Avoiding and managing cashflow risks

Further to our previous insight, identifying economic challenges within the construction industry, recent industry reports reinforce the significant impact of these issues.

• the Office of National Statistics September 2023 on Construction Output in Great Britain identifies that “Monthly construction output is estimated to have increased 0.4% in volume terms in September 2023; this came solely from an increase in repair and maintenance (2.1%), partially offset by a decrease in new work (0.8% fall) on this month…Quarterly construction output increased 0.1% in Quarter 3 (July to Sept) compared with Quarter 2 (Apr to June) 2023, this came solely from growth in September 2023 after two months of falls; the quarterly increase was because of repair and maintenance (0.7%), while new work saw a decrease of 0.3%.”
• PWC recently forecasted a -8% decline of total new build output in 2023.
• “The BCIS is forecasting construction output will fall by -5.4% in 2023, and by -1.1% in 2024, before returning to growth of +3.3% in 2025. Experian is currently slightly less gloomy with forecasts of -1.4%, -2.0% and +4.4% respectively for 2023, 2024 and 2025.”

In light of the market challenges, it is crucial to be alive to, and prepare for, associated risks by establishing robust contractual arrangements with project partners and your supply chain.

With that in mind, we consider in this Insight what might be done to avoid or manage such challenges at the procurement and contract negotiation phases.

Resiliency through procurement

In addition to undertaking financial due diligence on contracting parties and interrogating overall project viability, potential risks can be reduced by careful selection of procurement options.

Framework arrangements

Construction industry framework arrangements generally take the form of a formal framework agreement establishing a long-term relationship to deliver works as an ‘approved supplier’ for the ‘buyer’. Framework arrangements can be with a single supplier or multiple suppliers (consortium frameworks) and often set out the potential scope of work/services that may be instructed, an agreed set of prices, and the mechanisms instructing or ‘calling off’ such works/services. With multi-supplier framework arrangements, the buyer can run a mini-competition between the framework suppliers or instruct work to a specific supplier direct.

Potential savings can also be achieved through economies of scale, bulk discounts and fixed costs for anticipated types of work.

As parties work together more often, a greater rapport of trust and long-term relationship thinking is often established, enabling parties to be more open and direct if supply chain resiliency issues or other challenges arise on a project.

Additionally, where a buyer has multiple framework agreements or multi-supplier framework arrangements, this can provide the buyer with a ready pool of alternative suppliers in the unfortunate event of a supplier becoming insolvent during a project.

Project phasing

Another way insolvency risks can be managed is through considered project phasing.

Often, the longer the project programme, the greater the possibility of financial risks arising because of the following factors changing over time:

• fluctuating material prices, labour rates, and subcontractor costs
• changing economic factors, such as inflation, that put pressure on the project budgets
• changes in interest rates that increase borrowing costs at all levels in the project chain, affecting profitability/viability for developers and cashflow/credit facilities for contractors
• changes in weather conditions through seasonal changes and climate change can cause delays and disruption to projects.

Projects with a longer duration are generally more exposed to such risks. In light of this, suppliers who are asked to price for a single long project are likely to include a significant contingency to account for such risks. Additionally, even though suppliers might include contingencies, if they bear full responsibility for such risks under the contract they still bear the risk if these issues are more volatile than they allowed for.

Project phasing may alleviate some of these risks by reducing the possibility of such issues arising during the reduced durations of each phase. This can also improve cost control by enabling better estimating and reducing the need for risk contingencies by suppliers.

Procurement route

Choosing the most appropriate procurement route and form of contract (with a suitable schedule of amendments) are also a key element to maximising supply chain resilience.

Generally, from a developer’s perspective, each of the various procurement routes will achieve one or two out of three main project targets of:

• time — shorter duration and/or time certainty
• cost — cost certainty and/or lower overall price
• quality — control over design quality.

No single procurement route perfectly achieves all three targets, so careful consideration of priorities and selection of procurement route is imperative:

• Traditional procurement, where the employer’s design team completes the full design before engaging the contractor to undertake construction of that design, may mean:
  • improved time and cost certainty, due to full clarity of design from the outset of construction
  • possibly a higher cost, because of reduced scope for value engineering
  • high employer control of design, because all design is prepared by the employer’s design team.
• Design & build, where an employer’s design team produces an initial design and/or design requirements and the contractor is engaged to complete the design and construct the works, will generally achieve:
  • shorter duration, due to the possible overlap of design and construction stages
  • moderate time and cost certainty
  • potentially lower cost, due to shorter duration and scope for contractor value engineering during the design stage
  • reduced employer control of design, because the contractor is able to complete the design in line with often more general employer’s requirements rather than specific design.
• Often, pre-construction services agreements are utilised with design and build procurement, whereby the contractor is engaged earlier in the design stage to assist with design development before the main contract is let. This can also enable the contractor to undertake pre-construction surveys and/or pre-construction works, such as demolition and site preparation. This can enable the contractor to identify issues earlier and price more accurately for them rather than apply a significant risk contingency for unknown risks.
  
  
• Prime cost / cost reimbursable, where the contractor is paid its actual costs plus a fee, usually where the scope is not sufficiently clear to allow firm pricing, will generally achieve:
  • a shorter duration, because the contractor can commence works immediately
  • low time and cost certainty, because there is no agreed fee at the outset and the contractor is paid as it incurs costs
  • potentially higher cost
  • maintained employer control over design.
    
    
• Construction management / management contracting, where a construction manager or management contractor procures the design team and trade/works contractors on behalf of the employer as and when required for the project, will generally achieve:
  • a shorter duration, because design and construction can be carried out in tandem
  • moderate time certainty, subject to good project management by the construction manager or management contractor
  • reduced cost certainty, because overall cost will only be known once that last trade/works contractor is engaged
  • maintained employer control over design.

Clearly, each of the above procurement options achieve different results and risk allocations. These need to be considered carefully in the context of the current economic climate to ensure that an appropriate balance is struck, without too much strain being placed upon either party.

In addition to the more traditional forms of procurement, alternative procurement models include:

• Integrated Project Insurance (IPI) Model and alliancing contract, the aim of which, (as stated in the Government Construction Strategy 2011), is to have all those involved acting as a “virtual company” to streamline project processes. Alliance contracts generally involve one contract between the project parties determining how risks and rewards will be shared, thereby, seeking to minimise the chances of competing interests. Commonly used alliance contracts are the NEC Alliance Contract, the TAC-1, FAC-1 and JCT Constructing Excellence Contract 2016.

• Partnering contracts, which may on occasion be confused with alliance contracts, involve some level of commitment in principle to work in collaboration but all parties still act independently and may benefit or make a loss based on the terms on which each have separately been engaged.

Within the current challenging market conditions, it remains to be seen the extent to which employers are prepared to explore these more non-traditional procurement routes.

Resilience through security mechanisms

A wide range of contractual and financial security mechanisms are commonly used on construction projects, that can help protect against supply chain resiliency issues.

• Retention. This is where a proportion of each payment due to the supplier is withheld by the buyer until the project is completed, to incentivise progress to completion and making good of defects arising following completion. The level of the retention should be carefully considered. On the one hand, it needs to be set high enough to be a commercial incentive. On the other, setting the retention too high can put financial strain on the supplier. Additionally, historic problems with retention monies not being released on time, or at all, have had a negative impact on supply chain cash flow and can cause some suppliers to be cautious regarding them.
• Collateral warranties. These are direct contracts procured to create a contractual link between parties who might not otherwise have it, for example, between a developer-client and a main contractor’s sub-contractors or end-user tenants and the members of the project design team. Collateral warranties, in essence, guarantee the performance of the supplier’s obligations under its contract/appointment with the buyer for the benefit of the collateral warranty recipient.
• Project bank accounts (PBAs). This is a separate bank account set up to hold project funds prior to payment to the supplier. This gives the supplier comfort that, (at least a portion of), monies are in place to pay for their works. Often, PBAs require the buyer to ‘top them up’ regularly to ensure sufficient funds are in place for payment of the contractor/supplier. Historically, PBAs have often only been used on high value, complex projects because of the cost involved to set up and manage them.
• Retention / advanced payment bonds. These are given by a third-party surety, (usually bank or insurance fund), whereby they contractually agree to pay off an agreed sum on a specified event occurring. Common examples include:
  • retention bonds, obtained by a supplier in lieu of a retention being withheld by the buyer; and
  • advance payment bonds, again obtained by a supplier as security for any advance payments made by the buyer.

Such bonds can be put in place to assist the supplier, i.e. to remove any retention or enable advanced payments to be made, however they come at a cost, which is likely to be passed on to the buyer.

• Performance bonds. Here, a third-party surety agrees to satisfy the debt owed by the supplier to the buyer in the event of the supplier’s breach of contract. Usually, the maximum value of performance bonds is set 10% of the value of the contract works, (although this can be varied), and the cost for the performance bond is often passed on to the buyer in the supplier’s price. Performance bonds provide protection to the buyer from financial loss arising from the supplier’s inability to finish works. Most performance bonds in today’s market are ‘conditional bonds’, meaning that the right to claim under them is subject to the occurrence of specified conditions, which are usually breach by the supplier and an unsatisfied debt owed by the supplier to the buyer. Crucially, where the supplier’s contract is terminated, (e.g. for fundamental default or insolvency), often a debt that can be claimed under the performance bond is not established until after the project works are completed by a replacement contractor. Consequently, whilst the performance bond provides means for recourse in such circumstances, the buyer may have to wait some considerable time to claim recovery under the bond which will not assist with the buyer’s cashflow for the project, (although this can be addressed with other provisions — see below).
• Parent company guarantee. This is a contract whereby either:
  • the supplier’s parent company guarantees performance of the supplier’s obligations under its contract with the buyer (performance guarantee) or
  • the buyer’s parent company guarantees its payment obligations for the benefit of the supplier (payment guarantee).

Unlike performance bonds, parent company guarantees cost nothing. However, some parent companies can be reluctant to give such guarantees because this may fly in the face of their reasons for establishing a subsidiary company. There is also a risk that the parent company will be ‘dragged into insolvency’ in the event that its subsidiary suffers an insolvency event.

• Insurance. Various forms of insurance can offer protection for various elements of the project, such as:
  • damage that may be caused to existing buildings;
  • risk to the public or employees;
  • risk to the project works during the course of construction;
  • professional indemnity in relation to design;
  • in the case of more non-traditional procurement, (such as Integrated Project Insurance or an Owner Controlled Insurance Programme):
  • project wide insurance;
  • delayed start-up insurance;
  • business interruption insurance.

All parties involved in construction projects should discuss the most appropriate insurance arrangements with their brokers.

Resiliency through contract terms

There are many different ways that parties involved in construction projects can improve resiliency through contract terms.

Some fairly common examples include:

• Balanced payment terms can provide regular and timely cash flow to the supplier, whilst minimising exposure to the buyer. Shorter payment cycles will improve the supplier’s cashflow, reducing insolvency risk. On the basis that the buyer is still paying in arrears and the contract administrator is properly verifying completed works, (and presumably holding a retention), there is minimal risk to the buyer
• Retention of title provisions provide a degree of protection to suppliers by allowing them to repossess goods and materials if they do not receive payment and/or if the buyer becomes insolvent. However, such provisions can be overridden if the goods and materials are incorporated into the works or if they are resold to a third-party without notice of the supplier’s retention of title rights
• Payment for off-site goods and materials can assist with supplier cashflow by allowing payment for goods and materials before they are delivered to site. However, if this is permitted, it should be combined with obligations on the supplier to separate and demarcate the paid-for goods and materials, and for the provision of vesting certificates confirming that title has passed to the buyer before delivery to site
• Open book financial reporting can be required from a supplier, so that the buyer can monitor their cash flow and ensure that payments are being properly distributed to sub-suppliers. This may help the buyer identify cash flow issues earlier on
• Reasonable liquidated damages can provide the buyer recourse for delay, whilst not exposing the supplier to a disproportionate ‘penalty’. Generally, liquidated damages should be a genuine pre-estimate of the loss the buyer would suffer if completion is delayed. Weightmans have previously published an ‘Insight’ on the drafting and application of liquidated damages clauses which can be read here.
• Early warning notice requirements require early notification and management of issues with a view to risk mitigation. These could include cashflow issues and any issues down the supply chain
• Fluctuation/indexation provisions provide for price adjustments to account for changes in inflation, labour rates, material prices, etc. during the life of the project. Historically, there has been reluctance to utilise such provisions’ (other than on longer projects or facilities maintenance contracts). With current market volatility, such provisions might provide better cost-effectiveness for buyers than either having the supplier ‘pricing’ such risks or be at significant insolvency risk throughout the project
• Force majeure clauses excuse the affected party from liability for delays or non-performance caused by force majeure events, being those outside the reasonable control of either party, such as pandemic, government intervention, etc. Use of force majeure provisions can avoid parties being ‘locked into’ a contract’ (or at least provide relief)’ where external events have drastically altered the circumstances. Such clauses should include specific trigger events, notice (and if appropriate other) conditions and defined consequences of relief, e.g. suspension or termination
• Termination provisions can include bespoke drafting to allow the buyer to recover a forecasted estimate for completion of the works shortly after termination, rather than having to wait until it completes the project with an alternative contractor as required under many standard form construction contracts. Allowing the right to forecast and claim costs immediately upon termination allows a claim to be made not only against the terminated party but might also allow a claim against any performance bond given
• Step-in rights (within collateral warranties) allow the beneficiary under a warranty to ‘step into’ the shoes of the employer under the main contract to which the warranty relates. This could enable a buyer to step into the supplier’s contracts with the supplier’s supply chain so that the buyer can complete a project. The suppliers providing such warranties will however want to ensure that they are paid any outstanding amounts as a condition of step-in so they are not exposed.

Some other less common options include:

• Supply chain disruption clauses which address the risk of delays or failures in the delivery of goods or services by a supplier’s supply chain due to insolvency, force majeure, or termination within that supply chain. Such clauses may provide for alternative sources of supply or can be linked to other provisions, such as termination clauses
• Specific resiliency focused clauses which aim to enhance the resilience and sustainability of the supply chain by requiring flexibility, adaptability, collaboration, communication, innovation, and learning. Whilst probably more suitable for framework arrangements, (see above), these provisions could legislate for supply competition, automation, contingency planning, risk management, stakeholder engagement, and continuous improvement over the life of a framework.

How we can help

There is an abundance of procurement and contractual mechanisms which, if used correctly, can anticipate and protect against construction project risks, without significant disadvantage to other parties. In fact, many of these tools, if used reasonably and appropriately, can increase the chances to a successful project, which is good for all project stakeholders.

In the third, and final, instalment of this series on resiliency in the construction industry we consider what steps should be taken in response to insolvency of either buyer or supplier, to manage that situation and minimise exposure.

With a national team of construction law specialist lawyers, supplemented by lawyers in other legal disciplines relevant in the construction sector, Weightmans can provide:

• advice on drafting and negotiating construction and engineering contracts, including the various options and provisions discussed in this Insight
• legal support for managing construction projects and pursuing enforcement of contractual terms, whether through dispute management or formal dispute resolution processes; and
• wider advice on matters that might flow from the issues dealt with in this Insight, such as employment matters, regulatory issues, insolvency and restructuring options - all from advisers with focused experience within the construction industry.