Ebert Construction – the new retentions rules get mixed results

The new retention rules came into force in 2017 and their first big test came when Ebert Construction Ltd. went into receivership in July 2018. Geoff Hardy, a commercial lawyer, looks at how the rules performed - what went right and what went wrong.

When Mainzeal Property and Construction Ltd. went into receivership in 2013, its subcontractors lost $18.3 million in retentions.

That is because (in accordance with standard industry practice) those retentions had been used to pay expenses rather than being put aside for the subcontractors who had earned them. And even if they had been put aside, they would have gone to Mainzeal’s secured and preferential creditors instead of the subcontractors, because it was Mainzeal’s money, not the subcontractors’ money.

The financial pain the Mainzeal collapse caused and the resulting outcry spurred the Government into action, so they studied all the overseas regimes for the protection of retentions that had already been introduced, consulted the New Zealand construction industry, and ultimately decided to impose a requirement that retentions were to be held in trust for the tradesmen who had earned them. The new rules were then drafted and bundled into the Construction Contracts Amendment Bill that had been held up waiting for these new rules to be developed. It all happened with unseemly haste and without the degree of careful thought that ought to go into these things. The big hitters in the construction industry persuaded the Government that our rules should be “light handed” rather than detailed and prescriptive, so the industry was left to make it up as it went along. This is in stark contrast to the rules governing solicitors’ trust accounts which are much more sophisticated.

Consequently the first draft of the new rules occupied less than two A4 pages of paper (they are double that now as a result of a last-minute amendment). The proposed regulations that were intended to fill in some of the blanks were deferred indefinitely. And most importantly, the people that the Government should have spent more time with – construction lawyers and insolvency specialists – didn’t get sufficient chance to provide their valuable input.

The new rules came into force on 31 March 2017 and their first big test came when Ebert Construction Ltd. went into receivership on 31 July 2018. We know how the rules performed because Justice Churchman of the High Court passed judgment on them on 12 November 2018.

What went right?

It turns out that Ebert was a reasonably conscientious construction company that had taken its obligations seriously. It had 15 active projects on the go, a staff of approximately 100, and more than 150 subcontractors actively working for it. Ebert used the industry-standard subcontract then known as SA-2009, which contained detailed provisions concerning retentions. Ebert was obviously knowledgeable about the new rules and had gone to the trouble of acquiring an accounting software programme called CHEOPS that enabled it to comply. Ebert actually put all of its retentions aside in an interest- earning investment account, as it was required to do, which would have created a big hole in its cash flow. Perhaps too big a hole, as it turns out.

When things started to go pear-shaped for Ebert, the inevitable happened. The retentions that should have been withheld for subcontractors in June and July 2018 weren’t paid into the separate Retentions Account. Retentions that had previously been paid into the Retentions Account and were due to be released to the subcontractors, weren’t paid out. Ebert was liable for $9.32 million of retentions in total, but $4.86 million of that related to subcontracts entered into before 31 March 2017 so they weren’t required to be held in trust. Of the $4.46 million of retentions that were required to be held in trust, $3.68 million was actually held in the Retentions Account. So the shortfall was “only” something like $787,000, plus another $170,340 that should have been held in trust had Ebert correctly recorded that their subcontracts had been entered into on or after 31 March 2017.

Therefore, less than $1 million of funds owed to subcontractors who should have been protected by the new retentions rules, was lost. $3.68 million was safe, and will be paid out to the subcontractors who are entitled to that money, less the fees charged by the Receivers and their lawyers for administering the pay-out. That is why I give the new rules a partial pass mark. Were it not for the new rules, I suspect all of it would have been lost, because Ebert would not have put the money aside, and whatever was left of it in Ebert’s general account would have gone to the BNZ, the Receivers, the Liquidators, the employees, and the IRD.

What went wrong?

However the new rules get a partial fail as well, for the reason that the Government made very little effort to think through the potential pitfalls in the legislation, many of which were highlighted in Justice Churchman’s judgment. That judgment is unlikely to be the final say in the matter and there were a number of rulings that I believe will be overturned in the future, but for the moment it is the law.

And what the law says is this. Every time a construction contractor goes bust owing retentions to subcontractors, someone will have to apply to the Court to be appointed a receiver for the purpose of sorting out which subcontractors are entitled to what, and then to pay it to them. A subcontractor will only receive its retentions if they have been put aside in a separate account, with the balance of its payment claim having been paid to the subcontractor. If they haven’t been paid into a separate account then they are just unpaid invoices, not retentions. And out of the retentions account, before payment to the subcontractors, will come the receiver’s fees and expenses including the costs of applying to the court in the first place, which
will typically amount to tens if not hundreds of thousands of dollars. 

What will this mean in practice? It will mean that subcontractors who are owed retentions by small - medium construction companies are going to miss out. That will either be because the construction company doesn’t have a retentions account, or because there isn’t enough in its retentions account to cover the receiver’s fees and expenses, so no-one will apply to become the receiver. Consequently, in the vast majority of cases the whole objective of bringing in the retentions-held-in-trust regime is defeated, and the legislation turns out to be a lemon.

There is one other burning question that hasn’t yet been answered in the Ebert collapse. When the Government consulted the industry about the proposed legislation, we knew that there would always be a shortfall between the amount owed to subcontractors by way of retentions, and the amount actually put aside for them. Sometimes it would be as high as 100%. And if the construction company that failed to put that money aside has now gone bust - in which case it is pointless suing it for breach of trust even if you were allowed to - then how is the law going to be enforced?

The Government’s answer, having consulted with Crown Law, was this. Section 220 of the Crimes Act 1961 (theft by a person in a special relationship) and section 229 of the same Act (criminal breach of trust) would apply to directors and senior managers of construction companies who have knowingly and intentionally broken the rules. And the maximum penalty for committing those crimes is up to seven years’ imprisonment. Now in Ebert’s case, subcontractors lost almost $1 million of funds that were supposed to be held in trust for them, but weren’t. Are we going to see a prosecution under the Crimes Act? Or is this legislation merely a voluntary code of conduct that benefits only those subcontracting to large, sophisticated construction companies, and no-one is going to be held accountable?

by Geoff Hardy
Commercial Lawyer