Liquidity distress due to rising construction costs and pre-financing of work in progress: how do I prevent or solve problems?

Construction is picking up and it is noticeable everywhere. However, this positive trend does not mean that construction companies have definitively put the crisis behind them. In fact, construction projects are currently being completed that were taken on during the crisis period at so-called "crisis prices. Because there are also rising construction costs (labor and building materials), liquidity problems arise. In this article, we will discuss some options for responding to this.

Rising construction costs

Rising construction costs are currently the order of the day. Construction is in full swing and there is a shortage of piles, floors and sand-lime brick, among other things. The high demand for building materials logically causes prices to rise. So does the cost of labor. There is a shortage of good and affordable labor and therefore prices are rising.

Renegotiate on the basis of general conditions

In ongoing projects, contractors have options to pass on cost-increasing circumstances to the client. This is regulated by law and also by the most common general conditions (UAV / UAV-gc / AVA). However, the contractor must be able to prove that the price increase was not foreseeable during the acceptance of the contract and, in addition, the contractor must have warned the client about the price increase. In addition, only a significant price increase is eligible for compensation. Case law is not clear on what is meant by this, but last year the Arbitration Council for the Construction Industry gave an important rule of thumb. A price increase is significant if there is an increase of 5% of the contract sum due to the price increase of a component of the work.

In new tenders or bids, contractors have the option of including rising construction costs in the bid budget or in the offer. That contractors are taking rising construction costs into account is noticeable everywhere in the market. Consider, for example, the reports of budget overruns in tenders or the increasing number of failed tenders.

Renegotiate based on bankruptcy implications

If contractually there is no possibility to pass on cost-increasing circumstances to the client, it is still wise to enter into a discussion with the client. After all, liquidity problems at a contractor can result in bankruptcy, consider the recent bankruptcy of Bouwgroep Moonen.

A client suffers a lot of disadvantage from a contractor's bankruptcy. For example, the work will usually come to a halt for some time and the progress of the work is jeopardized with all the costs that this entails. Eventually, however, the work is often completed by a new contractor. This new contractor will not simply take over the contract. On the one hand because this contractor is also faced with rising construction costs and on the other hand because this contractor has to build on a job he is not familiar with. This risk will be factored in. These additional costs usually cannot be recovered from the bankrupt contractor and will be borne by the client. To avoid bankruptcy, a reasonable additional payment due to rising construction costs for the client may not be such a bad option after all.

Limit pre-financing of work in progress

In construction practice, work in progress must always be pre-financed. A long period of time often passes before materials purchased from suppliers are reimbursed by the client through the contract price. In the meantime, the contractor has often already had to pay his supplier and staff. When it is finally possible to invoice the client, a long payment period then applies. In light of the liquidity problems described above as a result of the crisis, is there nothing at all that can be done about this?

Contractors would be wise - and of course this is not new advice - to make the installment schedule negotiable as early as the conclusion of the construction contract. It is better to invoice smaller amounts more often to avoid pre-financing large amounts. This is also in the client's interest because the risk of serious liquidity problems on the part of the contractor is reduced.

It can also be agreed with the client that the purchase of materials may be invoiced directly at the time of delivery to the site of the construction project. For a construction company, it is then advisable to agree on short payment terms here: preferably shorter than the payment term agreed upon with the supplier.

Another possibility is that the client himself buys the material directly. Then the opportunity for margin on the material may evaporate, but that margin may be less than the interest paid to the bank to allow for pre-financing. A supply commission can also be negotiated with the supplier.

Conclusion

What is clear is that the crisis is still having an impact on construction practice. Liquidity problems due to rising construction costs are the order of the day. There are ways to pass on rising construction costs to the client, and there are also numerous options to mitigate liquidity problems in other ways.

It is important that you are aware of the options available to you from different legal perspectives. Our specialists in construction law, insolvency law and financing & securities therefore work closely together on this topic.

Written in collaboration with Marloes Beeren.