How financially secure is your project?

ARIE MOORE, ASSOCIATE, AND KATE HENDERSON, SOLICITOR, KENSINGTON SWAN’S CONSTRUCTION TEAM

OFTEN NEW ZEALAND contractors operate on little more than a handshake. Recent liquidations, such as Mainzeal Property and Construction and roading company Infracon, serve to highlight the risks with that approach and the importance of ensuring that there are safeguards in place to protect from insolvency.

Insolvency has also been at the forefront of the courts recently with the Supreme Court releasing its decision in the combined Fences & Kerbs, Hiway Stabilizers and Allied Concrete appeals.

The first step contracting parties should take is to ensure that a written (and signed) contract is in place that clearly sets out each party’s rights and obligations. Secondly, it is important that parties to a construction contract consider whether any additional security arrangements are required. Adequate security manages two major risks: performance and payment.

Performance risk

Insolvency is a potential performance risk for all parties to any project. Additional security to protect against this event will typically include retentions, bonds, and warranties.

Retentions from progress payments provide a principal or head contractor with a certain level of protection in the event that a contractor does not complete the project.

A performance bond is issued by a third party (eg, an insurer or registered bank) and also provides security in the event that a contractor fails in performance.

A bond in lieu of retentions (or a retention bond) is a bond offered by a contractor, instead of a principal or head contractor withholding retentions. Retention bonds are appealing from the position of a contractor/subcontractor, as they increase cashflow and reduce the risk of losing retentions in the event that the principal or head contractor becomes insolvent. However, principals and head contractors may not accept a retention bond and prefer retentions on the basis that ‘cash is king’.

Whether retentions or a bond are appropriate will largely depend on the parties involved and the value placed on having cash rather than a third party security. Regardless of which is obtained, the main benefit of both forms of security is that the funds lie separate from the principal or contractor.

In the context of performance risk it is also important to consider warranties. Ideally contractors will only warrant the work that they have undertaken. In reality, head contractors are responsible for the entirety of the contract works and often required to provide a corresponding warranty. Warranties are typically provided to cover works following their completion.

A trade warranty from a subcontractor may be worthless if the subcontractor is no longer able to make good on that warranty (due to insolvency or otherwise). Head contractors can mitigate this risk by considering the financial stability of the subcontractors they engage to work on a project.

Payment risk

Payment risk is a fundamental consideration. Contractors can protect themselves from exposure to payment risk by taking steps at an early stage to ensure that any parties that they are working for have the ability to pay the contract price and any variations that might arise under the contract.

If additional payment security is required, this is likely to take the form of a principal’s bond, or a direct payment agreement. As with a performance bond, a principal’s bond will sit with a third party and is able to be called upon if the principal is not in a position to pay a contractor’s costs.

A direct payment agreement may be appropriate for larger projects, and contemplates a tripartite agreement with a bank in which a loan is approved for the value of the project, as well as a contingency for variations. The agreement provides that the bank will pay out the amount if required upon certification of the engineer to the contract or a QS (whichever is applicable).

For contractors there is an element of payment risk in having retentions withheld from a project. To the extent that the party withholding retentions does not keep these funds separate from its working capital, the retentions may be lost if the principal or head contractor were to become insolvent. The collapse of Mainzeal is an example where a number of subcontractors lost retentions – there are currently around $18 million in subcontractor retentions claimed through the liquidation.

Conclusion

The security required to manage the performance risk and payment risk will vary depend on the particular project and party. On lower value contracts, retentions may be sufficient. However that is not always the case, and further security may be required to mitigate risk. The most important take away is the importance of adequate due diligence at the beginning of a project – know the people, the project, and the risk.