Carillion - too big to fail?
On 22 February Howard Kennedy hosted a round table for developer and construction sector clients. Among the issues under discussion was whether the construction industry is ready for a predicted rise in insolvency numbers, which was triggered unsurprisingly from the demise of Carillion. At the event Vernon Dennis, partner and head of Business Recovery and Reconstruction at Howard Kennedy, gave a short presentation, this article being a summary of the same.
In 2017 2,633 construction sector companies entered into a formal insolvency process. Construction is second to the financial services sector as the largest industry sector represented in the insolvency figures and is the 'fastest rising' sector. In addition a survey by accountancy firm Moore Stephens reported that 26% of companies in the construction industry are showing signs of financial distress.
The sector is potentially facing a perfect storm; with uncertain demand, rising material costs due to an increase in imports caused by a weakening pound, a skills shortage and the now seemingly perennial issue of Brexit uncertainty. The long term commitment that is required to obtain return from development is difficult to find in an uncertain economic climate. As a result the construction industry is currently being likened to a canary in a mine.
It was against this background that last year a number of profit warnings were made by the UK's second largest construction firm, Carillion. Carillion had grown to become a monolith, with a turnover of £5.2bn in 2016, a £1bn market capitalisation and 43,000 employees. In addition to significant infrastructure projects around globe and high profile involvement in major projects such as HS2, Carillion serviced 450 Government contracts; being a supplier of services to hospitals, schools and prisons and providing maintenance services for Network Rail and the Ministry of Defence. Surely Carillion was simply too big to fail?
In what must be the highest stakes game of chicken seen since the financial crash of 2008, the key stakeholders, a syndicate of Banks, the Government and the Board of Carillion in January staged 11th hour talks to see how the business could be restructured.
What occurred is slowly emerging, not least through the work of the Parliamentary Committee for Work and Pensions, but rather than a predicted restructuring through administration, the business collapsed into compulsory liquidation.
Despite the automatic termination of employment contracts, Carillion employees were implored to carry on working and the Official Receiver appointed six partners from PWC to act as special managers, to 'run' the Company. Business as usual was made possible by the Government underwriting the cost of public service elements carried on by Carillion.
But why wasn't administration used to restructure the business?
Initial reports that Carillion had just £29m left in cash in bank, and could not 'afford' to go into administration, proved to be somewhat misleading. It was far from secret that since July 2017 Carillion had been in detailed discussion with insolvency practitioners regarding a proposed restructuring of the business; a restructuring that would have been expected to have involved the use of an administration process. However what has become clear is that in the negotiations between Banks, Government and the Company, neither the majority of the Banks, nor the Government, were prepared to cover the costs and expenses of administration, namely the continuing trading costs and expenses that would have been incurred during administration.
The majority of the Banks (the Financial Times has subsequently reported that Barclays and HSBC had agreed to provide continuing support) were not prepared to risk further exposure. When they, as stakeholders, were so heavily exposed why were they not prepared to see if the business could be rescued or at least sold off in a timely manner, which would see their loss mitigated? Why were the likely trading receipts of the company during a potential administration likely to be dwarfed by the costs?
One of the issues lies in the problematic nature of construction company insolvency. The instigation of any insolvency process will in all likelihood be defined in any construction contract as 'an insolvency event.' This will allow for the election, at the option of the employer, the right to terminate the contract and exercise consequential rights such as 'stepping-in' to complete the works. The associated costs of finding a replacement contractor and taking over a project/site mean that it is highly probable that any value in the contract for the contractor is wiped out. As a result the contracts are more likely to be a burden as opposed to representing any realistic realisable value for the contractor. It is also near impossible to persuade an employer to continue to use a contractor carrying on business during an administration process.
Secondly even where the work has been completed and a debt remains, the employer is going to be extremely reluctant in handing over any unpaid element, wishing to retain some element in case defects arise in the future.
Another factor that must have caused the Banks to balk at the prospect of bailing out Carillion was the fact that many of the larger infrastructure projects were joint venture projects, which provided for rights of the co-venturers in the event of default. In many cases the other parties to the venture would take over the rights and obligations under the contracts.
In the case of Carillion there was also criticism that in a tightening market the management team had pursued contracts at too low a margin, with harsh penalties being extracted for delay. Three UK projects (two hospitals and a highway by-pass) were identified as being problematic, as were unpaid bills emanating from work in Qatar ahead of the football world cup.
This did not prove to be the case, with the flexibility of the UK insolvency system being evidence, an unlikely solution was found. By using compulsory liquidation, the Government has been able to make a more limited commitment to the Official Receiver, namely to only cover the costs that will be associated with continuing performance of the public contracts.
Was Carillion too big to fail? The Banks may have been unwilling to commit further funding and may have held a not unreasonable belief that the Government would step in to provide some form of funding/advance payment to ensure that Carillion did not topple over and that public services were maintained. This did not prove to be the case, with the flexibility of the UK insolvency system being evidenced, and an unlikely solution found, whereby the Government has made a more limited commitment to the Official Receiver, namely to cover the costs that may be associated with performing the public contracts.
Carillion was not too big to fail - it was too bust to save.
If you would like further information regarding any of the information above, please contact Vernon Dennis.