Key Points:

The inspection and bond regimes apply to the construction of high rise buildings of three or more storeys and with two or more dwellings.

Of the strata schemes constructed in the last 10 years 85% are reported to suffer from at least one form of building defect. Owners corporations are often the losers when it comes to building defects in their strata scheme, incurring large costs in order to carry out rectification works. With such high rates of building defects affecting homeowners and increasing criticism that NSW strata schemes are ridden with a lack of accountability, the NSW Government is looking to provide owners with a degree of protection through the first major strata law reforms which will come into effect this year.

The reforms to strata management at a glance

With 25% of greater Sydney's population currently living in strata schemes and predictions that this will rise to 50% by 2040, the NSW Government's new strata laws aim to tackle the perennial problem of defects in new builds. They do so by mandating an inspection regime by an independent inspector for new high-rise strata buildings, paired with a 2% bond put up by developers to cover defects in the building work that have not been rectified after two years.

The Strata Schemes Management Bill 2015, which implements those reforms, received assent in November last year. The Act is expected to commence mid-2016.

How does the new Strata Schemes Management Bill work?

The inspection and bond regimes apply to the construction of high rise buildings of three or more storeys and with two or more dwellings. Unlike low rise or single dwelling new builds, these buildings do not have protection under the Home Building Compensation Fund, so this new regime seeks to provide some level of protection for high-rise strata lot owners.

The inspection and defect bond regimes will only apply where the contract for carrying out the building work is entered into after the commencement of the legislation.

Mandatory defect inspection reports

The new law requires a developer of a strata scheme to arrange and pay for the building work to be inspected by a building inspector approved by the owners corporation.

The building inspector must not be connected to the developer, must act impartially and cannot represent the interests of the developer.

The inspector must provide an interim report between 15-18 months after the building work is complete. The developer and its builder will then have an opportunity to rectify any defects before the inspector prepares the Final Report (between 21-24 months after completion of the building work). The Final Report must identify any defects from the interim report that have not been rectified or any defective work resulting from the defect rectification work carried out in response to the interim report. The inspector is not free to raise new defects that were not identified in the interim report.

If the developer fails to appoint an inspector or the owners corporation does not approve the inspector proposed by the developer, the Secretary of the Department of Finance Services and Innovation may appoint an inspector.

Inspection reports must be considered by courts in any subsequent proceedings (if brought to their attention) but the reports will not be binding.

Building Bonds

In addition to arranging for building inspections, the developer will need to provide a building bond to the Secretary for the purpose of covering the cost of rectifying any defective work identified in the Final Report.

This new requirement will establish a safety net for apartment owners beyond their sinking fund and incentivises developers to rectify any defects rather than facing the cost (both financial and reputational) of having their bond called. It also provides some protection to owners where the developer is insolvent or is being unco-operative. The requirement does not limit an owners corporation's right to commence proceedings in the normal course.

Key features of the bond regime include the following:

  • bonds must be for the value of 2% of the construction contract price;
  • bonds must be given to the Secretary before an occupation certificate is issued;
  • failures to comply with the regime can attract fines of up to $22,000 per breach;
  • the bond may only be called by the Secretary for payment to the owners corporation of the cost of rectifying any defects shown in the Final Report. It is not available for use in relation to any other defects that may emerge;
  • the bond must be called within a specified time limit (yet to be set by the Regulations);
  • the bond must be used by the owners corporation within a reasonable time to rectify the defects; and
  • the bond must be used by the owners corporation to rectify the defects identified in the Final Report and not for any other purpose.

Initial maintenance schedule

The new regime requires "original owners" to provide an initial maintenance schedule to owners corporations in order to assist owners corporations in properly maintaining common areas. These initial maintenance schedules will contain matters to be prescribed by the Regulations. Original owners (ie. the persons that own the land when the strata scheme is registered, or for leasehold, the persons entitled to all the lots immediately after registration of the strata plan for the leasehold strata scheme) are usually the developers of the land on which a strata scheme is to be registered.

While owners corporations are not required to comply with the maintenance schedules, these schedules may provide developers with some leverage. If any disputes arise in relation to any reported defects, the schedules may be considered in proceedings. The schedules are therefore likely to become very important in managing and navigating defects as developers may be able to point to poor maintenance practices as contributing to the existence of defects.

Uncertainty ahead

While the new regime certainly seeks to assist the needs of owners in strata developments with defects and address issues such as certifier impartiality, it is unclear how effective it will be on a practical level in regulating and curtailing these issues.

Indeed, the reforms may be more effective if investment were dedicated instead to identifying and rectifying the defects before the building process is finalised. It is also questionable whether bonds for 2% of the value of the construction contract will in reality be sufficient to cover the actual cost of the defect rectification required and whether they provide sufficient incentive for developers to return to the site to rectify defects.

The reforms raise a number of key questions and concerns:

  • Who will ultimately pay the cost of bonds and inspection reports? It remains to be seen whether developers will, in practice, seek to pass this cost on to purchasers of strata units.
  • How the amount of the bond will actually be determined. While the bond is to be 2% of the construction contract price, the legislation reserves the right for the Regulations (yet to be drafted) to provide for how the contract price is to be determined. Given that the bond need only be provided "before an occupation certificate is issued", developers may have discretion to omit contract variations from the contract price if a bond can be provided upfront on contract signing (as opposed to just before an occupation certificate is issued and where the original contract price may have subsequently increased to account for variations).
  • Where the contract price is not a lump sum (eg. under a managing contractor or construction management arrangement) it remains to be seen how and when the 2% figure will be calculated.
  • Where the bond is to be called, how the amount of the bond to be claimed will be calculated by the Secretary. The Bill contains no detail as to the process of quantifying the cost of rectifying any defects identified in the Final Report, who is responsible for this calculation and whether the developer has any input into the decision.
  • Whether, in practice, the Secretary will police the obligation on the owners corporation to use the bond proceeds to rectify defects rather than retaining the cash.
  • Whether the Secretary will accept bonds provided directly by the developer's builder rather than from the developer itself.

It is likely that the Regulations will address many of the procedures and detail about the form, provision and maintenance of bonds that are currently unclear. Draft regulations are yet to be released.

What if it is too costly to fix the defects?

The legislation requires any proceeds of the bond to be used by the owners' corporation to fix the defects identified in the Final Report. It doesn't contemplate the situation where the cost of rectifying the defect is such that it would be unreasonable to spend the money to fix the defect, but the owners corporation has still suffered a diminution in value of the building. This distinction has long been recognised by the courts in a line of cases starting with Bellgrove v Eldridge (1954) 90 CLR 613.

For example, a swimming pool may not have the specified depth, having been constructed too shallow. It would be unreasonable to expect the owners corporation to use the bond proceeds to rebuild the pool and a 2% bond would be unlikely to be sufficient in any event. Yet it may be reasonable for the owners corporation to retain the bond proceeds to compensate it for the reduction in value of the building resulting from the shallower than usual pool. The legislation does not currently permit this and the bond proceeds would need to be repaid.

How does this affect you?

The changes will impact on developers, builders, owners corporations and certification professionals in different ways.

Developers will need to:

  • make proper allowances in their development budgets for inspections and bonds;
  • provide a bond to the Secretary before the occupation certificate issues;
  • provide an initial maintenance schedule and appoint appropriate building inspectors within the regime's time limits;
  • pay close attention to the preparation of the detailed initial maintenance schedules, as they may assist if there is a call on a bond;
  • seek legal advice regarding aligning downstream contracts with builders with the new legislative regime, otherwise developers may face exposure where the builder's contractual defects liability period has expired but defects rectification is required under the legislation. Developers should consider obtaining back-to-back bonds from builders (or consider providing a bond directly from the builder to the Secretary); and
  • seek legal advice where a call is to be made on a bond, including on the possibility of getting an injunction to prevent the call or seeking a review of the Secretary's decision to make the call or on the amount to be paid to the owners corporation.

Owners corporations will need to:

  • add building defects and their rectification to the first and subsequent AGM agenda items until expiry of the statutory warranty period;
  • act on time to apply to the Secretary to call on a bond if needed; and
  • seek legal advice on any attempts by the developer to injunct the call on a bond or if the 2% bond is insufficient.

Contractors should:

  • most likely expect that developers will seek back-to-back bonds from them for the two year period up until the Final Report is issued (or perhaps a bond to be given directly to the Secretary). This will essentially extend the standard 12 month defects liability period under a construction contract by a further 12 months; and
  • seek legal advice where a call is to be made on a bond they have provided.

Certification professionals should stay tuned for the Regulations ‒ these will specify the criteria that certifiers must meet to act as inspectors under the new regime.