The Impact of Construction Insolvency on Small to Medium Subcontractor Companies

In the modern dynamic construction industry, insolvency is a common phenomenon. Insolvency can be simply defined as a situation whereby a company is unable to pay its debts (insolvent) due to lack of insufficient assets to cover its debt. In this case, the value of the assets is subordinate to the number of liabilities. The moment a company turns out to be insolvent, certain courses of action ought to be taken which sometimes could lead to solvency. Upon recognition of solvency, the insolvent company must be very cautious not to further increase the liabilities. Insolvency of firm in the construction industry can have a significant impact on other firms. This research examined the impact of insolvency of construction companies on small to medium sized construction and manufacturing companies in the UK through review of existing literature. The results of the review showed that the main revolve around financial aspect part of it including cash flow management, delayed payments and reduction to payment. This study will involve reviewing both primary and secondary sources of information in an attempt to recall the factual information. With the accomplishment of the study, information on the effects of the insolvency of larger construction companies on the smaller subcontractor companies which have been recorded. The findings of the study will be of importance to the policymakers when developing frameworks used to mitigate the problems facing small to medium subcontractor companies in case of an insolvency of a more substantial construction company.

Key terms: Insolvency, Carillion Collapse, and SMs (small-to-medium enterprise)

Introduction

The construction and Manufacturing Industries play vital roles in the national economic growth and development. In the UK, the construction sector plays a significant role in the economic growth and development. According to the statistics released by the Office of National statistics in 2013, the growth of the construction sector by 2.5% in the third quarter of the year led to economic growth of the country by 0.8% within the same period. The above statistics, therefore, showed that construction sector is of great importance to the economy of the United Kingdom. Additionally, the construction sector is more labor intensive. Thus, it provides more employment opportunities to the citizens of this nation. The above information, therefore, depicts that fluctuations in the operations and numbers of the companies in the construction sector we lose significantly impact the economic growth of the whole nation. On the other hand, an increase in production within the construction sector will affect economic growth positively as supported by the ONS statistics

The primary job of the construction industries is to set up infrastructure, repair, and maintenance the existing infrastructures. However, this task is very complicated, and thus the various factors affecting its development process cannot be omitted. The main elements related to the growth of a construction industry include policies and visions of the industry, availability of institutional and material resources, environment, culture, thoughts and behavior, availability of financial and human capital and technological advancements (Fox and Skitmore 2007, p.182). The elements mentioned above determine the development of the companies directly or indirectly.

Concerning the elements mentioned above, it is vivid that insolvency of a larger construction company will affect the smaller subcontractor companies which are dependent on them. The bankruptcy of a construction company would affect the availability of material resources, availability of finance capital and availability of market to the products and services of the subcontractor companies (Lynch, 2011). The impacts mentioned above would lead to insolvency of the subcontractor companies due to the negative impacts on company development.

According to the UK insolvency statistics, released on 26 January 2018, the number of construction companies going insolvent has increased by 4.2% as compared to the figures of the year 2016 (Smith, 2018). The available data, therefore, shows that most of the companies are currently going bankrupt leading to their closure. The closure, referred to as liquidation, is likely to affect the economic growth of the nation and the operations of the smaller subcontractor companies which depend on the construction companies. In this view, more companies in the construction sector we face liquidation including the subcontractor companies which supplied the products and services to the more substantial construction companies (Wiklund, and Shepherd 2003, p.131).

In this article, the subcontractor companies have been used to represent the constituent companies which partner with the more prominent construction industries in their activities. This category of companies includes sectors which supply construction materials, construction designs, and other related construction requirements. The consumer firms, which depend on the construction companies to provide the conditions for their activities, can also be referred to as subcontractor companies (Stewart and Gallagher 2012, p.43). That the supplier and consumer firms are adversely affected in case of liquidation of a substantial company. The argument mentioned above, therefore, supports that most subcontractor companies and will be affected by the insolvency of more significant construction companies.

Most studies on the construction and manufacturing companies have mainly focused on explaining the failures of the project level but have not recognized the effects paused at the corporate levels (Arditi et al. 2000, p.127). Insolvency of a more substantial company is likely to cause very many challenges to the smaller subcontractor companies, which source their funds from the supply of goods and services to the larger companies. Liquidation the larger companies and will affect the cash inflows and outflows that is, the costs incurred and revenue earned from the sale of the products and services all the sub-contractor companies. This argument shows that liquidation of the more great construction companies affects the market for the products of the subcontractor companies leading to financial constraints and eventually bankruptcy.

As described by Smith (2018), 14, 937 companies faced off due to insolvency and liquidation. Out of this number, 2557 companies were operating under the construction sector. From the statistics, it is thus apparent that more industries from the construction sector are currently entering and bankruptcy. It is evident that most subcontractor companies are likely to be affected and we are venturing becoming insolvent. The ONS statistics also recorded that construction sector and has been the highest contributor to the company insolvencies in the previous five years, dating back to 2016. The above information, therefore, shows that there is need to identify the problems faced by subcontractor companies in the essence of an insolvency of the larger construction companies.

Following the current trends of company insolvencies under the construction sector, there is need to determine and set up effective strategies that would limit or reduce the number of companies going insolvent (Arditi, Koksal and Kale 2000, p.120). In addition, there should be frameworks set to rescue the sub-contractor companies in case of insolvency of a construction company on which they depend. The mitigation measures and the frameworks produced should be mutually beneficial to the construction companies and the subcontractor companies.

Various studies have been conducted on the construction company insolvencies in the United Kingdom. Numerous causes of company insolvencies under the mitigation measures have been recorded with the aim of providing frameworks for company recovery strategies. From the review, it was noted that most research is revolving around the larger companies, but the effects and the impacts posed by the insolvencies on the subcontractor companies have been neglected (Reuvid, 2002). The previous studies show very little information on how the bankruptcies of larger construction companies affect the subcontractor companies leading to their insolvency. This inadequacy of information compromises the strategies that would be put in place to rescue the sub-contractor companies in such distress. The above argument, therefore, provides the need to determine how the insolvency of more notable companies affects the survival of the subcontractor companies leading to the bankruptcy.

From the above information, a research niche can be drawn. To fill this research gap, a study which is structured into a single phase will be conducted. The study will review the existing literature extensively with the aim of determining the bottlenecks faced by the subcontractor companies due to the insolvency of a larger construction company. Additional information on the mitigation measures or the turnaround measures will be gathered from the existing literature with the aim of expanding and generalizing the theories, which have been used in the construction industries (Kale, and Arditi 2001). Further information on the relationships between the construction companies and the subcontractor companies with being reviewed and recorded. Understanding the relationship between the above-mentioned companies will help in investigating the problems associated with the construction companies’ insolvency.

Being a survey study, qualitative research approach which will apply the multiple case study approach will be used. The choice of the method to be used is borrowed from Tracey et al. (1995) study, which argued that a case study approach is essential in building a theory. As supported by Haddad (2009), secondary sources will be used in the formulation of the proposed mitigation measures. The reviewed resources will be used in the formulation of the strategies which are required to mitigate the effects of the insolvency of the more notable companies on the subcontractor companies.

Various objectives have been formulated achieve the aims of the study. Investigating the impacts of the insolvency of more substantial companies on the subcontractor companies is the primary objective of this research. This objective is supported by the fact that there is need to determine the bottlenecks that the smaller subcontractor companies face due to the bankruptcy and liquidation of the more significant construction companies. The specific objectives formulated to achieve this aim included; 1) to identify the main factors leading to company insolvencies in the construction sector; 2) to investigate the relationship between the construction companies and other small manufacturing companies; 3) to determine the problems faced by the small subcontractor companies in case of a collapse of a construction company; 4) to formulate strategies and frameworks used for the recovery of the affected companies; and 5) to propose recommendations for the consequent researchers and policymakers based on the findings.

Upon accomplishment of this study, a framework showing the various strategies that can be used to mitigate the challenges faced by the dependent companies in case of insolvency of a more substantial company will be recorded. The study will also offer a full review of the impacts of the bankruptcy of the construction and manufacturing companies on the small subcontractor companies. Additionally, the study attempts to enjoin various views from the individual stakeholders with the aim of producing common mitigation strategies with little or no adverse effects on the consequent stakeholders.

Literature Review

Various printed and electronic journals were used to further the understanding of all the previous studies conducted in the construction and built environment industry field. Additionally, reliable online sources of information were used in an attempt to understand the importance of the sector mentioned above and the insolvency problem it faces. Crucial information about the mitigation strategies and the relationship between construction companies and the subcontractor companies was also reviewed. The reviewed data was then recorded and discussed below.

Small to Medium-Sized Companies

To examine the impact of impacts of insolvency of construction companies on small to medium sized construction and manufacturing companies it is essential to understand Small to medium-sized companies (SMEs). Jenkins (2006, p.252) defines SME’s as non-subsidiary independent companies or firms which give jobs to less than a given number of employees. The particular number differs across countries. Two hundred and fifty is commonly considered the highest number of employees in which these firms can hire or employ according to the Europe Union. However, 200 employees are recognized to be the upper limit number of employees in some countries while per the United States, SME’s comprises of firms which have less than 500 employees. Small firms simply include those with lesser than50 workers or employees while micro-enterprise hold up to ten and other cases five employees. In some countries like European Union, SME’s can also be measured in terms of annual turnover which should not exceed EUR 40 million and or a balance sheet valuation of not more than EUR 27 million (Jenkins 2006, p.252).

SME’s have their own significant role in economic growth as they provide sources for most new jobs. More than 95 percent of OECD firms comprise of SME’s which assure for about 60-70 percent employment in the majority of countries (Storey 2016). As bigger companies reduce and outsource further functions, the impact of SME’s in the economy is escalating. The stiff competition basic in entry and exit of smaller firms consequently facilitate productivity growth and leading to economic growth. This progressive development contributes to high job turnover rates proceeded by churning in labor markets. Only less than half of these small start-ups last for a period exceeding 5 years, only a small fraction stand out and grow into the core group of high performing firms which propel industrial performance and innovation. This instigates a desire for the government to set up policies and framework requirements with the aim to enhance expansion and creation of new firms (Fuller‐Love 2006, p.180).

According to Morsing and Perrini (2009, p.6), the question of which sectors SME’s are found is a subject that can never go without mention. Generally, SME jobs are generated in the service sector which surprisingly commands about two-thirds of the economic activity and employment in OECD countries. Particularly, smaller firms are found in retail and wholesale trade, restaurant and hotel business, construction as well as communication and business services. SME also satisfy for the increased achievement in the manufacturing firms among many OECD countries, therefore, providing up to half of the OECD manufacturing employment (Jenkins 2009, p.35).

Currently, technology-intensive industries including biotechnology and information and technology are rapidly growing in number. This means SMEs to a certain extent overshadow crucial business subsector inclusive of marketing, human resource development, services correlating to computer software and information, business organization together with research and development (Stewart and Gallagher 2012, p.57). In recent years, about 10 percent annual growth in knowledge-based services has been recorded. This is particularly due to the elevated outsourcing by the vital manufacturing firms in conjunction with the recent technologies that have largely contributed to the market niches win by SMEs. The reality being that the medium firm size in strategic business services is just a fragment of the average size of firms in the manufacturing or even economy at large is clear evidence that SMEs is very vital in this particular field.

The Collapse of Carillion

Carillion is a major construction company and a global player in the promotion of Public-Private partnerships which has undergone liquidation in the UK. The collapse of this giant Carillion is a record of happened and that is wrong with Public-Private Partnership with respect to building and operation of public infrastructure (Loxley 2018). It supported and financed up to more than 60 Public-Private partnerships as well as providing facility management services at the time the construction was finished. Carillion was the second in position among the largest constructors. This company handled a large percentage of government outsourcing contracts, performed project financing and construction. It provided maintenance services including cleaning and catering in the health service hospitals in the UK and up to 900 schools completely relied on meals provided by the same Carillion (Loxley 2018). It was taken care the cleaning services of about 230 schools and at the same time maintaining 50,000 homes on army bases. Prison contracts and work on highways, as well as high-speed rail projects, were among its duties.

Carillion Company employed a total of 46,000 workers from worldwide, 19,600 in the UK and 6,000 in Canada thus making annual sales of 5.2 billion pounds. The main reason that led to the collapse of this giant Carillion was the failure to execute enormous debt commitment in 2017 (Loxley 2018). The huge debt was caused by the over-expansion of Public-Private partnerships, reduction of new public-private partnerships deals and remission in the implementation of a considerable number of its large P3s with big up-front costs in the UK since the government assesses the P3s strategy grapes with Brexit. Several factors all together led to the cash flow inconveniencies for this giant company, which previously had been concealed by the persisted expansion of Public-Private partnership business (Loxley 2018). In the process, profits were effectively decreased. July 2017, Carillion recorded 845 million pounds of debt, 470 million pounds on account of Public-Private partnership in Canada and the Middle East and consequently a total of 375 million pounds on the account of UK Public-Private partnership business (Loxley 2018).

The situation worsened and luckily the Tory government intervened in support of the private business in the public infrastructure and service provision and as a result, it was granted more contracts by the government, a sum of about 1.3 billion pounds towards the close of 2017. Despite all these efforts, the profit and cash flow problems persisted and by the New Year 2018 Carillion’s share price had gone down to 7% only of its may 2017 level thus the company faced liquidation (Smith 2018, p.21). This meant that the government of UK had no option but to chip in to make sure that school children did not fall short of food, that food and laundry facilities to patients were made available, that roads were properly managed and prisons well staffed. The significant question elevated by Carillion’s failure is that essential public services cannot at any given time be outsourced to private contractors; the government must underwrite risks of collapse.

Oversight of Public-Private partnership companies which is a responsibility of the auditors was also another issue under discussion upon the collapse of the giant Carillion. Carillion’s auditor (KPMG) granted a seal of approval to its financial statement just ten months before liquidation. This was contrary to Carillion’s own declaration of deteriorating finances toward towards the end of 2016 after which unsustainable increase in debt was announced (Loxley 2018). The facts remain that large auditing companies are obligated in all prospects Public-Private partnerships, from the evaluation of proposals and measurement of money value to assessment and auditing them such that it is almost impossible to be objective.

The collapse of Carillion significantly affected the smaller and medium sized companies who were carrying work for this giant company. Substantial proportion of Carillion’s construction work was project management undertaken by several small sub-contractor companies. Many of these small sub-contractor companies were left unpaid for the work they had already completed and the goods and services they delivered to Carillion. Generally, Carillion used to pay 120 days after the invoice date (Loxley, 2018). Therefore, not only were immediate outstanding work were affected but also those dating back months. Consequently, the collapse of Carillion created holes in cash flow of over 300, 00 small sub-contractor companies. Critical working capital disappeared from the balance sheet of these companies, which significantly affected their activities and stability. This impact was significant that both the government and the banking sector step in to support the SMEs that were affected by the collapse of Carillion.

Factors that Trigger Company Insolvency in the Construction Industry

According to Kale and Arditi (2001, p.547), most researchers conducted studies aimed at determining the drivers of failures and insolvencies in the built environment and the construction sector of the United Kingdom. Vast information regarding the various reasons for company business failures, bankruptcy and liquidation have been gathered and recorded by multiple studies.

Fox and Skitmore (2007, p.182) outlined the factors affecting the development of a construction industry of a country. In their argument, they included the following as the primary drivers of a company policies and visions of the industry, availability of institutional and material resources, environment, culture, thoughts and behavior, availability of financial and human capital and technological advancements. However, this was just a general conclusion having no background study on specific companies and the operations. Their argument was later supported by various researchers who supported the factors mentioned above as the key drivers of company development.

According to UK insolvency statistics (2018), company insolvency refers to the inability of a company to set off its debts and enter liquidation. It further expounds on it as a state where the company assets are less than the company liabilities. Company insolvency is therefore defined as a state in which the company’s obligations exceed total valuations of the company assets, and therefore, the company is unable to settle the debts from the creditors. Arditi et al., (2000, p.129) noted that an insolvent company has to either go into liquidation or a recovery process.

On the other hand, French D (2017, p.39) defines liquidation as the process that brings the existence of a company to an end by stopping all the company activities and transactions. Various aspects must be put into consideration when looking at liquidation including compulsory liquidation, voluntary liquidations, administrations, voluntary company arrangements, and administrative receiverships. Considering liquidation of a company, all the assets of the company are sold with the aim of settling the debts of the company.

Recently, numerous studies have been carried out by either groups or individual researchers, showing the causes of failures and collapse of significant construction industries in the UK. According to Butler, Christofferson, and Hutchings (2003), the company failure is dependent on the company size and age (p.57). The probability of a firm to fail reduces with the increase in its period of operation. In this study, they explained that at the invention time, the company is more prone to failure, however, as the company grows in the business environment the adjustments made in the company’s operations and activities minimize the occurrence of a failure. Generally, new companies usually lose alarm about their businesses, settings and management strategies but with more inventions and standardization of the company processes the management could understand and adjust to the environmental requirements and limits. He also argued that at the invention time the company has a narrow market range and little experience in their activities and thus can not conform to the full environmental settings. Arditi et al., (2000, p.130) also confirm the strength of this line of argument in their study. The study supported the above information premises by arguing that after a reasonable period in the market, the company in a business setting adjusts to create a good rapport with the creditors, suppliers, clients, and other organizations. The connections would help in a bidding a right company image and more business networks, required for positive yields of the business. Also, more clients and parties with interest in the company will prove the company legitimacy thus proportionately reducing the risk of failure. The above arguments depict that most of the companies which are likely to be faced off and are at high risk of failure are the subcontractor companies.

There is a possibility of reducing the risks of failure in the small and new companies through diversification, which is achieved by increasing the number of company’s activities and the company size, the risk of failure would be minimized. The study, therefore, argued that moving from a single production system to a multilateral production system would reduce chances of the company business failure. Another review Freeman et al. (1983) argued that the risk related to the smallness and newness of a company is of massive impact to the company development. However, in their argument, it was noted that the implications of brevity are less significant. Additional factors facilitating insolvency of construction companies can be highlighted in the case studies of bankruptcies discussed below.

In the first quarter of the year 2008, 500 building firms were stated to be insolvent, i.e., 500 companies abandoned their businesses due to bankruptcy. This number recorded the highest rate of insolvency since the year 2003 (Langdon, 2008, p. 73). The scenario in 2009 depicted the highest percentage of company insolvencies which was at 270,000, representing 11.9% insolvency rate. From the reports of the Office of National Statistics, this season showed the highest number of company insolvencies, which was more than the birth rates. In all the industrial sectors, the construction industry showed the highest insolvency rate with over 44,000 companies being insolvent in that year (Knight, 2010). The above data from the governmental organization strongly support that in the recent past, the rate of company insolvencies is on the increase in the United Kingdom.

Studies argued that environmental aspects are the significant determinants of survival or failure of the construction companies. These factors would be seen on the company performance, and they are known as the indicators. Dikmen et al., (2010, p.384) identified the indicators related to company failure and categorized the signs into the groups of “value chain,” ”resources,” ”decisions” and ”chance factors.” The factors mentioned above are organizational and environmental factors. The symptoms mentioned above can show growth and survival of the company, or they can indicate stagnation and failure of the company. For instance, weak administration and managerial skills are likely to raise the cost of production and operational expenses, inflict disagreements within the administration, and produce a lousy company outlook thus affecting the clients’ loyalty to the firm. Dikmen et al. (2010, p.383) argued that ”poor company image” is a determinant of performance as it is an intangible resource. He argued that companies with poor outlook would eventually collapse since the company image is a performance indicator. He explained the sources of a ”poor company image” to include insufficient capital and poor technical and technological capacity. Additionally, firm management and ownership could stagnate the expansion of the company, thus hindering its survival (Fletcher and Wearden, 2010).

 Collins (2001, p.45) categorized incompetence, poor working habits, poor financial management, lack of expansion or overexpansion and lack of managerial experience as the primary sources of company failures. The leading causes of company insolvencies included inadequate technical and technological capacity, low sales and profit, and industrial weaknesses. Kale and Arditi (2001, p.547) also conducted a study in which they declared that a poor company image, insufficient capital, poor relations with clients, poor networking and scarcity of resources were the main factors leading to company insolvencies. Butler, Christofferson, and Hutchings (2003, p.62) affirm that significant operating expenses, reduced technical and technological capacity, and reduced project cost estimation were the leading causes of company insolvencies. The above studies have identified the bulk of the information required for the reasons of the company insolvencies in the UK.

Impact of Insolvency of Main Contractors on Small Subcontractor Companies

Generally, insolvency of the main of the contractor companies affects various disciplines around the construction industry, particularly towards the small contractor companies. The issues mostly rotate around financial aspect part of it including cash flow management, delayed payments and reduction to payment. Cash flow among all is a very significant element of construction companies since there should be a pattern in the manner the cash flow. Matters to do with low overheads and low-profit margins are considered to be normal in the construction sector. But from workload reduction and increase in competition, margins are considerably reduced in order to manage the flow of work. This is one of logical strategy in stable and certain situations, however, construction projects are bound to uncertainty. Constructors’ payments can possibly be constrained by the consultant team or the client. In some cases, the clients fail to pay instantly while on the other hand consultants do not regularly certify fairly. Consequently, despite someone being a good contractor he/she has limited power over such conspicuous misuse of contractual victuals though they can mitigate the unfavorable effects with secure and cautious management (Alzahrani, and Emsley 2013, p.320).

 The main contractor companies in this case sequentially regulate the payments to the small subcontractor companies. The main contractor under these given situations can maneuver payments to small subcontractors for the purpose of counterbalancing complications with making payments (Ndekugri, and Russell 2005, p.399). Contract framework authorizes ruthless and aggressive financial applications and this behavior can, in turn, lead to increased level of ambiguity. Obviously, most of less meticulous and less able contactors tent to aggravate such situations for their convenience. Basically, small contractors are affected directly by the insolvency of the main contractors in terms of cash flow since under situation; the main contractors have the obligation and manipulate power overpayments to these small contractors. This can only mean that the insolvency does not only cause instability to the main contractor but also devolves down to the small and medium contractors (Lowe 2012, p.97).

Another discomforting issue pointing out to the insolvency of the main contractor is that the small and medium subcontractors usually endure delayed payment. According to Ruddock (2009), some large contractors usually pay small sub-contractors after certain period like 6 months. Therefore, insolvency of the main contractor will mean that the subcontractor will not be paid for the services and goods delivered for a period running six month, which can adversely affect their operation (Ruddock 2009). Since the cash flow to subcontractors entirely depends on the progression of the main contractor company, of course, the inability of the contractor to cover for its debt means that subcontractor will not be able to get their payment on time (Kenley 2003, p.21). Simply subcontractors’ payments are made periodically and in the same way, they pay for their supplies periodically too. It is therefore clear that subcontractors have no capital tied up in a project in case they receive payment before they undergo liability to pay their bills. On contrary, failure to get their cash or money in time totally changes the picture probably if payments to their supplies must not be delayed under any circumstance.

Under