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When an assurance is an empty promise

Michael Chesterman
Michael Chesterman February 21, 2019

As the inaugural Compliance Manager for the Building Services Authority, I was heavily involved in the development and implementation of the initial financial requirements for licensing in 1999.  A key aspect of these requirements was the concept of allowing a prescribed person or entity (covenantor) to assure Net Tangible Assets (NTA) to a licensee so as to ‘top up’ their level of assets.    

This is achieved through a Deed of Covenant and Assurance.

At the time Deeds of Covenant and Assurance were introduced, I viewed them as a significant transitional step in requiring contractors to have access to a suitable level of NTA to address an historically serious industry issue of undercapitalisation.  I never envisaged that 20 years later Deeds of Covenant and Assurance would still be in place, largely unaltered. I consider that over time contractors should have been required to increase their ‘real’ level of NTA in lieu of Deeds of Covenant and Assurance support.

Undercapitalisation remains a major problem in the industry.  In a report entitled “Review of Security of Payment Laws” by John Murray, AM, at annexure 3 (page 325), over a seven year period (2009/10 to 2015/16), it is the 6th ranked reason for businesses failing in the industry.    

My history with Deeds of Covenant and Assurance came flooding back to me last week when I read an article in the Courier Mail entitled “Chinese firm China Railway Construction Group chased by subbies claims no assets in Australia” where it was stated:

“A Chinese construction giant claims any attempt to force it to pay all debts owing from a collapsed Brisbane-based joint venture will likely fail because it has no assets in Australia.

China Railway Construction Group (CRCG) is being sued by Brisbane developer Devcorp in the Federal Court to recover funds it promised to pay if the Chinese company’s Australian venture was liquidated.

The Chinese group partnered with a Queensland building company Rimfire in 2016 as part of an ambitious plan to break into the booming apartment market.

But the venture, CRCG-Rimfire, was put into administration in 2017 with CRCG, the world’s third-largest construction company, securing a debt repayment agreement. The venture owes subbies and other creditors about $40 million. Devcorp is owed about $17 million.

CRCG agreed to pay unsecured creditors including subbies only $8 million, or between 41¢ and 57¢ for every dollar owed. That falls far short of the promise to pay all debts under a deed that it earlier agreed with the Queensland Building and Construction Commission (QBCC) that effectively guaranteed the payment of valid claims up to $1 billion.”

In a subsequent article entitled “Chinese legal system will be hard to crack for local developer” it is stated:

“the Queensland Building and Construction Commission (QBCC) undertook a “deed of covenant and assurance” with CRCG that purported to guarantee debts up to $1 billion if the Chinese company’s Australian venture was liquidated. The Chinese side is now arguing that deed is not worth the paper it is written on. According to The Courier-Mail’s Back our Subbies campaign, the CRCG-Rimfire collapse was the third-largest in Queensland over the past four years, beaten only by the failure of Ostwald Bros and Cullen Group.”

A check of QBCC licensing records indicates that CRCG – Rimefire Pty Ltd (license number 15015078) had administrators appointed on 16 November 2017.  The license was originally issued on 7 July 2016 with a Maximum Revenue allowed of just in excess of $18 billion.

This meant that the company could enter into contracts in total, up to this figure over one year.  The comfort provided to support contracts at this level was a Deed of Covenant and Assurance.

A Voluntary Administrators report dated 27 February 2018 provides a detailed outline of all aspects of the company’s operations.

What is a Deed of Covenant and Assurance?

As stated in the current Minimum Financial Requirements (MFR) for licensing, a Deed of Covenant and Assurance is:

“Where an eligible Licensee or Applicant does not have sufficient NTA in its own right for the level of Maximum Revenue required or the actual Revenue being generated it may, dependent on the entity’s structure, rely upon a Deed of Covenant and Assurance based on the Net Real Unencumbered Assets from a Covenantor as permitted under this policy, in order to meet the NTA requirement. The Covenantor must have and continuously maintain sufficient Net Real Unencumbered Assets in their own right to meet the value of the Defined Amount stated in the MFR Report.”

There are very comprehensive requirements applicable to the use of a Deed of Covenant and Assurance.  A covenantor assures a ‘defined amount’ to a licensee. The ‘defined amount’ is the difference between the NTA held by the licensee and the NTA required for the licensees Maximum Revenue.

To put this in very simple terms – it means that a licensee can ‘top up’ their NTA with the NTA of another prescribed person or entity.

I believe that another way to look at such situations is that the ‘defined amount’ under a Deed of Covenant and Assurance represents the extent a builder is undercapitalised.  The current MFR acknowledges this reality where it specifically states that reliance on a licensing deed is allowed “where an eligible Licensee or Applicant does not have sufficient NTA in its own right….

The MFR prescribe who can be a covenantor.  Typically a covenantor is a director of a licensee company.

An ‘accepted independent accountant’ acting on behalf of a licensee or applicant applying for a license relying on a Deed of Covenant and Assurance must provide a statement detailing the financial position of a covenantor and perform all reasonable checks “to ensure the existence, collectability and unencumbered value of assets being assured to the entity” (page 10 MFR).

Significantly the ‘accepted independent accountant’ responsible for determining the ‘net real unencumbered assets’ of a covenantor, must also complete and sign a prescribed form (attachment 5 of the MFR).  The ‘net real unencumbered assets’ stated in this form must at least equal the ‘defined amount’ the covenantor is assuring to the licensee or applicant for a license.

All these requirements are designed to ensure that at the time the ‘accepted independent accountant’ is assessing the convenator’s financial position, they have sufficient ‘net real unencumbered assets’ to support the licensee or applicant for a license.

What are the limitations of a Deed of Covenant and Assurance?

In an article dated 19 September 2017 entitled Crystal-balling the Minimum Financial Requirements for Contractor Licensing I stated that in relation to possible changes:

“There is an ability for licensees, other than those of a self certifying nature, in certain circumstances and subject to specified requirements, to be able to ‘top up’ their NTA by relying on a Deed of Covenant and Assurance from another related entity e.g director of a licensed company, providing that entity has “net real unencumbered assets” to support their financial commitment. However, this assurance does not require the legal transfer of assets into the licensed entity to support their MR.”

‘MR’ refers to allowed ‘Maximum Revenue’.

In a government discussion paper entitled “The proposed improvements to the Minimum Financial Requirements for licensing in the building and construction industry”, a number of issues are outlined that relate to the effectiveness of a Deed of Covenant and Assurance.  It is stated:

“The Deed of Covenant and Assurance provisions only operate effectively if the covenantor has, and continuously maintains, net unencumbered assets in their own right to cover the licensee’s debts. Recent building collapses involving companies reliant on these deeds have shown, however that this is not always the case. There are a number of possible reasons why a covenantor may be unable to pay in a liquidation scenario. For example, if the covenantor is the director of the licensee company it is likely that their financial position has declined in parallel with that of the company. Alternatively, the covenantor may have never met the requirements for providing the Deed of Covenant and Assurance (in which case the deed essentially represents an ‘empty promise’).”

As further outlined in the government’s discussion paper (page 21) the benefits of a Deed of Covenant and Assurance to creditors of a licensee is limited to “in the event the licensee becomes bankrupt or enters liquidation, the covenantor will pay the liquidator or other relevant creditors the amount set out in the Deed of Covenant and Assurance (the ‘defined amount’)”.

In other words a licensee has to succumb to insolvency before a covenantor can be requested to fulfil their promise and pay a defined amount.

Government wants more than an assurance

In an article entitled The New Min is the Old Max?, I pointed out that:

“Contractors wishing to be eligible to compete for any Government building project estimated to exceed $1,000,000 in value must first be appropriately pre qualified (PQ) with the Department of Housing and Public Works.

PQ financial requirements, significantly much tougher than the MFR’s, stipulate that Net Tangible Assets (NTA) have to be legally and beneficially owned by the contractor. This is not the case with the MFR’s.”

A stated policy objective of the contractor PQC financial requirements is:

“to reinforce security of payment on Queensland Government building projects and …”

With regard to the required NTA contractors must have to meet PQC financial requirements, it is also stated:

Deeds of Covenant and Assurance provided on behalf of the contractor to satisfy QBCC licensing requirements are excluded from NTA-Govt.(underlining my emphasis).

How can a contractor increase their NTA for government purposes?

Under section 2.4 of the PQC requirements, a number of legally binding and enforceable options are outlined that allow a contractor to address a deficiency in the required level of NTA.  These options are:

  • injection or transfer of assets to the contractor;
  • repayment or forgiving of loans or investments made by the contractor to related entities, subsidiaries or an associated entity;
  • entering into a government-approved business arrangement (i.e. a partnership, joint venture or group of related companies);
  • provision of an externally sourced unconditional undertaking to the contractor in a form approved by government; and
  • the contractor’s stated commitment that any acceptance on a government building project in excess of the contractor’s ‘Maximum Annualised Contract Value’, calculated under the One-Third Rule will be conditional on the contractor entering into a government-approved Deed of Guarantee and Indemnity.

I believe that these PQC financial requirements reflect a belief by the government that in discharging their capital works responsibilities, it is considered an unacceptable SOP risk to contract with a licensee who has assets ‘assured’ to them through a Deed of Covenant and Assurance.  

Final thoughts

I strongly support the right of the government to adopt such a tough capital works stance, particularly in relation to builders.  The government has a responsibility to ensure only financially strong builders, capable of meeting their payment obligations to subcontractors and others, are engaged under its capital works program.

However, such a tough capital works stance is in stark contrast to the situation in the private sector where subcontractors are exposed to contracting with some builders who have had to rely on another person or entity to ‘top up’ their licensing NTA.  I am of the view that if CRCG – Rimefire Pty Ltd had been licensed under any of these capital works options then they would have been in a position to cover a $40 million claim by creditors.

In making this statement I am not suggesting that overnight, the government capital works financial requirements should become the MFR for licensing purposes.  If this was to happen I believe that a significant number of builders and subcontractors would instantly go out of business.

However I am of the view that over a transitional period of time, there must be a move to require all contractors, builders and subcontractors to have a required level of NTA in their own right and to be able to operate without the support of Deeds of Covenant and Assurance.

I do note that the government is implementing a number of Improvements to the MFR and in relation to a licensing deed is proposing:

“If a licensee is relying on a Deed of Covenant and Assurance, they will need to provide the QBCC with detailed financial information about the covenantor to show they can honour their agreement.”

I have to say that I am somewhat surprised by this statement given the comprehensive covenantor financial information that presently has to be provided to the QBCC.

However no matter how many additional checks and inquiries the QBCC will undertake in relation to the financial position of a covenantor, it will always reflect a ‘snapshot’ back to an earlier point in time.In an article entitled SOP will continue to be a vexed issue in 2019, I stated:

“The current MFR’s allows financial information in a report to the QBCC to be up to four months old.”

Based on information released by the government to date I am of the view that when the QBCC is accessing financial information relating to a covenantor under the new MFR, it will continue to reflect a non-current position, possibly several months old.

I am certain that with its additional compliance powers and resources, the QBCC will identify more processing, procedural and policy issues associated with Deeds of Covenant and Assurance. This is a good thing and will result in a greater level of integrity in relation to the MFR.

However the financial position of an ‘approved’ covenantor can change a lot in a day, let alone several months and this is an inherent weakness of a Deed of Covenant and Assurance that should be acknowledged.

This reality, plus the fact that assured assets only become available on a licensee succumbing to an insolvent event, which may in parallel significantly affected the financial position of a covenantor e.g director of a licensee company, means that a Deed of Covenant and Assurance will on occasions continue to represent an ‘empty promise’.

I would be interested in your views.

Not intended as legal advice. Read full disclaimer.
Michael Chesterman
Michael Chesterman February 21, 2019

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