Construction Industry Insights

We’re very lucky to have one of the preeminent national litigation, construction and solvency lawyers in town, Mr. Joseph Scarcella joining us today.

Due to tech issues, we have transcribed this webinar for your convenience

Andrew: Morning, everyone. Hopefully you’ve all had a good, long weekend. We’re very lucky to have one of the preeminent national litigation, construction and solvency lawyers in town, Mr. Joseph Scarcella joining us today. Thank you, Joe. it’s nice when we can get industry experts to discuss what we’re seeing so thanks again for coming

Joseph: Thanks for having me.

Andrew: Construction industry insights is what we are focusing on today and we will cover four different areas during today’s discussion. The first is around some key metrics that I have come across whilst researching the industry as a whole. We will have a look specifically at the housing sector, because as we know that has been problematic of late. We’ll also look back at the last five years as to where things have come from, in terms of the industry metrics, and obviously where the trends are headed over the next five years as well.

Then, we’ll get to what we effectively see at the moment as a “perfect storm” in terms of what’s affecting the industry today. The issues around the increased cost of doing business with materials in some cases 100% more then what they were a short time ago, labor shortages given our close borders from the COVID-19 situation and on top of that, we’ve got compounding issues in terms of the supply and that not being guaranteed for the moment.

Then, I’ll pass it on to Joe, and he’ll look at the legal considerations in terms of stakeholders’ rights and responsibilities, and we’ll talk generally in terms of some of the things that we have seen in our experience in those particular types of collapses, and touch on a few of the most recent collapses in the marketplace.

We’ll then move on to restructuring options, what there is out there, what the projected outcomes of those options may or may not be, and then we’ll get some questions towards the end. Just on the question front, more than happy for people to jump in as we go.

So, just in terms of some of the key metrics, if you think about the construction industry overall, it’s made up of approximately 400,000 different businesses. That’s 90% of the small to medium-sized businesses that are in Australia. It’s a massive part of small to medium business in this country. It’s the second-largest industry in Australia in terms of its contribution to GDP. I was a little bit surprised myself that it’s the second-largest industry, but from the statistics that are out there, it happens to be the second-largest industry. So, what happens in this industry has a really marked impact on what happens to the Australian economy overall.

In terms of the breakdown of where that activity is, it’s mainly centred on the eastern states, predominantly New South Wales, Victoria, and to a lesser extent Queensland. We

know WA and that side of the country is more resources focused. The resources industry happens to be the largest full-time employer of any industry in Australia.

As I said, any impacts that are felt in the construction industry are going to have a large impact on the overall Australia landscape, and for us as an economy. And that’s something that’s a bit concerning when there’s the headwinds that we’re seeing within the sector at the moment.

Just in terms of the last five years to 2022, total revenue is now at $424.1 billion. The annual growth in the industry over the last five years on a year-on-year basis has contracted by 0.2%. The projections for the next five years are an increase of 1.5%, we’ll get to that in a while. In terms of profit margins, they’ve steadily decreased down to 8.1% at the moment. In terms of my experience, the profit margins that we’ve seen that have led to a number of business collapses recently are actually a lot lower than that. Obviously, the margin pressure there is something that’s weighing on the industry overall. In terms of wages as a share of revenue, surprisingly that’s come down somewhat over the last five years to 17.7%. And in terms of the number of businesses that are operating in this space year-on-year, it’s increased by 0.8%.

They are some of the key trends in the industry overall from 2017 to 2022.

In terms of additional macro-economic trends that also covered that period, for the first few years, there was solid growth in population, and continuing through to now, record low interest rates. So that’s underpinning demand overall in terms of new home builds in construction, and also in the road and rail transport infrastructure areas. The NBN rollout had also had a positive impact on the industry as well. In terms of the heavy and civil construction subdivision of the construction center, it’s remained subdued, which reflects the reduced investment in resource developments that we’ve seen up until recently, and government spending on the water and power capacity side of things.

In terms of where we’re looking for the immediate term, there’s an anticipated revenue fall of 5.7% through the 2022 year. And obviously, you can see that reflected in the overhang from the COVID issues and the other things I’ve mentioned in terms of headwinds. Joe will go into a bit more detail on that.

If we look at the housing or the dwelling construction subdivision of the construction industry, from my perspective and what I’ve seen within my own appointments, and what I’m seeing in the general marketplace, there are a lot of converging issues that are affecting the short-term trends in relation to builds and completion of builds. Obviously, we had the homebuilder subsidy which somewhat underpinned some of the demand in that area through the COVID period. And I know, anecdotally, just from my own experience in family-related building, there seemed to be a lot of work that was available particularly for small subcontractors over that period of time. That’s now started to abate, given the subsidies have now finished.

Again, COVID-19 delays in terms of supply, the anticipated rise in interest rates are also having an impact along with the upcoming federal election and the inflationary pressures that we’re seeing are affecting consumed confidence overall.

Demand for that particular area is forecast to recover over the next five years, but as it stands at the moment, there are obviously issues in that space. The great Australian dream of owning your own house, again, it still somewhat underpins dwelling construction. Obviously, there’s a quote there in relation to financial and emotional security that I found interesting, given that a lot of people strive to achieve that over their lifetime.

Joseph: I’ve seen a lot of clients in the building space , so they’re actually securing deals, and they’re actually building apartment blocks or townhouses for the sole purpose of putting in a rental clause, and then renting the units and those apartments, and obviously selling that down to investors. So, there is a move for the build-to-rent space, as well as student accommodation. There’s a bit of an uptick in that as well.

Andrew: Yeah, and that’s changing recently too. The build-to-rent space in Australia wasn’t something that was really there 4-5 years ago, and it’s coming to the forefront now has been part of the American landscape for a long period of time.

In terms of the external performance drivers through 2027, there’s obviously a chart here on the right, and you can see over the 2021-2022 period now, there’s a perception that there’s going to be a 15% negative impact on the number of dwelling commencements for a number of reasons, and obviously a decrease correspondingly from a revenue perspective. In terms of multi-unit apartment and townhouse space development, that’s fallen over the last five years. Much of that more recent stuff, and the current position in terms of the negative influence on appointments through 2022 and into 2023 is due to the COVID-19 building interruptions, as well as the other constraints around supply and availability of property there as well. In terms of mortgage affordability. We’re looking to now have interest rates rise, and potentially rise quite quickly, depending on what happens with inflation. So, that’s going to have some impact on demand in the short and medium term. And the price growth has obviously affected the affordability side of things as well. So, there’s a few things that are interacting there to influence what’s happening in this space in the short term. Over the next five years though, now that the borders are reopened and we’re starting to get people back in, which is great, that’s forecast to come back to a more normal level into 2024 and 2025, and obviously there’s some trailing off there in 2026 and 2027.

Joe: The other thing to point about that slide is, mortgage affordability has been stagnant for a long period of time, and what COVID has done is refocus domestic spending into property. You spend so much time there, and that has a huge amount of demand across the major cities. So, mortgage affordability is also an issue.

Andrew: It’s one of those things. I certainly haven’t seen it in my lifetime. My parents have talked about the high interest rates in the 80s and early 90s, but I’ll be interested to see what kind of impact these current raises or anticipated raises have on that space, and whether it’s more marked than the COVID. Obviously, the changes that we saw in terms of people being unable spend money on holidays in Europe, so they remodeled their house has been felt across the sector. It’s obviously an interesting space to see in the next period.

Just in terms of what we’re seeing overall, there’s a whole range of issues that seem to be impacting this particular space. I know Joe is going to talk about the fixed-price contract side of things and what he’s seen there from a legal perspective. But just overall, the macroeconomic headwinds, inflation, growing tensions in Ukraine, with the war, that’s actually affecting supply of wood and a number of other resources that Ukraine had a major contribution to the global supply of.

And obviously, interest rates, as I’ve alluded to earlier, those things, from a macro level are causing headwinds within the industry. Supply chain interruptions, the COVID-19 backlogs are continuing, even if they’re starting to clear in some places. I know China, Beijing is looking at similar lockdowns to what we had which will have a further impact on the shipping side of things. And locally, floods and fires that feel like a distant memory, they’ve had an impact on supplies as well. All these things coming to a head at once in terms of supply chain interruptions have been extremely problematic.

In terms of the insolvency side of things, industry insolvencies in the last quarter to December 31st of 2021 actually increased by 40%, and that trend has continued through the first quarter of 2022. I know you’ve been working on some larger appointments in terms of the construction space Joe, and that’s indicative of those particularly pressing matters. It doesn’t look like it’s slowing down at the moment. There’s a lot of talk at the water cooler about more potential insolvencies, and in media so there’s definitely a lot of scope for those particular insolvency events continue to increase.

Joseph: I think we’ll see quite a large builder go. And then I think we will see a lot of subcontractor pressure because subcontractors are the ones who significantly suffer in a company collapse. We anticipate there will be more issues on the eastern seaboard in the next couple of weeks.

Andrew: Good to know. You heard it here first. In terms of fixed-price contracts, it’s a bit of a race to the bottom. Other builders who have come in and taken over some of the larger contracts and found themselves in a difficult position and had to enter into Administration like ProBuild. So, the shrinking margins, increased costs as well as these fixed-price contracts that have limited scope to add additional costs too, are a major issue at the moment. Particularly on the home building front. It’s very difficult to enter into a fixed-price contract in a consumer-related space and then go back and ask for more money, simply because your overheads have increased in terms of supply. Just anecdotally, I was reading an article recently where there as a couple of building companies in Queensland that are asking for 50 grand extra contributions to some of these building contracts with fixed prices, and they had delays and issues with supply, and faced losses if they continue to complete these projects. And again, skilled labor shortage, the closed borders, record-low unemployment, has led to people asking for extortion amounts of money to be doing laboring jobs in particular, as well as the skilled trades sort of things, effectively just exacerbating things. All of these things at once – not even just at once, but over a prolonged period of time, the last 2 and a half years now – have now come to this pressure point that we’re seeing here.

Joseph: To add to that, it’s a result of the cash flow. But what they do is, I think I can get in and I’m going to build x number of apartments, therefore a fixed-price contract profit margin will be there. So, the problem of building and projection is the hardest part, because you project by based on today’s costs, but as Andrew talked about at length, there’s a change over the course of a year or two, of the average worth of a construction project. And the prices have doubled, there’s a labor shortage, there are floods – we’ve had the worst weather on the eastern seaboard – all of these add to delays, and the delays cost the builders, they can’t pay salaries and wages, and it just creates the perfect storm of pressure on builders and subcontractors. And the stress will start to show starts achieving that amount. And sometimes I have to, because I need the project to be live, sometimes I can’t afford to complete the project on particular parameters, and then the project collapses, and a new builder comes in, and the costs escalate.

Andrew: Yeah, and the abrogation on the contracts in those circumstances, it just adds an extra layer of costs. There are obviously some things there that you need to work through, particularly in a situation where there’s been a collapse, and you’ve got 5% completed. You’ve got subcontractors that have been paid 50% of the money for the work they’ve already done. And if someone is coming in to take that project over, chances are the subcontractors are in a good position to pressure them in terms of making them whole. So, there’s a whole range of things that pop up in those sorts of scenarios.

In terms of recent industry insolvencies, it’s not something that you probably haven’t heard of at the moment. Obviously, ProBuild was a larger one earlier this year, or over the last year. They’re all kind of blurring into one at the moment. Condev Constructions again, earlier this year. They decided preemptively that they weren’t going to be in a position to finish all their projects and decided to liquidate. It’s not good for all these types of events to be happening in this space, particularly in such a short time frame, which is, at the end of the day, the impact that the construction industry has on the overall economy and the flow-through effect that that has, given that it’s the largest employer and one of the largest contributors to GDP too.

All of those things affect us not just in the construction space, but in our everyday lives in terms of cost of goods and everything else that we’re doing from that perspective. So, whilst these insolvencies have gotten a lot of media attention, the fallout from those, and the subcontractor fallout that I’m sure we’ll continue to see over the next 6-12 months is something that’s going to have more of an impact on the larger market.

Joseph: I think something you spoke about earlier, when you move contracts across builders, there’s a classic example. Grocon was the first major building collapse, and that was almost two years ago. They were building a particular property here in NSW, which then ProBuild took an assignment of. Separately, the interior fitter that joined the job on that particular project collapsed. And that’s just one building where you’ve had three major collapses. So, that’s every builder, and the main interior fitter collapsed. So, here are those examples. And every time you move, every time a contract gets assigned, costs increase, and that shows you how difficult it is in the market at the moment, that this is a boutique kind of building, but it just couldn’t get finished. And now someone else is going to step in and finish it, but the liquidators haven’t been able to sell these projects at the new premium. It’s more like, taking the liabilities off our balance sheet and get rid of this. So, you’ll find the shareholders aren’t willing to put more money up, the banks aren’t willing either, or so it looks as though you have multiple failures on a particular building. Sometimes they’re handcuffed and say we have to because we’ll lose more if we don’t, but sometimes they say enough is enough. So, we have seen that point now, and we are recalibrating the building market.

Andrew: That’s a really good point, Joe. It’s just quite extraordinary that one particular building can have that impact on a number of different companies. Obviously, like you said, that just goes to show those stresses in the space, particularly in those ones where people come in and novate contracts to try and complete them.

So, now I’m going to head over to Joe. he’s going to talk about some of the legal considerations in the space.

Joseph: So, I think the main thing to understand about building contracts and building collapses is that there’s a complex matrix of legal documentation that underlies how a project gets from an idea to build. So, the main participants are the owner – that could be a developer – then the builder – head contractor – subbies- there’s even sub-subbies, and then the suppliers. This is all through the chain. So, you use that the contractual matrix is that there is a development agreement between the owner and the developer. So, the principal enters into a building agreement with the builder. Then there’s what’s known as a tripartite between the owner, the developer and the builder, which effectively gives the owner rights to the builder, and allows the owner to step in the position of the developer or the principal and force the builder to perform certain obligations.

Oddly enough, the builder tends to provide security to the developer, the developer tends to provide security to the owner, all secure in the fact that the building will be complete and will meet the specs. Now, the security is obviously significantly less than in a complete building, so that’s a problem. And these agreements have cross-collateral. So, if there’s a default by the builder, the builder has to pay the subcontractor, that’s a default on part of the developer to the owner, and that can collapse the structure very quickly. And obviously the builder then subcontracts down to subbies, and then they buy goods and services from suppliers.

So, what you have on a typical building contract is hundreds of different contracts with different parties, all with different rights. And it’s how those people exercise those rights which affects how the building project will actually continue. Naturally, in a rising market where the prices are good, no one really cares so much about their legal rights. But people call us in circumstances where the project isn’t progressing well, and they want to work out what their rights are. Can they step in, can they set off, can they refund payment, can they fire the builder, can they change subbies?

So, these are the reasons why when there is a building collapse it’s always a significant loss because the loss is felt all through the chain. And then, as we discussed, there’s one project here on the eastern seaboard, there were three major collapses. And it’s because every time the building is moved to a new developer, there’s going to be gaps and further work is needed. And it becomes more expensive because there is another layer of complexity, more legal costs, and associated bureaucracy.

So, what that really means is that, as the owner and principal, you probably hold 5-10% of performance bonds, or made guarantees to secure the completion of the project. But that’s so insignificant, if the project collapses, even anywhere up to a week or two before completion, because there are significant legal steps that can be taken. So, the real problem with building contracts is that they start with men and women on the site deciding, ‘we’re moving this partition three inches this way, because it lines up with the beam’, or they must put this air-conditioning in another way. If you’re the builder or a subbie, and you get a variation to the contract, then you’re going to wear that cost for moving the wall or moving the air conditioning vent. 99% of people on-site say they’re going to do it for the relationship. But then one move becomes two, three, 20, and all of a sudden there’s a large variation cost.

And we’ve acted on a job where this was the case, where a builder for a hospital was asked to move the walls three inches. That’s all. But the effect was millions of dollars in cost because of extra labor, extra materials, delay, the redesign, and they couldn’t recover. So, the complication of the legal matrix makes it much harder to make money on top of it, and I can tell you, builders are not on top. They have a conversation, principal to principal, builder with the developer of the site, they agree on the phone ‘I thought we agreed that you wouldn’t charge us, etc’. Disputation and that’s where you get into trouble.

Andrew: It’s problematic from that side too, especially when you really can be involved, and they’re trying to sort it out quickly, someone agreed to this or that- people having a conversation and it doesn’t get documented correctly, and it all falls over. At the end of the day, it’s one of those things – you need to document those things, even though it takes time and effort. I know project managers who are staying up to 11:30 just making sure you get the documentation right for this exact reason.

Joseph: I think that’s right. On one of the jobs, we were working with you, it’s exactly that. The builder undertook significant changes, suffered significant losses on the way that labor was used because of COVID and the round-the-clock scheduling. They said, ‘yeah, sure, we’ll look after you’, made representation such as that, and ultimately when they sat down to discuss ‘we’ll look after you’, I came to naught or very close to naught, which effectively caused this building to collapse. And maybe that building could have got that documented, or it was either misled. But it’s not an industry when people sue each other over a telephone call, or something discussed on the site. That’s something we’ll talk about. We should also talk about the assignment of contracts. That often happens in insolvency.

But generally, what also happens is a developer comes in and says to the owner of the land, ‘I’m the developer, I can do it, no problem’, and then I decide for whatever reason that I should move it to another entity. Maybe one entity has too many tax debts, or one entity has gone up in insurance, and we decide to move it. And contracts, from the time they’re entered, when the building starts getting out of the ground, disputes between developer companies and builder companies, just because it makes sense. So, for example, a builder company will have an amount of insurance, and it limits, and it projects might be $5 million and say, ‘well, I’m going to move the project to another company where we have $10 million in insurance’.

So, these arrangements happen quite often, and they’re often very innocent. I think a lot of care needs to be taken in this step, because if you aren’t careful of this you can start becoming undone. So, the first thing you look at is, what are the solvency considerations? Moving it from company A to company B, you think, ‘well, it’s all the same group, it’s all the same owners, you’ve still got the second director guarantees. And that’s because of this. Company A might be more solvent, Company B might be a startup and might not have as much capital, or as much rights on the board. Company A might have made a significant amount in profit, and the profit could have been all used on the moving contract. Then Company B picks up the balance that might necessarily be viable for me to continue to the end. The other thing that happens is when an assignment occurs between one company and the other, so two building companies in the same group, they release each other from their obligations, but company A and company B still have certain obligations back to the owner, and those obligation might still exist.

So, in the insolvency, they might be checking more than one company in the group, and then the guarantees are never relaxed, they’re always ever-present. So, whenever someone says, ‘well, we’re just going to move it from company A to company B because of insurance’, you shouldn’t be asking for financial undertakings, you should be understanding the financial capacity in the second company to complete the contract. And you’ve also got to consider, from a duty perspective, if you are the building company, by moving that contract from one company to the other – ‘am I depriving a company that might be insolvent or might become insolvent of future cash flow? Is that a breach of duty, and is that a transaction that can be avoided later?’ And these discussions, we’ve all found that they actually happen. This is just done as a matter of course, during the course of a building contract getting up out of the ground.

Andrew: From my perspective, when you’ve got 120 related entities developing or contributing to developments who might be subcontracting to development A and then subcontracts to development B, and there’s loans and all sorts of things that go across on a lot of these particular buildings, but from the head contract side, it just becomes an absolute nightmare to try and unwind.

Joseph: It’s a mess. What we call the labor party, and the labor contractual party schedule was like spaghetti, because there were that many lines that just extremely complex. And it just becomes impossible to disentangle at times. That’s one of the problems. Building companies and development companies don’t make it easy on themselves. It’s quite a pain, how they operate. So, I think that also adds layers of complexity and cost. And there

are loans, related party loans. The same loan will go around 10 times between 8 or 9 different companies, but you can only call that loan in once. If you pull that string, the whole thing collapses.

And the other issue with building companies is licensing. You need someone who’s actually got a license to build the thing. And the licensee is the director of the building company, and as soon as there is an insolvency there’s a show cause notice. So, if the director themselves have a building pass, but they said, ‘well, you may not be allowed to build because the building regulatory authority in the state says that an insolvency is an automatic show cause event, please demonstrate why you are entitled to continue to build.’ That’s been done on a lot of building insolvencies over the last few years. I’ve also done a lot of show cause responses. And it’s quite hard to protect the license, especially when there’s a group collapse. If there’s one or two minor collapses, that’s fine, but the building regulatory authorities are coming down quite hard on directors.

So, that means, someone like Andrew gets into the job, and they say, ‘oh, that building is 90% done.’ But it needs a building license. So, if the company that’s gone into liquidation has its building license suspended or under investigation, Andrew might be able to hire another building license, which effectively means get some other builder in, and will have to pay that builder over the odds to come in, because no builder and no insolvency practitioner wants to take over a job that someone else has started, because they just don’t know what mess is there.

So, this adds another layer of cost and complexity, and this also explains why building collapses are catastrophic failures. Complex transactional structure, complex internal structure with the builders and developers, licensing issues, and then all the regulatory issues about building OH&S. That means that, when there’s a collapse, it’s generally a catastrophic failure for any unsecured creditors and many subbies.

Andrew: Yeah. I’m just thinking about that in terms of the appointments that are taken in this space. I don’t think that I’ve ever continued to complete a project without someone coming and effectively assigning the contractor to complete it on my behalf. And like you said, the continuation of the project and the increased costs that go with that, again, lead to detrimental impacts on stakeholders.

Joseph: In the ones I have worked on we just assign the contracts from the insolvency practitioner to another builder on the basis that they take on certain liabilities. There is absolutely no money paid across. We just take the liabilities off the balance sheet, and that’s a good deal.

Andrew: Yeah, that’s probably the best deal you get in the circumstances.

Joseph: That’s because the market is, as you described earlier, it’s just chaotic at the moment. So, when you think about the principal, the developer, the first thing I need to do is get the short bill and get some security. Like I said earlier, the security is only 5-10% of the building cost. And under the standard contracts, that’s what it is. And standard contracts are very developer-friendly in terms of what the developer can force the builder to do. And because they’re the standard contracts and everyone uses them, as a builder you can’t say, ‘I’m not using that, that’s too developer friendly. I’m going to use another one.’ You just press yourself out of the market. Because the principal or developer says, ‘I’ve been using this one for many years, why would I want to change?’ So, there is that problem. So, developers will not get more than 5-10%. The standard contract, which is mainly in their favor, builders never push back on it, only minor changes. But usually everyone thinks the company is placed into the administration care of the builder, the developer can terminate and get a new contract in place. Well, under the new laws, since July 1st 2018, you can’t. You cannot terminate a contract solely by reason of the insolvency appointment of a counterparty, but you can still set off liabilities. So, for example, you’re the developer, the builder goes under, and you say, well, you owe them two million dollars on a progress payment, but you estimate there’s going to be 8 million dollars to finish the job in terms of losses, you just don’t pay. You can step in and kick out to the builder. You don’t terminate, but you step in and exercise your rights, and then you have other contractual rights like calling on indemnities and securities. The real issues, in principle, is that in the event of financial distress of the builder, what you should be doing is seeking to terminate on grounds other than insolvency, i.e. Something has been removed off-site or find another default, and then terminate and get rid of the builder, lock him out, and try and sustain your project. One thing that’s quite difficult in a building project is when you have a builder that is unhappy, that is about to go under. Things go missing off site. So, as soon as you feel the builder is in significant financial distress, you’ll be able to find in the standard terms a notice of breach and remove them. That might be the straw that breaks the camel’s back, but you’ll want to act quickly to exit the builder and get a new one appointed.

Now, everyone will talk about – why is it so hard on builders? They have the Security of Payments Act across all states, it’s uniform. The real thing is that you speak to builders, you say, you can’t do that, screw your business. If someone doesn’t pay in time, you go and get judgment against them. Subbies don’t do it. It’s just not done in the industry. Whilst every invoice says this is the payment requirement timeline under the act, it’s very rarely enforced because it’s a big no-no in the industry. So, as a builder, you really have to rely on your goodwill and say, ‘well, if I do this to the builder today, the word spreads that you only get paid on enforcing the Security of Payments Act, it’s really bad for my business, so I’d rather not do that. I’ll have the conversations off-site with the principal and make sure that they’re comfortable, and we’ll reach an agreement’, which as we said earlier, is often not documented. That’s why they get into trouble.

Andrew: It’s funny – obviously the Security of Payments Act was implemented to try and force people to pay, and from a practical perspective it just doesn’t happen.

Joseph: It’s more useful for subbies and smaller subbies who can afford to walk off jobs. Might not be the subbies, but for a main builder, not really. So, the other thing to look at is – and this is if you have a principal on the owner – if your builder was asking you for advanced payment, then you’re in trouble. If they’re asking for money in advance of work being done or on account of work being done, that’s not certified by the QS. You know that builder is in trouble. You should always avoid that and have decent conversation with them, ask them why. However, if you’re in that situation, you should speak to the builder to structure the payment so you can hold onto it. So, it’s a specific advance that’s covered by a trust and given some more security. But there are cases where builders have asked the developer for an advance because they’re a bit slow on X, Y and Z. The advance comes in, 2-3 weeks later, they’re in the same boat, they need another advance. So, effectively, all you’re doing is plugging a cash flow hole for the builder. So, be very careful with advance payments. Naturally, if you’re a builder, the more you get upfront, it minimizes your cost, you take as much profit out. But from a developer perspective, there should be a huge reluctance to pay any amount upfront other than certified or other than under the contract. And if you are the owner or the developer, you to the contracts, you don’t want the builder to argue, ‘I had that contract with Joe, things were fine, I was needed the extra time, and now I have been locked out’ – you’re always going to have these discussions and disputes. So, I think what you need to do, as a principal, and even a builder, is to hold the parties to the letter of the contract, and document it.

Andrew: And that’s important advice not just in a building capacity, but for anything commercial. It’s really making sure it’s documented and making sure you’re holding up to the contractual terms.

Joseph: So, as we discussed earlier, the builder generally has the license. So, the problem is that, if you’re a director and you’ve got a license, you’re generally not the right person to be a director. I don’t mean this in a pejorative sense. You’re a good builder, you know a project, and the same as why we don’t have lawyers managing law firms, because they’re shit at managing money. And the real point is that you’re a director, but you’re actually a builder. You say, ‘I’m just doing this because I have to, because the licensing requires me.’ But then you’re holding yourself to a whole bunch of other duties over the corporations, training, and people are getting appointed, and a whole bunch of other duties. So, when you become a director as a builder, make sure you understand those duties. Go to the Directors Institute and do a course there or speak to your friendly lawyer. There are heaps of information you get from the websites of Cathro and Partners and others. But you really need to understand your rights.

Andrew: In 99% of every appointment, I come across s181 to s184 breaches, and it is mind-boggling that people don’t take the time to understand what their duties and responsibilities are as directors.

Joseph: The first question I always ask in cross-examination of a director is do you understand your directors as a director under the Corporations Act. And without a doubt they say, ‘of course I do.’ And then I just ask those questions around their duties, each one of them. So, it is a really fundamentally crucial point. But where you get into problems is not just the General Duties under the Corporations Act – it is how you are pricing your contracts. As a director, you have got a duty to act in the best interest. So, for example, you price a contract with zero margin – that is a breach of duty. You think ‘I need to do it because I need to get business and then that will open up doors.’ But if those other things don’t happen, you’ve probably breached your duty. So, the pricing pressure can conflict with your duty as director. Whilst you might actually get the lowest price possible to get the job, you have a duty as a director to make sure the price isn’t so low that it isn’t in the best interests of the Company to take on. So, the point is, builders have a building license, become directors, and they make financial and commercial and financial decisions that they may not necessarily have the experience to do, and that leads them into trouble.

So, the main thing, if you are the builder and the director with all these rights and obligations, you need to start enforcing your rights to payment. Subject to what we said earlier, the commercial plumber really puts pressure on a developer, ‘pay me or I’m going to walk off-site’. They issued their invoice under the Security of Payments Act, when they do, the act gives you a judgment. It’s an unsecure judgement. It doesn’t give you security, it doesn’t give you any rights above anyone else. There’s nothing in the judgment that says you must pay the builder before you pay us. But more importantly, if a subbie issues you with a Security of Payments Act claim, you must pay the subbie, notwithstanding that the actual owner of the building site hasn’t paid you. So, that acts bites very badly if you’re a builder, because you’re stuck in the middle, you don’t want to make the claim and force the developer to pay you because that’s bad for business, but then some subbies will enforce that claim on you because they desperately need the money, and you’ve got no excuse.

And the other thing that also bites you is you give guarantees, because everyone signs a credit application for delivering concrete, steel, bricks, and at the bottom, it always says that you guarantee that you will pay personally. All of these things. And then things that you just say, ‘it’s never going to happen to me’. But it’s the failure to take that step. I recently negotiated a building contract where I asked for the caveat and the security to be removed. I said this should be removed, and it was a condition, and it was accepted. So, sometimes you can push back. The other thing – it’s the worst job in the world, but industrial action. In order to actually make contracts viable, builders bring in contract labor. So, you don’t have to pay additional benefits. And since COVID there was a lot of contract labor brought in. They can work 8 hours, you have to pay overtime, they can work 24-hour revolving shifts without necessarily having paid benefits.

Now, from the industrial relations perspective, people have views about it, but the unions have very strong views. And they’ve forced a lot of the builders to bring those contractors on payroll. It’s just blown out the cost by millions of dollars. So, you’ve got a fixed-price contract and you say, well, the way I can deal with it is, I can get a contract labor force in. Unions may come in and force you to take these guys on and you then suffer a catastrophic loss. You speak to the developer, or the owner and they say, ‘I can’t be paying extra just because you’re in a difficult position. I’m sorry’. And obviously, the increase in the OH&S, in the last 10 years, the increase in the OH&S is phenomenal. I think that’s a good thing, people are not dying on sites – there have been two tragic deaths in the last four months on a building site, but that’s quite important. And so, OH&S has increased, which is a good thing, but that’s an overhead that builder has too, and the builder guarantees to the owner and developer that everything is done legally on site. There can’t be any corners cut, everything is approved, it’s all OH&S standard. So, these are significant cost issues that the builder needs to consider, but that also bite on their duty as a director.

Andrew: And I think looking at all those things, the builder effectively piggy in the middle, having to deal with both sides, along with the industry itself, it’s tough.

Joseph: So, subbies effectively pressure because they don’t get paid if a builder collapses or a principal collapse. And they don’t often enforce security of payments. The biggest thing they can do is just walk off site and say, ‘I’m not working until you pay me’. They don’t have any security, they don’t have any real rights, especially the smaller subbies that just come in and do some pretty ordinary labor. The larger subbies have larger contracts which are effectively mini building contracts, but they never have securities. They’re often the second last to get paid, and the suppliers are the last. And this field is in their hands. If they miss one or two months from one particular job it could be quite catastrophic, because some of them can’t afford to do so. So, from the subbies’ perspective, one should get paid because you have a contract which entitles you to payment. Don’t ever commit when you’re not being paid. From the builder’s perspective, make sure to keep your subbies happy. If you can’t pay them in full, pay them enough money to keep them going. If they start falling apart, then you need to get another subbie and that’s going to cost you a lot more money. So, I think subbies suffer significant stress in a building collapse.

Andrew: They absolutely do. Like you said, they’re often the main losers in terms of these building collapses, unfortunately. A lot of the time, as you alluded to earlier, they’re very good with their hands, but in terms of running a business, it’s not something that they’ve ever been taught to do or have the ability to learn to do. It’s almost as if you are an employee, but you’re not. All these are really good points, Joe.

Joseph: And the last one is the supplier. Now, you need gyprock, you need a whole bunch of things to get a building out of the ground. But a supplier, the builder, then creates a security interest, which is effectively under the PPSA. So, the supplier will generally register against the builder a security interest, and that will be a purchase money security interest, and these have super-priority above all security in the middle. So, for example, you’re building a site, the gyprock supplier sets up an unregistered security, and there’s $100,000 of dollars’ worth of gyprock there. The building collapses, the supplier says, ‘I’m going to go over there and take it’. Even the bank who’s got the first mortgage over the builder can’t stop them.

Andrew: There have been many circumstances, I haven’t had any recently myself in the construction industry, but definitely in manufacturing, you have to try and come up with some sort of methodology to figure out how much of a material has gone in this particular product. And at the end of the day, the security still attaches to that product, even if it’s turned into something else. That’s another problem.

Joseph: Right, the first thing you tell a builder or a developer if one of the parties’ collapses is to secure the site. So, if you’re the developer or owner, and the builder collapses, the first thing you do is go to bunnings and get as many padlocks as you can, and you lock that site up. You don’t want anything coming in or coming out. So, your supplier coming with a truck to pick up the gyprock, foreman says, ‘I can’t let you in.’ And then there’s a dispute. The other issue is that supplies are getting better, but a lot of them, whilst they have security clauses in their agreements, a lot of them aren’t registered correctly, or a lot of them are registered late, and there are defects in the registration that have an impact. But the main advantage suppliers have is that builders, and sometimes subbies, sign a guarantee to the supplier that they will pay the supplier in full. Some will also agree that they will give the supplier security over their house. If they’re smart, they don’t own a house, but they will do that, and they won’t read it and won’t take advice on it, and the reason they do it is because it’s a standard in the industry and in supply. But I’m not delivering any more products until you pay me, cash on delivery. And obviously, the big bad liquidator comes along, and they’re the ones that got, but it’s all part of the ecosystem and the construction industry.

To summarize, the real points you need to take away from this is understanding your rights. That’s the most important thing. Your contractual and your legal rights. Understand what they are, understand your obligations. Next thing is, understand the early warning signs of insolvency of a counterparty or yourself. That’s where someone like Andrew will come in, and we can see there’s obviously a gap here. Because the earlier you catch your insolvency, the more you understand your rights. Whether it’s your insolvency or that of a counterparty, you’d be better off. If you wait, and you navel-gaze and reconsider, you will lose. Someone else will be doing exactly what I’m telling you to do. So, understand your rights and your contract, understand your obligations, and make sure you can identify if there are early warning signs or cracks in respect of yourself or counterparties. Then you react.

Andrew: That’s the point, to take advice. Joe is very good from the labor perspective and from the practical commercial perspective. I can also help out too. That leads us into a couple of restructuring options that are potentially available in circumstances where a developer, subbie, contractor, in a position where they’re struggling, and there’s cash flow or insolvency concerns. Anecdotally, there’s been a lot of inquiry from my side of things around Safe Harbour, whether there’s the ability for directors to be engaging in that form of restructuring. And it seems to have come on in leaps and bounds in the last couple of years in terms of its uptake, and whistle there isn’t a lot of data that’s publicly available around the uptake, just from my perspective, the inquiry level is there with people that we’ve been speaking to and engagements we’ve entered into in that space.

Joseph: I think six large building developer collapses I’m working on, their boards and directors have availed themselves to safe harbor.

Andrew: And that goes for the use of that particular mechanism. I’m not going to jump to time frames at this point, as we’re running a bit late. The second option is voluntary administration, a couple of different businesses from that, and gotten a few projects going too, which may not be the best outcome, it’s definitely a better outcome than if the doors got shot, padlocks go put on and nothing happened there. So, deed of company arrangement, which adds some breathing space for people to make contributions over time. And if for whatever reason there aren’t any of those options available, formalizing it via liquidation is probably something that you can consider.

Joseph: I think the point of this is, avail yourself to safe harbour if you can, and if not, it can be quite effective to restructure businesses with a large administration. So, it’s not the end. There’s a lot that can be done.

Andrew: Absolutely. There are all sorts of ways to approach. There’s definitely the possibility of good outcomes in my experience, depending on the situation. I guess there’s a few things to be considered when trying to avail yourself of safe harbour. There are obviously some hurdles that need to be jumped in terms of employee entitlements up to date, statutory lodgements up to date, those types of things, but obviously the directors have got to suspect insolvency. The real kicker here is them developing a plan that will provide a better outcome than if it goes into administration or liquidation immediately, implement that plan over a period which is where someone like myself or Joe can be a safe harbour advisor from the perspective of helping the board implement that plan. In terms of the options, if the plan works – great. The company has traded its way out of it. It’s obviously confidential in that the board is effectively the conduit to discuss the issues with the relevant stakeholders the businesses position, but it’s not something that needs to be publicly disclosed. And in terms of the licensing issues and claims by directors on guarantees, enforce those as well.

Joseph: I think that’s right. There’s a lot of people going around town saying it’s quite easy, but we’ve done a very in-depth analysis on what a better assessment and a better outcome actually means. And there’s a lot of tricks and provisions in there that no one has really tested. So, you really need to get expert advice on this if you are in that position. And also, if one of your counterparties you suspect is in safe harbour, or they’ve told you they’re in safe harbour, you probably need to get advice about what your rights are and what you can do.

Andrew: One of the major benefits if, for whatever reason, it’s not successful, it does exempt directors from insider trading claims from the civil perspective. Not necessarily from the criminal perspective, but it obviously provides a layer of comfort somewhat from a director’s perspective.

Joseph: And safe harbour can also be a plan that leads to administration. So, it is possible that if you’re still thinking, ‘I can’t sell the business’, there might be a chance to get into safe harbor for a period of time, apply for proper restructure, and then enter formal insolvency. So, I think the real point is, as we said in the other slide, understanding your rights and obligations, but also understanding the stresses and the potential insolvency of yourself or a counterparty. That’s the important thing you need to take away from today, because that will then alert you to think about your rights, your obligations, and then you can reach out to appropriate advisors to assist you.

Andrew: That’s really great, Joe. That’s where we’re going to leave everyone today. Joe, thank you very much. Your knowledge and your experience are obviously second to none in this space, and I really enjoy working with you. In terms of questions from the audience, if we’ve got any, we’re more than happy to answer them. If you would just type them in the questions pane. We’ve got one from Catherine. “Does safe harbor minimise the risk of a DPN?”

Joseph: No, it will not. That’s the short answer. If it’s a proper plan, you will be speaking with the tax office, and letting them understand what your plan is for repayment. However, issuing a DPN, no. On a job we did, we had a safe harbour for eight months, I think. There was an appointment, and the DPNs were issued effectively the day after the appointment. So, it provides a defense to insolvent trading, but it doesn’t exempt it. There’s no carve-out for DPN. In fact, it’s the contrary. You must keep all the taxes, filings and employee entitlements up to date to avail yourself of safe harbour.

Andrew: Just on the DPN side of things, I just don’t know really, from the ATO’s perspective. And obviously, there was a whole bit in the media about the 50,000 notices that got issued at the end of March around that. Whilst those notices weren’t directly DPNs, it was to the effect of, ‘we can potentially use this if we want to’. Communication has always been thin with the ATO in providing your appropriate documentation, making sure your lodgements are up to date, not defaulting on payment plans, all of those things contribute to the ATO’s position around issuing DPNs. it’s just one of those things. It’s part of the levers that they have in terms of debt collection, and whilst the last compute of years they’ve been allowed to use them, you can see that now is the time for people to actually be actively considering those things and making sure they’re taking those steps to keep the ATO apprised of the situation.

Joseph: And I think we’re going to see a lot more DPNs. I think the ATO wound up its first company last month.

Andrew: Yes, in a long time.

Joseph: In two years. So, the message to the ATO is, start collecting debts using DPNs. The COVID sympathy is ended, the economy is out of it, just start pushing. Because there’s billions of billions of upcoming debt, and everyone has been using excuses when they may not even apply, and as a consequence the ATO is not budging. If you haven’t got a proper excuse, you come down to us with a payment plan. If you don’t, you get personal liability.

Andrew: If you do have any further questions, feel free to reach out to Joe or myself. Our contact details are pretty easy to find, but I will have those and the copies of this presentation sent around in any case. Thank you very much again for your attendance and enjoy the rest of your day.

[END]

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