Retentions changes aim to protect subcontractors

The trail of unpaid creditors left by the collapse of Mainzeal in February 2013 highlighted the credit risk subcontractors take in the construction sector when providing services. The Mainzeal collapse illustrated the insecurity of retentions held by building companies such as Mainzeal which are intended to be paid out to subcontractors on the satisfaction that work has been completed in accordance with agreed standards, or such other conditions as may be imposed contractually.  In many cases the payment of retentions can be delayed due to factors outside the control of the subcontractor, for example compliance inspections by local authorities.  Quite apart from posing challenges to cash flow, the holding of retentions puts the subcontractor at the mercy of the credit position of the party holding the retention.

The Government’s response to this situation resulted in the Construction Contracts Amendment Act 2015. As well as extending the benefits of the Construction Contracts Act to consultants such as architects, designers, engineers and quantity surveyors, that Act introduced a revised disputes mechanism which is designed to be a “quick and dirty” mechanism for resolving disputes between parties to construction contracts.

The most contentious part of the new Act is a new retentions regime which requires retentions payable to be held in a “liquid asset” in trust from 1 April 2017. The conventional form of retention is a percentage of any progress payment due from contractor to subcontractor, and also applies between owner and contractor.  Retentions are generally released in stages such as practical completion, at the expiry of a defects notification period and after issue of the final completion certificate or equivalent.  If work is incomplete or there are unremedied defects, deductions can be made from those retentions with a lesser amount being paid to the contractor.  The intention is that the subcontractor will be motivated to complete the works to the required standard in order to be paid in full.

The issue which has arisen in practice is that in most cases, retentions are utilised by the party holding them as working capital which may or may not relate to the relevant construction projects. From a securitys perspective, the subcontractor has no more than a contractual right to be paid those retention sums when they fall due.  The subcontractor has no security in the retention amounts and has no ability to protect their position if they get wind of the contractor looking precarious.  In an insolvency, a subcontractor who is owed retentions ranks alongside all other unsecured creditors and may receive nothing at all at the conclusion of a liquidation.

The solution as set out in the Construction Contracts Amendment Act 2015 only applies to commercial construction contracts.  However this would still catch multi-unit housing projects which are essentially residential.  The changes imposed by the legislation include as follows:

• The contractor must hold all retention money on trust for the benefit of the subcontractor.
• Proper accounting records must be kept.
• The contractor must not appropriate any retention money to its own use and such money is not available for the payment of the debts or any creditor of the contractor other than the subcontractor.
• The contractor may invest the retention money and retain the interest earned but is liable to make good any loss to the retention money if the investment is unsuccessful.
• Contractual provisions aimed at delaying the payment of retention money beyond completion of the subcontractor’s obligations are void.
• Any attempt to contract out of the new provisions of the Act is void.

This essentially creates a trust in favour of the subcontractor. The issue from a legal perspective is that the Act provides that retention money need not be held in a separate bank account and may be commingled with other money.  This is inconsistent with the usual concept of a trust which is where funds are held separately.  One of the key requirements of the trust is that it must be possible to identify what property the trust attaches to and if not, the trust fails.  What happens if, as is usually the case, the contractor is funding their operations from a debt facility?  In that situation they will only draw down the net amount of any progress payment when the time comes to pay.  That means that the retention is part of the undrawn balance of the bank facility so there is no actual money for the trust to attach to.

One of the main problems with the new regime is that the requirement to hold retentions applies at multiple levels in the contractual chain. This will have the effect of sucking money out of the construction sector by having retentions held at multiple levels when there is only one end beneficiary.

The recent amendment to the Act now stipulates that the legislation will only apply to contracts entered into or renewed on or after 31 March 2017. However, it will be necessary for construction industry participants to start planning now how they will manage the new regime.  The Ministry of Business, Innovation and Employment has provided a guide for businesses which will provide further detail to industry participants.