By Ariana Stuart, senior associate, and Anna Cho, associate – Dentons Kensington Swan
The Construction Contacts (Retention Money) Amendment Bill (Bill) passed its first reading on August 6, 2021. It is currently with the Select Committee with a report due on November 25, 2021. The Bill will strengthen and clarify the retentions regime under the Construction Contracts Act 2002 (Act). However, not all retentions are held by way of money in a trust account. This article looks at another mechanism for retentions – a contractor giving a bond in lieu of retentions and the advantages of doing so.
Retentions regime – upcoming changes
The receivership of Ebert Construction exposed several shortfalls of the Act’s retentions regime:
• Retention money was not required to be held in separate trust accounts, and could be co-mingled with other money (such as working capital).
• Co-mingling increased the risk that retentions could not be easily identifiable in the event of insolvency, and that retention money be used as capital.
• There were no penalties for non-compliance with the retentions regime.
The Bill proposes significant changes to the existing retentions regime, including that retentions must be:
• Placed on trust as soon as possible by a contractor for a contractor;
• Held on trust separately from other moneys or assets of the principal;
• Held in trust account in a registered bank in New Zealand or in the form of complying instruments.
The Bill also introduces several changes, which we have covered previously in the September/October issue.
What is a bond in lieu of retentions?
Instead of a principal withholding retentions from each monthly payment cycle from the contractor, a contractor would provide a bond in lieu of retentions (or a retentions bond).
A retention bond is a complying instrument under section 18FB of the Act. It is taken out for each construction contract and covers the total amount of retentions to be held on that project. The retention bond avoids the need for a head contractor or principal to hold funds as per the requirements of the Act, while still complying with the requirements of the Act.
When considering whether to opt for a retentions bond, you should consider what form of bond to use (bank or insurance) and the type of bond to use (conditional or on-demand).
Bank bonds and insurance bonds
A bank bond (also known as a bank guarantee) is an undertaking given by a bank to pay an amount on demand to the named beneficiary (the principal or head contractor). These are arranged by the contractor, who must satisfy the bank that it can repay the bond, plus interest, if the bond is called upon by the beneficiary (principal). Banks will take security from the contractor (which is typically in the form of cash in bank or secured property).
On the other hand, insurance bonds are insurance products for which a premium is paid and cross-indemnities are given. Insurers offer a bond facility up to a nominated amount to cover forecast retentions holding over the next 12 months, and on expiry of this period, the contractor needs to gain an extension to the existing bond or reapply for a new bond.
On-demand bonds or conditional bonds?
Bonds can be ‘on-demand’ or ‘conditional’. Conditional bonds set out conditions that the contractor must meet before the bond can be released, i.e. if the contractor fails to meet its obligations, then the bond cannot be released back to the contractor. On-demand bonds have no such conditions and the bond can be released immediately when requested in writing, without needing to satisfy any preconditions. Conditional bonds are generally preferred and is more commonplace – the standard NZS3910:2013 form of bonds are drafted as conditional bonds.
Advantages for principals and head contractors
Retention bonds provide the same security to a principal as withholding retentions do. In the event that a contractor fails to comply with obligations under the Contract (for example by failing to rectify defects), the bond (be it on-demand or conditional) can be called on to provide funds in order to pay for another contractor to remedy any outstanding defects. Another key advantage is that retention bonds are easy to specify in contracts and they expire when the defects notification period ends, so there is no administrative burden or additional paperwork required.
Advantages for contractors and subcontractors
Bonds in lieu of retentions provides certainty over cashflow as the contractor will be paid for all work completed in the prior month with no deductions for retentions, and reduce the risk of losing retentions in the event that the principal or head contractor becomes insolvent. While subcontractors must pay the premiums, these premiums are considered well worthwhile given the cash flow certainty and financial stability.
NZS3910:2013 and retention bonds
NZS3910:2013 allows for the contractor to provide a bond in lieu of retentions. The retentions bond would be provided in a form. If a retentions bond can be provided, some consideration is required to amend the contractor’s bond provisions too, particularly the mechanisms on how the bond can be called on, and partial and full release of the bond.
Conclusion
When the retentions regime came in under the Act on March 31, 2017, there was an increase in use bonds in lieu of retentions. With the impending changes and broadening of obligations under the Act, we expect to see greater use of bonds in lieu of retentions, as these are ‘simpler’ to deal with. However, some parties may not accept a retentions bond and prefer retentions as retentions encourage cash flow for the project.
While NZS3910:2013 provides for bonds, it does not adequately deal with a number of issues and requires significant and often complex amendments. The current review of the NZS suite of construction contracts provides potential avenue for considering and addressing these matters, and providing general clauses on bonds in lieu of retentions.