Red flags in supply chains
Tom Andrews, Associate Director, Transformation Manager – Urban Dynamics, Nicholas Grewal, Associate Director, and Sam Furse, Associate, with Freddie Carter, Junior Associate, Osborne Clarke
OUR aim here is to provide practical guidance to spotting ‘red flags’ or early warning signs in supply chains.
How to proactively manage distress in infrastructure project supply chains
The presence of distress in a major civil infrastructure project can have significant repercussions on those within the supply chain, often creating issues with cashflow, causing delay to completion of project milestones and potentially resulting in substantial increased costs and/or liabilities.
However, as covered in this article, there are things that can be done to spot and manage these issues before/as they arise to avoid potential costly and lengthy disputes. While insolvency events may appear to arise suddenly, there are often warning signs or ‘red flags’ of distress well in advance.
While these do not necessarily demonstrate actual insolvency, they can indicate liquidity and solvency risks to the supply chain of your project. Spotting these warning signs and taking early action can significantly reduce their impact on the project.
What are the warning signs of distress in an infrastructure project supply chain?
Warning signs of distress in the supply chain of major projects, including those that are international and/or cross-border in nature, may include:
- Slowdown in performance of the works, project delays or missed deadlines.
- Delayed payment of subcontractors or others within the supply chain, requests for direct payments down the chain, or increased use of practices like reverse factoring.
- Quality issues (e.g. poor workmanship).
- Subcontractors and employees refusing to attend site.
- Aggressive invoicing, becoming increasingly litigious or seeking early payments.
- Lots of sudden claims across all of the entity’s /group’s projects.
- Sudden refinancing or engagement of restructuring or financial advisers.
- Chasing new contracts to win and potentially under-bidding to get cash flow started or to boost balance sheets.
- Resignation of key personnel or significant loss of staff and evidence of low morale.
- Increased financial oversight by head management or third-party advisers.
- Lack of communication or a delay in responding to questions.
- For listed companies, profits warnings, short-selling by the market, or suspension of trading.
- Late public filings, declining credit ratings, withdrawal of credit insurance.
- Market rumour or speculation in the press/social media (albeit treat with caution).
- Where work has been started under a letter of intent or other arrangement, a reluctance to engage in discussions about, or to execute, a comprehensive contract.
What to do if you recognise early warning signs on your project
If you suspect distress, it is critical for you to take early action to protect your position. It is also crucial that you fully understand your options, considering both your contractual and non-contractual rights and obligations. You should consider the practical steps and commercial implications of exercising those rights, some of which are explored in this article.
Taking early professional advice to ensure that you are cognisant of all of the available options (and the potential consequences of exercising those options) can be invaluable.
The details set out below consider the position from an English law perspective, albeit that some of the practical tips might still be relevant for other jurisdictions.
Suspension and termination
Taking early professional advice to ensure that you are cognisant of all of the available options (and the potential consequences of exercising those options) can be invaluable.
It is critical not to terminate a relationship with an entity showing signs of distress without first considering the overall position and the potential implications of termination on the project and the wider supply chain. Termination can have serious consequences (particularly if it is done incorrectly) and may require lender consent or may be unavailable from a certain point.
Where there are entities in distress directly upstream, you could consider whether you can suspend work/services to avoid incurring costs for which you are unlikely to get paid. If there are entities that are higher up the supply chain above the entity in distress, consider whether you have rights to request payment directly from them.
If a downstream counterparty (such as a subcontractor) appears to be in distress, make sure you understand your suspension and termination for convenience rights and/or if there are any other relevant grounds for suspension or termination.
Early planning and advice is invaluable. You may want to identify alternative contractors as potential replacements in the event of termination or insolvency.
Make sure that communications with alternative contractors make it clear that no termination has occurred and do not appoint the new contractor until termination has been affected. You should also consider the impact of relevant procurement rules that relate to your project, and how these would be managed if distress becomes present in the supply chain.
Payment and set-off
It is critical not to terminate a relationship with an entity showing signs of distress without first considering the overall position and the potential implications of termination on the project and the wider supply chain.
It is important to make sure that any payment claims have been properly made and, in the event of non-payment, to consider prompt debt recovery action, as recovery can be increasingly difficult as distress grows.
When making payments, only pay amounts that are contractually due and consider utilising any set-off rights to avoid or limit exposure.
Security and off-site goods and materials
At the outset of the relationship and on an ongoing basis, consider whether obtaining security or guarantees is necessary. In the event of insolvency, secured creditors benefit from greater priority and have a better chance of recouping an enhanced proportion of amounts owing.
Make sure you are aware of the triggers allowing you to enforce and consider whether any third-party security provides enhanced rights. If you are holding a guarantee from an entity in the same group as the distressed entity, consider the extent to which the distress might be prevalent throughout the group, affecting the prospect of recovery.
If there are off-site goods and materials, consider whether title has passed. You should also consider any practical issues in enforcing those rights; for example if the goods are located overseas or stored in a third-party location, or if they are impacted by third-party security.
Collateral warranties and step-in
It is not uncommon for some collateral warranties that are deliverable in relation to a project not to have been provide
It is not uncommon for some collateral warranties that are deliverable in relation to a project not to have been provided. If an entity is obligated to provide collateral warranties or similar instruments from all of its subcontractors, ensure that you hold a properly executed copy of each document.
Without that direct contractual remedy against subcontractors, it will be much harder to have recourse against subcontractors in the event of contractor insolvency. You should ensure that you also have a copy of the underlying subcontract (including schedules and specifications) because without this enforcement can be very difficult.
Insurance
You should check that all the required insurances are in place, the level of cover, exclusions, and be aware of the steps you need to make a claim. In the event that insolvency in the supply chain causes you loss, having an insurance policy which responds is likely to be the easiest way to recover.
Adjudication
You could also consider commencing adjudication to crystallise amounts due before any insolvency event if there are options to consider under the Third Parties (Rights against Insurers) Act 2010.
Remember to make formal claims in writing, and ask the contractor/consultant to notify its insurers, especially if it has professional indemnity insurance and design obligations (however, be careful not to request information from an insured party that may cause said party to be in breach of its insurance policy if certain information is provided).
Other possible steps to consider
Employers that are worried about a distressed head contractor should make sure that they can secure the site, make it safe, and cover up the works as appropriate.
Where the distressed entity has control of the plant, equipment and other materials on a site that it owns or for which it is responsible, it is advisable to conduct audits and closely monitor where they are located.
It is important to obtain up-to-date records (including photographic evidence) of works done, defective works and materials procured for the project. If there is any concern as to the financial health of a relevant party, procure a detailed survey of the project. You should also obtain copies of documents relating to the project from the contractor/consultant, consider any claims under bonds or guarantees, and review what retention (if any) is held under the contract.
If there are joint ventures in your supply chain, check what happens if the joint venture or just one joint venture party becomes insolvent. This will depend on if and how the joint venture is incorporated, the terms of the joint venture agreement, and the terms of any agreements that you have with the joint venture.
Conclusion
In terms of the outlook for the civil infrastructure industry as a whole, the UK Government has signalled its commitment to invest heavily in high-quality civil infrastructure.
This includes plans to invest over £600bn over the next five years to achieve this goal, split across economic and social infrastructure. In particular, £8.8bn has been pledged over five years for investments in public and sustainable transport infrastructure in some of England’s largest city regions, along with support for new nuclear energy builds and carbon capture schemes.
Nevertheless, major civil infrastructure projects which the UK Government invests in are not immune from distress, and as the construction industry (and the wider UK economy) continues to experience difficult trading conditions, the ability to identify early warning signs of supply chain insolvencies is crucial in order to best protect ongoing projects and the financial positions of parties involved in these projects.
It can add enormous value to understand the full range of both practical and legal steps that are available in the event of potential supply chain insolvencies.
Seeking professional advice as soon as you spot potential red flags in your supply chain can help to secure the best outcome for you and your project (whether it’s UK-domiciled or has crossborder or international elements).
Tom Andrews, Associate Director, Transformation Manager – Urban Dynamics, Nicholas Grewal, Associate Director, and Sam Furse, Associate, with Freddie Carter, Junior Associate, Osborne Clarke
Nicholas.grewal@osborneclarke.com
freddie.carter@osborneclarke.com