The payment retentions rules get some teeth

Most members of New Zealand Certified Builders (NZCB) do high-volume or top-end architecturally designed residential projects, and some commercial work as well. Not many do high-rise or infrastructure projects. Consequently, the members of NZCB generally get to use the NZCB suite of building contracts, which don’t provide for payment retentions. However, an increasing number of members of NZCB do the kind of work that requires them to sign one of the New Zealand Institute of Architects contracts or one of the New Zealand Standards contracts. Those contracts do provide for retentions, so it is becoming increasingly important that members of NZCB become familiar with the rules that apply to them. Those rules are currently being tightened up, and parties in the building industry are going to have to take them seriously for the first time.

It was the Mainzeal collapse in 2013 that motivated the Ministry of Business Innovation and Employment (MBIE) to write some rules around retentions. They studied all the overseas regimes for the protection of retentions, consulted the New Zealand construction industry, and decided that retentions were to be held in trust for the tradesmen who had earned them. The new rules were then drafted and inserted into the Construction Contracts Act 2002. The Government decided the rules were only to apply to commercial construction contracts, although the definition of “commercial” is a wide one and includes residential homes that are not going to be lived in by their owners, and all subcontracts whether they are on residential projects or not.

It is becoming increasingly important that members of NZCB become familiar with the rules that apply to retentions.

The party withholding the money is required to take some affirmative action to demonstrate that the funds are held in trust (or provide a bond or an insurance policy to the contractor instead). The rules say that retention money held in trust does not need to be paid into a separate trust account and may be mixed up with other moneys. But the party withholding the money does have to keep proper accounting records that correctly record all retention money held on trust, and those accounting records must be made available for inspection by the contractor.

The new rules were introduced in a bit of a rush, and without adequate consultation with construction lawyers or insolvency experts. Consequently, they lacked a lot of detail when they first came into force on 31 March 2017. Their first big test came when Ebert Construction Ltd went into receivership on 31 July 2018. The receivers applied to the High Court for guidance and permission to administer the funds, and Justice Churchman of the High Court passed judgment on the new rules on 12 November 2018. That was followed by the judgment of Associate Judge Paulsen on 8 April 2020 in relation to a similar application by the liquidators of Corbel Construction Ltd.

What these two judgments established was that every time a developer or contractor goes bust owing retentions to the contractors below them, someone has to apply to the Court to be appointed a receiver of the trust funds. The receiver’s fees and expenses will be paid out of the trust funds before the contractors’ claims. Contractors will only receive their retentions if they have been put aside in a separate account. If they haven’t been paid into a separate account, and the contractors haven’t been paid the balance of their invoice, then they are just unpaid invoices, not retentions.

What that meant, is that subcontractors who are owed retentions by small-medium construction firms were inevitably going to miss out. That is either because the construction company doesn’t have a separate retentions account, or because there isn’t enough in its retentions account to cover the receiver’s fees and expenses, so no-one will apply to become the receiver. Consequently, in the vast majority of cases the whole objective of introducing the retentions-held-in-trust regime came to nothing.

There are two aspects of the Ebert and Corbel judgments that were completely at odds with the legislation. The requirement for a separate bank account, flies in the face of section 18E(2) – “Retention money does not need to be paid into a separate trust account, and may be commingled with other moneys”.

Then there is Section 18I – “Any term in a construction contract is void that purports to require the payee to pay any fees or costs for administering a trust”. Despite that, the Ebert receivers and the Corbel liquidators were permitted to take their administration fees and expenses, as well as the legal fees for the application to the court, out of the trust funds.

Then there is the question of how to enforce the rules. If the company that failed to put that money aside has now gone into liquidation, it is pointless suing it for breach of trust, even if you were allowed to (which you are not). So, what was the intended solution? MBIE concluded that two existing offences under the Crimes Act 1961 – Section 220 (theft by a person in a special relationship) and section 229 (criminal breach of trust) – would provide the answer. These provisions apply to directors and senior managers of construction companies who have knowingly and intentionally broken the rules, and the maximum penalty is 7 years’ imprisonment.

Unfortunately, it hasn’t worked out that way. MBIE has apparently learned that to use those sections in the Crimes Act they would need evidence of an intention to defraud the subbies, which is a major stumbling block. So faced with growing criticism of the scheme, MBIE commissioned the accounting firm KPMG to produce a comprehensive review in August 2019, and the Building and Construction Minister Hon Jenny Salesa then published a Cabinet Paper on 7 July 2020 which proposed several enhancements to the scheme. Those are as follows:

Retention money won’t be able to be co-mingled with other funds, and instead it will have to be held in a separate bank account. Failure to do so will be a “strict liability” offence (so absence of intent is irrelevant) with a maximum fine of $200,000, and the directors of the company will be personally liable for a fine of up to $50,000 (although they can run a defence based on extenuating circumstances).

• When a property owner or a head contractor receives a payment claim from a contractor who has done work for them, the contractor typically gets a “payment schedule” in response. This tells the contractor how much they are going to receive, and why. There are six criteria under the Construction

Contracts Act that the payment schedule has to satisfy. There will now be a seventh – the payment schedule will have to say how much retention money is being withheld (if any), and in what form (cash, liquid assets, insurance, or bond). • If the party withholding the retention money goes into receivership or liquidation, the receiver or liquidator will automatically have the ability to administer the funds for the contractors who are entitled to them.

I’m not persuaded that receivers and liquidators didn’t already have that power, but it does no harm to clarify it. Presumably it means they won’t have to go to court, so that will save on legal fees, but the receiver or liquidator can still take their own fees and expenses out of the retention money. These changes were supposed to have been introduced to Parliament and adopted before the 2020 election, but that didn’t happen. It remains to be seen whether the incoming Government will persevere with them, but they are sensible reforms, so hopefully they will. Most larger construction companies already have a retentions trust account, but experience tells us that when financial disaster looms, the directors get desperate and stop following the rules. That has two consequences. First, contractors who are owed retentions will be only partially protected.; and secondly, the directors are now going to face the very real possibility of a criminal conviction.

Geoff Hardy is a partner in the Auckland law firm Martelli McKegg and is a construction law specialist. Contact Geoff on (09) 379 0700 or geoff@martellimckegg.co.nz. This article is not intended to be relied upon as legal advice.