Decision looming on retentions trust account issue

This article first appeared in the August edition of Infrastructure News.

Construction contracts typically provide for a portion of contractual payments otherwise due to the payee to be retained as a form of performance security.  Due largely to the alchemising effects of the Mainzeal collapse and a boost from overseas reform, the issue of whether retentions should be held in a trust account will be dealt with in the context of the Construction Contracts Act Amendment Bill. 

The Bill was caught in the pre-election squeeze.  It will not be passed until after the elections but it has already been through its second reading and is at the stage where late amendments can be moved via a Supplementary Order Paper (SOP) before it goes to its final vote.  The Bill may well be passed this year requiring the industry to comment on the subsequent detail swiftly.

Officials have already done a lot of the policy work behind a Government SOP to be presented by the Minister for Building and Construction at the relevant time.  Given the National Party’s commanding lead in the polls and assuming the portfolio is not reshuffled, that Minister may well be Nick Smith.

But – even if MMP delivers power to a Labour-led coalition – we can assume there will be reform.  Both Labour and the Greens have already tabled SOPs which would impose novel and some would say radical constraints on how retention monies are handled.  The intent is to increase protection to the lower tiers in the construction project food chain. 

Mind the gap

Retentions are generally calculated on a sliding scale according to the value of the job.  Typically, half the retentions are supposed to be released when the practical completion certificate is issued and the remainder at the expiry of the defects liability period.

The complaint is that they are intended to provide security against defects in the work, but are often slow to be released and are used by head contractors as working capital.  The sliding percentage scale often means that the head contractor can retain much more against the subbies than the amount retained by the developer.  The Greens’ SOP states that when Mainzeal collapsed, it had about $11 million in retentions held against it, but was withholding over $18.3 million in retentions from its subbies.  The reasons behind that warrant decent analysis but the gap is stark.

So what will reform look like?

There are two main legislative approaches available to the new government.  Enact a complete package or to do what the New South Wales Government did in 2013 – provide for the establishment of a retention trust in an amendment to their Building and Construction Industry Security of Payment Act 1999 with regulations to follow.  The latter kicks the detail into touch for now.

The other 2013 changes to the NSW Act came into effect on 21 April this year but the regulations to set up the trust have not been finalised so the transition from aspiration to reality is incomplete.  This is not as inept as it might appear.  Designing a workable and fair trust retentions scheme is a bit like climbing Mt Everest – much more easily said than done and you must pick the right route.

First there are the questions of scope.  Should it just cover retention payments (both SOPs) or capture all contract payments in keeping with the growing trend in the UK and elsewhere for larger government projects to require “ring fenced” Project Bank Accounts (PBAs) which have trust status?  Should it cover all tiers of construction payers and payees (the Greens’ SOP) – from developer to sub-sub-contractors, or only cover head contractor payments (Labour’s SOP)?  Should it cover residential contracts or just commercial and industrial projects (the Greens’ SOP and Labour’s SOP respectively)?  And should smaller jobs escape the net?

Then you must design your model.  A consultation paper released in November 2013 by the NSW Government laid out three broad options:

  • A “deemed trust model” – retention moneys are deemed by legislation to be held on trust for the benefit of the subbies even if they are not in a separate account.  This is the least intrusive but least effective option.  No segregated account is required, leading to inevitable issues with mingled funds and difficulties in trying to trace the trust money.  The money might still be used by the contractor for other purposes and a liquidator or receiver will have a complex task deciding what is available for each class of creditor.
  • Statutory construction trusts – retention money would be required to be held in a special account, the terms of which would prevent the money being used as general working capital and would also fence it off from the liquidator’s grasp.  This avoids many of the “deemed trust” issues but the administrative burden is large and the model only works if the rules are followed.  There are real risks that the contractors who are most likely to fail will be more prone to patchy compliance.
  • A statutory trustee – set up a trust to be administered by the Office of the Small Business Commissioner.  The New Zealand equivalent would be the Ministry of Business, Innovation and Employment.

The NSW Government prefers option three – a statutory trustee.  It considers this would be simpler and more cost effective than option two which would require the creation of thousands of separate trust accounts.  But even under option three, the administrative burden is vast, involving many thousands of transactions every month.

Reform is as much a part of insolvency law as construction law

And there are broader issues of policy to resolve.  How clear is it that the net economic benefits of the chosen model will be positive?  The model matters most in the event of head contractor liquidation, so it must fit well with insolvency law and policy.  There may be many other unsecured and vulnerable creditors owed significant sums for the supply of goods and services.  Does it necessarily follow that retention money owed to subcontractors and suppliers should be regarded as “their money” and deserve priority?  If so, should it be unlimited?  If these payments are protected by a trust the funds won’t be available to preferential creditors (notably the IRD and employees) or to secured creditors like the banks.  The costs of borrowing in the construction sector may rise. 

Where to from here?

Probably the easiest course for the New Zealand Government would be to make a generalised provision in the Bill for the creation of retention money trust accounts and then to wait and see what detail emerges from the NSW consultation process.   Insights will also come from the growing use of PBAs (or similar concepts) in the government sector in New Zealand and in various Christchurch rebuild projects.  The differences between the two jurisdictions are not large and we can always shelter behind the trans-Tasman harmonisation agenda. 

Regardless of what route is taken, there is a strong sense here that soon at least a toe will be in the water.  We can do better.  Legislative change will happen and the industry will be asked to focus on the “how” not the “should we”?  

John McKay is a commercial litigation partner who specialises in construction law and property disputes.

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Related topics: Infrastructure projects; Construction and major projects; Construction Contracts Act; Restructuring & insolvency

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