Economic Darwinism calls for intervention

Fletcher Construction's MARK BINNS looks at the argument for intervention in the construction industry.

The construction industry is cyclical, as is the issue of protection for industry participants.

In 1987, the Government repealed the Wages Protection and Contractors Liens Act. Although this was a highly complex and cumbersome act, it had provided contractors and subcontractors with a mechanism to protect themselves financially if owners or head contractors went broke.

The rationale for repealing the act was that it was inefficient, there was no consensus on how to reform it, and there was no reason why the construction industry should be treated any differently to other industries.

Although there is a high level of agitation within the industry for some change - with little consensus on what that should be - the wider community needs convincing that the construction industry needs special treatment.

A strong case can be made for legislative intervention because:

The industry has absolutely no barriers to entry. Companies or individuals with no capital base and very limited experience can set up in business tomorrow. Even worse, individuals associated with companies that have gone bankrupt and had questionable business practices can re-establish themselves the day after they have gone bust.

The industry is pyramid-like in nature, with the owner at the top and a plethora of subcontractors, sub-subcontractors and suppliers at the bottom. In a typical commercial building contract, the head contractor may only self-perform 25-30 per cent of the value of the contract, the balance being subcontracted out. The leverage potential is huge. Small, undercapitalised head contractors can take on the risks of complex projects of a size that will ensure serious financial difficulties for many parties if the project goes wrong.

Construction contracts are messy documents at best and defining the exact scope of work is notoriously difficult. If you are manufacturing widgets, the bargain with a buyer is relatively simple - they will buy 1000 widgets for $1 each, will pick them up on a certain date and pay 30 days later. In contrast, getting to the point of unambiguous agreement on the exact details of the bargain in a construction contract is difficult. This provides fertile ground for disputes to develop and for the unscrupulous to manufacture disputes and thereby delay payments to creditors.

There is unequal bargaining power in the industry. Fragmentation of the industry means that even the large contractors such as Fletcher Construction have limited bargaining power. Furthermore, that power decreases down the pyramid: the owner has the most and subcontractors (or sub-subcontractors) have the least. It never ceases to amaze me the risks that a number of head contractors are prepared to accept - even if those risks are outside their control.

These factors provide conditions that are ripe for abuse by those in the industry who are so inclined, particularly in difficult times.

Organisations such as the Federation of Master Builders has suggested self-regulation, but I believe such efforts are doomed because of the fragmentation and vested interests in the industry.

The master builders do not represent the interests of a homogenous group of builders; the interests of a small, one-man-band builder are vastly different to those of a large contractor.

Of course, the other side of the argument is that this is the free market at its best: parties are free to enter into whatever bargains they wish and if they accept onerous terms they deserve to bear the consequences. Such true economic Darwinism is seen by its proponents as ensuring an efficient industry.

This argument would probably be fine if there was any evidence that the industry (by which I include owners and their consultants as well as contractors and subcontractors) could learn from its past failures and implement a more disciplined approach to doing business throughout the chain. Unfortunately this evidence is non-existent.

Similarly, there is scant evidence that current practices deliver construction services to the economy in an efficient manner. There is without doubt severe competitiveness in the industry, but the corollary to this is a tendency for some contractors to attempt to maintain profit levels by less than honourable means: cutting corners in quality and work practices (often with safety implications); or by creating bogus disputes with subcontractors or spurious back-charges in order to reduce costs.

The result - a highly adversarial industry which sees significant value pass from the direct participants to lawyers and other consultants involved in resolving contractual disputes. In aggregate, the industry is inefficient.

I am sure no one believes the proposed legislation (based on NSW law) will provide a panacea for the industry's ills. It will not. In layman's terms, the legislation provides a system of adjudication to speed up cashflows in the industry and prevent parties relying on bogus disputes to delay payments.

However, what the legislation will clearly do is make the parties in construction contracts be a lot more mindful of the risks they are taking on and the ability of the other parties in the contract to assume the risks these parties are responsible for. There will be more accountability and less room to pass on problems (whether they are of your own making or not) down the chain to others.

At the end of the day, where you stand on this issue will depend on your philosophical standpoint. You may believe that the economic Darwinism exhibited by the construction industry is beneficial, or view it as an abuse requiring intervention.

For my part, I subscribe to the latter point of view.