Why you and your customer’s bank don’t always see eye to eye

If you’re a builder, then the basic business model is pretty simple. You add up the cost of providing the building materials the project requires, the cost of hiring the specialist subtrades who do the work you’re not qualified to do, the cost of providing your and your employees’ labour, and the costs of simply being in business, which are known as your overheads. Then whatever that total comes to, you charge your customer more than that, and the difference is your profit – what you feed your family with.

That’s all going to work out fine if your customer pays you. But that doesn’t always happen. Building projects cost a lot of money and take a long time. Homeowners often get caught by surprise when the project ends up costing way more than they thought, or they form the impression that the builder is ripping them off. Developers often overestimate the volume of sales they will be able to achieve off the plans and underestimate the project costs, or they finance their lavish lifestyles by not paying their creditors. Either way, those factors frequently result in the client not paying one or more of the builder’s invoices. Which means the builder can no longer pay his suppliers and subcontractors, let alone put food on the table.

To counter those risks there are a number of things the builder can do. He can refuse to do building work on credit and insist on being paid in advance. After all, there is no logical reason why the builder should provide the building work first and hope to be paid later. It is just as logical for the property owner to make a payment first and hope that the corresponding building work is done later. If the builder can’t negotiate that kind of arrangement, then at least he can protect himself in other ways. In his building contract he can reserve the right to suspend work if he isn’t paid, and he can get a second mortgage over the property in case the customer goes bust or is just blatantly dishonest. And he can use payment claims under the Construction Contracts Act to force customers to either pay up or explain in rational terms why they are not going to.

But just as importantly, the builder wants disputes resolved rapidly and fairly so that property owners don’t win them by unfair advantage – by taking the benefit of the building work and then simply withholding payment for it. For that reason, the builder wants the disputed funds paid into trust so that both parties are deprived on it and both have an equal

The lender has needs and expectations which are often in conflict with those of the builder.

incentive to resolve the dispute. The builder also wants a fast and low-cost method of resolving disputes over defective workmanship or materials, by having one independent expert paid for by both parties do a site inspection, interview both parties and make a ruling that both parties comply with. Finally, for disputes involving alleged delays or overcharging rather than defects, the builder can at least use the small claims courts or the adjudication system under the Construction Contracts Act so that he doesn’t have to spend a fortune and wait an eternity for the dispute to grind itself through mediation, arbitration or the Courts. There are two other ways that a builder can protect himself against financial disaster. If he is required to do a project on a fixed price basis then he can add in a substantial contingency to cover unexpected complications and he can charge extra for customer-driven or Council-driven variations that are outside of the scope of work that he was asked to price in the first place. And where it is simply too difficult to accurately guess the cost of the building project at the outset, he can do it instead on a cost-reimbursement basis where customers end up paying the exact value of what they received, but they run the risk of the project costing far more than they anticipated. If you are a builder doing complex residential building projects then you can generally build all of those safeguards into your building contract. But quite often you run into trouble when the homeowners go to a lender to borrow the bulk of the money required to fund the project. Because the lender has needs and expectations which are often in conflict with those of the builder.

So, for example, we frequently see situations where the lender insists on a ‘fixed price’ contract that cannot be adjusted by variations, provisional sums or cost fluctuations. We see lenders who want to delete many of the builder protections out of the building contract or use a different form of contract that is more weighted in favour of the owner. Some Banks insist on the builder being able to offer a third-party guarantee, which was a temporary problem for members of New Zealand (NZ) Certified Builders during the few months in 2020, when the Halo Guarantee was no longer available to them and is a permanent problem for builders who don’t belong to either NZ Certified Builders or Master Builders. And regardless of what the contract says, we frequently encounter situations where the lender will not advance more than what their valuer says is the value of the work done to date. Or the lender will not advance the final payment on practical completion but only on the issue of the code compliance certificate.

Why is it that the lenders want something different from what the builders want? Well, if you’re in the business of lending money, then the proposition is simple. You lend it out at a greater rate than the rate you had to pay to get it. And you make sure that your borrowers not only pay you that rate, but they also pay your money back. Knowing that some of your borrowers won’t be able to do that, either because of bad luck or bad management, you protect yourself against that risk in various ways. Those include taking security over land or other assets, insisting on a personal guarantee, or if neither of those is available, then lending the money at a higher rate, gambling that the greater returns are going to compensate you for the inevitable defaults.

Of course, you don’t want to have to rely on any of those forms of protection if you can help it and you would much prefer that your borrowers didn’t default in the first place. So, you check their credit history before you lend to them and you don’t lend to them if they have a history of bad debt or if they have no track record of consistent earnings at all. You only lend them an amount that you are confident they will be able to repay, with interest, out of their proven earnings. You don’t let them borrow from another lender on second mortgage and overcommit themselves, without your consent. And you don’t let them borrow more than a certain percentage of the value of their property at any given time. Because in the worstcase scenario, if the lender has to sell the property under a mortgagee sale, the sale might actually realise less than the debt owed to the lender once you have taken into account the discounted price you achieve in forced sales, the arrears of interest owing and the costs of conducting the sale itself.

All these factors lead the lender to adopt a conservative approach, which is often at odds with what the builder wants and needs and what the owner has agreed to under the building contract. The builder may have little option but to go along with it, if the owner is totally reliant on borrowed funds. Although the builder can force the owner to honour the terms of the building contract, it is usually quicker and cheaper just to bow to the lender’s demands. The better projects are those where the clients are contributing a significant proportion of the contract price out of their own savings, so that they can make payments in advance and pay invoices on time, irrespective of when the lender contributes its share. It would be nice if every job you got, was one of those.

The builder may have little option but to go along with it, if the owner is totally reliant on borrowed funds.

Geoff Hardy is a partner in the Auckland law firm Martelli McKegg and is a construction law specialist. Geoff also operates the Business Related Legal helpline for NZCB members, contact Geoff on (09) 379 0700 or geoff@ martellimckegg.co.nz for 20 minutes of free advice. This article is not intended to be relied upon as legal advice.