This alert briefly discusses key amendments to the insolvency legislation that the federal government has enacted and how councils can protect themselves from contractor insolvency in construction contracts.
Changes to insolvency legislation
Russell Kennedy recently published an alert on the measures available to corporations experiencing financial distress and the safe harbour provisions during the COVID-19 pandemic. A link is found here, however a summary of the provisions is below.
On 25 March 2020 the Coronavirus Economic Response Package Omnibus Act (2020) was enacted, providing temporary relief for financially distressed businesses. It introduced the following changes:
- a new insolvent trading 'safe harbour' comprising a six-month moratorium on insolvent trading liability for company directors in respect of debts incurred "in the ordinary course of the company's business";
- an increase to the threshold at which creditors can issue a statutory demand to a company from $2,000 to $20,000, and increasing in the period for a response from 21 days from the date of service to 6 months; and
- an increase to the minimum debt to initiate bankruptcy proceedings against an individual from $5,000 to $20,000, and increasing in the period for a response from 21 days from the date of service to 6 months.
The measures were scheduled to end on 24 September 2020 but will soon be extended to 31 December 2020.
The effect of these provisions is that some companies may be trading insolvent if not for the new temporary provisions. The Australian Restructuring Insolvency and Turnaround Association estimates that “at least 20 per cent of Australian businesses trading through the pandemic may be in the position where they would otherwise be trading insolvent without temporary legal changes, plus government and bank financial support”.
Councils should be prepared now for an increase in its contractors experiencing financial difficulty, as the construction industry is heavily reliant upon cash flow and can be susceptible to the impact of economic downturn. With this in mind, there are important steps that councils can take to protect themselves against insolvency which are set out below.
How local governments can protect themselves from insolvency in the construction industry
Construction contracts can protect councils from insolvency in a number of ways that ensure councils are not caught short when its contractor becomes insolvent. Some of the protections include:
- Security: generally construction contracts will include provision for council 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, council can “call” on or have “recourse” to the security if the contractor fails to perform as promised and council has a claim against the contractor. Council is protected against insolvency because it has converted the security into cash to satisfy the contractor’s debt. It is important that if council does receive bank guarantees that they have an appropriate system in place to ensure that the bank guarantee is kept safe, accessible and the relevant council officers know where it is; and council is aware of when it expires so that a new bank guarantee can be exchanged.
- 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 council to pursue the parent company for the default of the subsidiary 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 councils concerned about insolvency.
- Payment for off site goods or materials: it is not uncommon for contractors to request 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, councils may find themselves with a lower priority claim over the goods or materials in an insolvency. Accordingly, councils 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: councils 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. Councils can be caught out when the construction contract purports to transfer title in personal property to council but a third party has a superior claim under the PPSA legislation in an insolvency. Councils 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. Councils can protect themselves from insolvency by registering any security interest they have over personal property on the PPSA register.
- Termination: another remedy available to councils is termination of the contract. Such a remedy entitles council to claim damages from the contractor, and depending on the wording of the contract, may entitle council to take over the contractor’s plant and equipment to complete the works itself or by another contractor. However, the ability of councils to exercise its rights on termination will often depend on whether council has protected itself in the ways discussed 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 council. However, if council elects to terminate a contract they should be aware of the stay on enforcement of ipso facto rights. The ipso facto stay restricts the ability of councils to exercise termination, enforcement or other contractual rights under contracts that are triggered by the entry of the contractor into insolvency or a restructuring procedure. This means that if the contract contains a clause that states that the contract can be terminated upon insolvency of the contractor it cannot be enforced. However this does not restrict council from enforcing a right or terminating a contract for any other reason, such as a breach involving non-performance or enforcing a termination for convenience clause.
Key Takeaways
Insolvency in the construction industry can often be sudden and disruptive for industry participants. However, it is possible for councils to protect themselves from insolvency if the right steps are taken at the inception of the project.
Councils should consider these protections before they enter into contracts to ensure the right protections and safeguards are reflected in their construction contracts. Russell Kennedy can assist councils preparing their construction contracts or with any issues that may arise.
Further information
For more information how local governments can protect themselves from insolvency in the construction industry, please contact Kyle Gillan or Michael Bragg.
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