or rescheduling the amount of any outstanding debts owed to unsecured creditors, or form part of a wider group restructuring proposal.

If CVA proposals are duly passed by the required majorities at the requisite creditor/shareholder meetings, then they will be binding on all unsecured creditors. However, CVAs do not affect the rights of secured creditors (or preferential creditors), unless they also agree to the CVA proposals.

From a construction perspective, CVAs can be a useful tool in keeping projects alive, albeit the final outcome of any CVA will ultimately depend on other factors; for example, the onward cost of refinancing any secured debt.

Interplay between insolvency processes

In looking at all of the above scenarios, it's important to stress that the ability of parties to start any insolvency process will also depend on:

  1. statutory restrictions; and
  2. contractual restrictions (for example, inter-creditor arrangements).

When looking at exit strategy in any construction scenario, it is important to understand the interplay of these as they are complex and may vary on a transaction by transaction basis. Similarly, construction projects may involve other corporate entities (for example, limited liability partnerships, limited partnerships and general partnerships) where insolvency processes can vary and understanding those variations can be key in mitigating insolvency risk.

What does the insolvency of a counterparty mean for you?

As a counterparty to a construction contract with an insolvent company, whether or not you actually receive any money in the process (leaving aside CVAs) will depend on several factors including:

  • how much money is available from the realisation of assets for distribution to creditors; and
  • whether other creditors rank ahead of, or equally with you (for example secured creditors, statutory preferential creditors and other unsecured creditors).

Over the next three articles in this series, we will be looking more widely at what a contractual counterparty's insolvency means for you. We'll be considering what it means under your contract, and how to interact with the insolvency practitioner once appointed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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