Bankers Beware the Long Arm of the Building and Construction Industry Security of Payment Act 1999
Over Fifty Mutual Friendly Society Ltd & Anor v Smithies & Ors  NSWSC 291 demonstrates just how unexpectedly severe the Security for Payments Act (Act) can be for anyone that has an association with a building subcontractor carrying out work for a third party in circumstances where that third party has failed to pay the building subcontractor for the work performed.
The Act is intended to give trade contractors a better deal and to ensure that payments are made on a regular basis to trade contractors during the course of a construction contract. The Act provides a statutory procedure for trade contractors to serve a payment claim on ‘a person responsible for payment under section 13’ (the identification of that person responsible for payment is of course, in the first instance, a matter for the trade contractor). If the payment claim is not paid, the trade contractor may refer it within a short period of time, to an adjudicator who will determine if and how much money will flow from the respondent (the person identified as being responsible for payment) to the claimant (the trade contractor) under section 17 of the Act.
Historically1 there have been numerous complaints about developers, project owners and head contractors who were unscrupulous in compelling trade contractors to fund their projects by withholding money in respect of work properly completed. This approach was often disguised by the principal contracting party raising a dispute or imposing a ‘back–charge’ which the trade contractor was forced to either litigate or, where the non–payment effectively undermined the trade contractor’s ability to continue performance, abandon site and face the risk of being treated as wrongfully repudiating the building contract. Such business practices were claimed to be widespread2 and resulted in financial pressure and insolvency of many trade contractors.
Following the recent Over Fifty Mutual Friendly Society decision, the question could now be asked whether or not the Act has gone too far in making a wide range of people ‘associated with a building project’ potentially liable to pay the trade contractors, albeit on an interim basis, whether or not a cause of action at law exists to support the trade contractor’s claim against the ‘associated’ third party. This is particularly relevant to ‘recognised financial institutions’ who were thought to be protected from the operation of the Act under section 7(2) (a) (Financiers) but who may be caught within an ‘arrangement’ for the completion of a financially distressed project. Indeed, the Over Fifty Mutual Friendly Society decision may have the reverse impact and increase the financial risk and loss to trade contractors from failed projects because financiers wish to avoid exposure under the Act.
ARE PROJECT FINANCIERS EXEMPT?
Section 7(2)(a) of the Act makes it plain that the legislative intent is that the Act would not apply to financiers of building projects. section 7 states:
7 Application of Act
(1) Subject to this section, this Act applies to any construction contract, whether written or oral, or partly written and partly oral, and so applies even if the contract is expressed to be governed by the law of a jurisdiction other than New South Wales.
(2) This Act does not apply to
(a) a construction contract that forms part of a loan agreement, a contract of guarantee or a AUSTRALIAN CONSTRUCTION LAW NEWSLETTER #113 MARCH/APRIL 2007 31 contract of insurance under which a recognised financial institution undertakes:
(i) to lend money or to repay money lent, or
(ii) to guarantee payment of money owing or repayment of money lent, or
(iii) to provide an indemnity with respect to construction work carried out, or related goods and services supplied, under the construction contract.
To the ordinary reader and the financiers in particular this section would bring comfort because they are merely financing a construction project and as such will not be held liable to pay a trade contractor or subcontractor for construction work on the project. Einstein J in Over Fifty Mutual Friendly Society Ltd & Anor v Smithies & Ors  NSWSC 291 has demonstrated that this may be false comfort. Financiers may have to take special precautions to escape the operation of the Act and even then, unless adequately protected, they may have no option but to pay first and sue for recovery of the undue payment later.
Over Fifty Mutual Friendly Society (OFM) is a financier. This fact is normally proven by providing evidence that they are a registered financial institution with the Australian Prudential Regulation Authority (APRA). OFM entered into a series of loan agreements with the principal (borrower) for the purposes of funding a development project in Marrickville.
The loan agreements were standard and provided for the standard rights of a financier in the event of default or breach of the loan agreements by the borrower. The loan agreements were also subject to a first mortgage security over the development site. Having advanced several million dollars for the project the financier became concerned when the reported project costs started to exceed the approved project budget and indicated a substantial requirement for additional funds to complete the project. This was further compounded by reports of delays in the progress of the work indicating that the project would not be completed on time (and that this would be likely to cause a further increase in the project costs).
At the centre of OFM’s concern about the financial status of the project (and of the ability of OFM’s borrower to repay the construction loan) was OFM’s concern about the borrower’s management of the development project through a related (to the borrower) entity. The financier sought to rectify this by requiring that the borrower appoint an independent manager (approved by the financier), as the agent of the principal (borrower), to enable the borrower to meet its covenants under the loan agreements to manage the project in accordance with the project budget (approved by the financier) and to monitor and report progress to OFM accordingly. To ensure that costs were being properly incurred, the services of an independent quantity surveyor (appointed by the borrower) were also engaged to certify that accounts for project costs were properly claimed and were payable in accordance with the relevant contract terms. OFM intended that this provison of additional external project management and accounting oversight would ensure that the finance being provided be used for the loan purpose approved under the loan agreement and would protect or preserve the security for the loan (which would be improved by a completed project rather than a mortgagee sale of an incomplete project). The ‘arrangement’ would also ensure that the loan funds advanced to the borrower’s account would reach those who were performing the works. From the financier’s perspective, the right to put these project management and accounting arrangements in place were all rights that were and would normally be found in the loan documents for construction projects.
An alternative option for OFM, faced with a borrower in default and a project that was likely to exceed the approved project funding level, was for OFM to formally place the borrower in default under the loan agreement and to exercise its rights under the loan agreement and security to wind up the borrower and to sell the incomplete project, leaving the subcontractor with the cold comfort of a concurrent claim in an insolvent estate. Instead the act of prudence and benevolence to save project became the hook upon which the adjudicator and the Supreme Court found that the financier was bound to pay the trade contractors first and sue later. The path taken demonstrated the vulnerability of the financier and a fairly tortured approach which is focused on paying the subcontractor perhaps at the cost of legally defined principles which commercial parties assume will apply to their agreements and conduct.
The newly appointed independent professional project manager would be engaged by the borrower and funds for that engagement would be approved for payment under the project loan facility. To give further assurance to the project manager, arrangements were made for OFM to pay the project manager’s fee directly.
The agent of the principal informed the subcontractors that additional finance the project has been obtained. To address a previous problem where payment was made to the subcontractors from various different accounts, making a reconciliation of the claims difficult, OFM agreed to make payments which had been approved by the principal’s agent and certified by the appointed certifier, direct to the subcontractors.
The subcontractors were reminded that all their rights and obligations with the principal still remained on foot in accordance with the subcontracts concluded between each subcontractor and their principal contracting party.
GUILTY BY ‘ARRANGEMENT’
Notwithstanding OFM’s efforts to save the project, the principal (borrower) was unable to complete the project within the parameters of the provision of the additional finance. The head builder was placed into insolvency. The developer (borrower) appears to be without means to pay (and has no contract or other legally binding agreement with the trade contractors). The subcontractors turned to OFM for payment and in an adjudication application persuaded the adjudicator to direct the financier to make payments to the subcontractor on an interim basis alleging that the financier was the subject of an ‘arrangement’ under section 4 of the Act.
OFM submitted that Okaroo Pty Limited v Vos Construction and Joinery Pty Limited & Anor  NSWSC 45 (11 February 2005) is authority for the proposition that an ‘arrangement’ (for the carrying out of construction work) was to be read consistent with relationship of ‘construction work carried out under a contract’ even if all the levels of formalities of a contract were not present. That view was rejected. ‘Arrangement’ under section 4 of the Act could be something less than a contract. It could be the existence of circumstances giving rise to a right to claim payment on a quantum meruit basis but it also could be something less than a claim for restitution. Indeed, it appears that an ‘arrangement’ under section 4 of the Act could be something that did not constitute a legal cause of action. Nicolas J held that:
… the word ‘arrangement’ is apt to describe something less than a binding contract or agreement, something in the nature of an understanding between two or more persons—a plan arranged between them which may not be enforceable at law. (Newton v Federal Commissioner of Taxation (1958) 98 CLR 1 at p 7).
After spending money and court time on litigation the financier may get the money back. As it stands, it appears the interim regime under the Act is less concerned with a legally enforceable right (for the recipient to receive the payment from the payer) than it is with the directing of payment of money to an unpaid trade contractor or subcontractor.
The risk to financiers is that an ‘arrangement‘ is an amorphous term which can and will be used by an adjudicator to give effect to the perceived objects of the Act which is a direction to pay an unpaid or short–paid trade contractor or subcontractor. At the conclusion of the negotiations for the construction loan agreement (before the project commences) the financier may feel confident that they are protected by the words of the project finance agreement from any third party liability to the trade contractors or subcontractors that may be engaged to carry out the project. The loan agreement (and mortgage and other security agreements) will however, not make the financier immune to liability under an ‘arrangement’, that may be made at any time before or after the loan agreements are made, ready to make liable any person who can be said to have that loose association with the subcontractor with the trade contractors that carry out the construction work for the project.
No contract or term of the contract which attempts to ‘oust ‘the Act is valid. Section 34 of the Act provides:
34 No contracting out
(1) The provisions of this Act have effect despite any provision to the contrary in any contract.
(2) A provision of any agreement (whether in writing or not):
(a) under which the operation of this Act is, or is purported to be, excluded, modified or restricted (or that has the effect of excluding, modifying or restricting the operation of this Act), or
(b) that may reasonably be construed as an attempt to deter a person from taking action under this Act,
An ‘arrangement’, allegedly between the financier and trade contractors carrying out the work, is more than likely to be an after loan contract event and is likely to involve different parties. Precautionary loan agreement terms that attempt to exclude the risk of this liability for the financier are unlikely to be effective. The Act provides that the loan agreement is outside the operation of the Act. Provisions that attempt to go further than to exclude ‘other liability’ exposure for the financier are likely to offend section 34 of the Act.
Further, even if the financier adopts new forms and procedures to address this risk for their ‘problem loans’ the terms of any deeds or agreements with third party trade contractors will need to ensure that the financiers’ conduct stays within the ‘project finance arrangements’ and does not intrude upon the ‘arrangements for the carrying out of the construction work’ otherwise it will offend section 34 and be void.
WHEN IS AN ARRANGEMENT ‘PART OF’ A LOAN AGREEMENT
One would assume that section 7(2) (a) of the Act has its own remedial operation to protect project financier and to ensure that project finance is not made more difficult to obtain or more expensive. If a challenged ‘arrangement’ (between a financier and its borrower, including consultation with affected trade contractors) is part of a loan agreement then the Act should not apply.
However, because a financier will normally have concluded its finance documentation (with the borrower only) prior to the project, the likelihood is that an alleged arrangement affecting trade contractors or subcontractors on a financially distressed project (which would not be a contract or recognised cause of action between the financier and the trade contractors or subcontractors) will arise after the loan and security documents are signed. A material argument would automatically be that the ‘alleged arrangement’ could therefore not be part of the (earlier concluded) loan agreement.
Whilst the statutory language appears to capture all forms of ‘arrangements’ for the carrying out of construction work, the exclusion of ‘loan agreements’ only extends to matters that form ‘part of’ the loan agreement. This appears to be much more limited.
In the OFM adjudication the adjudicator did not refer to the loan documents. The loan agreements were complex and addressed non construction finance law matters. The trade contractor/subcontractors were ‘strangers at law’ to the finance agreements. The loan agreements of course are a matter of private agreement between the financier and the borrower. In these circumstances it would be expedient for an adjudicator to find that the ‘arrangement’ was not part of the (largely unknown and private) loan agreements between the borrower and the financier. That is indeed what the adjudicator said in the OFM matter.
CHALLENGING THE ADJUDICATORS AUTHORITY
A decision under a statutory power by an adjudicator that ‘consultation by a financier with trade contractors in the context of an agreement by the financier to advance additional funds to a borrower’ that fails to address in a reasoned manner whether or not the consultation (or other actions) formed ‘part of’ the loan agreement, would violate the rules of natural justice. The decision maker has failed to address a relevant matter in a reasoned and transparent manner. Unfortunately, under the scheme of the Act, that is a submission without force, particularly if the adjudicator says he or she has considered the matter or even ‘all the matters’ (without identifying them) raised in the adjudication response which would include the financier’s submission that the arrangement (if any is found) is part of a loan agreement; see Downer Construction (Australia) Pty Ltd v Energy Australia  NSWCA 49. The scheme of the Act is to provide authority for an adjudicator to decide quickly and to make some errors. The Act provides no right of appeal and the courts will permit only a limited right of review. The statutory scheme is that adjudication decisions are interim decisions and, where a payment is directed, the financier must pay and sue to recover the payment if the financier is aggrieved that it has no legal liability to the recipient for the payment. It is conceivable that a financier who has never engaged in any discussion or negotiation with a subcontractor (and importantly does not know his financial status) may be adjudged to have been party to ‘an arrangement’ for the carrying out of construction work because the financier exercised step–in rights contained in the project finance documents and issued directions (as authorised attorney or agent for the borrower) to trade contractors or to subcontractors.
In Consolidated Constructions Pty Ltd v Ettamogah Pub  NSWSC 110 (11 March 2004), McDougall J held at 
As a matter of ordinary English usage, something may be said to ‘form part of’ another if the first thing is included or incorporated within the second. The first thing may form part of the second as a result of some natural process or as a result of some artificial process (for example, a process of manufacture). In general terms, the words ‘forms part of’ seem to me to connote something akin to inclusion, as opposed to association. In a particular case, however, it may be difficult to discern the point at which association changes to inclusion: that is to say, the point at which one thing may be said to form part of, rather than merely to be associated with, another.
With respect to the learned judge this narrow definition of ‘part of’ was perhaps more convenient than apt. Generally ‘a part’ is any of the components of a whole that ought to be, whether by inclusion or association. His Honour’s definition is not very helpful in determining whether a financier’s actions to enforce the covenants of a loan agreement are ‘part of the loan agreement’ or merely associated with a loan agreement. McDougall J‘s interpretation provides scope to the adjudicators to find that steps taken by a financier under a loan agreement do not form ‘part of’ he loan agreement. Thereby ends the protection of 7(2)(a) of the Act for the financier.
In Corbett Court v Quasar  NSWSC 1174 (25 November 2004) McDougall J considered the question of whether or not a deed constituted a loan agreement and concluded that because the deed did not give the financier a right to make direct payments (of loan funds) to subcontractors, such conduct by the financier constituted an ‘arrangement’ outside the purview of the loan agreement contemplated in section 7(2)(a) of the Act. Whilst the judicial analysis on this issue is sparse, it appears the courts will not be minded to allow the exclusion of loan agreements and arrangements that form ‘part of’ such loan agreements to be widely applied or construed.
Even where an adjudicator wrongly finds that the arrangement is not ‘part of’ the loan agreement,the financier’s rights of redress are few. The most likely outcome is that the court will require that the financier pay the claimed amount to the unpaid subcontractor (as a payment under the Act) and sue to recover the amount in separate proceedings. In the Over Fifty Mutual Friendly Society Ltd case Einstein J at paragraph [19(v)] adopted the claimant’s submissions and said:
It is clear that an error by the Adjudicator in determining that an ‘arrangement’ existed [and thus a ‘construction contract’ within the definition in s 4 does not vitiate the Adjudication Determination.
His Honour also referred to John Holland v RTA  NSWCA 19 at ;  and  where Hodgson JA observed that a mere failure by the adjudicator through error to consider a provision of the Act, the contract or a submission does not invalidate the adjudication determination and that an omission by the adjudicator to consider a submission could not even conceivably justify a finding that the adjudicator did not make a bona fide attempt to exercise the relevant power.
In Downer Construction (Australia) Pty Ltd v Energy Australia  NSWCA 49 it was held that an adjudicator is required to make a determination within the parameters of the payment claim, but the determination of the parameters of the payment claim is a matter for the Adjudicator and a reasonable but erroneous decision does not invalidate the adjudication determination.
UNDERSTANDING THE ADJUDICATORS TASK
The manifest unhappiness that exists in the industry relating to the quality of the decisions of adjudicators perhaps arises out of a misunderstanding of their task and the objectives of the Act.
Adjudicators are not judges and in some circumstances they are not even lawyers of any significant judicial standing. They are called upon within a short space of time to make a decision on matters generally involving complex matters of law and fact. Anyone who has ever been concerned with a construction dispute will know how difficult those cases are and will be aware of the mountains of paper that have to be carefully read to properly present a construction case which can take weeks of evidence to resolve.
The adjudicator does not have this luxury. Adjudicators are put under enormous pressure to make a finding, encouraged by the notion that the Act is there to ensure that money flows to the entity that has performed work. Their function is how much money should be paid, rather than whether money should be paid. The system, it is said, will permit the debate of the latter question in another forum. For that reason the payment is at best an interim payment that may not even be predicated upon a recognised cause of action.
The adjudicator’s task is reinforced by the following principles reiterated by Einstein J in OFM (supra):
(a) The Act is intended to ensure that disputes are resolved quickly and with minimal opportunity for court involvement: Brodyn Pty Ltd t/as Time Cost and Quality v Davenport & Anor (2004) 61 NSWLR 421.
(b) The Act reflects an understanding that cash–flow is the life blood of the construction industry: Amflo Constructions Pty Ltd v Jefferies  NSWSC 856 at .
(c) The Act requires a respondent to ‘pay now and argue later’: Multiplex Constructions Pty Ltd v Luikens  NSWSC 1140.
For these reasons judges are reluctant to permit exceptions to the general rule that adjudication determinations are final and not open for review by the court because the parties can commence separate proceedings to determine the substantive issues: Shell Refining (Australia)
Pty Ltd v AJ Mayr Engineering Pty Ltd  NSWSC 94 at  where it was held that overwhelmingly the weight was against the grant of an interlocutory injunction and that relief is only available where rights will be rendered nugatory and where an entity will suffer irreparable prejudice.
The exclusion of the recognised financial institution from the operation of the Act is perhaps more theoretical than real. The system of adjudication under the Act undermines of the exclusion of loan agreements by recognised financial institutions under section 7(2)(a) of the Act.
The path taken by Einstein J in Over Fifty Mutual Friendly Society Ltd & Anor v Smithies & Ors  NSWSC 291 will result in a financier having to closely monitor his choices in a distressed project. It may be more prudent to wind–up the project as step–in rights may be treated as an arrangement under which the financier may obtain an undertaking from subcontractors to carry out construction work for the financier rather than the normal prudent business approach of a financier acting to ensure that loan funds are properly used (not diverted) and the integrity of its security (upon which the financier’s investors rely) is maintained. This will make all financier’s vulnerable to a fairly tortured one–sided approach focused on ordering payment to unpaid trade contractors by who–ever has means to pay without regard to the absence of a contract or other legally binding agreement between the financier and the party carrying out the work.
The answer perhaps lies in revisiting the project financing documentation (subject to constraints under section 34 of the Act) and in ensuring that all conduct, when exercising step in rights in the event of defaults or poor performance of a borrower, is clearly documented and communicated as steps taken under and as part of the loan agreement between the financier and the borrower. Acknowledgements from subcontractors that they have been advised that this is happening and that the financier is not assuming any role or liability in relation to the carrying out of construction work will assist in managing the financier’s exposure to liability under the Act but will not eliminate such risk of liability.
Alternatively the big end of town should visit Canberra. This is a debate for another day.
1. The immediate background for the Act in NSW was an October 1996 Government Green Paper entitled ‘Security of Payment’. That paper initiated a debate that culminated in a reform package in February 1999 that included the tabling of a Bill for security of payment modeled on UK legislation.
2. In Tasmania (which is considering the adoption of similar legislation), in a June 2006 report ‘Security of Payment in the Tasmanian Construction Industry’, a survey conducted by the authors of the report found that 43% of the surveyed industry participants had suffered security of payment problems in the last financial year and the late payment, partial payment or non–payment of payment claims had seriously impaired the financial position of about 25%.
3. Most subcontractors were engaged by subcontract to a head contractor party (now insolvent). The head contractor was engaged by contract to OFM’s borrower.
4. See also Taylor Projects Group Pty Ltd v Brick Dept Pty Ltd & Ors  NSWSC 571; Grosvenor Constructions (NSW) Pty Ltd (in admin) v Musico  NSWSC 344; and Herscho v Expile Pty Ltd  NSWCA 468