Dialogue: Building a law to redress balance

Businesses that survive by avoiding payments have real reason to fear new legislation, writes PETER DEGERHOLM.

For too long now, subcontractors have been a source of interest-free, unsecured capital to builders/contractors and developers/owners. Since the Liens Act was repealed in 1987, builders have been powerless to recover payments and resolve disputes.

Few construction companies now employ any significant labour force - they have reduced overheads and transferred the risks to the subcontractors carrying out most of the work. The New Zealand construction industry consists mainly of small businesses with fewer than five employees and self-employed people. The risk of performance and payment has been progressively shifted to contractors and subcontractors, and the rate of company failures has increased.

In construction contracts the cash comes from a single source, the developer/owner. It is paid in monthly instalments to the builder/contractor, who distributes it to the subcontractors and suppliers. The frequent payment delays contribute significantly to insolvencies.

Proposed legislation, based on recent British and New South Wales initiatives, should help to restore the risk-reward balance. The principal aim is to speed the cash flow, the life blood of this and any industry. This will have far-reaching implications for all participants.

The building industry has developed some unusual features and bad habits which cannot easily be addressed without Government help. These include:

Building materials belong to the property developer when installed, whether or not they have been paid for.

Disputes are common, as there is plenty of room for misinterpretation of contract documents, yet no easy way of resolving them. Arbitrations and legal actions can take years to resolve, and are often abandoned because of cost.

Payment flows are at best erratic. The industry works on a progress claim system. Subcontractors claim from the builder, who submits a claim to the architect. The architect or quantity surveyor assesses the claim on behalf of the developer (owner or client) and certifies a payment to the builder, who then pays his subcontractors and suppliers, who in turn pay their sub-subcontractors and suppliers. The lower-tier parties are used to waiting three months or longer for payment.

Subcontract agreements state that the subcontractor is not entitled to payment until (and unless) the builder has been paid by the developer - the infamous "pay-when/if-paid" clause. No other industry accepts such inequitable terms.

Some builders routinely deduct money from their subcontractors for alleged costs of rectifying damage or defects, or cleaning up the site.

Developers often require subcontractors to sign a "continuity guarantee" - a promise to complete the work if the builder's contract is terminated. The developer cannot lose if the builder fails.

Retentions are held from subcontractors, usually at 10 per cent and often greater than their profit margin. The "sliding scale" for retention calculations, which originated in the Liens Act, provides significant cashflow benefits to builders. Security for payments disappeared with the act's repeal, but retentions remain as a crude stick to assure performance.

Performance bonds are often demanded of subcontractors and builders to assure performance of the contract and fixing of defects. Yet few developers provide payment bonds to assure payment to the builder and in turn to the subcontractors.

Developers do not always have the money to complete their projects when they enter into the contract. This becomes apparent when they advertise for junk bonds to finance the partly completed development.

In all these features there is an element of "heads the developer wins, tails the subcontractors lose."

The number and scale of liquidations in the building industry is disturbing. Last year started with the Goodall ABL liquidation at a cost of $20 million to creditors, followed by two of the largest partitioning companies, Alotech and IBS, and numerous others. We are now seeing the second- and third-tier company failures as affected subcontractors and suppliers go into liquidation.

Industry associations have developed standard forms of contract over the years. Although these generally set out fair and equitable terms, they cannot be enforced, as the Commerce Act prohibits deals between competitors.

In drafting contracts there is a trend towards passing the risk of performance and payment down to the lowest common denominator - the subcontractor. If the subcontractor performs then timely payment should be guaranteed.

But builders and subcontractors don't learn lessons - they are often denied payment, yet they keep tendering to those same builders.

The small companies that characterise the industry do not have the resources to properly train staff.

There is a progressive loss of trade and management skill, and in an increasingly complex contracting environment, today's subcontractors are becoming more naive.

In 1996 the Building Subcontractors' Federation was established to encourage industry-wide improvement, represent subcontractor and supplier industry organisations and promote equitable contract conditions, practices and ethics. It now has 15 trade associations as its members, representing a wide cross-section of specialty trades and 4000 companies. Security of payment has been a prime objective.

Many of the concerns expressed by subcontractors were recognised in a Ministry of Commerce questionnaire in 1996.

In that year Britain passed a law which aimed to deal with many of the same problems that had been identified in New Zealand. In 1999, the NSW government announced its intention to adopt similar legislation.

But the NZ Government was not convinced that special legislation was needed for the building industry until the Law Commission published a study paper that November. This recommended legislation based on the NSW and British laws, aimed at improving the industry's cashflow.

Early last year, the three representative bodies - Registered Master Builders, the Contractors' Federation and the Building Subcontractors' Federation - agreed to work together to seek laws that would benefit the whole industry. The emphasis changes from security of payment for subcontractors' protection to construction contractor payment protection.

The new law will provide real commercial consequences for pay delays as opposed to legal remedies - disputes will be sorted out quickly and inexpensively to keep the project going and the cash flowing. When payments stop, so does the project. Now a developer really will care if a subcontractor is unpaid.

It will define entitlements to payment that cannot be eliminated by the "fine print" in contract conditions.

The legislation is a risk-management device. It will not remove the risk of insolvency in the building industry.

But the improved ability to obtain payments will expose insolvent operators at a much earlier stage.

Those who survive in the industry by avoiding payment obligations have real reason to fear the legislation.

Those who operate ethically will have to fine-tune their processes, but will welcome the change.

Hopefully, it will be a catalyst for a culture change in an industry that many consider to be dominated by cowboys.

* Peter Degerholm is executive officer for the Building Subcontractors' Federation.