Perspectives 2019: Legal Report

By Brendan Cash, partner, Helen Brown, special counsel, and Sam Thyne, solicitor, Kensington Swan’s Construction and Major Projects team.

Last year in our perspectives article we observed that 2017 had been notable for its lack of significant events. 2018 is almost over but we’ve seen the exact opposite.

This year the industry has been rocked by several high-profile insolvencies, the first test of the new retentions regime under the Construction Contracts Act 2002 (CCA), Kiwi Build launching into action and interesting moves in the infrastructure space.

Before discussing the big events of this year, we made several predictions last year. As is tradition, we look back to see how we did.

Our predictions for 2018 were:

• Continued capacity constraints in the industry – we predicted that the costs of operating in the construction industry would increase and significant resource constraints would present challenges to delivering successful projects. This has come to pass, with the strain showing at pressure points in the industry at the subcontractor/contractor level. Due to these pressures in the market we’ve seen an increase of in-project disputes, many of which are going to formal dispute resolution (typically CCA adjudication).
• Technology would have a larger impact – Over 2018 we expected to see technology enter more of the ancillary services. Technology such as augmented reality is becoming more common place in construction and infrastructure projects for tasks like identifying the location of underground services.
• Increase in housing, decrease in PPPs – The Government set a goal of building 100,000 houses over the next ten years and past rhetoric while in opposition towards public-private partnerships lead us to believe that it was unlikely that new housing projects (or any other projects for that matter) would be constructed under a PPP. This prediction has largely come to pass with Kiwibuild beginning in earnest and only one major PPP (Waikeria Prison, which was started under the previous Government).
• Focus on regional infrastructure – Along with housing we expected the Government would push through some larger scale infrastructure projects aimed at connecting the regions and boosting economic activity. This became a focus in 2018 and we discuss below some of the alternative infrastructure funding models that were developed this year.

The year that was 2018

Insolvencies in the industry

There have been several high-profile insolvencies in the construction industry, including the ex-Hawkins’ entities known as the Orange-H Group in May 2018, Ebert Construction at the end of July and more recently the Accent On Group and RCR Tomlinson, the large Australian engineering and infrastructure company that had just been awarded key work on Auckland’s City Rail Link.

In the case of Ebert, the receivership has left several large projects unfinished, principals and subcontractors out of pocket, and raised complex issues with how the CCA retentions’ regime works in practice.

Speaking anecdotally, following Ebert’s insolvency we have seen an increased focus on ensuring that documentation relating to agreements for off-site materials and subcontractor continuity guarantees are executed and that security interests are appropriately registered.

A recent development following the insolvency of Ebert has been a decision of the High Court about the administration of retentions held by Ebert under the new retention regime in the CCA. This was the first case to test how the regime worked. The High Court consented to the appointment of the receivers to manage the trust fund. This was an issue as the CCA is silent as to who would fulfil this role in a receivership.

However, further issues with the regime were revealed as a result of a hiccup with the way the trust fund was administered, including once Ebert’s solvency issues began to emerge. One issue was that, due to clerical and software errors at Ebert’s end, a category of contracts was incorrectly recorded as being entered into before the retentions’ regime came into force and no retentions were placed into the trust account for those subcontractors. Otherwise, prior to its insolvency, retentions were calculated but not transferred into the trust account.

The consequence of the overall management of the fund and Ebert’s insolvency was that the High Court ruled that several categories of subcontractors were not entitled to be paid out from the retention trust fund of $3.9 million that Ebert held. Those to miss out included those where the date of the subcontract was incorrectly recorded and those where retentions were calculated but not transferred into the trust fund and those retentions which were neither calculated nor transferred into the trust fund.   This was because in these cases Ebert had defaulted on its obligations under the CCA. Ebert had no intention to place retention monies in trust when it did not make any retention deductions.

It is unfortunate that deficiencies in the retention trust regime have resulted in those it was designed to protect missing out. Particularly given it was due to no fault of their own. However, it should be said that if Ebert went under prior to the retention trust regime coming into effect then no retentions would have been paid out and all subcontractors would have been (even more) out of pocket. While not perfect, the retention trust regime could be said to have at least partially succeeded at its intended function.

Overall, the case has highlighted some gaps in the CCA retention regime.  The receivers’ application would not have been necessary had the CCA prescribed what should happen to retention funds when insolvency practitioners are appointed to a retention holder. It would be helpful if the CCA was amended to deal with insolvent retention holders and to provide for consequences where the retention regime has been breached or ignored altogether. It will be interesting to see what, if any, action Ebert’s liquidators take in respect of this matter.

In respect of what subcontractors can do to better protect themselves, the CCA retentions regime provides those with retentions withheld from them the right to inspect the accounting records of the party holding the retentions accounts to ensure compliance with their obligations. While in an ideal world the onus shouldn’t be on the subcontractor to check the contractor is keeping their money safe, this is a powerful and possibly overlooked tool that can be used to ensure retentions are held properly.

Legacy of Mainzeal collapse

Five years after the collapse of Mainzeal the fallout continues. Recently, closing statements have been made in the High Court proceedings brought by the Mainzeal liquidators (Brian Mayo-Smith and Andrew Bethell of BDO) against the directors of Mainzeal. The liquidators have alleged breaches of directors’ duties and sought $75 million in damages. The liquidators argue that the downfall of Mainzeal was attributable to governance failures and reckless trading. By their analysis, Mainzeal should have ceased trading in 2011. Instead, the directors continued to operate while insolvent, relying upon inter-company loans and promises from related entities such as Richina Pacific.

While the applicants have alleged the directors’ subsequent actions to be breaches of their directors’ duties, the directors have denied all allegations. They claim that hindsight judgement is inappropriate, and the actions of the directors were acceptable at the time given the information available to them. Specifically, they referred to the prospect of work to come in the wake of the Christchurch earthquake as potential for Mainzeal to increase its revenue and so the directors acted as any others would have in their position.

As we wait for the Court’s judgement, it is of interest to consider the effects of a decision against the directors. The core of this case is whether the directors were justified in relying on the word of inter-related companies. Grant Graham of KordaMentha gave evidence for the defence in which he cautioned that such a conservative approach to risk would dis-incentivise directors from attempting to fix problems within their company when under financial stress. It may force trading to operate more on a cash-basis, which many companies would struggle to sustain.

If the claim is successful, it may foreshadow more claims against the directors of failed construction businesses.  For example, in the Ebert liquidation some creditors agitated to change the liquidators and expressed an interest in funding claims if the liquidators find grounds for them.  Interestingly, a litigation funder purchased some of Ebert’s debts, presumably with a view to funding and profiting from any claims.

Kiwibuild

The first batch of Kiwibuild houses have been built, bringing 28 new homes to the market towards the Government’s goal of 100,000 houses in ten years. With such an ambitious target we are expecting to see an increase in the speed Kiwibuild houses are built. In order to do this there will be more reliance on alternative building methods, such as prefabrication.

From a legal perspective, there are risks with mass producing housing. Specifically, quality is of real concern. The leaky building crisis took a toll on the New Zealand housing market that we are still seeing the effects of today, as many second-generation leaky building claims make their way through the courts. Such a massive housing production scheme could stretch the market’s capabilities which creates the risk of inferior housing and construction methods.

As mentioned above, there is a recent trend of turning to methods like prefabrication to mass produce housing. This presents its own complications, including:

• Banks’ concern over lending where manufacturing occurs off site, given there may be insufficient security against the mortgage until the prefabricated components are fixed on site;
• Insurers uncertainty over risk allocation; and
• Building consent authorities struggling to resource the processing of prefabricated buildings.

To ensure confidence in prefabrication, systems will need to be developed to address these identified risks.

Infrastructure funding

New Zealand has an infrastructure funding problem. A recent ANZ report has indicated that new capital investment in infrastructure has not kept pace with the rate of population growth, falling from $142 million per 1000-additional people in 2011/12 to $37 million in 2016/17. The problem is only getting bigger, and with the government doubling down on its commitment to reducing debt to 20% of GDP by 2021/22, further borrowing is not going to be an option.

Finding new means of funding infrastructure projects in New Zealand is becoming a pressing issue, one which could be remedied by turning to private funding options. Infrastructure Minister Shane Jones is obviously of the same mind, declaring New Zealand is “open for business” in April this year, opening the door to potential infrastructure investment partners. Several methods of alternative infrastructure funding have been explored this year including:

• Special Purpose Vehicles such as the one used to assist Fulton Hogan in funding the Milldale development. The long-term debt is attributed to the SPV, assisting the Council which is nearing its debt limits. That debt will be paid off by property owners in the area as part of their council rates.
• User-Pays Services, an approach to funding which may result in a more user-pays approach to infrastructure in New Zealand; be it through toll roads or ticket pricing of public transport, or repayments incorporated into local rates.
• Infrastructure bonds have been suggested by Labour’s spokesman on housing and Auckland issues Phil Twyford as a way of addressing infrastructure funding shortfalls.

 

The demand for infrastructure development has the capacity to move the construction industry into a more sustainable medium, moving on from the boom-bust cycle we are accustomed to. Finding new ways to fund projects would be a large step in the right direction of reducing the pressures and shortfalls the industry face at present.

2019 – The crystal ball

Looking forward to the year ahead we expect to see the following trends:

• More insolvencies – The industry is still stretched and this will start taking its toll on more companies. While we may not see as high profile of a collapse as this year we expect there to be more construction firms going under in the new year. It is possible that that may lead to more aspects of the retention regime being tested in the Courts.
• Fairer contract terms – This year we have seen calls for government departments to take a leadership role in fairer contracts with the industry. There has certainly been a lot of publicity about contractors taking on too much risk and that contributing to the failures in the industry. Obviously, the loss of significant contractors is not good for the local construction industry and needs to be addressed. We are predicting that this will translate to fairer contracts with appropriate allocation of risk. In particular, with more work than resources, fairer contracts will be important in order for principals and contractors to attract the best businesses to do work for them.  Related to this we are also predicting that contractors will be more willing to push back against unlimited liability contracts and other onerous contractual provisions.
• Disputes – given the continued stretched state of the industry we expect to see more disputes popping up, and the trend of in-project disputes continuing.

 

This article was written by Brendan Cash and Helen Brown. Brendan is a Partner and Helen is a Special Counsel in Kensington Swan’s Construction and Major Projects team.

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