Inquiry into Construction Industry Insolvency in NSW Submission by the Owners Corporation Network of Australia Limited

Introduction The Owners Corporation Network of Australia Limited (‘OCN’) is the peak body representing strata owners, helping owners in understanding and dealing with all the issues associated with strata living, working for positive legislative change and working for fairness for strata owners. OCN appreciates the opportunity to make a submission to the Inquiry into Construction Industry Insolvency in NSW. OCN is currently participating in a number of inquiries instituted by the New South Wales and Federal Governments including, in particular, the Home Building Act Review and the Federal Phoenix Companies Inquiry. Owners corporations and residential lot owners as stakeholders OCN notes that one of the Inquiry’s Terms of Reference is stated as “Consider legislative or other policy responses that can be taken to minimise the incidence and impact of insolvency in the industry.” Residential strata lot owners represent a significant part of the customer base for NSW developers and builders. Failure of a builder or developer impacts on the lives of residential lot owners. OCN as the peak group representing residential strata lot owners in New South Wales is witness to the impact of construction industry insolvency on residential lot owners. This submission is therefore divided into two parts. In Part 1 OCN sets out how a builder’s insolvency impacts on those stakeholders, the relevance of this to the Inquiry and our recommendations for further action. In particular we address the relationship between the current Inquiry and the NSW Government’s Review of the Home Building Act

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In Part 2 we address the specific questions raised in the Inquiry’s Discussion and Issues Paper.

Part 1: The impact of insolvency on lot owners The Relationship Between the Inquiry into Construction Industry Insolvency in NSW

and the NSW Government’s Review of the Home Building Act

In the event of a builder’s insolvency, owners corporations and lot owners are left without the remedy of having a builder return to rectify defects and must engage third party contractors. The costs of rectification may run into millions of dollars for a strata scheme. These costs are shared amongst lot owners and must be paid for from owners’ funds on hand or by special levies raised on owners. The additional levies required to rectify defects can impose hardship on owners who may have been unaware of defects when they purchased their lot some years earlier, or believed that such defects as arose would be rectified by the builder. The legislative response to protect lot owners Lot owners and their owners corporations are afforded under the Home Building Act two types of statutory warranty – a 2 year warranty in respect of defects generally and a 6 year warranty in respect of “structural “ defects. As part of its submissions in relation to the review of the Home Building Act OCN has recently made a submission in respect of the scope and definition of these warranties. OCN noted the widespread need to call upon these warranties due to the high level of defects evident in residential strata buildings. Other protections for lot owners OCN recognises that a financially robust building industry teamed with an effective certification regime could represent a major protection for lot owners. Should these policy objectives be attained lot owners will enjoy a greater level of protection. They will nevertheless still be exposed to the consequences of financial failure by builders and developers as and when it occurs. Consequences of a builder’s insolvency In the event of a builder’s insolvency lot owners and their owners corporations would be unsecured creditors for the cost of rectifying building defects that have been identified in their buildings within the statutory warranty periods. Lot owners and their owners corporations, as the beneficiaries of the statutory warranties, would also be contingent creditors for defects which have yet to be identified within warranty periods for up to 6 years into the future.

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Owners corporations and their lot owners are placed in the particular position of being financially dependent upon a builder’s solvency even though they may never have had any contractual relationship with the builder or been in a position to protect themselves commercially from the consequences of a builder’s insolvency. The legislative response to provide insolvency protection The response of consumer legislation to deal with this situation has been to provide Home Owners Warranty Insurance “HOW”. Such insurance has been funded from premiums paid by builders who were required to provide such insurance cover on all significant building work. The original scheme provided for home owners, including lot owners and owners corporations in strata schemes, to be able to claim on this insurance in respect of any defects covered by statutory warranties. These were referred to as “first resort” policies, where the responsibility for defect rectification lay with the insurer. Later HOW Insurance policies offered only “last resort” cover in that they were only triggered when the builder was shown to be insolvent or to have disappeared. However under both these regimes a safety net existed to allow owners corporations and their lot owners to recover the costs of defect rectification in the event of the insolvency of a builder. However in 2003 changes to the Home Building Act resulted in the removal of the requirement for builders to obtain HOW insurance cover for construction of residential buildings over 3 storeys in height. The consequences of the removal of “HOW” insurance The consequence of this change has been that the majority of lot owners in new residential strata buildings now do not have any insurance cover under which they can be recompensed for defect claims against an insolvent builder. This is in contrast to the owners of free standing homes who continue have access to HOW insurance to protect their claims in the event of a builder’s insolvency. The proportion of the NSW population living in multi storey residential strata is increasing resulting in a declining eligibility base for HOW Insurance. Due to the added complexity of multi storey residential buildings defects in this sector have the potential to be extremely costly to rectify. Claims by owners corporations are regularly settled for sums measured in millions of dollars. There is therefore no safety net for an increasing proportion of home owners who may be exposed to the large costs of defect rectification. Legislative failure The Home Building Act provides lot owners with statutory warranties to give them standing to claim the costs of defect rectification from builders. However it currently fails to provide a means by which owners corporations and lot owners can recover anything in respect of costs, where a builder enters into insolvency and the distribution

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to unsecured creditors is nominal. In an insolvency situation the protection afforded by statutory warranties is negated. The owners corporation and lot owner and the Inquiry To the extent that the Home Building Act fails to provide protection for a growing number of residential strata lot owners the position of lot owners in a builder’s insolvency administration is relevant to any inquiry into the incidence and impact of insolvency in the building industry. The current inquiry is heavily focused on the position of subcontractors who are seen as a group that is vulnerable to the consequences of a builder’s insolvency. Owners corporations and their lot owners represent another vulnerable group whose position is similarly deserving of consideration and whose position can be distinguished from that of other trade creditors. Approaches to protection We note that the inquiry does not see amendment of the distribution priorities set out in Sec 556 of the Corporation Act as an avenue for ensuring protection of subcontractor claims in insolvency. In any event even if changes to the provisions of the Corporations Act were to be considered part of a solution for protecting subcontractors, they would not serve to assist the claims of owners corporations and lot owners, many of whose claims would not crystalise until some years after the insolvency administration concluded. The focus of the inquiry has been to examine ways in which the claims of subcontractors can be protected by quarantining funds in a trust environment. Given the extended time periods over which defect claims can arise, setting aside funds in a similar way to cover claims would impact on the cash flow of builders and would not represent an industry acceptable solution. The beneficiaries of home owner statutory warranties need to be protected from the consequences of a builder’s insolvency. The established mechanism for doing this is Home Owners Warranty Insurance. It is capable of providing protection to a group of consumer creditors who may be substantially impacted by a builder’s insolvency many years after the builder has failed. Recommendations

1. The inquiry should in its report make reference to the failure of the Home

Building Act to provide effective consumer protection to owners corporations

and lot owners in residential strata buildings over 3 storeys in height in the

context of a builder’s insolvency.

2. It should be further noted that legislation recognises the need to protect this

category of consumers with statutory warranties, but that changes to the Home

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Owners Warranty insurance requirements have prevented owners corporations

and lot owners from benefitting from this protection, in circumstances where a

builder enters insolvency or is otherwise unable to pay its debts.

3. Home Owners Warranty Insurance protection should be reinstated for owners

corporations and lot owners in residential strata buildings over 3 storeys in

height.

Part 2: Inquiry into Construction Industry Insolvency in NSW Specific Terms of Reference

OCN agrees with the conclusion of the Inquiry that no single recommendation is likely to achieve the desired objectives of the Government and that the prospects of effective reform are likely to be maximised if an integrated approach is taken to a range of potential solutions and, in general, supports the adoption of the range of measures listed at pages 8-9 of the Discussion and Issues Paper. OCN’s submission is directed principally towards the residential sector of the construction industry. Terms of Reference: Paragraph 1 OCN notes the causes mentioned by witnesses to the Inquiry as explaining the disproportionate number of insolvencies in the construction industry in NSW compared with other Australian States and Territories and across other industries listed on page 13 of the Discussion and Issues Paper. OCN also notes that ASIC data shows that:

The construction industry had the highest number of insolvencies.

Across all industries, NSW accounted for 44.7 per cent of insolvencies, followed

by Victoria at 22.4 per cent and Queensland at 21.1 per cent.

A higher percentage of insolvencies is made up of small companies.

More than 60 per cent of these companies had fewer than five employees.

OCN also notes the advice from the NSW Small Business Commissioner that the ASIC figures are “likely to be understated as only 30 per cent of all small businesses are incorporated, the overwhelming majority trading as sole traders or partnerships”. Of particular concern to OCN, in light of its view expressed above that there has been a decline in the quality of building in recent years, is the fact that 71 per cent of the respondents to a survey of its members conducted by the Civil Contractors Federation NSW that they had limited their investment in business development, equipment acquisition, staff skills and improvement and innovation, due to the risk of insolvency.

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Questions/Issues for comment OCN accepts the view expressed by the Inquiry that subcontractors are not adequately protected. Terms of Reference: Paragraph 2(i) OCN believes that it is unreasonable for subcontractors to be compelled to provide what is in effect interest free finance to head contractors for periods of up to 90 days. Questions/Issues for comment OCN notes the view that the Building and Construction Industry Security of Payment Act 1999 has brought about a significant improvement in the position of subcontractors but is concerned at the evidence that:

Many subcontractors are reluctant to bring SOPA proceedings against

contractors

Evidence of a head contractor telling a prospective subcontractor that “if you’re

going to put [the statement referred to in paragraph 13(2)(a) of the SOPA Act] on

your progress claims then you won’t get the work””.

Evidence that the statutory declarations which are customarily required to be

provided by head contractors to the owner/principal advising the principal that

relevant payments due to subcontractors have been paid are in many cases false,

signed in blank, sometimes in a block, or are simply circumvented by the device

of the contractor “renegotiating” the terms of payment with the subcontractor

who has no choice but to agree, so that the money otherwise “due and payable”

to the subcontractor only becomes “due and payable” at a later renegotiated

date.

OCN recommends that the SOPA Act be amended to ensure that the object of the Act as stated in subsection 3(1) is attained and the procedure outlined in subsection 3(3) is followed. This may be effected by making the procedure outlined in section 13 of the Act obligatory, rather than optional, and imposing criminal penalties for failure to comply with section 13, as amended, and, perhaps, section 34. OCN also believes that action needs to be taken to strengthen the bargaining position of subcontractors to ensure that they are not compelled to enter into unreasonable payment terms and to take work at a price they would not otherwise agree to. One way in which this could be achieved is by requiring contractors and subcontractors to enter into standard conditions of contract which included a requirement to follow the procedure outlined in section 13 of the SOPA Act thus demonstrating that this was normal practice in the industry.

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Terms of Reference: Paragraph 2(ii) OCN notes the existing protection to subcontractors listed on page 18 of the Discussion and Issues Paper. Questions/Issue for comment OCN believes that the measures which have the greatest potential for improving protections for subcontractors include:

Strengthening the provisions of the SOPA Act, as discussed under Terms of

Reference: Paragraphs 2(i), 3(b) and 3(g).

Mandating the adoption of standard terms in construction contracts which

require cash security and retention funds to be held in trust.

Enactment of legislation along the lines of the proposals discussed under Terms

of Reference: Paragraph 3(h).

Terms of Reference: Paragraph 2(iii) OCN has particular concern regarding the impact of insolvency and the potential for insolvency on subcontractors and their employees. Questions/Issue for comment As discussed earlier in the Introduction, OCN believes that there has been a decline in the quality of building in recent years which has been exacerbated by financial pressures in the building and construction industry and is concerned that this will lead to a departure of skilled subcontractors and tradesmen from the industry. Reducing the impact of insolvency and the potential for insolvency on subcontractors and their employees is therefore a matter of public interest and not just an issue for the construction industry. Terms of Reference: Paragraph 3(a) For the reasons listed on pages 20 and 21 of the Discussion and Issues Paper OCN agrees with the view of the Inquiry that it is not appropriate to amend the Corporations Act to give unpaid subcontractors a preferred position in the ranks of creditors in an insolvency. Questions/Issues for comment OCN believes that there are no particular reasons why subcontractors in the construction industry should be given greater priority over other creditors by amending the Corporations Act. Increasing the priority given to subcontractors would by definition reduce the priority of other creditors and would be likely to result in increased delays and costs of administration of insolvent companies.

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OCN agrees with the view of the Inquiry that it is more appropriate to attack the problem of insolvency at its root cause by means of the other measures discussed in the Discussion and Issues Paper. Terms of Reference: Paragraph 3(b) OCN notes the Review of the Debt Recovery Process announced by the Better Regulation Office and the Department of Attorney General and Justice in October 2010 and the related Issues Paper. Questions/Issue for comment Although OCN acknowledges that litigation can be expensive and time consuming it does not agree that proceedings in the Local Court and District Court are inefficient and should be “done away with”. OCN notes that on 26 October 2012 the NSW Attorney General announced that the majority of NSW tribunals and other bodies exercising tribunal-like functions, including the Consumer, Trader and Tenancy Tribunal would be integrated into a new NSW Civil and Administrative Tribunal (NCAT) which is expected to commence operations in January 2014 but that the Government has not yet finally determined the role and the practices and procedures of the CTTT. OCN sees merit in the adoption of a legislative framework similar to that operating in Queensland, which is discussed under Terms of Reference: Paragraph 3(h). OCN has commented on possible enhancements to the provisions of the SOPA Act under Terms of Reference: Paragraph 2(i) OCN supports the amendment of the SOPA Act to enhance the provisions of the Act dealing with “due date” for progress payments along the lines of the provisions contained in the Queensland, Northern Territory and Western Australian legislation. Terms of Reference: Paragraph 3(c) OCN agrees that there is a pressing need for steps to be taken to improve the financial skills of those in the construction industry. OCN notes the observation by ASIC reported on pages 13-14 of the Discussion and Issues Paper that the most common forms of business failure include poor strategic management of the business, inadequate cash flow and poor financial control. OCN is also conscious of the observation on page 8 of the Discussion and Issues Paper that the ability to price risk adequately and a commensurate ability to manage that risk diminishes as one moves down the contracting chain.

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Questions/Issue for comment OCN sees merit in the suggestion that the responsibility for improving the financial skills of those in the construction industry should be brought under the umbrella of a statutory authority such as is done in Queensland, as discussed under Terms of Reference: Paragraph 3(h). OCN believes that all contractors should be licensed, as we believe is the situation in Queensland, and that a condition of licence renewal should be participation in appropriate forms of continuing education, as is currently the position with most professions. OCN also believes that steps should be taken to publicise the forms of self help currently available to subcontractors such as the availability of credit insurance and the ability to have relatively cheap financial checks carried out of the contractors for whom they contemplate working. OCN agrees that, due to cost and other factors, it is unlikely that the average subcontractor will be in a position to secure the establishment of a performance bond, but that the potential availability of such bonds should be publicised. Terms of Reference: Paragraph 3(d) OCN notes that little interest has been shown in proposals for the establishment of a mandatory insurance scheme to secure payments to subcontractors. Questions/Issue for comment OCN agrees that the costs of such a proposal are likely to be a major deterrent and notes the consequences of the paradox referred to on page 28 of the Discussion and Issues Paper. Terms of Reference: Paragraph 3(e) OCN notes that there is little appetite for the proposal to establish a discretionary mutual fund to compensate contractors for losses arising from insolvency of a lead contractor or principal. Questions/Issue for comment OCN believes that there are more effective measures discussed elsewhere in this submission and in the Discussion and Issues Paper to minimise the incidence and impact of insolvency in the construction industry. Terms of Reference: Paragraph 3(f) OCN notes that the Inquiry is giving special consideration to whether a statutory trust provision, modelled along the lines of the Contractor’s and Subcontractor’s Trust provisions in section 8 of the Ontario Construction Lien Act RSO 1990, c 30 should be adopted.

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OCN was surprised that the question whether a contractor should be permitted to have a free hand in the investment of funds received during the payment cycle which would ultimately become payable to subcontractors does not seem to have been previously canvassed in any detail and was not brought to the forefront of discussions or submissions to the Inquiry until the Inquiry began to focus particular attention upon it. Questions/Issue for comment OCN agrees with the view of the Inquiry that the argument that a trust arrangement should not be imposed as, in reality, contractors require continued and unrestricted use of progress payments during the payment cycle or they may ‘topple over’, is unmeritorious The Inquiry’s view is of particular relevance in the context of the views expressed by a significant number of witnesses that there are a significant number of companies in the construction industry trading whilst insolvent. OCN agrees with the Inquiry’s view that a trust arrangement, if properly implemented, would protect subcontractors in the case of a head contractor’s insolvency, against the misapplication of a progress payment already made to the contractor, the whole or part of which related to work carried out by the subcontractor. However OCN is has concerns regarding the administration of such a trust arrangement by the Head Contractor which raises questions of possible conflicts of interest, departure from the existing law which forbids a trustee from profiting from the trust and the need to supervise the Head Contractor’s administration of the trust. For these reasons, OCN favours a scheme where the funds are held and administered by a third party. Such a scheme could form part of a comprehensive licensing system established by legislation similar to the Queensland Building Services Authority Act 1999. OCN agrees with the Inquiry’s view that when it comes to retention funds, reform is necessary, and that such funds should be held in a genuine trust fund and placed in a separate bank account with two joint signatories. Terms of Reference: Paragraph 3(g) OCN agrees that subcontractors ought not to be relieved of their obligation to properly educate themselves in business and financial matters, to develop good financial and management practices and to be reminded that it is not possible for them, more than any other sections of the community, to be completely protected against all uncertainties and their own foolishness.

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Questions/Issue for comment OCN recommends that more publicity be given to the availability of relatively cheap sources of information currently available to subcontractors, including routine inquiries through companies such as Dun and Bradstreet and other information providers, details of which are available on the ASIC website. OCN has commented under Terms of Reference: Paragraph 2(i) on the need to strengthen the provisions of the SOPA Act regarding the contractor’s statutory declaration. Terms of Reference: Paragraph 3(h) OCN sees merit in the proposal by the NSW Small Business Commissioner that consideration be given to establishing an independent system whereby progress payment retention moneys are deposited to a central account similar to the NSW Retail Security Bonds Scheme but notes that the Inquiry does not presently favour such a structure. One advantage of such a system over a system where the moneys are held in trust by the contractor would be that there would be less risk of the funds being commingled with the contractor’s own funds and it would avoid the cost of supervision of the contractor to ensure that the funds had been properly dealt with. OCN noted under Terms of Reference: Paragraph 3(b) that the NSW Government has not yet finally determined the role and the practices and procedures of the CTTT. Questions/Issue for comment OCN favours the enactment of legislation similar to the Queensland Building Services Authority Act 1991 providing for the licensing of all contractors. OCN agrees that it is anomalous that in order to construct a two bedroom cottage in the far west of NSW, a builder must hold a home builders licence whereas a commercial builder engaged in the construction of a high rise building in Sydney does not require a licence. OCN notes that the Housing Industry Association expressed its firm view that it would be undesirable to introduce into NSW a similar legislative framework to that currently operating in Queensland under the BSA Act and noted in its submission that “the residential construction industry represents a distinct and unique component of the construction industry … (and that) the commercial and regulatory environment in which the residential construction industry operates must be distinctly considered when undertaking the Inquiry”. That is an unconvincing argument.

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It may be true that the residential construction industry represents a distinct and unique component of the construction industry, but it is a component that is subject to financial pressures and insolvency to the same extent as other components of the industry. OCN agrees that key provisions of the BSA Act include:

The licensing of all contractors seeking to undertake building work of any kind;

Rigorous financial assessment carried out on all contractors; and

Continuing audit requirements for all licence holders

OCN also notes that the Queensland Building Services Authority claims to take careful steps to ensure that it is always in possession of reasonably current financial information relating to contractors. The significance of this claim is illustrated by the phrase quoted on page 12 of the Discussion and Issues Paper that “accounting delayed is accounting denied”. A statutory authority of this nature should be able to provide a further means of self help to subcontractors by warning them of the risks of dealing with certain contractors. OCN notes that it is claimed that the Queensland authority funds its own operations on an almost revenue basis. It appears that it is funded to a significant extent by insurance premiums received. OCN notes that it is claimed that the operation of the BSA Act, including in particular the ranking capital requirements set out in the legislation, has operated to reduce insolvency in the construction industry in Queensland. Although it is difficult to gather hard evidence to support this claim, it appears to be consistent with ASIC data cited on page 14 of the Discussion and Issues Paper that across all industries, NSW accounts for 44.7 per cent of insolvencies and Queensland 21.1 per cent. Terms of Reference: Paragraph 4 OCN agrees that it is not appropriate for the Inquiry to recommend any proposal which intersects or conflicts with, or requires any consideration of, Commonwealth Laws and, in particular, that the Inquiry should not recommend any change to section 556 of the Corporations Act. Terms of Reference: Paragraph 5 OCN notes that the Inquiry will receive advice from an industry reference group including key associations and the Small Business Commissioner Conclusion OCN would be happy to discuss with the Inquiry any aspects of this submission.