Revising the Retentions Regime

By Nick Gillies (Partner) and Emily Woods (Solicitor), Hesketh Henry

Ebert Construction Ltd’s collapse in 2018 was the first test of the new retentions trust regime (Regime). The Regime, introduced as an amendment to the Construction Contracts Act 2002 (CCA) in 2017, was intended to protect retentions, primarily in an insolvency. Unfortunately, it has largely failed to live up to that aim following the decision in Bennet v Ebert Construction Limited (In Rec & Liq) [2018] NZHC 2934 (Ebert). This article considers the problems exposed by Ebert and the future of the Regime in light of this.

THE REGIME

Prior to the Regime, retentions were unregulated. As a result, retained money under a construction contract would typically be used as (interest free) working capital, and remained unprotected with little prospect of recovery in an insolvency (Mainzeal being the highest profile example of this). What’s more, it was (and arguably still is) not unusual to see ‘claims’ arise shortly before the final retentions were due to be released, with the contractor/subcontractor invariably then ‘cutting a deal’ and moving on rather than fighting for the full amount. This has a negative impact on cashflow in circumstances where the contractor’s/ subcontractor’s margin may be effectively tied up in the retentions. Seeking to redress these inequities and inefficiencies, the Regime came into law on 31 March 2017 with the philosophy of protecting retentions by requiring them to be held on trust. The trust status would, so the thinking went, protect retention money for the benefit of the recipient, and hopefully also impose some industry discipline (e.g. by requiring proper accounting records to be kept and made available on request, etc). To some extent, this has happened. Anecdotal and survey information suggest a tolerable level of compliance, most likely among the more sophisticated and/ or responsible operators. At the same time, there is perceptible non-compliance, either because some operators do not understand or are ignoring their obligations. Compounding this is a lack of sanctions to address breaches and, as we shall see in Ebert, a lack of protection when there are simple administrative failures.

EBERT

In July 2018, Ebert Construction Ltd was put into receivership. Ebert operated a separate retentions account (fund), but there was a shortfall in the amount held. As the CCA lacks machinery for administering retention money held on trust, Ebert’s receivers had to apply to the Court for directions as to how fund should be distributed. The Court identified five categories of retentions:

(a) Reconciled and transferred (b) Released but unpaid (c) Wrongly classified contracts (d) Calculated but not transferred (e) Uncalculated and not transferred. To the surprise of some, the Court interpreted the CCA as imposing an obligation to hold retention monies in trust, rather than simply deeming them to be held in trust. In practical terms, this meant Ebert had to have reconciled (essentially calculated in its accounting system) the amount to be withheld and then transferred funds of that amount into its retention account. Only once those proactive steps were completed were those funds held in trust (ie a trust was created). According to the Court in Ebert, the CCA does not automatically apply a trust status to retentions regardless of what has been done (or not done) with them. The consequence of this is that only those subcontractors whose retentions were ‘reconciled and transferred’ and ‘released but unpaid’ were entitled to a claim on the fund. Those whose retentions were in the other three categories were not protected by the Regime (as no trust had been created) and fell into the pool of unsecured creditors – entirely as a result of an administrative failure by Ebert.

This outcome is problematic. It seems arbitrary and inequitable to distinguish between classes of retentions according to whether relevant administrative steps have been carried out to create a trust. In doing so, the Regime fails to provide the level of protection that Parliament seemingly aimed to achieve with the Regime. Moreover, that protection is probably needed most against those who are not diligent or organised (or who even deliberately flout the Regime) and who are therefore less likely to take the necessary steps to create a trust according to Ebert.

IMPLICATIONS OF EBERT

As matters stand under Ebert, it is important that parties holding retentions set up and maintain a trust account to hold retention money. While the CCA says retention money can technically be co-mingled with other funds, in reality, best practice (and arguably the only workable approach) is to have a separate account. Without this there is an appreciable risk of a trust not being ‘created’. Those who are owed retentions should make sure the party holding them has taken the required steps to create and maintain a trust and that they continue to do so. This can be done by exercising the right to see the relevant accounting records under the CCA.

Other legislative gaps with the Regime, some of which were also highlighted by Ebert, include no definition of ‘liquid assets’, no ‘de minimus’ contract threshold, no prescribed audit records, no default interest for outstanding retention money, no administration machinery (requiring a receiver/liquidator to apply to the Court for administration directions), and no sanction on the holder or its officers for non-compliance.

WAS EBERT CORRECTLY DECIDED?

There are reasons to question whether Ebert was correctly decided in relation to the establishment of a trust. While a detailed legal examination of that issue is outside the scope of this article, two points stand out. First, and most importantly, there was limited consideration of the legislative purpose. When the CCA amendments were making their way through Parliament, the relevant minister at the time, Nick Smith, commented that the intended effect of the Regime was that retention moneys were to be treated ‘as deemed trust funds’ ((12 March 2015) 703 NZPD 2243). Similar comments were made on both sides of the isle. In summary, a deemed trust model appears to be what Parliament intended even if the legislative wording implementing this was imperfect. That intention makes sense in terms of protecting retentions and is consistent with the overall purpose of the CCA, which is essentially to help cash flow in the industry. Second, Ebert was not an opposed application. This perhaps explains the lack of consideration of the legislative purpose. Only two subcontractors made submissions as interested parties, and they did not oppose the application, but they expressed concerns about receivers’ cost and the overall efficiency of the application. As a result, there was an absence of arguments from those who were owed retentions or from industry bodies. Had the Court heard from the subcontractors who were prejudiced by Ebert’s own administrative failures or the decision had been appealed, the outcome may have been different. It is possible that the interpretation adopted in Ebert will be reconsidered in another case where more weight is given to the legislative purpose. Nevertheless, as the law currently stands, where a party fails to set aside retentions on trust, those retentions will not be subject to the Regime and the recipient’s interests will not be protected.

THE FUTURE OF RETENTIONS

By the end of 2019, the amount owed to Ebert’s creditors had increased to more than $123m. Ebert’s liquidators have formed a preliminary view that there might have been breaches of directors’ duties. Pursuing directors of insolvent companies in their personal capacities may be an avenue for the recovery of unrealised retentions given that the CCA provides no remedies. However, this is untested and, at first blush, there would be legal hurdles to such a claim, including whether any monies recovered from directors must go into the general creditor pool.

What is clear is that the CCA ought to be amended by Parliament in order

to best address the existing problems and limitations with the Regime and, in particular, to redress the lack of (intended) protection to contractors/ subcontractors in an insolvency. Although MBIE commissioned KPMG to undertake a review in the second half of last year, there is as yet no indication of what legislative changes are in contemplation. A centralised deposit scheme model (similar to residential tenancy deposits) has found favour overseas (e.g. Queensland and England), as have statutory penalties for noncompliance. Such features are likely to be considered (and should be) as part of that review. At the very least, when and how a trust is established over retentions ought to be clarified so that the industry can move beyond Ebert.

Nick Gillies is a Partner and Emily Woods is a Solicitor at Hesketh Henry, a commercial law firm based in Auckland, New Zealand.