As of October 1, 2019, payments and disputes on construction projects in Ontario will be conducted very differently.
Payments from owners to contractors need to be made within 28 days. Pre-certification or pre-approval of invoices is not permitted. An owner's dispute of an invoice must be made in a notice of non-payment within 14 days of the invoice, or the owner must pay the full amount of the invoice. All disputes are subject to very fast (30 to 45 days) resolution by way of mandatory adjudication.
There were also significant changes brought in on July 1, 2018 that the industry is still grappling with, such as mandatory payment of holdback, longer lien periods and later dates for release of holdback.
What does this mean for lenders, and are they ready for it?
While there are many, many changes to the Construction Act, here are the six most important and impactful issues for lenders to know, with the greatest potential for gaps and risk, whether they provide project financing or lend operating funds directly to general contractors and trade contractors.
1. Mind the (New) Gaps
The statutory payment periods of the new prompt payment rules (28 day prompt payment) and fast track binding dispute resolution (adjudication) could create some funding gaps.
These changes are likely to create funding gaps and stranded risk on projects since the payment rules are being imposed on owners, contractors and subcontractors, but not lenders. For example, it will be possible for an owner to be required by law to pay the construction holdback at the end of the lien period or progress payments after 28 days, but not be able to draw from its lender. An adjudicator could require the owner to pay for a change or an invoice that a lender has not approved. Interest, at mandatory legislated rates, will be incurred for late payments. Sometimes this will be a matter only of a short timing gap. Because these rules are mandatory, an owner's requirement that contractors comply with credit agreement conditions may not be enforceable.
Where will borrowers get their funds? Is a higher reserve required or prudent? If they have to borrow to cover these gaps, does the credit agreement allow that? Does that impact financial ratios and covenants, and borrowing base calculations?
2. All About the Flow
Most of the amendments are designed specifically to ease and expedite cash flow from the owner to the trade contractors and suppliers. Longer lien periods, prompt payment, mandatory holdback payments, and forced payments on adjudication will all have an impact on cash flows on a project. Provisions allowing for earlier release of holdback will also have an impact in some cases. This likely means a reduction in the borrowing needs of trade contractors and suppliers in their operations, but also a possible increase in needs by owners.
Do lenders' lending and cash flow models need to be updated? This is especially important for dealing with prompt payment. Do credit procedures allow for the release of funds within the obligatory timelines imposed on owners and contractors?
3. Update Your Documents
Many of the changes to the Construction Act will require lenders to revise and update their credit documents, and even their procedures and some practices, including ensuring their borrowers do the same.
The lien period was extended from 45 days to 60 days in 2018. The financial thresholds for the substantial performance test are now increased to $1,000,000 from $500,000. Approval by owners of draft invoices or pre-certification of invoices by the payment certifier are no longer permitted as of October 1, 2019. Owners need to issue notices of non-payment within rigid time periods for holdback and progress payments, or else be obliged to pay the full amount owing. Regular progress payments and payment of the holdback will happen much more quickly. The Construction Act incorporates 18 new forms, updates others, and generally imposes more procedure, formality and complexity on construction projects.
While being more rigid and formal, the Construction Act also allows for some new flexibility that borrowers may want. In specific circumstances, owners will be allowed to accept a bond or letter of credit instead of retaining a holdback, to release holdback early on a phased basis or on an annual basis, or to treat separate "sub-projects" as separate contracts. But this flexibility is only available if the construction contract expressly allows it. Do lenders' credit documents and procedures permit this?
Lenders' credit documents, policies and procedures need to catch up to the new regime, or risk conflicting with borrowers' statutory obligations and restrictions, or with borrowers' construction contracts.
4. Trust in Trusts
The Construction Act now requires contractors to deposit all trust funds in an account in the trustee's name, and to apply trust accounting rules by keeping separate books and records for each project's trust funds. This does not require a project-specific bank account or a fully segregated trust account, but does require contractors to treat trust funds as though they are separate in their books. This is to enable all construction trust funds to be traceable and not commingled with operating funds or other trust funds.
For lenders that loan to contractors, the use of accounts receivable that include any trust funds will be more difficult. Will this have an impact on your borrowers' borrowing base? Are additional reserves required? Do your borrowers keep proper books for their trust funds?
For lenders that loan to owners, there is a more remote connection to the contractor's trust fund obligations, but the health and strength of successful projects often relies on the discipline and diligence of the lender. Do you need to require your borrowers to confirm their contractors' practices? Should all trust funds go into a separate account from general reserves? What are the new best practices lenders will require on a project?
5. Timing – Does this apply to my project?
The Construction Act grants grandfathering to existing projects/improvements/contracts. But these grandfathering rules are more complicated than they appear. The rules of the old Construction Lien Act continue to apply with respect to an improvement if:
- a contract for the improvement was entered into before the date of proclamation, regardless of when any subcontract under the contract was entered into (for July 1, 2018 and October 1, 2019 changes, respectively);
- a procurement process, if any, for the improvement was commenced before the date of proclamation by the owner of the premises (including the making of a request for qualifications, a request for proposals or a call for tenders) (for July 1, 2018 and October 1, 2019 changes, respectively); or
- the premises are subject to a leasehold interest, and the lease was first entered into before the date of proclamation (for July 1, 2018 changes only).
It is very important for lenders to note that the date of the credit agreement has no bearing on which rules apply. It is entirely possible for a loan to be established assuming the old rules apply to the project (e.g. 45 day lien period or no prompt payment), but for the new rules to, in fact, be binding on the owner and contractor.
During this transition time, it will be very important to be clear about which regime applies, or risk creating gaps and conflicts on the project.
6. Reforms are coming across Canada
When it comes to prompt payment, Canada is far behind other Western countries, but not for much longer.
While these reforms and amendments apply just to construction projects in Ontario, prompt payment and adjudication reforms are coming across the country. Already, Saskatchewan and Nova Scotia have passed new construction laws which are, as of the date of this article, waiting to be proclaimed. The House of Commons passed federal prompt payment and adjudication laws with bi-partisan support and is waiting for the completion of the federal election. Several other provinces have introduced legislation or have announced pilot projects or law reform committees.