Lara Bennett is an executive director in the PwC restructuring team and has worked in the construction sector.
The failure of Mainzeal Property and Construction in February 2013 resulted in unsecured creditor claims of more than $150 million, including $18.3m in retentions held at the date of the collapse.
This major failure led to increased focus and public debate about the issue of payment security in the construction sector.
In October last year, the Construction Contracts Amendment Act 2015 (CCAA) was passed into law with the aim of clarifying and expanding the provisions of the original Act.
The most material change, which was added following the collapse of Mainzeal, is subpart 2A (CCAA-2A) which introduces a statutory trust regime for retentions.
The new regime takes effect on March 31 next year and the associated regulations are still pending, but nonetheless the practical impacts of this new legislation will be significant and will ripple across the entire supply chain.
Retentions are amounts withheld from a contractor or subcontractor to ensure agreed works, including correction of any defects, under a construction contract are completed before final payment is made.
Importantly, CCAA-2A requires those holding retentions to also hold sufficient cash or other "liquid assets" (expected to be defined in the pending regulations) on trust to support the amounts owed. In the event of a collapse, the "trust" assets would then be ring-fenced to meet retention obligations. As such, they would not be available to any other type of creditor.
Increased equity levels in the property and construction sector and further measures to reduce the risk of loss in the event of corporate failure are welcome.
However, CCAA-2A in its current form may not achieve the desired outcomes and could potentially have adverse consequences for the sector, contrary to the intent behind this new regime. We outline some of the key issues below.
Are there sufficient available assets to comply?
Based on 2015 construction activity levels, a minimum of almost $600m of "liquid assets" will be required when the new regime takes effect. These assets cannot be subject to any form of existing security or encumbrance.
Many industry incumbents will be unable to comply with the initial requirements and will therefore be in breach of the legislation. A transitional approach, such as requiring only new retentions withheld after March 31 to be supported by liquid assets held in trust, would ease the financial impact of moving into the new regime.
Will trust assets be fully recoverable in the event of a failure?
There has been discussion on the use of accounts receivable or upstream retentions for the purposes of CCAA-2A.
These assets are not liquid in nature, particularly in a failure scenario where the principal or contractor that has failed will typically be unable to meet its obligations to complete works, settle sales, provide necessary warranties or remedy defects.
As a consequence, retention monies will not be released and customers will withhold payment of progress claims, resulting in inadequate recoveries to meet retention obligations. To illustrate this, in the Mainzeal collapse, only 11 per cent of accounts receivable and upstream retentions owing at the date of receivership have been recovered.
What will this really cost and will it exceed the benefit?
Applying a net funding cost of 5 per cent per annum means that $600m of retention trust assets would cost the industry $30m each year.
It is important to consider these costs with reference to the magnitude of the retention loss risk CCAA-2A seeks to protect against, such as the $18.3m of retentions in Mainzeal. Compounding this issue, construction is a highly competitive sector, with single digit profit margins prevalent.
Any funding cost is likely to be spread across the supply chain through a combination of lower margins for subcontractors, contractors and principals, and will inevitably result in higher costs for the ultimate purchaser or end user of the property constructed.
How easy will it be to administer the new regime?
In its current form there are a number of areas in the new regime which may result in legal disputes and practical difficulties, including the risk of conflicting claims on specific assets, the effect of existing registered security interests, impacts on statutory priorities such as employee entitlements and the cost of realising trust assets in the event of a failure.
Positive steps to bolster the capital base of principals and contractors across the construction sector are essential for its stability and success, and this is the intended outcome of the new regime.
However, these issues with CCAA-2A need to be addressed to avoid further financial strain on the sector at a time when increased capacity is needed to meet market demand and to minimise scope for confusion and cost.
The way forward
Irrespective of any potential clarification or amendments to this new legislation, all stakeholders in the sector, including those not specifically party to a construction contract (including materials suppliers, financiers, employees, tenants, purchasers, directors and auditors) need to understand the impacts of CCAA-2A.
Knowing your rights and obligations and appreciating the risks that will arise under the new regime is essential for achieving positive, rather than suffering adverse, outcomes.