Out of the ashes of the Hartner Construction collapse in 2001 rose the 2002 Construction Contracts Act, which aimed to give subcontractors a degree of security around payments.

Just over 10 years later, it seems nothing much has really changed, with subcontractors again bearing the brunt of another major construction company failure. No doubt the blame and recriminations surrounding Mainzeal’s management performance leading up to the collapse of New Zealand’s third largest construction company will continue for months to come, but if any good is to come from such a tragedy this time, then the industry needs to focus on the clearly unresolved issues surrounding subcontractors payments. A strong message needs to be sent to politicians that there needs to be further change.

From all the heartbreaking Mainzeal stories across New Zealand over the past few weeks, there is a common theme of unfairness about the treatment of sub-contractors’ retention monies. Estimations are that there is a large amount of money being held for jobs that have been completed and monies not released. Although these funds do not belong to Mainzeal, they hold them in their now frozen bank accounts and their fate lies with the receivers.

For those not familiar with commercial construction contracts, a retention is a sum of money held back by the main contractor for a period of time after practical completion (usually one year). This period is commonly referred to as the ‘defects liability period’. If any problems should occur with the subcontractors work within the defects liability period, then the subcontractor will get the chance to rectify the problem. If the subcontractor fails to do so within the terms of the contract, then the main contractor can use the retention monies to employ someone else to do the work. After the defects liability period is up, the subcontractor has a right to receive his retention money back, minus any deductions.

With the tight margins most subcontractors are working to these days, you can be assured most (if not all) of the subcontractor’s profits are tied up in these retentions. This means any subcontractor project profits cannot be realised for over a year after practical completion. Therefore Mainzeal is effectively holding the profits of hundreds of subcontractors over various contracts stretching over several years, and the affected subcontractors have no real security over this money.

The history of this practice can be traced back to 1791 where the statutory provision of liens for Master Builders in Maryland, USA was provided. In New Zealand the first legislation that covered this situation was the Contractors and Workers Liens Act of 1892, this was based on the American Model and had further changes and amendments over the years, most notably in 1939 under Michael Joseph Savage’s Labour government. The major thrust of this legislation was that although a retention of the contract monies were held, the contractor and, more importantly, his subcontractors held a lien against the principal’s land and chattels until all monies were recovered.

Ironically this legislation was revoked by another Labour government under the Wages Protection and Contractors’ Liens Act Repeal Act of 1987. Unfortunately after all the tinkering with the Act over the years, it was felt the legislation was not working well and needed repealing. Although it had its problems, the Act was still a means for subcontractors to go to court to fight their case and like so many contentious issues in parliament, the repeal was rushed through against the wishes of many subcontractor organisations.

Unfair

It is interesting to note that some subcontractors caught up in the current Mainzeal drama are now considering all their options, including their rights under the Personal Property Securities Act, as a possible means to provide for such security and the prioritising of it against other creditors.

Many subcontractors point to the fundamental unfairness of retentions schemes. This is undoubtedly highlighted by the fact that under the ‘sliding scale’ retention regimes commonly operating in New Zealand, the main contractor actually makes money on retentions and uses them as a cash cow at the expense of the subcontractors’ cash flow. As most commercial contracts in New Zealand are based upon NZS 3910:2003 they follow the retention scale noted in Schedule 12.3.1 of this document:

The percentage to be retained from each progress payment and the limit of the total sums retained shall be:

(a) In respect of the Contract Works:

• Total Retention
• • 10 % of the first $200,000, plus
  • 5 % of the next $800,000, plus
  • 1.75 % of any amount in excess of $1,000,000
  • With a maximum of $200,000 when aggregated
• Defects liability retention
• • 50 % of total retention

On first glance this seems to be a fair enough, however on a large construction contract the subcontractors are signed up to the same sliding scale as the main contractor. This is a subtle point most people miss.

Figure 1: Typical retentions on a $3m construction contract using the NZS 3910:2003 sliding scale. The main contractor’s own costs are $327,000 and can be funded significantly by the $151,800 of surplus retentions

Importantly with most subcontract packages being a small part of the total contract value, the majority of subcontractors never get over the $200,000 mark therefore forfeiting the full ten percent retention. However once the main contractor gets over his first $200,000 he is only paying five percent, then 1.75 percent over the million. So he is collecting at ten percent and paying out effectively less than half of that. He is very soon in a positive cash flow position in his retention account and is then free to use this money to fund his project or receive interest from the bank on it. Figure 1 estimates what could potentially happen on a small $3m construction contract.

As you can see from the bottom line, even on a typical small $3m construction project, the main contractor has roughly $150,000 of collected subcontractor retention money left over in his account after paying the principle their retention (by the end of the project). Granted, half of this should be paid out at practical completion, with the other half held until the one year defects period is finished. As the percentage is retained off each progress payment, the main contractor has had the use of this money throughout the project and the subcontractors have not.

Some of Mainzeal’s contracts stretched into the hundreds of millions of dollars. How much subcontractor retention money are they holding?

As you can see from our estimated totals, the retentions held are roughly half the main contractor’s own works (shown in red line) and possibly more than half if you deduct the main contractor’s profit margin. Extrapolated out, you can see how important a funding source retentions can be to a main contractor. As main contractors do less and less physical work on site as they do today, and more of just the management of subcontractors, this situation can only get more pronounced.

The other generic issues for subcontractors in regards to retentions (no relation to the Mainzeal issue) surrounds the process of claiming the retention back even when the main contractor is still solvent. There are two issues here. The first is that a lot of subcontractors have poor record keeping methods and forget to claim their retention money after the year is up. Sad, but true.

Of course under the Construction Contracts Act, unless a claim is made, the main contractor is under no obligation to pay any money. The other issue is when under pressure to secure the next project, the retentions held for the last project are given up by the subcontractor to the main contractor as a ‘discount’.

On the flip side from a main contractor’s point of view, although the retention fund can provide an extra cash flow, the main contractor does carry a lot of risk because if something really disastrous goes wrong during the defects period then the cost of remobilising and fixing the problem for the subcontractor may be so much larger than the retention held against them, they simply walk away.

Need for change

Many states in Australia prefer the use of bank bonds in lieu of retentions. In this situation the subcontractor’s bank provides a bond to the main contractor for the total amount of the retention payment, calculated using the same schedule as above.

NZS 3910:2003 does provide for this method under Item 12.3.3. The main problem with this scheme for the subcontractor is again the retrieval of the bond at the end of the project and the fact there is no independent administrator and there is nothing to stop the main contractor calling up the bond at any time. It also does not allow the subcontractor to fund the retentions from the project progress claims and may affect his credit with the bank. In some cases this can result in overdraft limits being reduced by the amount of the bond often adversely affecting larger subcontractors covering a lot of projects.

In the UK, the National Specialist Contractors Council (NSCC) has started a ‘Fair Payment’ campaign (www.fairpaymentcampaign.co.uk) with the stated aim of outlawing the use of retentions. Their website states: “NSCC believes that the withholding of retention is an outdated practice which is unnecessary in the modern construction industry. The best guarantee of quality lies in the choice of a competent and qualified supply chain and NSCC Specialist Contractors are committed to seeking to attain the highest applicable standards in health and safety, training and technical performance. NSCC recommends that, whilst its Specialist Contractors are free to negotiate their own respective contractual terms, they do not accept cash retentions.”

Options

So moving forward for New Zealand subcontractors, some alternatives to retentions for consideration could be:

• The use of independent project trust funds to hold retention monies, so if one party goes bankrupt then at least the subcontractor’s retentions would be recoverable.
• A government agency set up to hold retention monies, similar to the bonds collected by the Ministry of Business, Innovation & Employment (formerly the Department of Building and Housing) on domestic rentals, and recovered either by sign-off of the two parties involved or through a disputes tribunal process. This could be funded by the interest payments on the money held.
• Bonds, administered by an independent third party.
• Industry fidelity funds.
• The securing of retention monies in commercial contracts against the principal’s land and the prioritising over other creditors.
• The use of incentives or bonuses for defect free buildings.
• The abolishment of retentions and the industry relying on standard means of redress available under commercial law – or reliance on reputations and trust …

One thing is clear. Another large building contractor has gone bust holding money not belonging to them and it’s going to be a hard slog for the out-of-pocket subcontractors to claw it back.

There needs to be change in the New Zealand construction industry in regards to retentions.

So, what will the legacy of the Mainzeal collapse be for subcontractors?