Bracing for recession: mitigating challenging economic conditions
It has been a calamitous few years for all in the wake of the Covid 19 pandemic and the severe supply chain issues resulting from the war in Ukraine. To make matters worse, during the first half of 2022, the prospect of a recession dangled above us like Damocles sword, and recently it appears the thread has snapped. Sam Thyne looks to see what the construction industry can do to counter these challenges.
What does a recession mean for the construction industry? Unfortunately, we know all too well, with the memories of the 2008 recession still fresh for many. In the 2008 Great Recession, the construction industry saw reduced growth, fewer new projects, massive levels of insolvency and unemployment, more disputes and increased delay on ongoing projects. It is, unfortunately, a very bleak picture.
Anyone involved in the construction industry will tell you that cashflow is king. Without a steady stream of cashflow, the construction industry flounders. In times of recession, consumers spend less on building which has the effect of reducing new orders in the industry. This means less work for everyone, and fiercer competition for the work there is, which usually results in contractors cutting thinner margins. All this slows down cashflow and spells trouble for the industry.
However, while the prognosis looks grim, parties should be actively working to mitigate any fallout by utilising contractual mechanisms they already have in place.
Contract award
There is a myriad of commercial considerations that go into the tendering and bidding of projects, so many that it would be naïve of a legal article to try address them. Focussing on the contractual mechanisms, however, parties should consider the type of contract they are entering into.
Fixed price lump sum contracts are the most prevalently used form of contract at present. They’re popular because (at least, at first glance) they offer certainty to the employer, and an opportunity to the contractor. If the contractor can be efficient, they can increase their margin. However, “fixed price” may be one of the biggest misnomers in the industry, as variations and claims often increase the initial lump sum price.
There are disadvantages to this model during the current economic climate. First, with the massive increases in costs of materials, the initial lump sum costs are no longer economic. Contractors who are lucky enough to have a change in cost mechanisms in their contract are using these to make claims and those that don’t may be stuck paying the cost. Second, as (absent any valid claims) a Contractor is tied to their price, in a more competitive bidding environment, their margins are eroded almost entirely. This sets up a more combative relationship between employer and contractor.
Parties may want to explore different methods of contracting, such as cost reimbursable (or cost plus) contracts. These are contracts where the employer pays the costs of the works plus a percentage of profit to the contractor. There are, of course, nuances and variances to this model. A key feature of cost reimbursable contracts is that the employer has greater oversight of costs, and more opportunity to scrutinise and approve them prior to costs being incurred. While cost reimbursable contracts are often considered more expensive and less certain for the employer, with proper cost forecasting and scrutiny, these concerns can be mitigated. If managed well, there is the huge benefit of avoiding any nasty surprises in terms of variation and claims. For the Contractor, while they do not have the opportunity to increase their margins through efficiency, they have the benefit of a guaranteed margin, which is valuable in times of uncertainty. A bird in the hand...
Exploring different contract models may assist parties in navigating the more difficult economic conditions.
Insolvency
Another unfortunate consequence of a recession is an increase in insolvencies in the construction market. Insolvencies can be incredibly damaging to a construction project and often end up costing the employer much more.
In order to mitigate the impact of a contractor insolvency, employers should first make sure all their paperwork is in order. A common document required as part of a construction contract is a collateral warranty provided by subcontractors. Among other things, this allows the employer to step into the shoes of the contractor in the event of a contractor insolvency and continue the works with the existing subcontractors, at the same contract price. This is a quick and efficient way of continuing the works with the most appropriate sub-contractors. However, as with any bit of fiddly paperwork, these documents are not always executed. Employers should ensure that they have executed collateral warranties from all subcontractors.
In addition, employers should stay vigilant about the solvency of their contractors and look out for warning signs, in particular, high staff turnover, decreases in labour on site, slow progress and delay, removal of plant and equipment, requests for early payment or payment outside the payment regime, agitation from sub-contractors about not receiving payment, and an increase in unsubstantiated claims. When problems start to become apparent, employers should make their own preparations and consider the implications that the insolvency may have for the project. Would it be more costly to assist the contractor with their solvency issues or have another contractor finish the work? It may be the case that the best option is to provide assistance to the contractor to allow them to finish the job.
Finally, employers should be aware of what the contract says in the event of an insolvency. For instance, termination provisions usually entitle the employer to terminate on the insolvency of the contractor; however, there are careful notice provisions that may need to be observed. Even where the contractor is insolvent (or appears to be), the employer needs to be very careful about exercising termination rights under the contract.
Disputes
Instances of disputes rise during recession. Matters that may not have been worth fighting for become worthwhile when any extra cash is a necessity.
Documentation is crucial to any dispute. Both contractors and employers should ensure that their records are comprehensive and that there is written record of everything going on in their projects. In particular, both parties should ensure that instructions relayed on site are accurately documented in writing.
Extra vigilance should be taken when it comes to contractual notices and other conditions precedent under the contract. A failure to comply with a strict notice requirement can result in a party’s contractual recourse falling away, a trap you don’t want to find yourself in ever, but particularly during tougher economic conditions.
Conclusion
There is very little positive spin we can put on the challenging economic conditions ahead. In order to best weather the recession, parties to construction projects need to be familiar with the contractual tools they have available to them and make sure they are exercising them appropriately. Much like with the Covid 19 pandemic (where some parties may have found themselves without an adequate force majeure mechanism to address the issue), unless they can come to an agreement, parties are stuck with the bargain they made. By ensuring compliance with even the most frustrating of contractual requirements, parties put themselves in a better position to withstand the turmoil.