Industry insight No.3: Cash gridlock issues in the construction industry

December 21, 2015

 

 

Construction analysis: Sarah Schütte of Schutte Consulting Limited looks at payment issues in the construction industry, the causes and possible solutions.

 

I am writing this in my hotel room in New York. This morning, I observed a traffic intersection closely. The traffic flowed in fits and starts in accordance with the colours of the lights. Sometimes, someone drove too slowly and got hooted or shouted at to speed up. Sometimes, someone drove through on red and got pulled up by the traffic cop standing nearby.

 

Mostly though, car by car, each person went about their business, letting someone go first if needed to help the traffic flow, and continued towards his or her destination--and so it is with construction and engineering project cash flow. Cash moves (or should move) in accordance with the rules laid down by contract and overseen by law. Sometimes, a tardy payer receives a stroppy letter, which forces them to pay sums due. Sometimes, someone breaks the rules, refuses to pay and gets taken to adjudication, where the adjudicator raps them over the knuckles and awards payment and interest and costs. Mostly though, each organisation goes about its business and, having performed its duties and paid or been paid accordance to its role, arrives at project completion.

 

So what is the problem?

The problem remains that cash flow gets gridlocked-- and it tends to be those at the bottom of the sub-contracting or sub-consulting chain, who are most affected.

 

Is there evidence to show this?

Recent research as reported in Bibby Financial Services' SME Confidence Tracker shows that small and medium-sized enterprises (SMEs) are taking the brunt of the economic jitter following the surprise May 2015 election result. The numbers make sobering reading:

o 25% consistently experience bad debt

o 55% of construction industry SMEs wait over 30 days to be paid, an increase of 11%, and

o 4% are on the brink of collapse due to non-payment of fees due

 

My ad hoc research indicates that some small businesses routinely wait much longer than 30 days. We are not talking about the odd, disputed, invoice. This is simple days sales outstanding (DSO) and a high DSO is unhealthy--it indicates poor collection activity, an unsatisfactory (or unsatisfied) customer base and poor corporate risk management, all of which can affect its industry and insurance market profile as well as causing operational difficulties.

 

Why is late payment still a problem in 2015, 20 years after the Latham report?

One reason is the economy, in general terms. Clients are still feeling the pinch and, after the Autumn Statement, this situation is not likely to dissipate, and end users/developers continue to operate at a lower profit margin than is desirable (see: The Autumn Statement 2015 for construction lawyers). For Tier 1 (main) contractors, there are still plenty of contracts, let during the downturn at a rock-bottom price, which are not yet complete, but where margins are squeezed to minimum profit (or even loss), so they squeeze their suppliers. Holding on to cash is effective--either to avoid paying, or to negotiate to pay less, or to retain it (and earn income on it) until it is balanced by other income and can be released.

 

Aren't the practices of 'pay when paid' or 'pay when certified' outlawed?

Yes, but only since 1 October 2011. Sir Michael Latham's 1994 report 'Constructing the Team' famously stated 'Cashflow is the lifeblood of the building industry', adopting a Lord Denning phrase from 1965. Sir Michael studied cashflow and made suggestions to improving it, including outlawing 'pay when paid' and 'pay when certified'. Sir John Egan's 1996 report 'Rethinking Construction' agreed, and they were much debated during the end stages of consultation for the Housing Grants, Construction and Regeneration Act 1996 (HGCRA 1996) which was based largely on Latham's report.

 

Ultimately, however, the 'pay when certified' provisions were excluded from HGCRA 1996. This was very disappointing to SMEs in particular--who tend to operate at Tier 2 and below, where most gridlock occurs. However, 13 years later, provisions prohibiting pay when certified were included in section 110 (1A-1C) of the Local Democracy, Economic Development and Construction Act 2009 and are now in force.

 

How are people getting around these outlawed practices?

There are two main reasons:

 

o insistence on a hierarchical contractual structure:

◦ devolution of risk down the contracting chain causes risk to stop at a certain point, and therefore to query whether money is 'due'

◦ lack of transparency by parties contracting on different forms prevents flowdown of responsibilities

◦ poor contract management, monitoring and/or administration at end-user level (eg funder to developer) exacerbates delay

 

o because freedom of contract prohibits very little in terms of dealing with:

◦ payment terms, which stagger timing down the contractual chain so that money does not become due

under a lower contract (eg contractor to sub-contractor) until, effectively but not expressly, due and

paid under the higher contract (eg employer to contractor)

◦ lack of availability, and use, of project bank accounts (escrow accounts), which ring-fence money

◦ framework contracts at nil value require heavily discounted fees

◦ charges made to join or remain on approved supplier lists

◦ widely-drafted set-off under a contract or even between multiple contracts

 

The effectiveness of any contractual term will depend on the precise words used and, crucially, whether the words are challenged--but this does not stop the drafters from trying, or 'commercial negotiations' occurring notwithstanding any drafting.

 

By 'commercial negotiations', do you mean playground tactics?

Yes, sadly, there seem to be organisations out there who, for no good--ie justifiable, legal or contractual--reason, adopt the tactic of refusal to pay, until the SME gives up or settles on receiving p pence per pound.

 

What does this mean in practical terms for industry SMEs?

SMEs are in effect funding major projects. The double whammy is that they perform at risk and charge zero interest. Also, from a compliance perspective, SMEs risk trading while insolvent notwithstanding strong sales and/or projected income. The effect is eroded trust in an industry where relationships can naturally be fragile due to the hierarchical structure.

 

What can be done to unstick the gridlock?

During my time in industry I have found this checklist to be helpful:

 

o risk management strategy--choose your commercial partners carefully. Which relationships do you value?

Who is respectful of your business? Is the other party a member of the Prompt Payment Code?

o proposed contract terms--read and understand the content and take advice, especially on non-standard (bespoke) forms of contract

o respect your business--don't accept contract terms which put your organisation at undue risk just to secure the deal

o be mindful of your statutory rights to:

charge interest at 8% above Bank of England Base Rate under Late Payments of Commercial Debts (Interest) Act 1998

◦ refer the issue of late payment, or failure to issue a pay less notice, to adjudication (pursuant to HGCRA 1996)

◦ suspend all or part of any work yet to be performed for non-payment (HGCRA 1996, s 112)

o employ tight credit control--press until cleared funds are received and keep written records

o aim to form long-lasting collaborative relationships with key clients and suppliers, treat them right and communicate clearly about what is acceptable and what is not

o consider partnering--contracts such as PPC 2000 perhaps swing too far for many, but contracts such as NEC3 are popular for taking a balanced approach (at least, in standard form). The SME may not be in a position of influence, but it is good to be wise to the options.

 

Can court action be taken to recover debt?

Yes, but civil proceedings can be prohibitively expensive for SMEs in terms of upfront costs, and court fees increased again in March 2015. Another option is to issue a statutory demand under the Insolvency Act 1986--a serious but effective step.

 

Mediation also plays an important role, and can be a relationship-saver, but the procedure costs money, and if one party is unwilling, then it is a non-starter. Following Sir Rupert Jackson's report, alternative dispute resolution is becoming more popular, but is not always straightforward.

 

Is the government taking any steps to assist SMEs, given the huge number and size of projects which it invests in?

Yes. The Small Business Enterprise and Employment Act 2015, which will come into force in stages during 2016, should help SMEs by:

 

o requiring, from April 2016, a payment term between 30-60-days--30 days already in government contracts

o implementing a compliance requirement on large companies to publish data on payment performance--poor performers may be 'named and shamed'

o launching a new Small Business Conciliation Service, which is intended to 'help small businesses settle their problems with large corporations' and to 'avoid expensive legal costs and maintain business relationships by reaching mutually satisfactory agreements'--the detail is scant at the moment, but it looks like a mediation platform and payment issues will fall squarely within its remit. Hopefully it will be another, inexpensive, tool in the SME's kit.

 

This article was first published on Lexis®PSL Construction on 25 November 2015.

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