All construction projects have risks.
One common way principals manage their risk is by taking security from the contractor as part of the construction contract.
Security takes a number of different forms, but ultimately the primary goal is the same: to give the principal a buffer against potential losses or defects should the contractor not deliver under the contract.
In practice, of course, the taking of, use of, and return of security can get a bit tense when there is a disagreement.
In this article we’re going to take an initial look at the concept of security in commercial building contracts, the types of security that are commonly used, and some of the tips and traps along the way as your contract progresses.
What is Security in a Construction Contract?
Security is money. Specifically, it’s the contractor’s money that the principal has access to and can make a claim on in certain circumstances.
Essentially, the principal holds the contractor’s money in one form or another – usually in an amount equal to 5% of the contract price – until the contractor has delivered the project as required under the contract.
What are the Different Types of Security?
The type of security provided by the contractor will depend on the size and scope of the contract. However, generally, the three most common three types of security are:
- Retention moneys (also called cash retention);
- Unconditional undertakings – bank guarantees and insurance bonds; and
- Parent company guarantee.
Retention moneys, or cash retention, is the simplest type of security that can be provided. This is when a percentage of each progress claim is retained by the principal (eg 10% of each payment claim) until a certain capped amount is retained (eg 5% of the total contract sum).
The benefit of this form of security is that contractors avoid the costs that accompany bank guarantees. Principals also have easier access to the money (as it is already in their bank account).
However, a contractor’s early cash flow on the project is limited by the reduced payments. As a result, contractors need to consider their ability to pay for products and any required subcontractors if a percentage of their claims is being withheld.
One significant risk here for the contractor though is the potential of not being paid that retention back at the end of the contract. In theory many contracts require a principal to quarantine retention funds in a separate account. In practice this almost never happens. As developers have no similar financial requirements to function like licensed builders do, it’s entirely possible that a developer runs out of money just in time for the final claim – having spent the retention. This is a significant downside risk of cash retention, especially if the developer is a special purpose vehicle (a $2 company that exists only for this project). This is another good reason to know precisely who you are getting into business with on your project.
There is legislation in New South Wales and Queensland which regulates how retention monies are dealt with under certain head contracts and subcontracts.
Unconditional Undertakings (no upfront payment)
“Unconditional undertaking” is an umbrella term used to describe bank guarantees and insurance bonds.
Essentially both of these documents do similar things: a well funded third party promises to pay the principal an amount of money on demand. The original document is given to the principal, and all they need to do is to walk into the appropriate venue and ask for the money.
In terms of actually claiming the money, the paying party (usually a bank) is not entitled to question the principal’s entitlement – they must hand over the money on demand.
Of course, the contract itself will have terms about when and how the principal can claim on the security.
Similarly, the bank will usually want some kind of charge over the assets of the contractor before they will agree to issue the security.
Often, two undertakings are given, each for 2.5% of the contract sum, which facilitates an easier return of half at practical completion. The benefit is that undertakings free up cash for the contractors whilst still providing principals with a comfortable level of security that is essentially upfront, but not paid in cash by the contractor.
Of course, on the other hand, a contractor runs the risk of having the security called. If this happens, then the bank will want to be paid back the money it has handed over one way or another, so the flow on effects can be significant in larger projects.
Parent Company Guarantee
Some company structures mean that a lot of a party’s wealth is actually held by their corporate owners – the “parent company”. Normally the assets of the parent company are protected of course, but not if that parent gives a guarantee.
As indicated in the name, the parent company becomes responsible for any defaults by a Contractor under this security – think of it like you are the guarantor of your favourite child’s first investment property.
Of course, for a parent company guarantee to have any value, the parent company itself needs to have the means to support it.
How does a Principal Call on Security?
Calling on, or recourse to, security, means:
- Accessing the funds held in retention;
- Claiming the money from the bank guarantee;
- Calling on the parent company to pay.
Any competent contract that requires security will also usually set out the circumstances in which that security may be called. Some common circumstances include:
- if the contractor fails to pay a debt due under the contract;
- the contractor can no longer perform the contract; or
- there are defects that the principal requires are rectified but which the contractor fails to rectify.
If the contract requirements for recourse are met, the principal can have recourse to the security.
Depending on the contract, the principal may be required to give notice prior to having recourse to security.
Can a Contractor prevent recourse to security?
More often than not, security is claimed in circumstances where there is a dispute about the principal’s entitlement to do so.
If a principal believes it is entitled to claim the security and intends to do so, then the only real way of “forcing” it not to do so is to seek a Court order preventing them from taking that action.
This can be difficult, but it is not impossible. However, the details of such an application are beyond the scope of this article.
Legislation affecting security in Construction Contracts
Security under commercial building contracts in Queensland is governed by the Queensland Building and Construction Commission Act 1991 (Qld). Some of the major provisions to be aware of are:
Set-offs under Building Contracts – s. 67J.
If a principal seeks to use security or a retention amount to obtain an amount owed under the contract, it must give notice of that intention within 28 days of becoming aware of its right to do so.
Limits on retention amounts and securities other than subcontracts– s. 67K.
Where the contracting party under a building contract is the principal, the total value of the retention or security cannot exceed 5% of the contract price.
However, this condition can be contracted out of by the parties if they comply with section 67K of the QBCC Act. The limit can be exceeded for security provided for unfixed plant and materials.
Limits for retention amounts and securities for subcontracts – s. 67L.
The total value of all retention and securities that can be given or retained cannot exceed 5% of the contract price for the subcontract. The limit can be exceeded for security provided for unfixed plant and materials.
Limits on deductions for retention amounts – s. 67M.
Under this section, only 10% of each progress payment can be deducted for retention.
Limits for retention amounts and securities for building contracts after practical completion – s. 67N.
This section affirms the above in relation to unconditional undertakings – only 2.5% of the contract price can be withheld as retention or security after practical completion.
Statutory defects liability period – s. 67NA.
This provision prescribes a statutory defects liability period of 12 months for the release of retention or security on contracts that do not otherwise provide for one and which runs from the date of practical completion.
Change in Legislation that may affect you
Recently, legislative changes have imposed new regulations concerning the failure to pay retention amount and notice about the end of the defects liability period. Be sure to read our article here to check that you are complying.
Understanding the options for providing security, how it works, and the circumstances in which a principal might claim on the security are critical areas for good contract negotiation and administration.
If you need help working through the options, negotiating an alternative, or are in a dispute about recourse to security – we can help. Just reach out here.
Batch Mewing wish to acknowledge the contribution of law clerk Marquessa O’Leary in the production of this article.