More Money, More Problems: Construction Disputes Following Covid-19

The Covid-19 pandemic has posed many threats to our way of life over the past eighteen months, and the construction industry is no exception. With constant changing of Government restrictions, lockdowns and challenging working conditions, the disruption has wreaked havoc on the construction industry and impacted every part of the supply chain. One consequence of this is the boom in construction disputes and alternative dispute resolution procedures.

While the vaccine rollout has proven to be a lifeline to economic recovery, the opportunity to act unfaithfully still exists and will continue to be exploited by employees, employers and external fraudsters. Financial crime has historically always been an issue in the construction sector, and the pandemic has made the sector even more vulnerable. From fraud claims to contract disputes and delay claims, the industry is set for a bumper year.

This article examines the common areas of construction disputes with the involvement of forensic accountants:

Fraud and financial crime
Contract disputes and pricing
Delays

Fraud and financial crime

The construction industry’s exposure to financial crime has been heighted by the pandemic. Opportunities for crime within the sector exist across the life of a construction project, from fake training certification, bribery in procurement, tax evasion, price fixing, to misuse of cash and other assets. As well as creating opportunities for individuals to commit fraud, the pandemic has, in a way, incentivised fraud as a survival mechanism for some to cope with the adverse trading conditions the pandemic has created. Identifying fraud is a case of knowing where to look and what to recognise. Employees, employers and third parties are likely to resort to any number of new and old techniques, including:

Cash payment fraud: cash is still heavily used in the construction industry, as many contractors and subcontractors still prefer cash payments for their services. Construction projects are commonly the most expensive thing consumers will pay for, who may be asked to provide large upfront payments. The placement of a large cash sum into the hands of a contractor can result in them taking the money and using it for something else, leaving subcontractors unpaid and the job unfinished. By creating a clear cash audit trail and minimising the use of cash payments, a business can more effectively manage its cashflows and identify fraud more quickly.
Invoice fraud: research by Tungsten estimates that construction businesses lose more than £1.8bn from invoice fraud each year, the most of all sectors surveyed. This includes those affected by business email compromise scams, which have become one of the most financially damaging scams of the modern day. When the pandemic started, more and more companies had to quickly adapt to a cyber world whilst working from home, which created vulnerabilities in their processes and systems and a fertile breeding ground for fraud to occur. Enhanced fraud risk training, with particular focus on cyber security, is paramount for a business to keep its employees informed of the ongoing invoice fraud risks. Common red flags include duplicate invoices, changes in bank account details and the receipt of unexpected invoices.
Supplier fraud: this is an emerging trend that coincides with the rise in the cost of building materials (discussed further below). Supplier fraud includes the supply of incorrect/low quality goods, or the receipt of fewer goods than ordered and/or counterfeit materials. Construction companies should have a robust inventory system that effectively manages the inflow of materials on a project.
Theft: after only two weeks of lockdown, in April 2020, theft from construction sites rose by 50% in the UK as thieves looked to take expensive tools, equipment and cash to make quick money. This was in stark contrast to the overall 40% drop in crime rates more broadly following the implementation of lockdown measures. Even prior to the pandemic, Allianz estimated that the industry lost £800m in 2017 through theft and vandalism. Whilst external security measures are the most obvious protection, other internal controls should be in place to deter and avoid any losses from staff.
Tax evasion: making false declarations to HMRC, whether it be via falsely claimed deductions, ‘off record’ income or abuse of the Construction Industry Scheme, is thought to be widespread practice in the construction sector. In the annual “Measuring Tax Gaps” 2020, HMRC estimated that tax evasion contributed £4.6bn towards the tax gap. Though HMRC’s report does not measure this data for individual industry sectors, the construction sector has traditionally been associated with high levels of noncompliance.
Covid-19 support payments: the construction industry is often seen as key to economic recovery, which results in large cash outlays as part of government incentives. This is frequently preyed upon by fraudsters who seek to secure these funds illicitly, for example by improper furlough/bounce back loan applications. The above factors and the construction sector’s high exposure to fraud raise the question of how to identify when fraud is occurring and how to mitigate the risks. Business owners are often best positioned to initially identify anything unusual, particularly when there are accounting irregularities in the financial records. However, to understand the extent of the offence it is important to engage with a professional to undertake a comprehensive review of the business records.

Whilst the pandemic has created greater opportunities for fraud within the construction sector, fraudsters are developing more sophisticated tactics and increased digitisation has outpaced the ability of companies to update their systems quickly enough to combat the rising fraud cases.

Contract disputes and pricing

Market indications and the general uncertainty of future trading conditions show that 2021 may bring the perfect storm of a negative economic environment, increasing the likelihood of future disputes across the supply chain. These factors include material and labour supply chain shortages and the unveiling of new taxation rules against the already challenging backdrop of Brexit. Although construction is one of the fastest recovering sectors from the pandemic, construction disputes have more than doubled in 2021 compared to 2020. The average value of a dispute in the UK rose to £27.7m last year, up from £12.6m in 2019.

The source of contract disputes vary considerably and include a mix of legacy contracts entered into prior to the pandemic and newer contracts, the latter potentially including additional clauses to mitigate the risk of the current supply and pricing issues. However, on both fronts, cost recovery is paramount following the pandemic and the level of working capital required to stay afloat in the competitive marketplace is increasing. Construction businesses are therefore keen to increase their cash reserves accordingly.

Pricing

As businesses shift their focus to rebuilding after a tough eighteen months, contractors and subcontractors face considerable risk when pricing new jobs given the uncertainty of the last eighteen months. Optimistic contract pricing can lead to late payments and result in relationships between contractors and subcontractors quickly turning sour.

Pricing strategies have become increasingly fraught given the inverse relationship that has developed throughout the pandemic between supply and demand of materials. Although lockdown restrictions caused supply to fall, this was met with increased consumer spending on home improvements. Demand is far outstripping supply and consequently the cost of materials has skyrocketed. According to the Department for Business, Energy and Industrial Strategy, the cost of materials for repair and maintenance work rose 12.8% between May 2020 and May 2021. On a larger scale, in June 2021 construction output reached a 24 year high.

Contracts within the sector are not generally fit for volatility, and depending on the wording of the contract, cost inflation may fall onto the contractor or consumer. The rise in the cost of materials is so significant that contractors who agreed on contract prices only months ago may find themselves deep into the contract reviewing their pricing and dispute resolution clauses.

Force majeure

A matter of critical importance in these disputes is whether the pandemic constitutes a force majeure. This is an unforeseeable event that prevents/delays performance, either indefinitely or for the duration of the force majeure, and it is outside the control of the parties to a contract. Force majeure events usually entitle a contractor to an extension of time and relief from liability for delay liquidated damages.

There is no single established principle for force majeure in English Law. Rather, the circumstances in which it applies depend on the whether a contract contains a force majeure provision and the wording of the provision. Some contracts treat a force majeure as neutral (i.e.the risk lies where it falls), and some entitle the contractor to recover any costs suffered or incurred because of the force majeure.

This means that although some contracts stipulate what events would constitute a force majeure, where this not the case, there is a lack of clarity on whether a force majeure has occurred, and consequently whether one or both of the parties’ contractual performance obligations are excused.

The significance of this from an accounting perspective is that where Covid-19 is not deemed to be a force majeure under a contract, the occurrence of the pandemic is unlikely to relieve a party from its liabilities, and there may be a viable business interruption claim. A company’s loss claim can be complex when there are several factors at play. This is only exacerbated when overlayed with the impact of Covid-19. In such scenarios, calling on a professional to quantify the scale of the loss is necessary, and would likely involve making various assumptions and calculating the alleged loss under a number of counterfactual, or ‘but for’, scenarios.

Delays

The pricing and demand issues discussed above give rise to another source of dispute: project delays and missed deadlines, which is perhaps the most obvious claim likely to arise as a result of Covid-19. Significant strain had already been placed on supply chains prior to the pandemic due to ongoing negotiations from Brexit, and Covid-19 has made a bad situation worse. Government measures imposed to mitigate the effects of the pandemic have further hampered construction companies to meet agreed deadlines. Multiple lockdowns, as well as restrictions on the number of staff members permitted on site, have caused production to come to a grinding halt for prolonged periods in the past eighteen months. In recent weeks, labour shortages have been particularly acute following the NHS Covid app ‘pingdemic’. In the first week of July alone, more than 500,000 people in the UK were ‘pinged’ by the NHS Test and Trace app, which resulted in thousands of tradespeople and lorry drivers self-isolating, causing further delays across the supply chain.

The timing of delays is important when assessing the availability of relief due to Covid-19 and will vastly depend on the individual contract provisions. If a party is entitled to delay claims, it is vital that there are sufficient records to support the additional cost and time incurred, and any financial loss.

Failing to meet deadlines as part of a construction contract on grounds of the inability to obtain materials can have serious legal ramifications, and it is questionable whether the inability to obtain materials is an adequate defence in the eyes of the law for a party to justify delays. We therefore expect to see such matters tested in Court in the coming months.

Conclusion

Following the onset of Covid-19, the scope for disputes in the construction sector has never been higher. Current reports show that 3 out of 4 contractor disputes relate to Covid-19, and the risk of a steep rise is imminent. Disputes in a post Covid-19 world are likely to centre around fraud, spikes in material costs and delayed projects, and we expect it to carry on well into the future.

If you would like to learn more about how we can help your business, please get in touch with the Forensic Accounting Team or get in touch with your usual contact at Azets.

More Money, More Problems: Construction Disputes Following Covid-19