What Constitutes Insolvency Under the Construction Act?

Insolvency is a catch-all term that applies to both businesses and individuals that are unable to pay their debts.

The causes and consequences of insolvency may vary, but it has the same fundamental meaning across business types and industries. 

Insolvency in the construction industry is common because building firms have to take on significant risks for low margins first and get paid second.

For the purposes of the Construction Act,  insolvency is defined at Section 113 as:

(2) For the purposes of this section a company becomes insolvent—

(a) on the making of an administration order against it under Part II of the Insolvency Act 1986,

(b)  on the appointment of an administrative receiver or a receiver or manager of its property under Chapter I of Part III of that Act, or the appointment of a receiver under Chapter II of that Part,

(c)  on the passing of a resolution for voluntary winding-up without a declaration of solvency under section 89of that Act, or

(d) on the making of a winding-up order under Part IV or V of that Act.

(3) For the purposes of this section a partnership becomes insolvent—

(a)  on the making of a winding-up order against it under any provision of the Insolvency Act 1986 as applied by an order under section 420 of that Act, or 

(b)  when sequestration is awarded on the estate of the partnership under section 12 of the Bankruptcy (Scotland)Act 1985 or the partnership grants a trust deed for its creditors.

(4) For the purposes of this section an individual becomes insolvent—

(a) on the making of a bankruptcy order against him under Part IX of the Insolvency Act 1986, or

(b)  on the sequestration of his estate under the Bankruptcy (Scotland) Act 1985 or when he grants a trust deed for his creditors.

(5)    A  company,  partnership  or  individual shall also be treated as insolvent on  the occurrence of  any event corresponding to those specified in subsection (2), (3) or (4) under the law of Northern Ireland or of a country outside the United Kingdom.

What Makes Insolvency in Construction Unique?

Insolvency is a big problem in the construction industry because of the unique nature of building projects. They tend to be long running with complicated chains of contractors who all have an interrelationship.

 Here is an overview of what makes insolvency unique under the Construction Act:

•  Long projects are the hallmark of the construction industry and are usually characterised by stage or interval payments. Delays to work and/or settling invoices can cause terminal financial problems for contractors
• ‘Pay when paid’ clauses used to cause a financial log jam in the contractor chain with irreparable cash flow consequences, but such clauses have now been prohibited by legislation
•  Construction is a uniquely competitive sector, and contractors are prone to underestimating the cost of work to land business. Construction is also highly price-sensitive, particularly for smaller firms trying to compete with big organisations with economies of scale. Consequently, it is easy to become unprofitable
•  All businesses struggle in an economic downturn, but construction is a particularly fragile sector — it’s easily susceptible to a recession and takes longer to bounce back

Reasons for Construction Insolvency

The construction industry presents many unique challenges for businesses to remain solvent. Not least the complicated, long-running, and often multi-party projects which characterise the building sector.

Insolvency rates in the construction industry are often much higher than in other sectors.

Cash Flow and Liquidity Issues

Cash flow and liquidity problems are the main triggers of insolvency in the construction industry — a sector uniquely characterised by stage/interval payments and also well-known for delays.

Taxation issues are often hidden beneath cash flow problems. It can be tempting to use funds put aside for taxes to ease liquidity concerns, but this usually only shunts the problem further on down the line. Catching up on VAT can be a real challenge for companies that dip into their tax reserves to address cash flow issues.

In the past, HMRC was more accommodating to small businesses struggling to pay VAT than it is now.

Section 113(1) of the Construction Act 1996 aimed to ease the burden on cash flow by prohibiting ‘pay when paid’ clauses unless one of the parties has already become insolvent.

Pay when paid clauses were previously commonplace and often caused a domino effect throughout the sub-contractor chain, which seriously impacted cash flow and solvency.

Unprofitability

It is perhaps a statement of the obvious that not being in profit will typically cause insolvency at some point, but this issue is particularly relevant to the construction industry.

Construction is extremely price-sensitive and highly competitive — a perfect storm tempting companies into underquoting a job to win work only to find that they are completing without profit. Delays in payments can also exacerbate the impact of profitability on solvency.

It’s a conundrum if you can’t win work without quoting the lowest price, leaving a business with little or zero profit. More prominent companies often receive a higher return than smaller ones due to economies of scale and efficiency. It is hard for small contractors to compete effectively.

Market Forces

Construction companies usually find themselves in the midst of a complex chain of suppliers and contractors. At any point, a link in the chain can go out of business owing money, which has a knock-on effect on the other companies.

A struggling firm will likely delay payments to creditors, only worsening the situation when insolvency finally strikes. Construction firms tend to have more significant debts upon insolvency than companies in other sectors.

All businesses struggle in a recession, but the construction industry has some unique pinch points. 

Construction tends to experience a lag in a period of economic recovery as there is often a delay between the upturn and confidence returning and the start of new building projects. Potential investors are typically slow to come back to the market.

On average, a construction company may have to wait two years before it experiences signs of recovery after an economic decline. Businesses in other sectors often bounce back far more quickly.

Construction Industry Scheme (CIS) Tax Arrears

The CIS requires every construction company to register with HMRC and verify the employment and payment status of subcontractors — plus deduct the appropriate amount of tax from the sub-contractor to pay HMRC.

Monthly statements must be submitted to sub-contractors, and monthly CIS returns sent to HMRC. 

CIS arrears are mandatorily payable to HMRC, which adds a further degree of pressure and complication to a construction company that may already be struggling.

Types of Individual Insolvency

Bankruptcy

Bankruptcy is an option when an individual cannot pay back their debts. Bankruptcy is also available to sole traders and partnerships.

A creditor could apply to make an individual bankrupt if the money owed is at least £5,000. The bankruptcy period lasts around 12 months, after which the individual may be ‘discharged’.

Assets owned by the individual can be seized and sold to pay off the debt. Bankruptcy can seem like an attractive way out of debt to some, but it will lead to difficulties in obtaining any form of credit or mortgage further down the line.

Individual Voluntary Arrangement (IVA)

An IVA is where an individual makes an arrangement with their creditors on how and when to pay their debts. If the creditors accept the proposal, the agreement becomes legally binding. An IVA is often a viable alternative to bankruptcy.

An IVA allows a sole trader or partnership to continue trading, which can make it a more attractive option than bankruptcy, particularly if cash flow problems are short-term. 

Individuals with regular household incomes can be good candidates for an IVA.

IVAs tend to create affordable payments for a specified amount of time with part of the debt written off. There is no minimum unsecured debt level for an IVA, but they tend to be used for more significant personal debts, in excess of £15,000.

Types of Company Insolvency

Company Voluntary Arrangement (CVA)

A CVA is a restructuring and rescue option allowing directors to remain in control of the business and, hopefully, enable the company to survive. In many ways, it is the corporate equivalent of an IVA.

Like an IVA, a CVA is a formal agreement with creditors to repay the amount owed in part or in full over a specified period of time. It is a legally binding agreement if the creditors accept it. Any debts remaining at the end of the agreed repayment period are written off.

It is essential to demonstrate that the business is ultimately viable, likely profitable and is just experiencing a ‘bad patch’. A CVA cannot be used as a delaying tactic to avoid an inevitable liquidation.

Compulsory Liquidation

Compulsory liquidation is when the court orders a company to be wound up, usually instigated by a creditor presenting a Winding Up Petition (WUP).

If the WUP remains undefended or unsatisfied, the Official Receiver can realise the company’s assets and pay creditors as much money as is available in respect of their debts.

A winding up petition can be defended. There is a narrow window of opportunity to explore different options to keep the company afloat, but time is of the essence.

Creditors’ Voluntary Liquidation (CVL)

One of the statutory duties of a company director is to take appropriate action if it is clear the company is no longer viable and heading rapidly towards insolvency. A director must cease trading. To continue would be to commit the offence of wrongful trading.

A CVL is a slick and quick option for a company with no viable future. Shareholders pass a resolution to wind up the business and vote to appoint a liquidator. There is no need for a court order.

The liquidator will pay the creditors as much money as is available. Creditors have a vote on the choice of the liquidator, and their preference prevails if it differs from the shareholders. 

Administration

Administration is relevant to limited companies with a reasonable prospect of resolving liquidity issues and trading profitably again. An administrator is usually a licensed insolvency practitioner who can protect the company whilst it is rescued.

If rescue is feasible, an administrator can often achieve a better result for creditors than on a winding up. Administration is a viable option for a business facing a very aggressive creditor.

Conclusion

Helix Law’s expert commercial team can assist with short and long-term liquidity issues and help provide strategic and workable solutions designed to ease stress and result in the most favourable outcome.