As a property owner (or principal) one of the biggest risks on a building project is the builder/ main contractor ‘going under’ during construction. While relatively uncommon, it is a reality across the building industry and the threat is increased in difficult market conditions. Whether you are engaging builders for a large commercial project or for your first home there are security protections that you can employ in order to help mitigate some of the risk. This article explores some of the more common mechanism and practical tips that property owners can use to help give them some piece of mind.
Retentions are sums of money withheld by the owner on each progress payment. These retention monies are normally held for the duration of the project and can be used by the owner to rectify defective or non-completed work. Generally, the amount retained is applied on a scale. For example New Zealand Standard 3916 uses a scale that is 10% on the first $200,000 then 5% on the next $800,000 and 1.75% on the balance, up to a total aggregate amount of $200,000. One half the retention amount is released on practical completion and the other is released at the end of the defects liability period. Retentions are widely used on commercial contracts. They are seen as a relatively cost effective method of providing some level security to property owners. The amount of money held as security is relatively small so retentions are sometimes used in combination with other security mechanisms.
Under the Construction Contracts Act 2002, a property owner is required to hold retentions on trust for the builder. Practically this means that retention money is “readily identifiable” from the property owner’s other money and this is normally achieved by having the funds in a separate bank account or trust account. If retention funds are misappropriated then those responsible may be held personally liable for breach of trustee duties.
In general terms, a performance bond is a promise by a third party to pay money in the event the builder fails to perform under the contract. Performance bonds stand alone from the contract itself as security and are normally issued by specialist construction insurers or banks. Performance bonds can be drafted so they are either ‘on demand’ or ‘conditional’.
An on demand bond means that the bond issuer must pay the money if there is call on the bond. There are only very limited circumstances that a contractor can prevent a on demand performance bond being paid out once called. An on demand bond is seen as better security for an owner as they can have the money in hand and argue later (if need be). A conditional bond, requires certain conditions to be satisfied before the bond issuer is required to pay out on a call. This normally means default by a builder that is certified by an engineer, other expert or determined by the contract’s disputes process.
The amount of a performance bond varies as a commercial consideration. The majority of the cost of the bond (if not all) is normally covered by the owner and therefore it is a commercial decision for an owner as to whether they want to pay for the cost of performance bond.
Bank guarantees are similar to performance bonds, however they are issued by trading banks and banks normally require the builder to provide extra security (i.e. mortgage security or security over cash deposit funds). This means that the cost of a bank guarantee can be more expensive than a performance bond.
Personal guarantees from the individual(s) that own the building company are low to no cost to the builder. However, they are not that common because it means the building company owner is personally on the hook for any liability. Normally personal guarantees are only provided by smaller builders on smaller projects. Owners need to consider the possibility of recovery against a personal guarantee and this might mean asking for a statement of assets and liabilities and checking whether major assets are held personally or in a trust.
Master Builders, Certified Builders or other third party guarantees are regularly the only security provided for residential builds. These guarantees offer specific remedies to owners in the event of the builder going under. It is important to read and understand the extent for the benefits under a third party guarantee. Normally they are heavily limited to both the circumstances where the guarantee will respond (such as loss of deposit, structural defects) and to cap pay-outs to less than the actual loss incurred. These guarantees are often fronted by industry bodies such as the Master Builders Association and Certified Builders, but the security issuer is normally an insurance company. This means that a claim process on a third party guarantee is often the same as any other insurance claim in that they only respond to the extent of the cover as provided in the guarantee policy. The owner often pays the cost of the guarantee as part of the contract price and this is normally in the region of $1,500 - $3,000.
Construction contracts are normally drafted so that progress payments only charge for work completed & materials installed. This means that an owner is paying for work actually done, rather than in advance. If the builder is invoicing in advance for work not yet completed and then goes under, the owner will have to pay again to have someone else complete it. Therefore, it is important that the payment mechanisms in the contract only require payment once work has been done. If there are to be deposits for materials off-site or not yet installed then appropriate security should be held by the owner by way of a specific agreement with the relevant supplier/ manufacturer.
It is also important for an owner to properly review the builder’s payment claim (progress invoice) to ensure they are correctly allocating costs to completed work and noting if there are any defects/ issues so payment can be set-off. Often this payment claim review process is completed by a qualified professional (quantity surveyor, project manager or engineer to the project) engaged by the owner. The Construction Contracts Act 2002 regime means payment schedules must be produced if an owner wants to counter the amount payable on any claim for incorrect allocation of completed work or issues with works completed.
On larger projects there is only a minimal amount of ‘building’ work completed by the head contractor/ builder. The majority of actual building work is done by subcontractors and suppliers. Continuity guarantees are agreements between owners and subcontractors or suppliers which require the subcontractors to warrant that they will work directly with the owner in the event that the head contractor goes under. This can allow the owner the option to continue with the works with the same people on the job, and with largely the same timeframes and cost. This is often hugely more beneficial than having to find a new workforce and materials in the middle of construction of a project.
When you are considering your next building project it’s important to think about what security you require. There is a number of factors that come into play, including your risk profile, the size of the project and the cost to you for that security. The specialist construction law team at Cavell Leitch can guide you on security options that could potentially save you thousands of dollars.
If you would like any further information or advice then please contact Jeroen Vink or another member of the team at Cavell Leitch.