Financial Protection in the UK Building Industry

Bonds, Retentions and Guarantees

Patricia Hillebrandt, Will Hughes, John Murdoch

• Publisher: Routledge
• Year: 2002
• eBook ISBN: 9781135805579
• Topic: Architecture
• Subtopic: Architecture General

Financial Protection in the UK Building Industry provides comprehensive treatment of an increasingly important but complex aspect of construction management. The term 'Financial Protection' refers to the various mechanisms by which funds are made available to ensure the due performance of a party's contractual obligations.
This book looks at the legal and economic background to the problem of providing financial protection to clients to guard against poor performance and/or the insolvency of contractors, consultants and sub-contractors. The inclusion of practical guidance notes and summaries makes this a valuable guide for the construction professional as well as for the researcher.

1 Introduction

1.1 SCOPE OF THE REPORT

The research for this report has been financed by and undertaken under the aegis of the Reading Construction Forum by researchers in The University of Reading, who have worked under the guidance of a steering committee. The original research proposal, which contains the terms of reference, is included in Appendix A. The steering committee members and research team are listed in Appendix B.

The purpose of this research project is to study the forms of financial protection which are used in the UK construction industry. Financial protection¹, for this purpose, refers to the various mechanisms by which funds are made available to ensure the due performance of a party’s contractual obligations. Such measures are used to cover, among other things:

• the insolvency or bankruptcy of employers, contractors, subcontractors or consultants;
• the inability of contractors, sub-contractors or consultants to perform contractually acceptable work;
• the inability of an employer to pay a contractor, or a contractor to pay a sub-contractor;
• the inability of a low bidder to accept a contract. The aim of the research project is to ascertain the following:
• what types of protection are currently in use in the construction industry,
• which kinds of contracting party use them,
• who supplies them,
• how contractors make the required arrangements for their employers,
• how employers make the required arrangements for their contractors,
• how much each of the various financial protection measures costs,
• who ultimately pays,
• what overlaps (if any) there are in provision,
• whether these measures achieve what their users intend.

It should be noted that many of the risks against which financial protection is sought are common to a number of different contractual relationships. Thus, for example, the risk of non-payment applies not only to main contracts, but also to sub-contracts and consultancy agreements. The same is true of the risk of defective performance. In order to emphasize this common basis, this report frequently uses the terms “purchaser” (to mean any person who pays another to perform work or services, or to supply materials) and “supplier” (to mean any person who performs work or services, or who supplies materials, in return for payment).

The need for financial protection against the potential extra expense brought about by insolvency and/or poor performance seems exacerbated by two features of the UK construction industry: the low capitalization of construction companies and the high frequency of insolvencies within the industry. This report examines the incidence of insolvency in order to assess its impact on the need for financial protection.

For the sake of convenience, the report deals separately with performance obligations and payment obligations. However, it should be noted that some types of financial protection (such as bonds) may be used to underpin obligations of both types.

The main forms of financial protection used to underpin performance obligations are:

• Retention of part of what becomes due to the other party until performance is shown to be satisfactory (coupled with a right of recourse to the retention fund in compensation for failure of performance);

• Performance bond/guarantee. This may be provided by:

• a “connected” third party (e.g. a parent company); or
• an “independent” third party (e.g. a bank or insurance company which issues bonds as a purely commercial enterprise);

• Liability insurance carried by the defaulting party (e.g. consultants’ professional indemnity (PI) cover);
• Inherent defects insurance.

The main forms of financial protection used to underpin payment obligations are:

• Advance payment (e.g. into a trust account, to be released by instalments);
• Payment bond/guarantee². Again, this may be provided by either a “connected” or an “independent” third party;
• Payment of retention monies into a separate trust account.

1.2 RESEARCH METHOD

The project involved four phases: a desk study, in-depth focus group interviews, gathering of data from a survey and other sources, and assessment of the findings.

The results of the desk study are included under each broad heading of the report and an annotated bibliography is included at Appendix C.

Four focus group meetings were held, involving a total of 22 practitioners: 6 clients, 6 consultants, 7 main contractors and 3 trade contractors. Each focus group contained a range of practitioner types. At each meeting, a member of the research team acted as a prompter, using a list of critical subject areas to ensure that the interviewees covered the relevant points, while the rest of the team took notes. The discussion was allowed to take its course so that the participants could raise whatever matters they thought were relevant. After each focus group meeting, the researchers met to combine their notes into a comprehensive record of the discussion. These combined notes were then indexed by listing the various comments under headings and cross—referencing them back to the notes, giving an indication of the frequency with which each issue was raised.

When all the focus group meetings had taken place, the notes of each were combined so as to bring out, for each of the protection measures, the complete range of views expressed.

The main issues raised by the focus groups are included under each broad heading of the report. Summaries of the focus groups and the content analysis index of all the focus groups are included at Appendix D and E.

In addition to the focus groups, face-to-face interviews were held with individuals from surety companies and law firms.

Lastly, a survey of 150 contracts was undertaken. The initial plan was to contact respondents by telephone and allow them to choose whether to have the questionnaire administered by telephone or by mail (or not at all). With very few exceptions, respondents elected to complete the questionnaire in writing. However, responses were patchy and very slow. It also proved very time consuming to find, over the telephone, the right person in any organization. Because of these difficulties, it was finally decided to send questionnaires unsolicited to as many individuals as possible.

The first stage of the survey, with advance telephone contact, yielded 66 completed questionnaires. The second stage produced a further 84 completed forms from 983 distributed. However, accurate response rates cannot be calculated from these figures as many respondents agreed to complete forms for more than one project, as well as distributing photocopies of the form within their organization. The questionnaire is reproduced at Appendix F and the analysis of the results at Appendix G.

1.3 OUTLINE OF THE REPORT

Chapter 1 of this report introduces the reader to the contracting environment and examines the reasons why financial protection is commonly perceived as necessary. It deals particularly with insolvency, which is often cited as a major reason for needing financial protection. Chapter 2 deals with the various types of financial protection available in respect of performance obligations (i.e. those owed by main contractors and consultants to the client, and by sub-contractors to the main contractor). Chapter 3 deals with protection up the contractual chain against non-payment. The conclusions of this study are presented at Chapter 4, including some suggestions for changes to common industry practice.

1.4 GUIDANCE FOR INDUSTRY

On completion of this research, a further document was produced by the research team. This is separately available, but for convenience the main body of it is reproduced here as Appendix I. This contains guidance for clients, contractors, sub-contractors and consultants on what to take into account when running construction projects.

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¹ See glossary

² See glossary

2 Background and context of financial protection

2.1 THE BUSINESS ENVIRONMENT

Within the context of industry generally, construction is unusual in that its basic contracting arrangement, under which a building is to be supplied for a certain price, routinely involves:

• a product which does not exist at the time the agreement is made,
• a product which is unique in design, or at least specific to its ultimate location,
• a product which is complicated to produce and which incorporates contributions or components from many different business organizations.

Given these features, it is not surprising that there are many pitfalls in the production process. There are risks for all parties and the demand for financial protection of all types is high.

The producers of the product (main contractors and sub-contractors) frequently operate with very little financial capital because, historically, they have not needed to own fixed assets and have been able to finance their operations using credit from various suppliers and clients. They are vulnerable if they estimate costs wrongly, if they are short of work or if they perform badly. Insolvencies and bankruptcies are high in the construction industry (see section 2.4).

The increasing reliance on sub-contractors (Hughes et al., 1997) has resulted in the involvement of more firms in each construction project, with a consequent increase in the number of contracts. This trend has also reduced the main contractor’s direct control over the work, though not necessarily his risk.

Attitudes to consultants have changed over the last few decades. Legal actions against architects and engineers for problems related to their professional work were once almost unthinkable; they are now commonplace, and this is reflected in the levels of claims against professional indemnity insurance policies and in the premiums payable.

2.2 RELATIVE CONTRACTUAL POWER

It seems that the financial protection available to and demanded by the various parties to the construction process varies according to the power of the parties and their motivation. The last twenty years or so have seen substantial changes in both of these factors.

First, the client has become more powerful. Frequent clients, and especially client-developers, have become so large that they have been able to enhance their expertise and knowledge of the building industry. Such client sophistication, coupled with their buying power in the market, has increasingly enabled them to dictate terms to contractors. This has been especially so when the market is in recession, as in the period from 1989 to 1995. In such circumstances, a client who wants financial protection is able to insist on it.

As for infrequent and inexperienced clients, these are usually dependent upon institutional funding for any substantial construction project. Where this is so, the “power” of the client (in terms of demanding financial protection) is effectively the power of the funder.

Powerful and knowledgeable clients are nothing new. Public sector clients have always been in this position, although such clients have traditionally had no particular interest in using their power to do more than enforce the agreed contractual arrangements. Decreases in public expenditure brought about by privatization, contracting out and the private finance initiatives (PFI) have replaced public clients to a large extent by clients whose main motivation is to make profit.

A second major shift has been in the relationship between main contractors and sub-contractors. A massive increase in the proportion of work sub-contracted has meant that the main contractor today makes profit, not by performing construction work efficiently, but by managing sub-contractors. That management includes getting the best bargain possible. Especially during a period of shortage of work, main contractors have been able to wield power over sub-contractors who have no other source of work.

The distribution of power may change again as major specialist contractors come to have a more direct relationship with the client, especially under construction management projects and the increase in partnering arrangements. However, these trends are likely to affect only large projects. A more general shift in the relative bargaining power of the parties could occur if there were a very large increase in demand for construction, leading to a supply shortage.

2.3 THE NEED FOR FINANCIAL PROTECTION

2.3.1 Performance obligations

A project participant who purchases goods or services from another is automatically at risk from any failure of performance by the other, since this is likely to have adverse financial consequences. Such failure of performance may consist of:

• defective performance;
• late performance;
• non-performance.

As to the reasons why such failures occur, these ultimately fall into two categories:

• won’t perform;
• can’t perform.

In theory, protection against the possibility of “won’t perform” should be adequately provided by the terms of the contract under which the goods or services in question are purchased. Refusal to perform will be a breach of that contract, and an action for damages is intended to provide compensation for all the resulting losses. The question which then arises is why there is still a perceived need for other “financial protection” measures. To this question there appear to be at least three answers:

1. A claim for compensation must be pursued through litigation or arbitration, both of which are uncertain, time-consuming and expensive. Moreover, even a wholly successful party is likely to suffer a shortfall in what is recovered, since the costs awarded will rarely cover all the expenses incurred in the process.
2. In respect of minor cases of defective performance, litigation/ arbitration may be perceived as not worth pursuing.
3. “Won’t perform” may turn into “can’t perform”.

As for cases of “can’t perform” (i.e. where the supplier of the goods or services is insolvent), the need is for protection against the financial losses which result from the failure of performance. In order to tailor financial protection measures to that requirement, the purchaser requires an informed decision as to the magnitude of the risk. Three factors are critical:

1. How likely is it that the supplier will become insolvent?
2. How great a loss is likely to result from that insolvency?
3. Will the purchaser require funds immediately following the supplier’s insolvency (i.e. how crucial is cash flow to the purchaser’s survival?)

2.3.2 Payment obligations

Any project participant who supplies goods or services to another is automatically subject to the following risks:

• under-payment;
• late payment;
• non-payment.

As with the “performance” risks described above, the reasons why payment risks materialize are ultimately either:

• wo...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Executive summary
• Acknowledgments
• Glossary
• Abbreviations and acronyms
• 1 Introduction
• 2 Background and context of financial protection
• 3 Protection for performance obligations
• 4 Protection for payment obligations
• 5 Conclusions
• Appendix A Research proposal
• Appendix B Steering committee members
• Appendix C Annotated bibliography
• Appendix D Summaries of focus group meetings
• Appendix E Index of focus group meetings
• Appendix F Questionnaire for survey
• Appendix G Analysis of completed questionnaires
• Appendix H Analysis of Dun and Bradstreet data
• Appendix I Guidance for industry
• References
• Table of cases