Australia: Collins inquiry into construction insolvency: Part 2 - safeguarding sub-contractor payments

Part 2 of a two-part analysis of the recommendations of the NSW Construction Industry Insolvency Inquiry. Part 1 considered the proposed NSW Building and Construction Commission.

The Inquiry aims to safeguard the interests of sub-contractors and was initiated by the NSW Government following a year marred by high levels of insolvency in the NSW construction industry.

The Final Report, released on 28 January, contains 44 recommendations. They include establishing a new regulatory body (NSW Building and Construction Commission), requiring contractors to set up and administer project trust accounts and strengthening the security of payment legislation.

This second instalment considers the recommendations to require contractors to set up construction payment trusts for all projects over $1m, strengthen the security of payment legislation and reform government contracting.

CONSTRUCTION PAYMENT TRUSTS –THE IMPLICATIONS

As the law presently stands, the construction contract sets out the payment terms and creates a debtor-creditor relationship between contract parties. The terms of the contract not only deal with payment obligations but also other protection and liability mechanisms such as set-off rights and termination and default and security.

Upon certification of payments due to contractors and subcontractors, the certified amount becomes a debt (which are personal rights at common law as well as equitable property interests). At present, the contractor is charged with managing that money responsibly as part of its working capital. The Report seeks to fundamentally change that position.

The Report recommends substantial changes to the parties' power to make their own arrangements. The Report makes reference to the Maryland statutory trust scheme and Ontario's Construction Liens Act and Project Bank Accounts. It will be useful to understand what aspects of those legislative schemes and contractual trust structures will be considered and adopted. The devil is in the detail.

An overriding purpose of statutory trust schemes such as Maryland's Construction Trust Fund Statute and the Ontario's Construction Liens Act is to protect the flow of payments from the principals all the way down the line to the lowest tier subcontractors, suppliers and tradesmen (via a cascading waterfall of statutory trusts at the different levels). They also create other obligations and encumbrances for owners and financiers. Will this slow down the investment in the infrastructure and building sectors and exacerbate the current economic challenges?

Those statutory schemes and the law related to construction in general arising from the reach of those schemes is a complex area and very technical. It will be useful to understand the costs of putting this scheme in place, and the impact it will have on owner's ability to finance projects or ability to deal with the property if there is a lien against the property placed by a party far down the chain. Good for the lawyers but is it good for the industry?

Depositing the moneys in statutory trusts (while attempting to give some certainty to subcontractors and their employees that they will get paid) cuts across the protection and liability mechanisms that the principal (or the head contractor as the case may be) generally put in a place in a contract.

Protection mechanisms such as set-off rights, access to security, termination and recovery of damages will be complicated by an additional layer of statutory regulation through the creation of statutory trusts. Contractors at all levels already have the benefit of security of payment and contractors debt recovery legislation.

A trust structure potentially encourages a "principal party" to a contract to reduce the amounts payable to ensure they retain more security or increase the level of security (in bank guarantees or insurance bonds) that the "contractor party" has to provide to realign the protection mechanism currently in place. This means banks will potentially impose greater capitalisation requirements for the "contractor party" in circumstances where a statutory trust structure has limited that party's ability to manage its working capital. It contradicts the notion that the law should not interfere with how commercial parties contract.

A further question that arises is whether the final trust beneficiary (often an under capitalised subcontractor trading as sole director corporation) will use that money to pay its workers. Will contractors be required to carry the double impost of limited working capital and industrial action if the ultimate workers remain unpaid?

And what of the contractors' employees? In the event of a contractor insolvency where project funds are held in trust, those funds will no longer be available for distribution in the liquidation to contractors' employees. The Report's recommendations could see that problem transferred to the Commonwealth by means of the GEERS scheme.

SECURITY OF PAYMENT, PAYMENT TERMS AND STATUTORY DECLARATIONS

The Report recommends amendments to the NSW Building and Construction Industry Security of Payment Act. When coupled with the construction payment trust outlined above the reforms are essentially a statutory codification of contract payment processes.

The Report proposes abolishing the need to include a notation on payment claims in order to invoke the SOP Act process. It appears claims for payment will attract the automatic operation of the SOP Act, the rationale being to enable subcontractors to have recourse to the SOP Act without fear of intimidation or reprisal. This assumes many subcontractors have chosen not to invoke the SOP Act, rather than the more probable scenario, that they have simply not known how to invoke and enforce it.

The statutory notation serves an essential purpose. It notifies the claim's recipient that the powers of the SOP Act are being invoked, thereby reducing the risk that claim recipients fail to respond as required.

A more effective means of reducing industry resistance to the SOP Act is the Report's recommendation to remove the right of a claimant to choose its own adjudicator. While claimants do not in fact presently chose an adjudicator, the recommendation would seem to be directed at the claimant's existing right to chose the authorised nominating authority, which in turn chooses the adjudicator from amongst its stable. While the existing mechanism puts some distance between the claimant and the adjudicator, there exists a strong industry perception that this still gives rise to a claimant-friendly forum. This reform should be embraced by Government as a means of eroding the unfavourable industry perception.

The Report recommends expanding the jurisdiction of the SOP Act to enable adjudicators to determine disputes concerning performance securities on an interim basis. Inclusion of a remit to consider bank guarantees may well see the need for a significant expansion of the matters to be considered by adjudicators, including claims for damages. Creation of a new (and perhaps less rigorous) forum for such matters would see adjudication become the "new injunction". Might such a reform effectively render performance security less commercially valuable?

Similarly, the Report recommends an increase in the SOP Act jurisdiction to enable adjudicators to resolve disputes concerning the entitlement or otherwise to retain retention sums. Given that adjudicators can already make interim decisions on retention, the proposed power of "resolution" of retention disputes suggests that what is being considered is a power to make a final determination on retention. This, surely could not be decided fairly other than through a consideration of all issues in dispute.

Another such recommendation concerns the residential building sector, with the proposed expansion of the jurisdiction of SOP Act adjudicators to resolve disputes in the home building sector in respect of projects valued at $1m or more.

As to contractual payment terms, the report proposes mandatory maximum payment periods, with payment terms for contractors extending no longer than 15days and payment terms for subcontractors extending no longer than 28 days, coupled with penalty rates of interest for late payment. Additionally, the Report recommends a right for subcontractors to suspend work for non payment within that timeframe, but no such corresponding right appears to be afforded to contractors.

Finally the report calls for mandatory statutory declarations as evidence of downstream payment, coupled with increased enforcement powers relating to false declarations.

Government projects attract an additional layer of recommendations, with Government posited as the vanguard for industry reform.

The Report calls for Government to re-evaluate its value for money criteria, with the suggestion that value for money has become a euphemism for lowest price. Significant policy thought would be necessary if any reweighting was to be required, in order to ensure that true value for money can be achieved. No doubt, Government would also need to be prepared for the budgetary impact.

The Report favours rolling financial checks on contractors to Government. Government contractors would seemingly face two layers of financial checks; one by the NSW Building and Construction Commission and another by its Government client. The question for Government is why the need for an additional layer of financial monitoring if the industry wide checks are to be probative?

Seemingly in addition to the statutory payment trust, the Report recommends the use of mandatory Project Bank Accounts on all Government projects. What is not clear is how such Project Bank Accounts will sit with the mandatory trust requirements that are also favoured.

Finally, the Report recommends establishing some kind of dispute prevention and resolution process following the lines of those recommended by Dispute Resolution Boards Australia, for every Government contract with a project value of over $10m. While the dispute avoidance function of DRBs is commendable, enshrining such arrangements in legislation raises the question whether Government is prepared to pick up such a standing cost on hundreds of projects (possibly with thousands of contracts) or whether that cost would be passed on to industry.

CONCLUSION

The Report recognises that challenging economic conditions have played a substantial role in the rate of insolvencies. The key question for Government remains: how will more regulation impact NSW's competitiveness as a destination for the much needed investment that underpins the building and construction industry?

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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