Does the new Regulation really achieve its policy aim? Or has it created a loophole that head contractors might be tempted to exploit?

New South Wales Parliament has recently enacted the Building and Construction Industry Security of Payment Amendment (Retention Money Trust Account) Regulation 2015 (NSW) (the Regulation).The Regulation will apply to contracts entered into from 1 May 2015.The Regulation requires retention money held by head contractors under construction contracts with a project value of $20 million or more (the $20 million threshold) to be held in trust for the subcontractor from whom the money has been retained. That money is to be held in a trust account established with an authorised deposit-taking institution. The Regulation will impose a number of administrative and reporting requirements on head contractors.

Application of changes - projects with a value of at least $20 million

Clause 5 sets out the circumstances in which the trust account provisions will apply. The Regulation applies only if the contract sum under the head contract with the principal reaches the $20 million threshold. For the purpose of determining the value of the head contractor's contract with the principal, the value is to include any "variation to the contract" (more likely, strictly speaking, to be a variation to the work the subject of the contract) after the contract is entered into. However, if the value of the head contract reaches the $20 million threshold after the contract is entered into, the mandatory retention requirements will only apply to contracts between the head contractor and subcontractors entered into after the value of the construction project reached the $20 million threshold.

Circumventing the new regime

This limit on the application of the changes to head contracts entered into after the value of the original contract reaches the $20 million threshold appears to us to be curious. It firstly withholds the benefit of the trust account from existing subcontractors. It also appears to leave open the possibility of head contractors structuring their contracts to avoid the new requirements. For example, a head contractor and a principal could enter into a contract with a project value of (just) less than $20 million, but agree that additional work to the value of, say, $5 million be identified as a separable portion in the contract, which is to be performed as a variation at the future direction of the principal. The principal could later give the direction that the separable portion be performed, bringing the value of the contract to $24 million and thereby exceeding the $20 million threshold. The application of the new trust requirements would then be triggered, but would apply only to any subcontracts entered into between the head contractor and subcontractors after this point in time. The additional works could simply be directed as a variation under each relevant subcontract. No new contracts between the head contractor and the subcontractors would be required, and the application of the new retention money trust requirements could be completely avoided.

History of the Regulation and limits on its Application

The public consultation draft of the Regulation was published in December 2014. Interestingly, the draft Regulation did not include the limitation described above. In that draft, the value of the project likewise  included variations, such that projects could become caught when they subsequently exceeded the $20 million threshold, but was not limited to subcontracts entered into after that threshold was reached.

The final form of the Regulation was presumably amended in response to concerns over the ability of head contractors to retrospectively comply with the Regulations in relation to retention moneys retained before the threshold was reached. However, the way in which this change was effected seems to have significantly reduced the circumstances in which the trust requirements will be imposed. Variations under the head contract will usually affect the same subcontractors with whom the head contractor has existing contracts and therefore, despite the threshold value being reached, no new contract will need to be entered and the trust account requirements will not apply to them. The Regulation will therefore have little effect when a contract reaches the $20 million threshold during the project, as little of the further work is likely to be made the subject of a new subcontract.

Arguably, a better solution to this problem would have been for the Regulation to apply to both existing and future subcontracts, but to limit the application of the new trust account requirements to all retention monies received after the head contract has exceeded the $20 million threshold, i.e. even for subcontracts entered into before the point in time the threshold was reached.

Practical Difficulties

There are likely to be difficulties in determining when the $20 million threshold has been reached. Disputes often arise during the course of performance of a contract, and they may not be resolved until significantly later, after the dispute resolution procedures have resolved the final head contract sum.

By way of illustration, consider this scenario - under a $19.5 million contract, the principal gives a direction, which the head contractor alleges involves a $1 million variation, which would take the contract past the $20 million threshold. However, the principal denies this, arguing that the work in question formed part of the head contractor's original scope. The dispute is formally pursued by the head contractor under the head contract's dispute resolution provisions, and six months later (this timeframe is of course optimistic!), an expert makes a final and binding decision that the direction did involve a $1 million variation and thus took the contract sum to $20.5 million. The Regulation offers no clear path as to what the head contractor is to do (and when) as to setting up trust arrangements for any relevant retention monies.

Further, the Regulation does not provide for the situation in which a negative variation or set off occurs which takes the contract sum below the threshold. On the Regulation's current wording, in our view, the head contractor would need to continue the trust account arrangements even if the head contract value was subsequently reduced below the $20 million threshold.

Future of the Regulation

The New South Wales Government has indicated that, subject to the implementation of the Regulation and further industry consultation, the measures may be expanded to apply to subcontracts for non-residential projects with a value of $1 million or more. If the Government goes ahead with these plans, this will limit the scope for head contractors to circumvent the new retention money trust account requirements in the manner described above.

Conclusion

From a policy perspective, the purpose of the new trust account scheme is to ensure that subcontractors' retention money is secure in the event of head contractor insolvency, so that they are eventually paid the amounts to which they are entitled for work that has been completed in accordance with the terms of their subcontract. However, the Regulation appears to leave a loophole for head contractors wishing to avoid the costs and administrative burden of the new trust account requirements. In our opinion, the object of the changes would be better achieved by removing this loophole, and reframing the provisions to apply prospectively to all moneys under all subcontracts, whether or not already let, that are retained after the $20 million threshold is reached. This solution would make compliance by head contractors more practical and achievable (and far reaching) in situations where the threshold value is only reached through variations ordered after execution of the initial contract.