Construction Bulletin - what will 2017 mean for you?

MERW Construction team: key trend picks for 2017

Overview

New Zealand’s highly resource-constrained construction industry is driving trends in procurement and project contracting at all levels in the market. Generally, we see market forces reducing contractor participation in competitive tenders (although noted exceptions include large infrastructure, marquee and local and central government projects). In response, principals/clients are looking at alternative procurement strategies (such as ‘Early Contractor Involvement’ – ECI) to secure contractors and development milestones and supply chain and pricing certainty. We identify 5 key trends for 2017 in the industry across contracting, law changes and possible case law developments.

Backdrop: Resource Constraints

The New Zealand construction market is experiencing resource constraints at all levels which will likely continue. In the residential sector, there was a 17% increase in building consents issued in the year to September 2016. In Auckland, there were nearly 10,000 consents issued and the RCG Development Tracker identifies nearly 7000 residential units currently under construction in the region.

The commercial sector is also busy with significant projects underway and planned in Auckland (Commercial Bay, Sky City Convention Centre, NDG Tower, Customs Residential and others (see: Emerging Auckland's private development tracker), the ‘Anchor’ and other earthquake rebuild projects in Christchurch (such as the Christchurch Convention Centre and the Metro Sports Facility). Queenstown is another strong market (another Convention Centre there, a shopping centre, tourism facilities and a fringe town centre recently announced). There are a number of significant infrastructure projects in the pipeline or under procurement (including the City Rail Link, Puhoi to Wellsford, Wellington Gateway, Schools PPPs and irrigation projects). There is also strong Government contracting (which will increase as a result of the recent earthquakes – especially in Wellington and Kaikoura).

Overseas, engineering and construction companies are facing significantly reduced demand as a result of the oil price collapse in 2015 (read PWC’s report on this here). Perhaps relatedly, we are seeing ‘tier 1’ Australian, Chinese (China State Construction Engineering Corporation) and European (e.g. Vinci) entering the NZ market to take advantage of the increased demand for construction here (and with potential to also deploy excess capacity they may have in their organisations and supply chains offshore). However, even with those additional contractors, our expectation is that resource constraints may become more severe and will necessitate the need to develop unique procurement strategies to attract contractors’ interest.

1. Procurement strategies to de-risk project price increases

A: Increasing use of ECI

ECI is a procurement process (which is often utilised alongside traditional design and contract procurement models) where clients/principals engage a contractor (or contractors) for specialist project and construction advisory services at early project stage. The contractor may receive a fee for the services. The overall intent of the ECI phase is to ‘de-risk’ the project.

The ECI process has advantages over traditional competitive tendering in the current market by securing contractors and their supply chain and allowing early identification of risks (in particular the availability of the supply chain). This promotes greater pricing and programme certainty.

B: Cost reimbursable contracts and open book sub-contractor packages

There continues to be significant supply constraints at the medium to lower value levels of the market (i.e. under ~$20m) and we are seeing widespread use of ‘cost plus’ contracts in such projects. That approach is attractive for contractors because it de-risks potential price increases in sub-contract packages while providing an opportunity for a transparent procurement process for principals.

C: Direct supply arrangements

Clients at all levels of the market are employing or considering direct sourcing materials and alternative supply chain models. We note, for example, an increased willingness from principals to carve out certain building elements and directly source those materials. We also note a growing trend of contractors and subcontractors sourcing building materials online from abroad and bypassing traditional supply chains.

2. PPPs and outcomes based contracting

Public Private Partnerships continue to be popular with central Government. The New Zealand PPP contract model uses an ‘outcomes-based’ approach in the procurement of construction and long term service obligations (rather than relying on detailed specifications). Under an ‘outcomes’ approach, a client might, for example, simply ask for a cricket ground to be built and maintained for the purpose of playing cricket during the season (rather than detailing how often the grass is to be mowed, lines painted, drainage maintained, and the like). This approach drives innovation from leading contractors to meet outcomes within budget.

The success of the New Zealand PPP contractual model is evidenced by some non-PPP projects adopting certain key features of the NZ PPP model including: bundling of construction and operation procurement and ‘outcomes-based’ requirements within a budget or ‘affordability threshold’.

Outcomes based approaches are also helpful should an interpretation dispute arise because courts tend to prefer and place greater emphasis on documents that seek to describe the overall objectives of the contract (such as employers requirements) rather than technical specifications or details. Accordingly, by describing the outcome contracted for, parties can be more certain about what they are bargaining for.

3. Security for contract obligations

A new Construction Contracts Act 2002 (CCA) retentions regime comes into force on 31 March 2017 (read more from us on this: here and here) will force parties to reconsider how they provide project security. The new regime provides that from April next year, principals and head contractors in construction projects will be required to hold all retention money (i.e. money held from parties for the purpose of securing performance) “on trust” for the benefit of contractors and subcontractors. We expect parties to hold these funds in different accounts for ease of accounting/ reporting. We think that contractors with good bonding capacity will prefer to offer bonds in place of retentions to secure their obligations.

4. Increased frequency/ complexity of adjudications under the CCA

CCA amendments came into force in September 2016 broadening the definition of ‘construction work’ to includes design, engineering and quantity surveying work (consultants) (read more: see our article ‘CCA Captures Consultants' by Janine Stewart and Shukti Sharma).

Consultants carrying out this work are now subject to the payment process and adjudication regime. Also, under the new provisions, parties can now enforce adjudication determinations regarding disputes about rights and obligations, including breaches of contract.

This means that claims alleging a consultant had an obligation to exercise reasonable care and skill in carrying out their work pursuant to a term in the contract may be referred to adjudication and then enforced through the Court. This brings with it a myriad of considerations and challenges for consultants and their professional indemnity insurance programmes.

Because of this change, we expect more substantial and complex claims go to adjudication. Additionally, parties increasingly ‘save up’ multiple issues until an adjudication at the end of a project, again increasing complexity. In response to such claims, adjudicators are likely to extend time frames for parties to file claims and responses and for issue of determinations. But even (relatively) lengthier adjudications remain a faster dispute resolution procedure compared to similar claims if tried in the Courts.

Overall, parties are increasing aware of the CCA adjudication process and contractors especially see the benefit of ‘pay now argue later’ regime. And even if the adjudication determination is challenged, those subsequent disputes often reach commercial settlement as parties generally have a low appetite for continuing the dispute well beyond project completion.

5. Court of Appeal decision in Ebert Construction will impact on project funding arrangements

In November 2016 the Court of Appeal heard Ebert Construction’s appeal in respect of a voidable transaction claim originally brought by liquidators of a failed development company. As a brief recap: under the Companies Act regime, in the two year period preceding a company’s liquidation (known as the ‘specified period’), payments or transactions made by the company are vulnerable to being avoided or ‘clawed back’ by the company’s liquidators (See: section 292 of the Companies Act 1993).

The Ebert Construction case specifically concerns the practice of Direct Agreements (sometimes called Tripartite Agreement) in construction financing. In the High Court, Associate Judge Doogue determined that a payment made by a third party financier to a construction contractor under a Direct Agreement was liable to be set aside as if it had been made by the development company (See: Sanson & Anor v Ebert Construction Ltd [2015] NZHC 2402). The essence of the Associate Judge’s reasoning was that advances by the financier “were the property of” the development company. Accordingly, the fact that it was the financier (not the developer) who paid the contractor was “neither here nor there”.

Previously, the commonly held view in the construction industry was that payments made by third party financiers under Direct Agreements did not fall within the scope of the liquidation of a development company. The High Court’s decision did not bear out that expectation. This outcome represents a significant increase in the risk that construction contractors will be out of pocket if a development company falls into liquidation – because liquidators may then seek to ‘claw back’ payments even if they have been received directly from a financier, and for the time period of up to two years prior to the liquidation. Anecdotal evidence is that construction contractors are now becoming wary of Direct Agreements, if they in fact offer no better protection (in this particular respect) than if they had contracted only with the developer.

Some industry observers have suggested that to ensure construction contractors do have security for payment, financiers ought to be included in constructions contract so the contractor can pursue the financier directly. Another suggestion is for the contractor to take a preferential security interest (be it on the development property itself or otherwise). However, both of those options are likely to be unsatisfactory to financiers, who would then bear additional risk or reduced preferential security. Alternatively, contractors might look to more informal risk management strategies such as building the risk of ‘claw back’ into the overall project price; or requiring the developer to certify their solvency when progress payments are made, or some sort of continuous disclosure regime (which would better arm contractors to fend off a ‘claw back’ application from a future liquidator or at least allow the contractor to become aware of solvency issues and plan accordingly). However, being obliged to make such disclosures would be seem deeply unattractive to developers; as well as ultimately offering uncertain benefit to the contractor (as a future liquidator could still prove by other means that the company was actually insolvent at the time notwithstanding). As such, the Court of Appeal’s decision stands to have a significant impact on project funding arrangements in the future.

We will issue an update on the outcome of the appeal when it is known.

(Disclosure. MinterEllisonRuddWatts acts for Ebert Construction Ltd).

Custom Street Hotel Ltd v Plus Construction NZ Ltd [2016] NZHC 2011

A recent decision of the High Court could significantly extend contractors’ termination rights under the most commonly used New Zealand Standard Form Contract (NZS) – 3910.

The decision

Custom Street Hotel Ltd v Plus Construction NZ Ltd [2016] NZHC 2011 was an appeal from an arbitral award made in relation to a NZS 3910:2003 construction contract (the relevant clauses are largely the same as the current NZS 3910:2013). The principal, Custom Street Hotel Ltd (Custom Street), failed to pay two of its scheduled amounts totalling $258,507.62 in response to payment claims served on it by the contractor, Plus Construction NZ Ltd (Plus Construction). As a result, Plus Construction issued a default notice requiring Custom Street to remedy its failure to pay within 10 working days (clause 14.3.3 of NZS 3910).

Clause 14.3.3 relevantly provides that if a principal’s default is not remedied within 10 working days of the contractor’s notice, the contractor can “require” the Engineer to suspend the works and “following such suspension”, the contractor becomes entitled to terminate the contract. In this case, Plus Construction purported to terminate the contract prior to any such suspension taking place. The parties disputed whether a valid termination had occurred.

Custom Street argued that the words “following such suspension” would serve no purpose if the contractor was entitled to terminate immediately upon communicating its intention to do so to the Engineer. The arbitrator disagreed and considered that, notwithstanding such wording, the Engineer’s refusal or failure to take the “purely formal step” of suspension would not deny the contractor its substantive rights to termination under clause 14.3.3. While the High Court held that the arbitrator did not err in holding that Plus Construction was entitled to terminate the contract, unlike the arbitrator, it approached the issue in the context of the Contractual Remedies Act 1979 (CRA), rather than the contract itself. Gilbert J held at paragraph [37]:

“Under NZS 3910:2003, if the principal fails to remedy its breach prior to the expiry of a 10 working day notice, this would be a breach of an essential term that would normally entitle the contractor to cancel the contract under the Contractual Remedies Act.”

Essential terms

If a contractual term is broken by another party, and the parties have agreed (expressly or impliedly) that the performance of that term is essential to the party seeking cancellation, section 7 of the CRA allows that party to cancel the contract. Generally, a term qualifies as “essential” if it is a condition or promise of such importance that the party would not have entered the contract without it.

Gilbert J’s decision does not set out in detail why Custom Street’s failure to remedy its “breach” before expiry of Plus Construction’s notice renders the performance of the breached term as “essential”. Indeed, clause 14.3.1 lists six potential defaults by the principal but NZS 3910:2003 contains no such express provision regarding the essentiality of these terms.

In our view, there are two or three possibilities:

(a) The Court has held that in construction contracts such as NZS 3910, it is implied that the obligation to pay a scheduled amount is an essential term (Option A); or

(b) The Court has held that the effect of clause 14 is that the six potential defaults specified therein are agreed to be essential terms and/or that they can become the equivalent of an essential term by the contractor giving notice (Option B).

Possible interpretations of the decision

Option A is consistent with the “pay now/argue later” regime set up by the Construction Contracts Act 2002 (CCA). However, such an interpretation is a gloss on the plain wording of clause 14.3 and an extension of the recognised essential term that payment should be timely (MacIndoe v Mainzeal Group Ltd [1991] 3 NZLR 273). MacIndoe concerned an express provision in a sale and purchase agreement that payment within the time specified in the default notice was “of the essence”. While such express clauses on timeliness may give rise to contractual termination rights (in addition to CRA remedies), it is not as clear-cut whether non-payment of a scheduled amount meets the essentiality threshold of express or implied agreement required for valid cancellation under the CRA.

Moreover, if Option A is a correct interpretation of the decision, then any unpaid scheduled amount, whether that is $1 or $1M, would trigger the contractor’s ability to cancel under the CRA as essentiality is not concerned with actual amounts. Further, if this is the case, it would be difficult to see how the non-payment of an unanswered payment claim by the principal should not also be treated as an essential term. This would have “drastic and far-reaching consequences” and decision-makers should be encouraged to interpret termination provisions in construction contracts strictly to avoid such concerns (Brown & Doherty Ltd v Whangarei County Council [1988] 1 NZLR 33 (HC) at 36).

If Option B were the case, one would expect clause 14 to provide for an automatic right to terminate, rather than require the works to be suspended prior. However, Gilbert J reviewed the contractor’s right to suspension in the CCA and held at paragraph [34] that:

“…. consistent with the position under the Act, if the contractor chooses to take the step of suspending the works under the contract, this will not amount to an affirmation precluding cancellation in reliance on the same breach. This is made clear by the words “Following such suspension the contractor shall be entitled … to terminate the contract”.

In other words, if the contractor affirms its statutory right of suspension by way of notice to the Engineer, then it essentially does have an automatic right to terminate once the notice expires unremedied after 10 working days.

Yet Option B faces some challenges in light of Whata J’s decision in Kumar v Nandan & Ors [2016] NZHC 935. There a sale and purchase agreement contained a process for cancellation if the deposit was not paid on the due date for payment. While the court recognised that timely payment of deposits is an essential term in such agreements, Whata J held that the vendor’s ability to cancel for non-payment was only triggered after the method stipulated in the cancellation clause was complete. The overall scheme of the clause as a whole plainly envisaged a three-step interlocking process and a reasonable person would not anticipate that a vendor could simply issue a notice of cancellation immediately on the non-payment of the deposit (at paragraph [57]).

Similarly, a reasonable person reading clause 14.3 would not anticipate that a contractor could terminate the contract simply by giving notice under clause 14.3.3 without any instruction from the Engineer regarding suspension. A holistic view of NZS 3910 suggests that suspension is a necessary precondition to termination – under the contract itself and under the CRA.

Option B would also ignore parties’ basic entitlement to contractually agree on termination rights without such necessarily meeting the statutory threshold for termination in the CRA. The most obvious example is a termination for convenience clause which essentially permits the principal to terminate at its discretion.

Observations

What is clear is that the decision in Custom Street v Plus Construction will have implications for contractors and principals alike operating under NZS 3910 and possibly other standard form construction contracts.

If the decision is intended to be specific to NZS 3910’s terms, then all NZS 3910-based construction contracts must be approached on the basis that non-payment of a scheduled amount within the time required automatically gives rise to a breach of an “essential” term and the contractor’s corresponding right to terminate, irrespective of the quantum of the unpaid amount and without the contractor first having to suspend the works in accordance with clause 14.3.3.

Given that NZS 3910 contains no express provision that says that payment of a scheduled amount is an essential term, if such an approach is to be taken to NZS 3910 contracts, there is no reason why it should not apply to other standard forms of contract. The whole purpose of using a standard form contract is to allow the parties to “rely on a uniform construction being given to standard terms” so that “they can prudently incorporate them into the contracts without the need for detailed negotiation or discussion” (Pioneer Shipping v BTP Tioxide [1982] AC 724 (HL) at 737). If Gilbert J’s interpretation of clause 14.3 becomes well-established, it will take strong evidence to show that the parties intended a different meaning from the well-established interpretation. This would mean that as a matter of law, a contractor who has not been paid a full scheduled amount on time (no matter how small the shortfall) has a legal right to not just suspend its works under section 24A of the CCA, but also to terminate under the CRA.

Based on this judgment, contractors’ positions have become significantly stronger and interpretations in line with Options A or B have the potential of having far-reaching consequences. As the majority of disputes arising under NZS 3910 are referred to adjudication or arbitration, there will be very limited scope for Gilbert J’s decision to be revisited by the High Court and in the meantime, being a High Court judgment, adjudicators and arbitrators ought to be bound by it.

Adjudication under the Construction Contracts Act 2002 – what you need to know over the Christmas holidays

Much of New Zealand shuts down over the Christmas and New Year period. Unfortunately, the Construction Contracts Act 2002 (CCA) contains a trap for the unaware. And some parties who know the trap seek to capitalise upon it through ambush tactics over the Christmas and New Year break.

In this Construction News we look at common issues that we see and some important tips to minimise the risk of being caught out.

Click here to read.

The Construction team has a team working over the Christmas/New Year period, so please contact us if you need more information.

Introducing PAT

Given the increasing focus on time and cost efficiency, compliance and the rise in disputes, we’ve noticed an increased demand for tailored training. In response, we’ve developed an innovative new offering for the construction industry – the Project Advisory Toolbox (PAT).

PAT provides in-house, customisable training focused specifically on your needs. You’re encouraged to pick and choose training modules to suit you and your team. These modules address issues during the life cycle of a construction project, from the concept stage to the end of the limitation period in respect of latent defects.

Rather than sending individual team members to expensive training sessions facilitated by external providers, PAT is a cost-effective solution for the whole team. We can come to you, or host you in our boardroom. By defining topics of interest at the outset, we offer you specialised training on specific areas of interest.

Check out what PAT has to offer here: http://pat.minterellison.co.nz/

If you have any queries on PAT, please contact us.

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