Construction contracts and changes to insolvency laws

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Reforms to insolvency laws will prevent contracting parties relying on certain clauses in construction contracts effective from 1 July 2018.

The reforms introduce changes to the Corporations Act 2001 (Cth) and are likely to impact significantly on construction contracts.

The laws aim to assist contractors who are facing financial difficulties by allowing them to trade their way out of the predicament rather than having the contract unilaterally terminated. A contracting party will no longer be able to rely on an ipso facto clause to end a contract in certain circumstances pertaining to the other party’s financial position.

Participants in the building industry should be aware of the effect of these changes and review their contracts and internal processes accordingly.

What is an ipso facto clause?

Ipso facto is a Latin phrase which, broadly interpreted, means ‘by the fact or act itself’. Ipso facto clauses are regularly used in contracts to enable a party to terminate the contract based on the existence of a fact or circumstance, rather than default by the counterparty.

The trigger allowing the party to invoke the ipso facto clause will generally be an insolvency event. In the construction industry, such clauses can be grounds for a principal to terminate a contract when the subcontractor runs into financial difficulty. The provisions are drafted broadly to encompass not only actual insolvency but precursors to insolvency such as the appointment of an administrator.

The benefit to a principal of invoking an ipso facto clause is its ability to mitigate loss by taking action once the risk of insolvency becomes apparent. The contract will allow the principal to exercise certain rights before an actual insolvency occurs, such as:

  • terminating or modifying the contract;
  • suspending works, stepping into the contract and / or engaging third party subcontractors to complete outstanding works;
  • calling on bank guarantees, securities or retentions;
  • setting off claims against payment claims by the subcontractor.

How do the reforms change ipso facto clauses?

The new laws restrict a party from relying on an ipso facto clause by reason of:

  • the counterparty entering a scheme of arrangement or voluntary administration;
  • the counterparty’s financial position, credit rating or possibility that it might be under administration.

Effectively, the reforms put a ‘stay’ on a party exercising certain rights on the basis of a potential or pending insolvency. The contractor benefiting from the stay has an opportunity to continue receiving the benefit of the contract and trade its way out of financial difficulty.

If the contractor company subsequently goes into receivership or liquidation, the stay is lifted, the protection no longer exists, and the ipso facto rights will be enforceable.

The reforms do not affect other termination rights (such as non-performance).

In some circumstances, the stay may be lifted – either by arrangement between the administrator and the party seeking to rely on the ipso facto clause, or on application by that party to the Federal Court where it would be appropriate and in the interests of justice to do so.

The new laws are mandatory and cannot be contracted out of, with special government intervention powers being granted to address any loopholes.

The laws are not retrospective, thus any ipso facto clauses existing in contracts entered before 1 July 2018 will remain intact.

Why make these reforms?

The laws are part of an insolvency innovation reform package. They follow safe harbour provisions recently introduced to give additional personal liability protection to directors facing cashflow issues who take certain steps to better the company’s financial position.

The reforms aim to find an appropriate balance between encouraging enterprise and protecting the community.

By imposing a stay on the exercise of an ipso facto right in certain circumstances, it is hoped that a distressed contractor will be in a better position to trade its way out of the financial predicament and remain solvent.

What should those in the construction industry do?

Managing financial risk during a construction project has always formed an integral part of management. Introduction of the ipso facto regime places even greater importance for principals to implement proactive risk-management processes.

Moving forward, construction companies should understand the potential effect of the ipso facto regime on future contracts and review processes to ensure that they:

  • carry out comprehensive pre-contractual checks on all counterparties including company and name searches, PPSR checks and inspections of financial records;
  • have systems in place to identify early signs of insolvency of the counterparty;
  • obtain director guarantees and / or parent company guarantees;
  • consider / check termination for convenience clauses in contracts; and
  • strengthen other termination clauses that are not affected by the reforms such as termination based on non-performance.

If you or someone you know wants more information or needs help or advice, please contact us on +612 9248 3450 or email [email protected].

Bond… I’ve Been Expecting You… NSW Strata Building Bonds and Defect Inspection Scheme Finally In Play

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On 1 January 2018, a new strata defects bond and defect inspection scheme came into effect in New South Wales.  The new scheme is set out in Part 11 of the Strata Schemes Management Act 2015 (NSW) (Act).

In short, the new scheme applies to residential (or partly residential) strata developments that do not require home warranty insurance (ie developments of more than three storeys) and:

  1. requires developers, before an occupation certificate is issued, to lodge with the Department of Finance, Services and Innovation (Department) a bond equal to 2% of the contract price for the works (Defects Bond); and
  2. creates an independent defect inspection and reporting regime that is linked to the release of the Defects Bond.

The new scheme has been introduced in response to numerous cases of defective building works in high rise residential developments that often leave owners corporations out of pocket.  The need for the scheme is supported by the high volume of cases commenced by owners corporations against developers and builders for the rectification of defects.

The scheme does not apply to building work under construction contracts before 1 January 2018.

Defects Bond

Before an occupation certificate is issued for any part of the development, a developer of a residential (or partly residential) strata development that is more than three storeys high must lodge the Defects Bond with the Department.

The amount of the Defects Bond is 2% of the contract price, ie the total price paid under all applicable contracts for the relevant building work as at the date of issue of the occupation certificate.

The Defects Bond may be in the form of a bank guarantee or a bond.

Together with the Defects Bond, the developer must lodge with NSW Fair Trading various documents including: a copy of the building contract(s); relevant specifications; relevant warranties; ‘for construction’ and ‘as-built’ drawings; design certificates; and subcontractor certificates.

Owners corporation claiming on the Defects Bond

An owners corporation may claim all or part of the Defects Bond to meet the costs of rectifying any defective building work identified in the Final Report (discussed below) or with the consent of the developer.

A claim on the Defects Bond must be made within the later of 2 years after the relevant building work is completed or 60 days after the Final Report (discussed below).

The moneys realised from the Defects Bond must be used to rectify defective building work or for costs related to rectification.  Any excess amounts must be repaid to the developer.

Defect inspection regime

An independent building inspector (Inspector) must be appointed by the developer and approved by the owners corporation at a general meeting.  The Inspector must impartially carry out inspections of the building works at two different stages after completion and produce reports of the inspections – the Interim Report and the Final Report.

All costs incurred in respect of inspections and the production of the Interim Report and the Final Report are to be borne by the developer.

Interim Report

The Inspector must prepare the Interim Report and provide a copy to the developer, NSW Fair Trading, the owners corporation and the responsible builder not earlier than 15 months but not later than 18 months after completion of the building work.

The Interim Report will identify any defective work and, if practicable, the cause of that defective work.

Final Report

If the Interim Report does not identify any defective building work, the developer may apply to the Department to determine that a Final Report is not required and that the Interim Report is to be taken to be the Final Report of the purposes of the Act.

If the Interim Report identifies defects, the developer must arrange for the same Inspector that prepared the Interim Report to prepare a Final Report.

The Final Report must be carried out by the Inspector not earlier than 21 months and not later than 2 years after completion of the building works.  The Final Report must identify any defective building work which was identified in the Interim Report that has not been rectified, any defective work arising from rectification works associated with the Interim Report and how the defective work identified in the Final Report should be rectified.  However, the Final Report must not contain any matters which relate to defective work not previously identified in the Interim Report, unless those defects are a result of rectification of those previously identified defects.

Contractual considerations

To take into account the new scheme, it is recommended that industry participants consider the following issues when preparing and entering into construction contracts.

  1. Given that the Inspector must prepare the Interim Report and the Final Report more than 12 months after the completion of the building work, extended defects liability periods should be included in construction contracts so that a developer can require the builder to rectify the defects identified by the Inspector. Defects liability periods of at least two years or that are referable to the Inspector’s Interim Report and Final Report will be common.
  2. Construction contracts should require builders to supply all documents necessary to be lodged with the Defects Bond to ensure that the developer can comply with the new scheme.
  3. Construction contracts should clearly provide whether the developer or the contractor is responsible for lodging the Defects Bond with the Department.  A developer cannot contract out of the new scheme but can require the contractor to supply the Defects Bond or require the contractor to provide additional security equivalent to or greater than the amount of the Defects Bond with corresponding rights of recourse to that security as the owners corporation has under the new scheme.

If you or someone you know wants more information or needs help or advice, please contact us on +612 9248 3450 or email [email protected].

Quantum Meruit Building Work Claims

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When a contractor makes a claim for ‘quantum meruit’ they are seeking payment of a fair and reasonable amount for the work they have carried out and any materials they have supplied as part of that work.

A claim for quantum meruit does not necessarily rely on any amount specified in the construction contract but is essentially a claim for payment for ‘what the job is worth’.

Construction contracts in NSW are subject to the provisions of the Home Building Act 1989 (NSW) (the “Act”). Written contracts are required for all work over $5,000. For home building works over $20,000 more extensive contract documentation is required.

In particular, the insurance requirements set out in Sections 92 and 94 of the Act apply to all residential building works with a value of $20,000 or more. Failing to meet the requirements of these sections can prove to be very costly for a contractor and it is important to understand both the obligation to insure and the effect that a failure to insure residential building works may have on a contractor’s right to payment.

You need insurance

Section 92 provides that a person must not carry out any residential building work unless they have in place a contract of insurance that complies with the Act, taken out in the name of the person who contracts to do the work and for the specific work in question.

A certificate evidencing the relevant insurance must be given to all parties to the contract.

Importantly, section 92 provides that a contractor must not demand or receive payment under a residential building contract, whether as a deposit or some other payment and regardless of whether or not work has commenced, from any other party unless the insurance requirements of this section have been met.

Section 92 also provides that if the same parties enter into two or more contracts for work to be carried out in stages, the contract price will be the sum of the contract prices under each of the contracts. This means that insurance obligations cannot be avoided simply by breaking a larger contract for the same building project up into smaller areas of work.

In addition to not being able to make a demand or receive for work if the insurance requirements of section 92 are not met, heavy penalties apply if a contractor is found to have breached this section. These penalties increase for second and subsequent offences and can include, for an individual, imprisonment for up to 12 months in addition to any monetary fine.

Consequences if you fail to insure

Section 94 deals with the effect of failing to insure residential building works. It provides that if the insurance required by section 92 is not in force at the relevant time, a contractor will not be entitled to a claim for damages or be able to enforce any other remedy in respect of the contract which has been committed by another party. This includes any claim for quantum meruit.

Notwithstanding the general prohibition on quantum meruit claims outlined above, section 94(1A) provides that if a court or tribunal considers it just and equitable, a contractor may be allowed to recover money on a quantum meruit basis.

The court or tribunal may consider a range of factors when deciding the question of quantum meruit including the impact on the resale price of the property if no contract of insurance is provided. Even if a quantum meruit claim is allowed the contractor will still remain liable for damages and will be subject to any other remedy available to the other party for any breaches of contract.

It is possible to obtain insurance for residential building work after work has been carried out. If insurance is obtained after work is done the work will cease to be considered to be uninsured work for the purposes of section 94. This is worth considering given the ongoing liability for damages and other remedies that the contractor will remain liable for even after a quantum meruit claim is allowed.

The commercial reality of residential building work is that even with the best will in the world disputes between contracting parties do arise. It is therefore important that all insurance obligations are fulfilled prior to entering into the contract to ensure, not only that you have complied with your legal obligations but also that if a dispute arises, you will be able to be paid for the work you have done, preferably without the need to instigate costly legal proceedings.

If you are unsure of how best to meet your obligations it is always sensible to seek legal advice prior to entering into any contract for residential building work. We are always happy to assist in this regard as we know that timely legal advice may save you both time and money, not to mention a great deal of stress, in the long run.

If you or someone you know wants more information or needs help or advice, please contact us on +612 9248 3450 or email [email protected].