Major changes in the building and construction Sector
The Construction Contracts Amendment Act (Act), passed in October 2015, heralds significant changes for entities working in the construction sector – though some of the anticipated benefits may take time to filter through.
The Act was a response to challenges in the industry, particularly to the harm suffered by many of the parties who worked for Mainzeal and other companies that have gone into liquidation leaving a trail of unpaid creditors.
There are three main areas of change:
- a new retentions regime where an amount equivalent to retentions payable must be held in a liquid asset in trust from 1 April 2017;
- a revised disputes mechanism to speed up dispute resolution which has relatively quick timeframes and prompt enforceability; and
- the consultants to projects (architects, designers, engineers and quantity surveyors) are now given similar rights and obligations to the other parties to a construction project.
This article deals with the retentions component of the changes, a late and hastily put together addition designed to look after subcontractors and contractors who have had difficulty getting paid on completion of a job.
In that context, the retentions changes are well-intentioned but, due to the financial consequences on those that hold retentions, it will (at least initially) fail to deliver all expected benefits. This is because the industry has always relied on using retentions as a source of working capital.
However, because the bulk of the margin on a construction contract is tied up in the retentions deducted from the construction company by the property owner, there has been insufficient time for the industry to get financially ready for the changes.
Furthermore, while getting quality data to back this up is difficult, anecdotally, there is a sense that over half the construction companies and sub-contractors that deduct retentions may not be financially capable of putting liquid assets of a corresponding value in trust.
Therefore, there is a significant risk of non-compliance and that will lead to an inability to provide bonds and the financial failure of some organisations. None of this is good for an industry already struggling to meet the demand for further building.
Who will the changes impact?
The retentions regime only applies to commercial construction contracts, but this will still catch the majority of multi-unit housing projects. If one of the parties to the contract is an individual who intends to reside in the property, his or her contract is not caught by this regime, but other contracts relating to the project (such as between the builder and the plumber) will still be caught.
There may be a minimum threshold amount (called a de minimis amount) before obligations start, but this threshold has not yet been determined. In any event, it is anticipated to be relatively low so that there is protection for the smaller contractors who have suffered heavily in the past.
Assets of an equivalent value to the retentions deducted must be held on trust. In the event of an insolvency event, these assets will be trust money to pay out the retentions or fix any defects relating to a specific retention. These assets rank ahead of all other parties in a liquidation, so they rank ahead of secured creditors, staff, IRD, etc.
The retention money may be held in cash or in a liquid asset that can readily be converted to cash. While this may appear to provide flexibility and a wide range of assets which can be used as trust funds, the commercial reality for property developers and construction companies is that the only significant asset that they have which is liquid and readily converted to cash is cash at the bank itself.
The Ministry of Business, Innovation and Employment (MBIE) is working on the development of regulations to describe the assets that may qualify as liquid and BDO has been asked to assist with this. The view at this stage is that retentions receivable will not qualify as a liquid asset that can readily be converted into cash and therefore this regime will place the obligation on holding gross retentions, rather than net retentions, on trust.
Accounts receivable are also not likely to meet the definition requirement, as the Act requires all progress claims to be paid within 20 working days, so there should be a point in the month where there are no accounts receivable and therefore no assets held in trust.
As retentions payable are a substantial liability for construction companies and some property developers, this will have a massive impact on cashflow.
It is important to note that, while the retentions regime commences on 1 April 2017, planning needs to occur now.
For property owners and developers, the likely solution is to draw down additional funding from their financiers at each monthly drawdown and put that amount into a separate deposit account. This will increase the bank funding costs. This needs to be negotiated with bankers now.
For construction companies, the challenge is greater and for many, the financial commitment could be 5-8% of annual turnover. For those that do not have substantial cash reserves already, this will significantly impact upon cashflow, the ability to provide security for bonds and the quantum of projects able to be handled. It will certainly not help Auckland build more houses at a faster rate than at present.
Putting assets in trust equivalent to the retention payable amount occurs when the underlying progress payment is “payable”. We are all accustomed to deductions such as PAYE occurring at the time that the underlying transaction is paid, but this regime focuses on when the underlying transaction is payable, which may be earlier than when paid. There are a range of dates on which a claim item may be “payable”, but best practice is to use the date on which the amount is contractually due to be paid. Under NZS3910:2013, this is 17 working days after the payment claim is lodged and, under the Act, cannot exceed 20 working days.
MBIE is currently preparing regulations to support the Act. BDO is hoping that further guidance will be issued as there is currently a significant number of interpretation and practical challenges with the Act.
There is currently no clear guidance on how funds are put in trust. Best practice will be to open a bank account in the name of the entity deducting the retentions and, as part of the account name, call it a “Trust Account”. Parties will then need to agree with their bank that the funds in that trust account are not caught by the bank’s security arrangements over the business assets.
Does a business have sufficient financial capacity for this regime?
Prepare this calculation to see:
If the amount at the bottom is a negative amount, professional advice should be sought promptly.
Although there are no penalties specifically included in the legislation, the regime is effectively self-policing. The subcontractors and contractors that have had retentions deducted are entitled to inspect the records of the retention holder at any reasonable time. This process needs to be very carefully managed, otherwise there is a risk that they will obtain sensitive commercial information – the construction sector is renowned for the effectiveness of its grapevine in spreading rumours.
The Government has announced it is introducing legislation which will delay the effect of the new regime, but the start date and other requirements remain unchanged.
The proposal is that the trust obligations will only apply to contracts entered into on or after 31 March 2017. It will also apply to contracts that are renewed for a further term from that date, but only on retentions withheld during that further term, and will also apply if the parties agree.
This is very favourable news as it deals with the greatest uncertainty – whether it is a gradual start or a tsunami effect where all retentions held may have had to be held in trust on day one. As well as now being a gradual start, this change also delays the financial impact, providing more time for businesses to build the additional financial resources they will need.
Those that deduct retentions will need to keep very detailed records of the retentions and trust monies. In most cases, the record-keeping requirements will be more extensive than the current record-keeping.
The old days of only paying retentions when requested or otherwise sitting on the money are over. If retention monies are not paid as soon as all contractual obligations have been met, the holder must pay interest on the outstanding amount.
The BDO construction team has prepared a checklist of requirements to comply with the new regime and is available to assist you in ensuring that you are ready for it from a financial, record-keeping and inspection perspective. For further information, please contact James MacQueen, Advisory Partner, Construction and Real Estate Sector National Leader, BDO Auckland at firstname.lastname@example.org.
The new retentions in trust regime for construction contracts is the subject of an ADLS webinar to be held on Wednesday 30 November from 12pm to 1pm. Presented by James MacQueen and Geoff Hardy, Partner, Martelli McKegg, it will provide insights into the operation of the new laws relating to retentions. For more information, click here.