Morton Fraser Construction Bulletin February 2010

In the last edition of our E-Bulletin we considered the state of the commercial property market, and the impact that is having on the construction industry. Three months on, very little has changed in that sector. There is still some activity in the investment market and still a perceived shortage of suitable product for the money that is chasing the high end investments, but not enough demand to stimulate development to fill the gap. The development market itself remains slow and will be for some time to come.

There are, however, certain sectors which are comparatively active at the moment, with an obvious example being the energy sector, and in particular renewable energy. Many organisations within the construction industry have transferrable skills and can, with an element of re-training or re-inventing, readily switch from advising on the design of an office block to advising on the design of a wind farm, or from carrying out the construction of a hotel to carrying out the construction of a waste to energy plant. In many cases the principals are similar, it’s just the sector and therefore the commercial and political drivers that are different. At Morton Fraser we have seen an increase in our involvement in energy projects over the last 3 – 6 months which tells us that our clients are looking at this sector as a more certain work stream than commercial property at the moment.

We have, in the last 3 months, also seen some high profile property company casualties. The administrations of the Kenmore Group and subsequently the Kilmartin Group may have been predictable given market conditions, and certainly there was much speculation, but that does not make them any less sad news for the industry, as these were two of Scotland’s star developers over recent years. Many such property companies are going to the wall with live projects still underway, which in a lot of cases the banks or administrators will want to see through to completion so as to realise any potential profit left in the development. There is additional construction work coming out of these types of scenarios, particularly for design and cost consultants if what is needed to get the project to completion differs materially from what was envisaged at the outset, which can often be the case. There can also be knock-on additional work for contractors and subcontractors. These are, however, small positives against the backdrop of a sector that is still very much struggling.

In the next edition of our E-Bulletin we may well be in the midst of a General Election. That would seem an appropriate time to take a look at what the Government has done to help the construction industry during the recession, and what more the next Government can do, whoever that may be.

Lisa Dromgoole

Insurance can be a bit of a sticky issue in the construction industry. While on the one hand insurers want to limit their risk exposure, on the other there can be some quite strict stipulations on acceptable insurance levels that will allow a consultant and/or contractor to carry out a particular project. It’s all about striking a balance - exposure against costs - and all in all, professional indemnity insurance (PI) can be a bit of a headache.

Once the negotiation of contract documentation is over and an appropriate level of insurance for a project is set, it should be plain sailing. Proof of PI cover is exhibited and parties move on. Contracts are signed, the development begins and in reality all keep their fingers crossed that the whole insurance debacle was simply a formality and there will be no need to make any claims. But what if claims are necessary? Out comes the insurance paperwork.

Let’s say that you expected a consultant to hold a PI level of £5 million each and every claim. You requested proof of this and through a copy certificate you got it, but according to the underlying policy documentation issued by the insurer, this isn’t the full story. Somewhere in the depths of the policy documents are a few surprises that might put a twist on your “each and every” policy.

There can be one or two surprising clauses in underlying policy documentation which have not been reflected in certificates – “aggregation” being the buzz word here. Believe it or not, and rather confusingly to say the least, we have seen a situation where a clause in standard issue policy documentation sought to aggregate the whole of an each and every claim policy, while others sought to aggregate specific elements of insurance.

The existence of aggregation clauses in underlying insurance documents (that are on the most part intended to run alongside our “each and every claim” cover example) might be more common than you think. We are not for one minute suggesting that your average insurer is guilty of some shoddy disclosure practices. Understandably, they need to balance their risk exposure adequately and they can’t be expected to outline the entire policy in a certificate of insurance. From a due diligence perspective they tend to be a request for proof of the level of PI cover, nothing more. The problem is, all insurance documentation for a specific policy really must be read together to get the full picture, but more often than not you don’t get to see the policy terms and conditions. You take what you have to be the whole story.

What can be done to tick all the boxes?

Several parties can learn lessons here. Firstly, the consultant or contractor should be familiar with the underlying policy documents so he knows exactly what level of cover he has and any aggregations that might not be immediately evident. Any discrepancy in cover actually available against what he is warranting under contract documentation can easily put him in breach of that contract and perhaps not knowingly so.

Second, those carrying out the due diligence exercise might want to probe a bit further than the surface documentation. In some instances a certificate confirming the level of insurance may not be quite enough. Arguably, questions as to the existence of specific aggregation clauses contained in the underlying policy documentation should be raised. In many instances a commercial view can be taken on these and any risk may be neither here nor there, but at least parties will be in full knowledge of what is being offered. Sifting through underlying policy documentation is not a job anyone really savours and it’s not a set of documentation that you are likely to be readily offered from insurers. A few probing questions to the contractor/consultant to put past their insurers would be enough here. Policy documents are usually standard issue, so it hopefully shouldn’t provide for too much in the way of legwork from the insurer’s end to answer the queries. Go easy though – have it in your mind exactly what you want to know. One thing insurers don’t want is to spend their time solely answering queries on policy documents.

Our advice? PI is a minefield so tread carefully. Also, take a pragmatic view on things. Your average contractor or consultant has enough of a headache getting insurance in place these days so don’t come down too hard on them if a sensible, commercial view on cover can be taken which negates perceived risks. Lastly and most importantly, satisfy yourself that you have all the information – a few extra questions just to be sure doesn’t do anyone any harm to avoid any unexpected surprises.

Elaine Sims, Solicitor
Construction Team

It would be near impossible to avoid the recent press coverage over fines imposed by the Office of Fair Trading (“OFT”) as a result of their multi million pound inquiry into bid rigging which began in 2004. For those unfamiliar with the term, bid rigging, largely in the form of cover pricing, is a type of fraud where one or more bidders arranges for competitors to submit an artificially high bid. This bid is not intended to win the contract but is submitted as a genuine bid to give a misleading impression to clients about the level of competition. This form of collusion is illegal in the UK under the Enterprise Act 2002. It almost always results in economic harm to both the client seeking the bid and to the public who ultimately bear the cost as taxpayers. Contracts involved in the OFT inquiry included public authority work as well as private tenders.

The OFT uncovered evidence of cover pricing in over 4000 tenders involving more than 1000 companies leading it to conclude that it was a ‘widespread’ and ‘endemic’ practice throughout the construction industry. Fines were imposed on more than 100 construction companies and the key message resulting from the inquiry was that bidders should not engage in cover pricing in any form. If a potential bidder is unable to submit a competitive bid then it should refuse to submit at all and be prepared to tell the purchaser the reasons for this.

Those found guilty of offences claimed that cover pricing is a historic and industry wide practice not understood to be illegal and for the most part, its purpose was to enable a company to provide a bid that appears plausible and be close enough to the winning bid that the firm would be considered for any future tenders.

Crucially, they argued, during the tender process there would always be a number of competing tender bids so the winning price would be a competitive price anyway, thereby rejecting the claims that the practice was either fraudulent or anti-competitive. Controversially, and contrary to the OFT’s intention to send a ‘strong signal’ that this type of behaviour was unacceptable, critics have argued that the construction firms who were found guilty managed to escape with fines averaging only 1.1% of their turnover.

The OFT inquiry has concluded and the fines have been imposed but still the issue refuses to go away. Bid rigging continues to make headlines around the world. In Australia, cover pricing is being investigated by the Australian Competition and Consumer Commission with a view to imposing hefty fines of up to 10% of a company’s turnover on guilty parties. In Japan, bid rigging is both a violation of Japanese criminal law and their anti-monopoly law but remains common practice.

A number of academic research studies carried out both in Japan and in the USA revealed it to be a system which inflated the cost of construction projects estimated to waste billions of Japanese Yen a year in tax-payers money. Despite thirteen high profile lawsuits concerning bid rigging in local government contracts being ongoing since the 1990s, the resignation and conviction of a high profile governor and years of negotiations by the Japanese government in trade talks, bid rigging appears to continue unabated. In the USA, the practice is a criminal offence under the Sherman Act and in Canada under The Competition Act but this has not prevented its practice nor widespread investigations taking place.

The intention of the OFT inquiry in the UK may have been for the construction industry to clean up its act but it is impossible to predict to what extent this will happen. However, it has served to highlight what is and what is not acceptable practice and to warn firms who have already faced investigation that they will now be expected to be particularly aware of the competition rules. If they fail to do so, they will face severe penalties.

For advice and assistance in relation to bid-rigging please contact your usual contact for details of Morton Fraser’s fraud and financial crime team.

Lisa Dromgoole

Many of us in the construction industry seem to be hearing the same old bed time story over and over again: A instructs B to do the work; B does the work; A does not pay B; for months the parties dispute the level of payment due; B becomes fed up waiting for payment and takes steps to wind up A.

Is this the most appropriate way to deal with a disputed debt?

From an economical point of view, it is preferred if parties can correspond with one another to resolve a disputed debt. After all, they may have a good working relationship which they will be keen to preserve and do have the most knowledge of the contract at the centre of the dispute. Relationships can deteriorate rapidly in the event that parties fail to fulfil their contractual obligations regarding payment timeously.

That having been said, you can only listen to the words, “the person dealing with this is in a meeting” or “a cheque is on its way” for so long. Soon, parties become paranoid and what could be genuine comments are considered to be stalling tactics. With those in the construction industry still feeling the raw effects of the recession, it is perfectly conceivable that the promised cheque may never arrive.

But can the non-paying party relax in the knowledge that a court is unlikely to grant a winding-up order if the debt is genuinely disputed? The recent case of Lachonta Foundation v GBI Investments Limited [2010] EWHC 37 (Ch) would suggest not. In most cases, a court will dismiss a winding-up petition if there is a genuine dispute between the debtor and the petitioning creditor about whether the debt is due. In this English case however, the High Court placed a company into compulsory liquidation, even although the company had legitimate grounds to dispute the debt that the winding-up petition was based on.

Through case law, it has been accepted that, in exceptional circumstances, the court has discretion to place a company into compulsory liquidation, despite there being a dispute about whether the debt is due. This court decision is the first to consider the specific factors that the court should take into account when deciding if the circumstances of a case are exceptional. The following factors are relevant:-

1. Does the petitioning creditor have an adequate alternative remedy to compulsory liquidation?

2. Would the debtor company be solvent, if the court were to discount the petition debt?

3. What prejudice, if any, would the debtor company suffer if the court made the winding-up order?

In this case, the court granted the winding-up order. So debtors be warned: if your balance sheet is not looking too healthy, you may be at risk of being wound up. A court needs to consider what the most appropriate course of action for both a debtor and creditor is. It would be wrong to regard winding up a company as an idle threat. Nowadays, creditors are increasingly aware of their options to recover a debt and will not hesitate to pursue them. Lachonta confirms that courts will not hesitate to support them.

If you have outstanding debts, don’t bury your head in the sand – seek legal advice.

Alan Henderson, Senior Solicitor
Construction Team

The recent case of Royal Bank of Scotland plc v William Derek Carlyle serves as a salutary tale to funders to take extreme care in giving assurances to developers in the context of a loan arrangement. In this case the defender is a property developer. The bank agreed to provide him with a bridging loan in order to allow him to purchase land at Gleneagles Hotel in Perthshire. The repayment date was stated in the loan agreements to be 12 months from drawdown. The repayment date came and went with no repayment by the developer. The bank raised an action to recover the loaned funds. So far so good.

None of these facts were challenged by the developer in the context of the court proceedings. He accepted that he had failed to repay the loan by the repayment date however he raised an interesting and complex argument that an assurance was given by the bank at the time of the loan agreement that additional funding would be given to allow the development of the plot of land purchased. He submitted that the assurance was given by the Bank in the knowledge and with the intent that he would act on it be entering into the original loan agreements. The Bank did not provide any additional funding.

The developer’s case was that the assurances given by the Bank regarding additional funding amounted to a collateral warranty of which the Bank was in breach. He sought to counterclaim for damages in excess of the principal sum craved and withheld payments due under the loan agreements pending resolution of his claim for damages.

The judge in this case held that assurances by the Bank and its employees to the effect that additional funding would be made available amounted to a collateral warranty. A witness who was an ex-employee of the Bank provided evidence to the effect that assurances had been made orally regarding additional funding which was held to be sufficient to constitute the contractual relationship required for a warranty to exist.

Parties should take heed and funders in particular take care when negotiating loans that the loan documentation details all of the discussions between the parties and that assurances in relation to further funding are restricted to assurances which are to be followed through.

Lisa Dromgoole