Insolvency In Construction: What Is Insolvency?

Insolvency is high on the agenda in the construction industry.

In the first of this mini series, we take a look at the meaning of insolvency and summarise the main insolvency processes that can typically affect parties involved in construction projects. The series will also address contract issues and minimising risk, so keep an eye out for our future articles on this topic.

Those working in the construction sector will be now familiar with the overall concept of insolvency, particularly following Carillion's collapse into liquidation in January. The construction industry has never been a stranger to insolvency though.

Whilst the impact of insolvency can be mitigated to some extent, in order to do so successfully, parties involved in construction projects need to have a good understanding of what 'insolvency' actually is, so that they can spot the warning signs and plan ahead.

What is insolvency?

There isn't actually a legal definition of 'insolvency'. However, if:

from a cash-flow perspective, a company can't pay its debts when due; or from a balance sheet perspective, the value of a company's liabilities is greater than the value of its assets (factoring in any future and contingent liabilities), then a company is technically 'insolvent'.

That's because in both circumstances, a company is deemed to be unable to pay its debts, which in turn allows a creditor, certain other parties or indeed the insolvent company itself (or its directors) to ask an English court to make an order to wind the company up and ultimately, put it out of business (often referred to as 'compulsory liquidation').

Difficulties in mitigation planning

One of the key problems with mitigation planning in construction projects is having access to real-time information on the financial health of a construction counterparty. Publicly available information is typically out of date (for example, filed accounts at Companies House represent a company's historic accounting position for its latest statutory accounting period), so up front due diligence and frequent monitoring of performance under construction contracts are vital in assessing insolvency risk.

Unfortunately once cash-flow or balance sheet pressures actually arise, it can be too late to save a construction project. So, when negotiating any construction contract, it's important to consider what events might directly or indirectly evidence pressure on a counterparty's cash-flow and balance sheet. Exit/termination rights can then be planned around them. This also has the advantage of identifying counterparty insolvency risk before it crystallises; in turn allowing the possibility for practical discussions between parties before things take a turn for the worse. (The next article in this mini-series will look at exit/termination rights in more detail).

Is insolvency just a matter of cash-flow and balance sheet?

The short answer to this question is no.

Whilst a company's cash-flow or balance sheet are key indicators of a company's financial health, it's important for parties to construction...