By Jonathan Forsey*
In June 2016 New Zealand construction rates reached $17.8 billion nationwide. This construction boom is the result of an upswing in construction in Auckland coinciding with the continuing earthquake rebuild in Christchurch, and seismic work in Wellington. New Zealand’s construction industry is expected to be the single biggest driver of employment growth in any sector over the next two years. While the Christchurch earthquake rebuild is levelling, construction in Auckland is being driven by residential and commercial building projects.
This article summarises the payment claims and adjudication processes contained in New Zealand’s Construction Contracts Act 2002 (the Act). This article continues to a discussion of recent changes to the Act provided for in the Construction Contracts Amendment Act (the Amendment Act) with regard to the Retentions Regime. These changes have generated considerable discourse and this article will provide perspective on the implications the new amendments will have.
The payment claims process
The payment claims process allows the parties to a construction contract to agree on express terms for payment. A payment claim is an invoice for payment which must be issued by the party for work done under a construction contract. The Act prescribes the formal requirements for the payment claim. If the payment claim does not meet these requirements it will not be valid. The principal is not then required to respond to the payment claim.
If a principal wishes to dispute a payment claim they must respond with a payment schedule. As with a payment claim, the formal requirements of the payment schedule are contained in the Act. The principal must then pay either the figure in the payment claim or the figure they have proposed in their payment schedule. The parties will then attempt to resolve their dispute.
The adjudication process
The adjudication process is an alternative dispute resolution process designed to deliver a determination quicker than the court system, mediation or arbitration. Adjudication can, however, be undertaken simultaneously with those other processes.
Adjudication can be initiated by either party by serving a notice of adjudication on the other party. The Act contains the requirements for the notice of adjudication which, among the other form requirements, must set out a statement of the respondent’s rights and obligations in the adjudication and an explanation of the adjudication process. This notice establishes the width of the adjudicator’s jurisdiction; if the establishing party fails to include a dispute at this initial stage it cannot be added later.
The adjudicator must then be appointed within five working days either by the parties or they may request a “nominated body” appoint an adjudicator. Following the adjudicator’s appointment the claimant has five days to provide an “adjudicator claim” to the adjudicator and the respondent which provides their evidence documents and statements. The respondent will then respond in the same form.
The claimant may then reply and if the adjudicator permits the respondent may give a final reply. There are a range of strict timeframes involved here which are irrelevant for the purpose of this article but parties should be made aware they cannot be extended.
The adjudicator may then request copies of any documents not already provided, appoint an expert to advice on certain issues, call a conference of the parties and carry out an inspection of any construction work or any other thing to which such dispute may relate.
The adjudicator then typically issues a written determination. The adjudicator will require the parties to pay their fees before they release the determination. Any amount payable under the determination may be entered as a debt in the District Court. It can then be recovered as a debt, the same way as any other court judgement.
A new retentions regime has been introduced by the Construction Contracts Amendment Act (the Amendments Act). Retentions are the portion of funds held back from payment by the party to a Construction Contract. Retentions can be held between principal and head contractor but may also be held back by a contractor when dealing with a sub-contractor. These are retained to ensure a contractor performs their obligations under the contract. The retained funds have to be held separately by the retaining party at each level of the contract even if they all ultimately relate to the one construction contract.
The catalyst for the new regime was the collapse of Mainzeal Property and Construction (Mainzeal) in 2013. The Mainzeal collapse left over $100 million owing to creditors and around $18 million of that owing to sub-contractors.
Subcontractors typically did not receive Mainzeal’s retained funds after the collapse. The following failure of many small construction companies who acted as subcontractors in a Mainzeal head-contract lead to a concerted call for legislative intervention.
Subcontractors will welcome the security and certainty that the Amendments Act brings. The amendments apply from 31 March 2017 to contracts entered into or renewed after that date. It should be noted that the Act will apply to subcontracts entered into after 31 March even if the head contract was entered into prior to the date.
The retentions regime now requires that the party holding retention funds (the Retaining Party) must hold those funds “on trust” for the benefit of the second party to the contract. The retentions must also be held in the form of cash or other liquid assets that are readily converted to cash, and properly accounted for.
The money is not required to be held on a separate bank account and can be co-mingled with other retention moneys and ordinary cash. This creates a “deemed trust model” as opposed to the strict requirement to hold separate funds.
The deemed trust model is intended to be less onerous for the retaining party. However, it may cause issues in other areas. The model may result in difficulty for the contractor or subcontractor in proving that the retaining party does in fact hold funds on trust. Likewise the retaining party may have difficulty showing that they have met their trust obligations. In order to avoid these problems the retaining party may consider holding funds in a separate deposit account.
The new changes also allow retention money to be held in the form of “other liquid assets that are readily converted into cash”. The key motivation for the retaining party to invest in other liquid assets is that that party is entitled to earn interest on the retained funds. Therefore retaining parties with substantial retained funds are incentivised to place the funds into short term investments. They will of course be liable for the full value of the retained funds should any loss occur.
Various commenters have speculated as to what exactly will constitute “liquid assets that are readily converted into cash”. Currently some commentators are placing reliance on accounting principles as to what will constitute an asset and what will be considered liquid. Certainly whether this is the correct course and the exact meaning of these words will either be clarified by litigation, further intervention from the legislature or regulatory guidance.
Most commentators appear to agree that liquid assets will include assets which:
This will include assets such as term deposits, bonds and possibly a retaining party’s accounts receivable. Based on the accounting principles accounts receivable will be considered an asset. However, retaining parties should give consideration to whether those accounts receivable are due within three months, and additionally make allowance for any portion of those accounts receivable which may be lost due to bad debt.
The latest changes also allow the retaining party to hold retained funds in the form of a financial instrument such as insurance, a bond or a guarantee. It is a requirement of the Act that the instrument must be issued either by a licensed insurer or registered bank. If the party intends to retain funds in this form the instrument must:
From the perspective of the subcontractor or contractor the financial instrument may be the most attractive and secure option. They can be certain that the retention moneys will be available in their own name and will not be diverted to repay other creditors in the event of a collapse. The difficulty is that the retaining party may incur considerable cost in establishing the instrument. The retaining party is prohibited from passing this cost onto the contractor or sub-contractor. This means it is likely unattainable for small construction companies to utilise a financial instrument to retain funds.
The Principal may only use the retained funds to pay out the contracted party once payable under the contract; to resolve any other issues with the contracted parties’ obligations under the contract; or under other circumstances set out in the construction contract. The Act also includes a provision for regulation to prescribe a penalty interest rate for non-payment of retained funds. As of yet this has not been done and parties should therefore include such a penalty rate in their contract.
What do we think the implications of this regime are likely to be?
The retentions scheme is a reaction by the legislature. While the regime has been imposed with the intention of provided security to contractors we have some concerns. As the regime is currently being road tested it will be seen shortly whether there is a need for adjustments to be made.
Implications for project finance
Ordinarily secured and preferential creditors are assured of their priority. However, financiers will now have another factor to consider when making loans to finance construction projects. This may impact construction projects’ ability to gain finance. At a minimum, financiers are likely to be asking how a retaining party will hold retained funds.
Implications for the retaining party (principals and head contractors)
The retaining party, operating in an industry renowned for its tight margins, will be required to hold considerable funds static on deposit. This is likely to tighten a retaining party’s cash flow further when undertaking a project.
While large firms may have the means to invest in financial instruments smaller firms using sub-contractors will likely be prohibited by cost and be forced to hold cash deposits.
Implications for insolvency practitioners
Insolvency practitioners will need to consider retained funds immediately on entry to any construction firm. A liquidator should be aware that a firm’s ordinary cash account may contain funds held “on trust”. Considerable time is likely to be spent ascertaining the value of the funds being held on trust, adding expense and uncertainty for the liquidator and the creditors.
* Jonathan Forsey is a Special Counsel specialising in construction. His expertise includes contract negotiations, retentions, compliance, insurance and regulatory matters, as well as contract disputes and negligence issues. He can be contacted at email@example.com.