Insolvency in the construction industry is a perennial concern for contractors who can be thinly capitalised and depend on reliable cash flow to meet obligations to staff and suppliers.
The Commonwealth Government’s response to the Senate Economic Reference Committee Report on Insolvency in the Australian Construction Industry released in June 2017 is therefore a timely reminder to consider how best to protect yourself against insolvency in the construction industry.
What the Report said
The Committee’s Reports was critical of the effects of insolvency in the construction industry. It made a number of findings, including:
- the construction industry has a disproportionately high level of insolvency. Although the industry accounts for 8 to 10% of GDP it accounts for 20 to 25% of all insolvencies
- the industry is burdened with around $3 billion in unpaid debts each year with flow on effects for the industry
- the occurrence of illegal “phoenixing” is high and poorly policed in the industry where participants will become insolvent when they can no longer meet their obligations only to rise from the ashes through a new corporate structure
The Committee made 44 recommendations to Government to address the issue.
The Government’s response to the Report
The Government’s response to the Report includes recognition of the high rate of insolvency within the construction industry and the problem of “pheonixing”.
The shared responsibility between the States and the Commonwealth for regulation of the construction industry makes the process of reform challenging. Nonetheless, the Government is taking steps to address this which will be of interest to the construction industry, including:
- the Minister for Employment will undertake a wide ranging review of security of payment legislation in Australia and will report back no later than 31 December 2017. It remains to be seen whether uniform security of payment legislation will be pursued by the Government.
- the Attorney General will consult with other Departments on the trial of Project Bank Accounts for Commonwealth funded projects and may refer to the Australian Law Reform Commission whether a statutory trust account regime should be implemented for the payment of subcontractors, noting that this payment mechanism is commonly used in managing contractor style contracts by the Commonwealth
Regardless of the Government’s response to the Report, there are important steps that owners and principals can take to protect themselves against insolvency which are set out below.
How to protect yourself from insolvency in the construction industry
Not surprisingly, owners and principals have developed mechanisms for protecting themselves against insolvency that have proved effective over the years. This includes:
- Security: generally construction contracts will include provision for the principal to take security for the performance of the contractor’s obligations under the contract. The form of security can vary but typically includes bank guarantees or cash retention. Depending on the terms of the contract, the principal can “call” on or have “recourse” to the security if the contractor fails to perform as promised and the principal has a claim against the contractor. The principal is protected against insolvency because it has converted the security into cash to satisfy the contractor’s debt.
- Parent company guarantees: more commonly on larger projects, construction contracts will include a requirement for the parent company of the contractor to guarantee the performance of the contractor if the contractor fails to perform. This allows the principal to pursue the parent company for the default of the downstream company where the parent company may remain financially viable and hold additional assets. Given the prevalence of complicated corporate structures and thinly capitalised operating companies for some builders, a parent company guarantee can often provide additional comfort to principals concerned about insolvency.
- Payment for off site goods or materials: it is not uncommon for contractors to require payment for goods or materials before they are delivered to site or incorporated into the works. If the contractor becomes insolvent before the materials of equipment are delivered to site or incorporated into the works, principals may find themselves with a lower priority claim over the goods or materials in an insolvency. Accordingly, principals can protect themselves by requiring security for the advanced payment, transfer of title to the principal upon payment and (less commonly) the registration of a security interest under the Personal Property Securities Act 2009 (Cth) (PPSA).
- PPSA: principals can also protect themselves from insolvency by ensuring that any security interest they have under the contract with their contractor is registered on the PPSA register. Principals can be caught out when the construction contract purports to transfer title in personal property to the principal but a third party has a superior claim under the PPSA legislation in an insolvency. Principals in the construction industry are less likely to register their interest in personal property either because they are not aware of the need to do so or because of the administrative burden. Principals can protect themselves from insolvency by registering any security interest they have over personal property on the PPSA register.
- Termination: a common remedy for contractor insolvency is termination of the contract. Such a remedy will entitle the principal to claim damages from the contractor (for instance, on a cost to complete basis) and to take over the contractor’s plant and equipment to complete the works itself or by another contractor. However, the ability of the principal to exercise its rights on termination will often depend on whether the principal has protected itself in the ways noted above because once the contractor is insolvent the chances of recovering damages from the contractor directly are low unless additional protections have been put in place by the principal.
Insolvency in the construction industry can often be sudden and disruptive for industry participants. It is possible for principals to protect themselves from insolvency if the right steps are taken at the inception of the project.
Principals should consider these protections before they enter into contract to ensure the right protections and safeguards are reflected in their construction contracts.
If you require any further information, please contact Kyle Gilan.
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