Construction contracts retentions - a new regime from 31 March 2017
On Friday 31 March 2017 an important amendment to the Construction Contracts Act 2002 (CCA) comes into force. This amendment introduces a new retention scheme, designed to safeguard retention money in the event of insolvency of the holding party.
The scheme will apply to a commercial construction contract either new or renewed after 31 March 2017. While the protection is welcome, there are added costs and complications for those who hold retentions, and their funders.
What is retention money?
Retention money is an amount held back from a payment made under a construction contract. It is usually a percentage of the amount payable of each instalment. It is generally held to ensure that a contractor performs all of its obligations under the contract, and is then released either on practical completion or after the end of a defects notification period. At the moment, retentions are not required to be held on trust.
Retentions can be held at different levels, as between principal and head contractor, and between head contractor and subcontractors, for example. Each retention has to be separately held by the responsible payer at each level, even if they all ultimately relate to one construction contract.
Does the retention scheme apply to all construction contracts?
As the CCA currently stands, after 31 March 2017 the retention scheme will apply to all commercial construction contracts. Care must be taken in checking whether or not a construction contract is commercial in nature, as the definition of a residential (non-commercial) contract is narrow.
The CCA includes a provision which would allow regulations to prescribe a minimum contract amount for the scheme, so that smaller contracts would not need to comply. It was anticipated that regulations would be in place to provide the sort of guidance common in overseas jurisdictions. However, no regulations are currently proposed, so the retention scheme will apply to all commercial construction contracts which provide for retentions, regardless of value. If no retentions are held, then compliance is not a factor.
In a move which will relieve the pressure of immediate compliance, the Regulatory Systems (Commercial Matters) Amendment Bill (Amendment Bill), which is currently before Parliament, will amend the CCA so that the retention scheme will only apply to contracts entered into or renewed after 31 March 2017, rather than all contracts in existence on that date. It will apply to subcontracts entered into after that date, even if the head contract was entered into prior.
What does the retention scheme require?
The retention scheme in the CCA requires that where any party to a construction contract (party A) is withholding retention money from the other party to the construction construct (party B), party A must hold that retention money on trust for the benefit of party B. The retention money may be held either in cash or in “other liquid assets that are readily converted into cash.”
The Amendment Bill is also inserting an alternative option, allowing party A to obtain a financial instrument such as insurance or a payment bond, which will provide third party protection of the retention money.
The option to hold the retention money as cash is simple. Party A simply retains the relevant percentage of the payment, and holds it on deposit in a bank account. However, this can require a payer to hold large cash reserves.
The retention money that is held on trust is not required to be in a separate account; if party A has multiple construction contracts then the retention money for each contract can be mingled. However, the mingling of funds can make provision of records proving that the funds are held on trust problematic, and may make demonstrating that trust obligations have been met problematic.
Other liquid assets
Rather than holding large cash reserves, retention money may also be held in “other liquid assets that are readily converted into cash.” There is no definition of liquid assets in the CCA, so the exact details of what this encompasses is unclear. It is likely that this will be an aspect of the scheme which has to be clarified through litigation, in the absence of regulatory guidance.
The current view, based on documents referred to when the retention scheme was first suggested, is that liquid assets will include assets which:
- are used as part of party A’s cash-management functions;
- have an insignificant risk of changes in value; and
- will mature within three months.
This will include assets such as term deposits, bonds, and potentially party A’s accounts receivable (to the extent that these funds can be realised within three months). Anyone who intends to rely on their accounts receivable to form part or all of their retention money must give consideration to whether or not the accounts receivable will be realised within three months, and make an allowance for that portion of accounts receivable which is likely to be unpaid, either as a result of a dispute or as a bad debt.
As an alternative to holding retention money on trust, the Amendment Bill will allow party A to rely on a financial instrument, such as insurance, a bond, or a guarantee. The instrument must be issued by either a licensed insurer or a registered bank, and must:
- be issued in favour of party B or endorsed with party B’s interest;
- require the issuer to pay the retention money to party B if party A fails to make payment on the due date; and
- enable party B to enforce payment from the issuer.
From party B’s perspective, the financial instrument may be the best option. It provides certainty that the retention money will be available, and will not be diverted to repay other creditors. However, there will be a cost to party A in setting up the instrument. Party A is prohibited by the CCA from passing this cost on to party B. It may be expensive or simply not possible for medium or small construction companies or sole traders to utilise financial instruments.
When can retention money be used?
Retention money can only be used by party A in limited circumstances:
- to pay party B the balance owing, once the retention money is payable under the construction contract;
- to resolve any issues with non-compliance with party B’s obligations under the construction contract; or
- in other circumstances set out in the construction contract.
The CCA provides that the penalty interest rate for non-payment of retentions could be prescribed by regulation, but this has not been done. It therefore falls to the parties to ensure that their contractual arrangements provide for this.
Can parties to a construction contract set up alternative arrangements?
No. The CCA provides that if a construction contract includes a provision where the purpose, or one of the purposes, of that provision is to avoid the application of the retention scheme, then that provision will be void.
Therefore the parties are prohibited from contracting out of the retention scheme. However, the parties may agree to alter some of the provisions, by specifying, for example, that the retention money must be held as a cash deposit in a separate bank account.
Implications of the retention scheme
The aim of the retention scheme is admirable, but there are many implications for various industries.
Implications for owners and head contractors
Unless they rely on financial instruments, owners and head contractors will be required to hold sufficient liquid funds to pay all retentions which have been withheld. For large construction companies, with multiple projects, this could easily result in many millions being held on deposit.
Unfortunately, bonds will probably only be available to the largest contractors, and the insurance policies covering retentions, which are readily available overseas, are at the moment uncommon in the New Zealand market.
Implications for insolvency practitioners
In the event that party A becomes insolvent, and an insolvency practitioner becomes involved, whether through a receivership, liquidation, or voluntary administration, the insolvency practitioner will need to immediately consider retention money.
Receivers will not have the ability to access or direct the distribution of funds held on trust.
If the retention money is not held in a separate account, but mingled with other funds, it will be difficult to ascertain what, if any, funds are available for the operation of the business. This could add uncertainty and expense to the process of realising assets for secured creditors.
Implications for funders
The retention scheme will create a new priority for retention money, before any claims by secured and preferential creditors of a company. The funders of construction projects will need to take into account these new requirements when assessing the liquidity of a business and deciding whether to provide finance. In particular, they will need to be clear whether cash or accounts receivable are being used on trust for retentions.
The new CCA retention scheme is likely to increase the cost of construction due to the increased compliance costs. Construction businesses will need to put robust processes in place to be able to account for all of the retention money that they hold on trust. They will also need to ensure that they are accurately assessing the value of their liquid assets, if they choose to rely on that method for retentions.
Anyone with questions about how to comply with the retention scheme should contact a member of our Construction and Projects team.
Disclaimer: the content of this update is not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.