New Retentions Regime
Better Protection for Sub-contractors
The collapse of Mainzeal Property and Construction Limited (“Mainzeal”) was one of the more significant construction insolvencies in New Zealand. When Mainzeal collapsed, significant retention monies were due or potentially due to various subcontractors. However, Mainzeal did not have sufficient funds available to meet those obligations leaving many subcontractors out of pocket.
The problems with the current retention scheme highlighted by the collapse of Mainzeal has, at least in part, resulted in a number of changes to the Construction Contracts Act 2002 (“the Act”). One of the most significant changes introduced was a new regime relating to retentions which came into effect from 31 March 2017. For all commercial construction contracts (but not residential construction contracts) entered into after that date, retentions will either be held subject to a statutory trust or alternatively there will need to be a “complying instrument” in place.
What are Retentions?
Most commercial construction contracts contain a provision whereby an amount of money is withheld (typically between 5% and 10% of the amount of the payment) by a principal or head contractor from the contractor or sub-contractor (as applicable) as security to ensure that the other party meets its obligations under the contract, particularly to provide building work that is free of defects and completed on time. The intention is that if those conditions are met the retention monies will subsequently be released to the contractor (or subcontractor). However, if the work is not completed on time or if there are defects that the contractor/subcontractor does not remedy, then the retentions are available to go towards the costs of late completion and/or remedying the defective work.
Generally speaking retentions are paid out in two stages. 50% of the retentions will normally be paid at the date of practical completion, with the remaining 50% once the defects liability period has ended and any defects have been remedied, usually 6 to 12 months after practical completion.
What was the problem with Retentions?
The problems with the prior retention regime were starkly illustrated by the failure of Mainzeal. As was commonly the case, retention monies that had been withheld from the subcontractors were used as working capital, essentially treating the retention money as an unsecured interest free loan. This had the effect of transferring some of the business risk to the subcontractors who are generally less able to manage the risk of a project. When the contractor failed, monies owed by way of retentions are effectively unsecured claims.
Statutory Trust for Retentions
In an endeavour to alleviate the problems referred to above, the new retention regime requires that all retention monies in commercial construction contracts be held on trust for the benefit of the party from whom they have been withheld. Furthermore, proper accounting records must be kept and made available for inspection by the party from whom the monies have been withheld. In addition, the retention monies may not be used for any purpose other than the purpose of remedying defects in the party’s performance of its obligations under the contract. Importantly, retention monies must not be used by the party withholding them for its own purposes and such funds are not available for the payment of the debts of that party owed to anyone other than the party with whom the payment has been withheld and are not available to be taken in execution by other creditors. Finally, retention monies must be held either in the form of cash or in other “liquid assets” that are readily converted to cash.
Although the retentions are held subject to a trust, the party holding the retentions is nevertheless permitted to invest the retention monies and retain the interest earned, which is contrary to the usual position regarding trust relationships. Furthermore, retention monies are not required to be held in a separate bank account and may be intermingled with other monies, including the retaining party’s own funds. Again, this is contrary to conventual trust obligations.
It is possible to avoid the obligation to hold retentions on trust if the payment of retentions is backed by a “complying instrument”. Essentially a complying instrument will be a bond, guarantee or insurance policy issued by a licenced insurer or registered bank in favour of the payee on which the payee can call if the retentions are not paid when due.
The intent of this alternative option is to provide relief against the capital requirements that could arise from having to hold retention monies in cash and/or other liquid assets. However, it will undoubtedly be the case that there will be a cost incurred in obtaining a complying instrument.
The way forward
The extent to which principal head contractors will take up the alternative option of the complying instrument remains to be seen. Similarly, it remains to be seen whether or not those electing for the statutory trust alternative will hold their funds in a separate bank account or intermingle the funds with their own funds. However, in light of the fact that the payee is entitled to access of records, the intermingling option may be less favourable as it would inevitably involve disclosure of potentially commercially sensitive information. Undoubtedly, the most straightforward means of complying to the retentions regime would be to hold retentions in a separate bank account designated for that purpose.