July 22, 2016

The Show Must Go On: Contracting Strategies for the Impact of Brexit - Insolvency

This article looks at the worst case scenario – insolvency within the supply chain.  At the time of writing the currency and stock markets have remained reasonably steady since the referendum, although Sterling exchange rates seemed to have found a new level.  However, recent days have brought some concerning news.  For instance, the Bank of England has said that the underlying indicators show that the economy is "probably" experiencing a "material slowing" and that the credit market is becoming more risk averse.  Although the Bank of England has taken some steps to improve the availability of credit, such as reducing the amount of capital banks must keep on their books, there are other worrying signs that the industry is becoming affected.  For instance the UK Purchasing Managers Index has fallen for the construction sector from 51.2 points in May 2016 (construction output expected to grow) to 46.0 points in June 2016 (construction output expected to shrink).  Last week shares in UK property firms started to slide following the decision of Standard Life to freeze redemptions from its £2.9 bn property fund and other funds have followed suit. Earlier this week, a medium sized contractor, Dunne, entered into administration.

Although it is still far too early to panic (and, again, this is not 2008), the spectre of insolvency in the supply chain does seem to be rising again.

Cash is King

Following the Brexit vote, some developers in the UK construction industry will be concerned about demand for their projects waning, and turning into "white elephants," and will be looking to protect their financial positions. Similarly, participants on the supply side of the industry, who generally carry on their businesses on slender profit margins, which can disappear very quickly, will be worried that payments to them will slow down or dry up, causing them immediate cash-flow difficulties, and strained relations with their banks. Banks may also be nervous about continuing to provide credit to businesses, which they may now consider have over-reached themselves, and present too great a risk in respect of their borrowings. In these economically uncertain times, cash is king, and the collection or retention of cash can become crucial not only to profit and loss accounts and balance sheets, but also to very business survival.

In these trading conditions, many participants in the UK construction industry may be profoundly affected by decisions made by those higher up in the contractual chain, as to whether to pay or to defer or withhold payment. In particular, the withholding of a payment by an employer from a main contractor can create an immediate financial predicament for the main contractor, and force it to withhold payment from its sub-contractors and suppliers, with similar behaviour occurring down the contractual chain, as the payment "tap" is "turned off". Thus, one incident of non-payment within the contractual chain can have serious ramifications for parties lower down.

Some twenty years ago, Parliament passed the Housing Grants, Construction and Regeneration Act 1996 (the HGCRA), with the aim of improving payment practice.in the UK construction industry. It did this primarily by requiring notices to be given, calculating the amount of each interim and final payment to be made, and of each withholding of payment or set-off which would be raised. The HGCRA also provided that any party due to receive a payment which was disgruntled by the amount of the payment which had been notified to it could adjudicate against the paying party "at any time." Thus, the age of payment and withholding notices and of statutory adjudication dawned.

When the HGCRA was amended in 2009, the new payment regime was "tweaked", by the advent of pay less, and default payment notices, with the intention of further restricting the possibility of payment abuse by paying parties in the construction industry.

However, the HGCRA (as amended) is not the complete panacea for ensuring proper payment practice in the UK construction industry. The legislation has no application to construction activities which are not "construction operations" under it. Additionally, and crucially in the current context, parties are still permitted, by sections 111(10) and 113 of the (amended) HGCRA, to rely upon "withholding upon insolvency" and "pay-when-paid" provisions in their constructions contracts, in the event of the insolvency either of a receiving party or of a party higher up in the contractual chain.

Withholding upon Insolvency and Pay-when-paid

The economic volatility following the UK Brexit vote has brought sections 111(10) and 113 and their possible effects sharply into focus.

Section 111(10) operates in this manner. If a construction contract contains a provision which allows a paying party to withhold payment from a receiving party if the receiving party becomes insolvent, then the paying party need not pay the receiving party in such a scenario. This is so even though the deadline for the giving of a pay less notice by the paying party to the receiving party has expired, when one would have imagined that the paying party would have acquired a legal obligation to pay.

Section 113 prohibits a paying party under a construction contract from making its obligations to make payments to the receiving party conditional upon its receipt of payments from a third party, unless the third party becomes insolvent.  Therefore, the practice of what is widely known as "pay-when-paid" is banned, unless it is specifically linked to the insolvency of a third party higher up the contractual chain.

The exercise of pay-when-paid rights in the situation of an upstream insolvency is bound to a very emotive subject. Commentators have suggested that it may be more difficult for a paying party to adopt a pay-when-paid position in these circumstances than first thought. It is likely that a paying party seeking to rely on a pay-when-paid provision following the insolvency of a third party, may have to establish that the reason for its non-payment of the receiving party is the insolvency of the third party, and not due to its own default or that of its other subcontractors.

Suspension or Termination on Insolvency

If an employer or a contractor enters into a formal insolvency process during the course of a construction project, the solvent party and the insolvency practitioners of the insolvent party must carefully scrutinise the provisions of the contract, to see how the parties' future relations will be governed.

The 2011 edition of the JCT Forms provides that, if a contractor commits one of a number of defined insolvency events, its employment under the contract is not automatically determined (as used to be the case under the older JCT editions). Instead, the employer is given a right to terminate the contract, by serving notice, if it wishes to do so. In the meantime, the contractor's obligations to continue carrying out the works, and the employer's duties to make further payments to the contractor, are put into suspense. This is supposed to give the employer a breathing space, to consider the implications of the contractor's insolvency, and to decide whether or not it wishes to give the contractor's insolvency practitioners an opportunity to negotiate terms with it, for the "build out" of the development, which may perhaps involve a replacement contractor and the "novation" of the contract over to it, or for the insolvency practitioners to sell the insolvent contractor's business.

If, in such a scenario, an employer under a 2011 JCT Form decides to serve a termination notice, it is entitled to engage a replacement contractor and to withhold further payment from the insolvent contractor until the works have been completed by the replacement contractor. Within a reasonable time of that point, a notional final account has to be prepared between the employer and the insolvent contractor, in which the employer's costs of completing the works and the total amount of the payments which it has made to the insolvent contractor are deducted from the total amount which would otherwise have become payable to the insolvent contractor under the contract. Often, no money is due to the contractor and its insolvency practitioners once such a final account has been prepared.

Under the 2011 JCT Forms, the regime for an employer's insolvency is similar to that of a contractor's insolvency, but the other way round. The parties' obligations are put into suspense with the contractor having the option to decide whether or not to give notice of termination.

Where one party has become insolvent, the position under the NEC Engineering and Construction Contract is similar. The contract gives the other party the right to terminate it, if it wishes to do so. This again leaves open the possibility of the solvent party and the insolvency practitioners of the insolvent party negotiating terms for the completion of the works or a sale. 

Whilst such provisions permitting the negotiation of a "build out" or "novation" following an insolvency are laudable, practical realities commonly mean that a build out or a novation is not a possible option. Once an insolvency occurs, labour and materials tend to disappear from a construction site very quickly, and surviving contractors and subcontractors naturally wish to turn their attentions to projects where they perceive that their chances of obtaining payment are higher. Accordingly, the fact of an employer or a contractor entering into a formal insolvency process often spells the doom of the contract in question. For this reason, insolvency practitioners frequently wish to sell an insolvent contractor's business immediately after their appointment, by way of a "pre-pack" arrangement.

The Insolvency Process and Collecting Debts

Whilst on the issue of insolvency, over recent years we have seen a marked increase in the use of insolvency proceedings (or perhaps more accurately, the threat of those proceedings) being used as a method to collect debts.  As a first point it is worth understanding that the very purpose of the insolvency jurisdiction of the Courts is to act in the pursuit of the public interest, namely that insolvent companies should be wound up for the benefit of all creditors.  To threaten the use of the process to collect debts on behalf of a sole creditor (rather than the creditors as a whole) is frequently regarded by the Court as an abuse.  Certainly if there is a suggestion that a such a threat is being made to collect a debt which is genuinely disputed, a Court will readily grant an injunction to restrain the presentation of a winding up petition or its advertisement.  Such an injunction would normally be accompanied by a cost order against the 'creditor'.

Having said this, a credible threat to issue a winding up petition is a very hostile move and puts a great deal of pressure on the paying party.  Although the party demanding payment ('the 'creditor' for want of a better term) risks paying the costs of the 'debtor' following an application for an injunction to restrain the presentation or advertisement of a winding up petition, the 'debtor' risks much more.  If an injunction application is unsuccessful, and a winding up petition is presented and advertised, then there will be an immediate impact upon the operations of the debtor business, often including the withdrawal of banking facilities that the debtor might need to rely upon in order to operate.   Of course, if the 'debtor' business enters into an insolvency process as a consequence then this may leave the 'creditor' in a position where he may only collect pennies in the pound of the debt, if anything at all.  Therefore the actual issue of a winding up petition often will benefit no-one.

Given these asymmetrical risks, and the existential threat to the debtor company, a credible threat to present a winding up petition might well move the 'creditor' to the top of the list, leading to payment or (at least) negotiations.  Therefore it is by no means unusual to see these threats when they are, in fact, just thinly veiled attempts to collect debts. 

The process will often look like this.  The 'creditor' company issues a 'statutory demand' whether in a formal document or by letter (in the case of a company).  The effect of this document is to say that monies are due and owing and, if they are not paid within a short timeframe, then the 'creditor' will treat the failure to pay as evidence that the 'debtor' is unable to pay its debts as they fall due.  This is one of the grounds under which a Court may make an order for winding up a company and, so the creditor will say, it is his intention to issue a winding up petition.  In turn, the 'debtor' will often attempt to identify a reason why the debt is disputed; for instance, that the conditions for payment have not yet been met, or that the debtor has its own claim against the creditor (a 'cross claim') which it is able to raise as a defence of set-off to extinguish the debt.  The 'debtor' will therefore ask the creditor to permanently withdraw its threat to present a winding up petition, failing which the 'debtor' will apply to the court for an injunction to restrain the presentation. Occasionally, the petition is presented with little or no warning, and then the threat is to obtain an injunction, to prevent its advertisement.

A careful dance will often follow whereby the 'creditor' will withdraw its immediate threat pending the 'debtor' producing evidence of its defence/claim against the 'creditor' whilst preserving the right to present the petition or to advertise it if the creditor believes that the defence is not genuine.  Often this process may lead to negotiations/settlement.

If the 'debtor' does apply for an injunction the Court will, when considering whether to make a winding up order or whether to grant an injunction restraining the presentation or advertisement of a winding up petition, be looking for any triable issue or arguable case which shows that a debt is genuinely disputed.  The court will not go into the detail of the case, nor make any finding as to whether the defence will succeed or not.  The threshold for obtaining an injunction is therefore very low. 

This low threshold is well illustrated by the findings of the Court of Appeal in Wilson and Sharp Investments Ltd v Harbour View Developments Limited (2014) (applying the decision in R&S Fire and Security v Fire Defence PLC (2013)).  In that case the paying party had issued four interim certificates under a construction contract, certifying payment of around £900,000 which was outstanding.  No Pay Less Notices had been issued against those interim certificates.  The creditor threatened to issue a winding up petition based upon this debt and the 'debtor' applied for an injunction, attempting to rely upon a series of cross claims against the 'creditor'. 

Anyone familiar with recent case law under the HGCRA will be forgiven for immediately thinking that where an interim certificate has been issued, with no corresponding pay less notice, must mean that a debt is certainly due, and there is no prospect of the 'debtor' now raising a defence by way of set off or otherwise.  However, the Court of Appeal in Wilson and Sharp said that, in exercising its discretion as to whether to restrain the presentation of a winding up petition, it may take into account genuine and serious cross claim by the 'debtor' against the 'creditor', even in the absence of valid Pay Less Notices where both the HGCRA and the contract would prevent those issues from being raised in adjudication or in normal court proceedings.  It is worth noting that in R&S Fire and Security, the Court decided that it could take such cross claims into account if it believed them to be genuine or serious, but that on the facts the cross claims did not meet this test.  Therefore, the Court refused to exercise its discretion in restraining the presentation of a winding up petition.

You should be aware that if you present a winding up petition, any settlement payment made by the debtor company may later be voided.  This is because there are strict insolvency rules that void any payments made by the debtor company between the presentation of a petition and a winding up order being made (this is why the debtor company's bank account is frozen once the bank finds out about the petition).  It is also possible for another creditor to take over carriage of someone else's winding up petition.  This means you could present a winding up petition to increase pressure to obtain a payment, be paid, find another creditor takes over the petition, winds the debtor company up, and you have to repay the settlement money.  Sometimes, therefore, it is best to threaten the presentation of a petition (and perhaps even serve a draft copy), but not go the extra step of presenting the same at court.

As can be seen, this is a high risk and complicated area of law.  However, if genuine insolvency does creep into the supply chain then we would expect that the incidence of threats to issue winding up petitions will increase.  These need to be very carefully handled, whether you are the 'debtor' or the 'creditor', as the consequences of getting it wrong may be extreme.