Insolvency: lessons learned from Carillion

Many thanks to Partner Richard Dyton and Managing Associate Simon Kenolty from Simmons & Simmons LLP’s Corporate and Commercial - Projects team for yesterday’s highly informative review of the recent Carillion Insolvency.

Introduction: Carillion - what caused the collapse?

The talk took a detailed look into the Carillion collapse including consideration of if there were any advance warning signs and whether it is demonstrative of industry wide problems or a one-off isolated incident.

In light of this, the following points were made:

• There were a number of early warning signs: a profit warning in July 2017 revealed Carillion’s contracts were valued at £845m less than previously thought. There was also a reported decline in contractors entering into collaborative agreements (including joint ventures) with Carillion in the lead up to the insolvency. This was coupled with significant delays in payments being made to subcontractors. That said, importantly, during the period that Carillion received three profit warnings, it was also awarded a total of £2bn of government contracts.

• Indicative of industry wide problems/could it have been avoided: the construction industry is frequently the industry sector that experiences the highest level of insolvencies. Build UK (a representative body of 40% of organisations within the UK industry) considered the collapse of Carillion was not “unexpected or a huge surprise”. Citing, amongst other matters (including financial market practices), the transactional nature of construction projects, and the way in which business relationships exist between the various parties involved in the projects, as key facets to Carillion’s demise. However, although the Carillion collapse may be illustrative of wider problems the primary causes were likely to be poor management and a failure to identify and deal in a timely manner with matters that may lead to insolvency.

Discussion: consideration of the impact on industry practices; and mitigating the fallout from insolvency

Reference was made to the various practices that may be brought about to attempt to prevent similar situations occurring. These included the Construction Retention Deposit Scheme which (following a Government consultation on law and practice on the use of retention schemes) may become mandatory.

The talk also provided useful guidance on what steps practitioners should take throughout the life of the construction project to try and mitigate the potential for insolvency to take place. These included:

• Pre-qualification: carrying out due diligence in respect of the contractor’s financial health and considering whether the pricing gives the contractor adequate commercial incentive to perform. It was recognised that credit rating assessments can help although this information is not always available.

• Contract stage: carrying out a thorough review of the contract to ensure the relevant party’s position is protected. This will involve matters such as ensuring that subcontractors (including architects) have the right to retain IP rights to their work product unless fees are paid. Also, ensuring that all contractual documents, including collateral warranties, are signed before work commences and are available when needed.

Discussion was also had regarding the various funding and payment models available for a construction project and how these processes are affected by Insolvency. Examples include:

• Parent company guarantees: these are only useful if the parent company does not also become insolvent (as was the case for Carillion).

• Performance bonds: typically there are a number of conditions that apply to these types of bonds in circumstances where a party to the construction contract is insolvent. For example – the money will not automatically be transferred to the benefitting party in the event of insolvency – it will have to be demonstrated that loss has been suffered (for example following an adjudication decision or a final account on completion of the works).

• Retention: a useful financial tool where defective works emerge. Defects often occur where contractors are experiencing financial difficulties/ on the onset of insolvency as there is often not enough available resource to complete the works in line with what the contractor agreed pursuant to the contract. This is particularly relevant in light of the recent government consultation into “the practice of cash retention under construction contracts” and the introduction of the Construction (Retention Deposit Schemes) Bill 2017 - 2019 which aims to ensure that retentions are retained in a third party trust scheme. The bill in scheduled for a second reading on 27 April 2018.

There was also discussion regarding the available mitigation processes following insolvency - such as considering whether to terminate the contractor’s employment. It was noted that in the majority of circumstances, although there may be a contractual right to terminate for insolvency, a contractor’s insolvency is not necessarily a breach of the contract. It is often the effect of the insolvency on the contractor (for example not being able to complete its works) that results in a breach of contract.

The options for securitisation of claims (in effect selling any claims against an insolvent contractor to a third party) were also discussed. It was noted that it is more likely that there would be a market for selling a claim in circumstances where the underlying contract with the insolvent contractor is high value.

Conclusion

A key take away from the talk is the need for early warning signs to be quickly identified and for effective wording in contracts to mitigate the potential losses arising from insolvency. Parties should also make sure that the right documentation is in place. They must also understand what the contracts provide for in the case of insolvency - a contractor insolvency does not mean that the other party can disregard the contract and doing so might expose it to a claim from the insolvent contractor.