Insolvency in the building and construction industry. New thinking. Old problem

Michael Chesterman July 26, 2018
SHARE

Insolvency in the building and construction industry is a major issue that governments of all persuasions have struggled to address.

In his final report of a review of Security of Payment Laws dated 21 May 2018, Mr John Murray AM, stated (page 16):

“Over the past decade, while the construction industry has accounted for 8–10% of GDP, it has also accounted for 20–25% of all insolvencies in Australia. Indeed, there are on average more than 1700 insolvencies in the construction industry every year, affecting thousands more creditors.”

This issue was the subject of an enquiry by the Senate Economics References Committee (SERC), with a report handed down in December 2015.

In the reports executive summary it is stated:

“The economic cost of insolvencies in the construction industry is staggering. In 2013–14 alone, ASIC figures indicate that insolvent businesses in the construction industry had, at the very least, a total shortfall of liabilities over assets accessible by their creditors of $1.625 billion. Others who have analysed the data place the amount at $2.7 billion. The construction industry consistently rates as either the highest or second highest as against all other industries when it comes to unpaid employee entitlements.”

Directors have very specific duties and responsibilities under the Corporations Act 2001 (Corporations Act). Aside from a number of general fiduciary duties, the most significant duty a director of a company has is to prevent it from trading insolvent.

There are penalties and consequences of insolvent trading, including civil penalties, compensation proceedings and in some instances, criminal charges.

A company is insolvent if it is unable to pay all its debts as and when they fall due.

In such a situation directors of the company must not allow it to incur further debt. Unless the directors can promptly restructure, refinance or obtain funding to recapitalise the company, generally the options of directors are to appoint a voluntary administrator or a liquidator.

As the inaugural Compliance Manager of the Building Services Authority I witnessed many building companies proceeding into voluntary administration, where the directors were genuinely attempting to achieve a successful restructure of the company, only to see their efforts come to no avail principally because of parties terminating contracts.

These building companies then usually preceded into liquidation with unsecured creditors like subcontractors normally getting a nil dividend on their debt.

While there were some directors that could only be described as “rogues” in that they were totally dismissive of their duties and responsibilities and essentially used the company as means to illegally increase their personal wealth, it was my experience that this was not the intent of the vast majority of directors whose companies ran into financial difficulty.

However when confronted with their company experiencing financial difficulties, a number of these directors chose not to promptly seek insolvency or restructuring advice out of fear of clients terminating contracts if the recommended course of action was to appoint a Voluntary Administrator.

Causes of insolvency

I am not in any way defending directors who adopted such a “head in the sand” attitude. I am merely pointing out that for a building company to survive and indeed flourish, it is imperative that they complete contracts and regularly bill for work done to ensure good cash flow.

In the SERC report (page 17) it is stated:

“Inadequate cash flow or high cash use, poor strategic management of the business and poor financial control, including a lack of record-keeping, accounted for the highest number of business failures. These were not the only causes, however, as poor economic conditions and trading losses accounted for a considerable number of insolvencies.

The evidence received by the committee indicates that in addition to the usual market factors referred to above, non-market factors, including highly unequal power relations in contractual relationships, non-payment of contractual obligations and a range of civil and criminal non-compliance with the corporations law are contributing factors.”

Furthermore the SERC report identified poor industry payment practices as ‘a key driver of financial distress and risk of insolvency’ (page 22).

However I am of the view that it is a mistake to think that by solely focusing on poor payment practices in the industry, insolvency issues in the industry will be resolved.

Furthermore I believe that governments of all persuasions have been guilty of reworking existing legislative measures for addressing insolvency or payment problems in the industry, repackaging them and then presenting them to the industry as new reforms. I believe, the Building Industry Fairness (Security of Payment) Act 2017 (BIFA) suffers from this repackaging.

BIFA does not address insolvency issues in the industry. It is focused on addressing payment issues in the industry from a subcontractor’s perspective only.

In my article entitled ‘Construction Innovation — it’s not just about Apps!’ I stated:

“Despite the building and construction industry undergoing massive changes since 1974 to the point it is almost unrecognisable, aside from PBA, the initiatives in the BIFA are recycled ones. Over the years these initiatives have been modified or changed, but fundamentally they seek to deliver SOP to subcontractors through a combination of long established payment, contractual and licensing initiatives.”

‘PBA’ refers to Project Bank Accounts that are for controlling and directing the flow of money between subcontractors and builders and the reference to 1974 is the year the Subcontractors’ Charges Act was passed, an initiative which is retained in BIFA.

While BIFA may deliver improved payment outcomes for subcontractors and therefore reduce their risk of proceeding into some form of insolvency (I sincerely hope this is the case), it does nothing to address builder insolvency issues.

A client not paying a builder for work done, resulting in cash flow problems for the builder, may cause the builder to proceed into some form of insolvency. This is just as a significant issue for a builder as is it for as a subcontractor.

New Insolvency thinking

The Treasury Laws Amendment (2017 Enterprise Incentives №2) Act 2017 amended the Corporations Act 2001 (Cth) to prohibit contractual termination rights arising on the occurrence of an insolvency event.

Specifically these reforms prohibit the enforcement of contractual rights because a company is in voluntary administration, receivership or subject to a scheme of arrangement, which is a procedure under Part 5.1 of the Corporations Act that allows a company to reconstruct its capital, assets or liabilities with the approval of its shareholders and the Court.

Any such termination clauses, known as ipso facto clauses will be unenforceable.

The new law commenced on 1 July 2018, and the amendments will apply only to contracts entered into after the new law commences.

There are exemptions as set out in the Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018 or the Corporations (Stay on Enforcing Certain Rights) Declaration 2018, but in terms of the construction industry they are very limited.

The main exception relates to contracts entered into on or after 1 July 2018, but before 1 July 2023, and pertaining to certain building projects with a value of at least $1 billion.

The Minister for Small Business, Mr McCormack stated in the second reading speech of the relevant Bill:

“An ‘ipso facto’ clause is a provision that allows one party to terminate or modify the operation of a contract upon the occurrence of some specific event, regardless of otherwise continued performance of the counterparty. The operation of these clauses can reduce the scope for a successful restructure or prevent the sale of the business as a going concern.

The amendments in part 2 of this bill will make certain contractual rights unenforceable while a company is restructuring under certain formal insolvency processes.

This reform is aimed at enabling businesses to continue to trade in order to recover from an insolvency event instead of these clauses preventing their successful rehabilitation.”

Elsewhere in the second reading speech Mr McCormack stated that in relation to these ipso facto reforms and associated Corporations Act reforms known as “Safe Harbour”:

“Together, these amendments will reduce instances of a company proceeding to a formal insolvency process prematurely. Where companies do enter into particular formal insolvency procedures, they will have a better chance of being turned around or of preserving value for creditors and shareholders

This in turn will promote the preservation of enterprise value for companies, their employees and creditors, reduce the stigma of failure associated with insolvency and encourage a culture of entrepreneurship and innovation.”

Furthermore, in the relevant explanatory memorandum it is stated:

“The Government is reforming Australia’s insolvency laws. Our current insolvent trading laws put too much focus on stigmatising and penalising failure.”

As the BSA Compliance Manager I did not have sufficient exposure to companies placed under receivership or subject to a scheme of arrangement to form an opinion as to whether these ipso facto contract reforms may have assisted them in successfully trading out of financial difficulties.

However I am of the view that the ability for a voluntary administrator to trade a company out of its dire financial position through completing contracts and recovering payments due is a potential game changer when it comes to reducing the incidence of insolvency in the industry.

Current contractor licensing positions

Minimum Financial Requirements

Under the current QBCC Act financially troubled building companies proceeding into voluntary administration may have their license suspended or cancelled.

Why?

Section 35 (3) 0f the QBCC Act states:

“Without limiting subsection (1), a contractor’s licence is subject to the condition that —

(a) the licensee’s financial circumstances must at all times satisfy the relevant financial requirements stated in the board’s policies; and

(b) variations of the contractor’s turnover and assets must be notified, or notified and approved, in accordance with the relevant financial requirements stated in the board’s policies.”

The key words above are a “licensee’s financial circumstances must at all times satisfy the relevant financial requirements stated in the board’s policies”.

The current Minimum Financial Requirements (MFR) states under section 1.4 that:

“It is also a statutory condition of holding a licence that the Licensee’s financial circumstances must at all times continue to satisfy the relevant Minimum Financial Requirements stated in this policy. If a Licensee breaches a condition on their licence, their licence may be suspended or cancelled under section 48 of the Act.”

The MFR stipulates that licensees must have sufficient Net Tangible Assets (NTA) to support a Maximum Revenue allowed and satisfy a Current Ratio requirement of 1:1 at all times.

In simple terms this current ratio requirement means licensees must have at least $1 in current assets for each $1 of current liabilities. Licensees that satisfy this requirement have sufficient current assets to meet their current liabilities. They are solvent.

As previously stated a company who is unable to pay its debts as and when they fall due is insolvent. In such situations the directors of the company may appoint a voluntary administrator to investigate the company’s affairs, to report to creditors and to recommend to creditors whether the company should enter into a deed of company arrangement, go into liquidation or be returned to the directors.

A licensed building company that proceeds into voluntary administration would certainly at that point of time not be complying with the current ratio, and therefore failing to satisfy the MFR “at all times”. The situation in respect of NTA would vary from company to company. It may be the case that some companies would have sufficient NTA to meet that MFR criteria.

However in all cases, a company placed under voluntary administration may have its licence suspended or cancelled under section 48 of the QBCC Act for failing to meet the current ratio criteria.

Section 32 CA (1) of the Acts Interpretation Act 1954 states:

“In an Act, the word may, or a similar word or expression, used in relation to a power indicates that the power may be exercised or not exercised, at discretion.”

In a press release dated 12 June 2018 the responsible Minister, The Hon Mick de Brenni stated “an approved regulation for Minimum Financial Requirements will operate from 1 January 2019.”

This means that until then the current Board approved MFR’s will apply up until 1 January 2019.

Excluded individuals

Under Part 3A of the QBCC Act a current director of a company which goes into voluntary administration after 1 July 2015 is excluded from holding a contractors or nominee supervisors licence for 3 years. A Fact Sheet produced by the QBCC fully outlines all the relevant details in this regard.

These ‘anti phoenix’ provisions are designed to ‘prevent persons responsible for poor financial management from running a business in the building industry’ (see above linked Fact Sheet).

This one size fits all’ legislation does not distinguish between those directors who genuinely may attempt to trade their company out of financial difficulties and those who are just rogues.

What does this mean?

It is possible that a voluntary administrator will be appointed to a licenced building company where its prospects of trading out of financial difficulties could be significantly enhanced as a result of these ipso facto contract reforms, only for the QBCC to exercise its discretion under section 48 of the QBCC Act and suspend or cancel the companies licence because of it failing ‘at all times’ to comply with under the MFR Board policy.

The above excluded individual provisions would also apply in all cases.

New MFR and amended excluded individual provisions needed to support ipso facto reforms

I would like to see the new MFR support these ipso facto contract reforms and clearly and unequivocally allow for the licence of a building company under voluntary administration to remain in place during the duration of this insolvency event.

What I am advocating is very different to the MFR applicable for building companies NOT the subject of voluntary administration. There should be a clear distinction and different criteria in place for:

  • On the one hand, distressed companies who have sought help and are attempting to trade out of their difficulties under voluntary administration; and
  • On the other hand, all other circumstances where director’s have done things like, put their head in the sand, or attempted to divert funds and assets, or driven the company into the ground in an unrecoverable position.

This voluntary administration MFR needs to reflect the reality that to trade a building company out of financial difficulty will take time but if it happens, it will be under the expert direction and guidance of the voluntary administrator and not the directors of the company. This should give considerable comfort to creditors and indeed the government monitoring the companies performance under voluntary administration.

On emergence from voluntary administration a company would then be required to meet the normal MFR.

I have some views on what a voluntary administration MFR should be which I will outline in another article.

The ability for a voluntary administrator appointed to a building company to be able to rely on a licence (subject to the company meeting the MFR voluntary administration criteria) and not having contracts terminated for insolvency reasons (however there may be other reasons contracts could be terminated) during the period the company is under such an arrangement may allow it to trade out of financial difficulties and in the process, pay all creditors outstanding monies owed.

I would also like to see the excluded individual provisions amended to allow for the recognition of directors of building companies who seek timely and appropriate insolvency and restructure advice (distinct from illegal phoenix activity or illegal movement of assets), promptly act on such advice and appoint a Voluntary Administrator, who with the benefit of the ipso facto laws and hopefully new supporting MFR, successfully manages the company back to a solvent position.

To be very clear I am only advocating that the excluded individual provisions be amended to recognise proactive and positive behaviour and actions taken by directors in an effort to save their company.

I think such a new approach is worth exploring. I would be interested in knowing what others think.

I would also like to invite you and your team to get future fit on 13 August 2018 at the home of Helix Legal, The Capital. If you are interested in what is just over the horizon and how you get ready for it bring your team along. As with all of our innovation series events you will also hear from those at the forefront of change in the construction industry.

Not intended as legal advice. Read full disclaimer.
Michael Chesterman July 26, 2018

The insight you need, right in your inbox.

Stay up to date with all the important updates - legal and otherwise - plus get exclusive invites to events designed to educate and empower our industry.