What can be done to improve the UK construction industry's fiscal health?

The UK construction industry suffers from high fragmentation, low margins, relatively low investment from the public purse – the governments Construction Sector Deal being one notable exception – and a 'cards close to the chest' mentality. These characteristics make the sector unique and sometimes engender some questionable payment practices, including elongated payment terms and unjustified delays to payment.

The collapse of Carillion in 2018 shone a spotlight on some of these murky payment practices and, just seven months prior, the fire at Grenfell Tower exposed the serious safety shortcomings that can arise from exerting financial pressure on a supply chain. Indeed, in the Hackitt report, Dame Hackitt commented: 'Payment terms within contracts (for example, retentions) can drive poor behaviours, by putting financial strain into the supply chain. For example, non-payment of invoices and consequent cash flow issues can cause subcontractors to substitute materials purely on price rather than value for money or suitability of purpose'.

The industry must – and is beginning to – respond to the tragedy of Grenfell by introducing more robust safeguards. As well as these crucial safety considerations, starving the supply chain of payment rarely makes good commercial sense anyway, in that it heightens the risk of smaller companies becoming insolvent, and of the main contractor having to deal with the delays, costs and complications that arise as a result.

The Housing, Grants, Construction and Regeneration Act 1996, commonly known as the Construction Act. The Act, and more specifically the statutory, obligatory regimes for interim payments and adjudication was enacted following Sir Michael Lathams landmark report Constructing the team. It introduced certain minimum standards and safeguards for payment practices. Sir Rupert Jackson, when sitting as Lord Justice of Appeal, took the opportunity to praise the statutory regime as part of his judgment in S&T (UK) Ltd v Grove Developments Ltd [2018] EWCA Civ 2448, concluding: 'Overall the payment regime and the adjudication regime have been successful'.

However, the minimum standards are quite easy to comply with; Section 110 of the Construction Act states: 'the parties are free to agree how long the period is to be between the date on which a sum becomes due and the final date for payment'. This means the time between the works being carried out and payment can be – and often is – a number of months without infringing the Act. Also, adjudication has become a costly and at times protracted process. Parties will routinely incur costs in excess of £50,000 without the costs protection offered by litigation, and be forced to accept that key members of their project team will be distracted from their day jobs while they fight an adjudication, which can often last for two to three months, rather than the 28 days envisaged in the Act.

Project bank accounts (PBAs). PBAs divide opinion, but despite significant criticism relating to their effectiveness, the government still sees them as a good idea and they are being used on several public sector projects – particularly Highways England projects. They have also been mandated for contracts above a certain value by the procurement authorities in Scotland, Northern Ireland and Wales and are growing in popularity in Australia.

The principle is a straightforward one: the money is held in a central account and then all members of the supply chain are paid simultaneously. This avoids delays and deductions as the money flows down the chain. It also takes away the risk of upstream insolvency, which could starve all those below the insolvent company in the chain.

Critics, however, say that PBAs complicate matters, as fair payment practices together with well-drafted contracts and security documents ought to provide the necessary protection already. Furthermore, they can be costly to set up and administer, the contractor loses control of the capital and they have no bearing on a payer's assessment and certification of the sums due to their supply chain, so don't really tackle the real problem.

Retentions. It is common for a percentage of each interim payment – typically five per cent – to be retained by the paying party, with half released when the works achieve practical completion, and the remaining half released at the expiry of a defect rectification period. This holds back money due to the supply chain as security, in case they fail to perform. However, often the retention is not released at all, due to a set-off for contra charges or some alleged defect rectification costs, and the payee finds itself in the frustrating position of having to pursue sums that should already have been paid to them.

Both industry and government are torn between ring-fencing the retention funds in a trust, abolishing retentions altogether or maintaining the status quo. The main blocker to an absolute abolition seems to be around finding a viable alternative. While a payment bond is often cited as the obvious alternative, this may prove impractical if smaller enterprises are unable to access bonding facilities without paying a significant premium.

Payment charter and code. The Construction Supply Chain Payment Charter, agreed by the Construction Leadership Council (CLC), states: 'Fair and transparent payment practices are essential to the achievement of successful integrated working on construction projects'. The charter sets out 11 fair payment commitments and the CLC confirm that their 'ambition for 2025 is that the construction industry's standard payment terms are 30 days and that retentions are no longer withheld'. Although the charter has attracted some notable signatories and press coverage, critics say it lacks teeth as there is no real penalty for failing to comply with the commitments.

The Prompt Payment Code is regarded as the gold standard for payment practices. The code has set 30 days as a target that all signatories should work towards. The upper limit of the code is that signatories have to pay 95 per cent of their invoices within 60 days, or they must explain that non-payment was due to exceptional circumstances.

Signatories to the code can be suspended and removed from the list if they are revealed to be poor payers. This means there is an incentive to comply with the code to avoid reputational damage. However it remains to be seen whether the reporting, and the question of whether a company is a signatory to the code or not, will necessarily be enough to drive change.

The UK may be able to learn some lessons from other jurisdictions. In France and Australia, for example, there are regulations enabling subcontractors to seek direct payments from the employer in circumstances where the main contractor is in default. The principle of privity of contract prevents this in the UK, albeit collateral warranties do often include step-in rights – effectively enabling an employer to pay and instruct a subcontractor – in circumstances where the main contractor becomes insolvent. It may be that wider payment provisions could be added to collateral warranties to allow direct payment from employer to subcontractor for some other contractor defaults too.

To improve cashflow, the UK could legislate to make 30-day payment terms mandatory, backed up either by a short-form adjudication process – as used in Australia – or through penalties imposed by the government – as in Japan. Alternatively, similarly to the USA, the UK standard form contracts could add a statement confirming that all subcontractors will be paid the sums due to them within 30 days, with a contractual penalty if the contractor fails to make payment.

A new decade provides a new opportunity to change payment practices and improve the health of the construction industry. All we need to do is decide the best way to do it.

David Greenwood is a senior associate at Pinsent Masons  david.greenwood@pinsentmasons.com

Related competencies include: Contract administration Project finance