Blood and Money

As anybody who’s been shaved by a barber with a cut-throat razor knows, there are situations where you have to trust those with whom you enter into commercial relationships. And as every contractor in Britain knows, it takes a certain amount of faith to work for an employer whose thumbs are forever resting gently on your carotid artery …

The analogy is a close one. Money is, as Lord Denning declared, the lifeblood of the industry. And like blood, any interruption in the flow of money is a serious matter. Much of the complex legal structure that regulates the relationships within the industry is concerned with deciding who owes what and when they have to pay it. Every week, the courts produce new rulings, precedents and observations. And the major legislative development in recent history, the Housing Grants, Construction and Regeneration Act 1996, aka the Construction Act, was largely concerned with improving the circulation of cash. All of which raises an obvious question: why do so many firms still complain that the system doesn’t work? And why is the industry arguing so furiously over the upcoming review of the Construction Act?

The point of view of those towards the top of the payment chain is admirably clear. John Bradley, director of legal affairs at the Construction Confederation, had this to say about a government consultation document asking whether changes to the 1996 act were needed: “We are concerned that this document has been prepared largely on a misconceived basis. It appears to assume that payment problems are rife, whereas the opposite is true.

” The response from smaller firms further down the supply chain is equally clear: Bradley is wrong. They point to the Specialist Engineering Contractors Group’s estimate that, at any given time, about £3.2bn is being held as retentions. And if that weren’t enough, under the current mechanisms of the act, there is no legal requirement for a main contractor to clarify when it intends to pay its subcontractors, nor to provide a definite account of the amount due. It is required to issue a notice informing the payee of the amount to be paid, but there is no sanction for not doing so. In any case, the amount only becomes binding if agreed by both sides or if it is determined by a third party under the contract.

This uncertainty over when payment is due has caused misery for many smaller firms who cannot properly budget for future contracts and wage bills. Instead, they are forced to adjudicate to establish when a debt has arisen. The director of one subcontractor, who did not want to be named, said that in at least 95% of cases he did not know what payment he was going to receive until the money arrived. He said: “Unless there is a proper structure for establishing that we are owed money, the problem of payment abuse will continue, as there is nothing in the act stating what constitutes the debt and when it arises. We suffer greatly at the hand of main contractors.”

The Specialist Engineering Contractors Group has suggested that these problems could be remedied by an invoice system. This would allow subcontractors to bill contractors for the work they have carried out. The sum claimed would automatically become the amount owed, unless the main contractor challenged it by issuing a withholding-of-payment notice, along with reasons, within a short period of receiving the invoice. The move, the group says, would bring construction into line with most other industries, in which the party carrying out work is responsible for billing the client to ensure it is paid fully and on time.

Outdated legislation

Another concern is the time that a main contractor can legally wait before it has to hand over its first interim payment. The often lengthy gap between the subcontractor’s initial investment and its first interim payment, which is not due until work has commenced on site, has been exacerbated by the government-sponsored trend towards off-site construction. This can leave some firms with a huge initial outlay and a long wait before they see any return on it. Marion Rich, the legal and contractual affairs director of the British Constructional Steelwork Association, says many of her members have been hit by this wait as they attempt to engage more in prefabrication. “Steel contractors making prefabricated structures spend between 80% and 90% of their project cost before they get on site,” she says. “The impact on firms having to bear this initial cost is huge. We are calling for the law to be changed so payment starts when a contract starts.

I don’t understand why construction has such different payment terms to other industries.

There is nothing in the act stating what constitutes the debt and when it arises

Acting as the industry’s insurers

Another risk that subcontractors must bear is the chance that they will be shut out of their money if a firm north of them in the supply chain goes bust. This problem is made worse by the current legislation, as pay-when-paid clauses are perfectly legal in cases of upstream insolvency. “The act currently expects the subcontractors to act not only as insurers of main contractor insolvencies but also of employer insolvencies,” says Rudi Klein, chief executive of the Specialist Engineering Contractors Group. “We should get rid of pay-when-paid unequivocally.”

There is also concern that pay-when-certified clauses, under which a contractor is only obliged to pay its supply chain once the work on the main contract has been certified complete, are effectively being used as pay-when-paid clauses. “Pay-when-certified clauses exist solely as a means of getting round the ban on pay-when-paid conditions,” says Klein. This may or may not be true, but the problems that can arise from certification are made clear in the case of Hilton Building Services. The firm is owed £90,000 in retention money for work it completed on Hull City football stadium in 2002, as main contractor Birse Construction has not received its overall certification for the project.

Retentions death warrant

The abolition of retentions is perhaps the pre-eminent policy goal of subcontractors. Retentions enable a client to keep a proportion of the value of the contract, typically 5%, as insurance against defective workmanship. The sum is disbursed once any defects have been rectified. The Construction Confederation may argue there are no widespread payment problems in the industry, but as far back as 2003 a House of Commons trade and industry select committee acknowledged the pressure that retentions place on small firms. A report into the practice states: “The retention system is a very considerable burden upon the industry, especially the small and medium-sized companies that make up the bulk of the construction sector.”

The committee’s view is borne out by a glance at the balance sheets of specialist firms. M&E contractor Goodmarriott and Hursthouse estimates that 25% of its £4m balance sheet is tied up in retentions (see case study, above left), and there are companies operating on far smaller margins that are experiencing the same problems. One £2m turnover company claimed it has a retention account of £116,249 spread over 317 contracts. Another small contractor, who did not want to be named, says that as much as 20% of his firm’s turnover was held on retentions at any one time. “There is no other industry in the UK that places such a burden on small companies,” he says.

Chasing shadows

he risks to which small and medium-sized firms are exposed

Pay-when-certified clauses exist solely as a means of getting round the ban on pay-when-paid

as a result of retentions swiftly become apparent when a main contractor goes bust, taking with it all the payments owed to those down the supply chain. Half of the £14.9m losses sustained by trade contractors in the wake of the Ballast UK collapse in 2003 consisted of retentions. And it is understood that when roofing giant Rock Asphalte went into receivership earlier this year, one of

its suppliers took a £100,000 hit.

Retentions held by an insolvent main contractor can result in a sudden end to a company’s career. Many others are slowly brought down by a result of a gradual build-up of money owed; these

firms either call it a day or shift to less contentious business

(see Butterley Engineering case study, page 43).

Even without an upstream insolvency, firms can find it almost impossible to get their money back. The industry abounds with stories of retentions held back for a decade.

A large proportion of costs involved are accrued in chasing the payments that would have kept these firms afloat. Recent research by the Forum of Private Business found that the industry’s 51,000 small and medium-sized enterprises spend a total of 127,500 hours each week seeking payment; on average, these businesses spend 2.5 hours a week on the task.

With the industry facing its busiest period in recent history as it prepares for the Olympics, the government has a vested interest in ensuring as many firms as possible are available to carry out work. If it chooses to believe that payment problems in the industry really aren’t of concern, it does so at its peril.