Managing the risk of insolvency on a construction project
With the new Construction Contracts Act retentions regime in place, and rising construction costs, more and more businesses in the construction industry are facing solvency issues. Contractors are finding their cashflow is tightening and margins are decreasing.
This article looks at some suggestions on how Contractors can structure their construction contracts to limit exposure to insolvency situations. At the outset, we consider the two key areas of:
1 Maintaining cashflow
2 Dealing with retentions
Price Proposal should factor in risk allocation
Contractors commonly tender projects at a low level in order to win the project. This often leads to "blowing the budget" and reduced cashflow.
This could be mitigated if Contractors carefully review their Price Proposal and be clear what risks they are taking on. For example, has the Contractor taken on the risk of design changes? If so, the Contractor takes on the risk of any extra cost or work involved in the revised design. It is all too common that a Contractor tenders on the basis of a concept design, which then changes throughout the project into a design markedly different from that which the Contractor tendered for.
Ideally, the Price Proposal should be based on key assumptions that incorporate these risks, such as, the Price Proposal is based on the design as at tender stage, and any changes to design will be subject to further cost. The key is to ensure those assumptions are brought through into the Contract Documents so the Contractor can rely on the assumptions should there be material changes in the scope of works.
Keep cashflow regular and consistent
Consistent payment periods that align under head contracts and subcontracts are critical to ensure cashflow is constant.
A major risk for Contractors is when the Principal makes deductions or suspends payment. The Contractor is suddenly devoid of cashflow, but still facing claims from subcontractors and suppliers. Contractors should ensure that any Subcontracts line up with the Head Contract in terms of delay damages, EOT claims and release of retentions. For example:
- Include provision for the Contractor to pass on delay damages to the Subcontractor at the same rate as in the Head Contract, to the extent the Subcontractor is responsible for the delay.
- The Subcontract could provide that the Subcontractor is only entitled to an Extension of Time for the grounds provided under the Head Contract, and only to the extent granted under the Head Contract.
- Include provision that if there is a dispute under the Subcontract which is the same as or related to a dispute under the Head Contract, the Subcontractor is bound by the determination of the dispute under the Head Contract.
- Increased retentions held by the Contractor under its Subcontract, at a higher level than in the Head Contract, allow for recovery of margins and assist the Contractor retain cashflow.
The above clauses would need careful drafting to ensure the effect does not infringe the prevention in the Construction Contracts Act 2002 against making the Subcontractor's payment conditional on the Contractor receiving payment from the Principal.
Onerous Special Conditions
The New Zealand standard form contracts, such as NZS 3910:2013, are often heavily amended in order to allocate risk and specify dispute processes on a project-specific basis. We frequently see very onerous special conditions in relation to timeframes for notifying of variation claims, EOT claims, and dispute notices. For example, the special conditions may require the Contractor to provide a fully substantiated EOT claim within 5 working days of the event giving rise to the claim, and an absolute bar on claims made after this time. This is usually unworkable but, if not complied with, can have negative effects on the project and the Contractor's cashflow.
When negotiating the Contract, the Contractor should check any amendments to these timeframes and ensure they will work for the project team. If possible, consider whether more favourable timeframes can be agreed.
Dealing with retentions
Provide a bond in lieu of retentions
The new retentions regime, introduced from 31 March 2017, requires that retention monies must now be held on trust in the form of cash or liquid assets. This is relevant to Principals and Contractors and Subcontractors in providing some protection.
In the event of the Principal's insolvency, the Contractor's retention monies are protected from the Principal's other creditors because they do not form part of the Principal's general pool of assets. However, there is no requirement that the Principal hold each set of retentions in separate trust accounts; retentions from various projects can be commingled and mixed with the Principal's own funds. So in the event of a Principal's insolvency, there may be no separation of the Principal's own monies (which are subject to security interests) and the monies held on retention. There may even be no liquid assets available for Contractors to attempt to recover their retentions from.
A bond in lieu of retentions may therefore be a more practical alternative. The Principal then holds a bond and in the event of defective work, the Principal can call on the bond for cash, rather than resort to retentions. A bond in lieu of retentions has two key advantages:
- There is no risk that the Principal goes insolvent and the retentions, which may be properly due to the Contractor, are lost amongst the Principal's other assets and distributed to all the Principal's creditors.
- A bond in lieu of retentions ensures the Contractor retains greater cashflow throughout the project. The Contractor's progress payment claims would (theoretically) be paid in full, without deductions for retentions, and the Contractor would not need to wait until the end of the project to receive the final payment.
What sort of bond should Contractors get?
There are two main sources for a bond in lieu of retentions – bank bonds or insurance company bonds.
Bank bonds are treated in the same way as any other loan facility; they are financial accommodations which must be secured by appropriate assets (cash in the bank or secured property). Contractors must also satisfy the bank that they can repay the bond, plus interest, if the bond is called upon. Bank bonds are therefore included in the Contractor's indebtedness, regardless of whether the bond is likely to be called upon. This means the bank bond is on the Contractor's balance sheet, which may affect the Contractor's available working capital.
Insurance company bonds are treated differently. They are seen as contingent liabilities, similar to an insurance contract. An insurance company bond is therefore not on the Contractor's balance sheet, and would not affect the available working capital in the same way as a bank bond. For this reason, insurance company bonds are normally more expensive to obtain.
A major concern for Contractors under the new regime is that they also need to hold subcontractor retentions on trust. Previously, Contractors could rely on the upstream retentions (from the Principal), to satisfy the retentions that may become owing to the Subcontractors. Now, Contractors must hold cash or liquid assets on trust for the Subcontractor retentions, and cannot rely on upstream retentions.
Not only does this affect cashflow, but it could also burden Contractors with additional costs in terms of accounting methods and reporting requirements. There is little guidance from MBIE to date on what constitutes liquid assets, but the general position is that upstream retentions would not constitute liquid assets. It may be that Contractors can look at other ways to protect themselves from Subcontractor defective work and also retain cashflow. Potential options could include using milestone payments, or holding bonds in lieu of retentions.
As for Principals, Contractors can similarly obtain a bond in lieu of retentions from Subcontractors. This may be a cost effective way for Contractors to maintain cashflow throughout the project and still have reassurance that the costs of any Subcontractor defective work will be recovered.