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Welcome to the first edition of Build Up.

Our focus is on keeping you up to date on the latest commercial property industry developments and the advocacy we do on your behalf.
Every edition we’ll provide independent expert analysis and commentary on topical issues from our research partner, Sense Partners.
In this edition we also have Hazelton LAW discussing the recent Mainzeal judgment and the key learnings construction company directors need to consider. 

Construction Sector Accord:
A potential step change

Over the last few months I have been part of the Accord Development Group. It’s been a positive opportunity to work alongside other industry leaders to partner with Government to make real change in our sector. We all understand the issues facing commercial and residential builders – the Construction Sector Accord is a first step towards addressing them. The Accord establishes a set of behaviours and values which all parties agree to uphold. We see these as being the ‘rules of the game’ moving forward and I’d like to see them widely promoted to help improve the sector’s culture. 

The Accord is the first stage. Now, the Government and the Development Group will work with a wider group of sector leaders and representatives (clients, contractors, sub-contractors, and suppliers e.g.) to develop a work plan. The plan, which the Government will release later this year, will have a set of agreed actions to deliver the Accord. We will be working with the Government to ensure progress on these actions happens. 
We will keep you fully informed and we’ll be seeking your views once the Government releases the work plan. More Accord information is available at here.

Providing sector leadership: the Vertical Construction Leaders Group 

We’ve all seen the plight of larger construction companies dominate the news. While the vertical construction sector is facing numerous challenges impacting its health, viability, and reputation, we have been working behind the scenes in seeking to address these. Our Vertical Construction Leaders Group, made up of the CEs and senior managers of New Zealand’s major construction companies, has been working with KPMG to develop a sector strategy. 

The strategy seeks to address these challenges through a sector led approach. We believe it’s crucial for the ongoing reputation of the sector we acknowledge existing challenges and proactively address them. This requires a shift in how the sector works. The risks of company failures, a further damaged reputation and much needed commercial developments failing are too great. We need to work better and smarter to deliver a better performing, stronger, and more sustainable sector. We will keep you up to date when we release the strategy. 

Reform of vocational education, a good thing? 

Members have mixed reactions towards the Government’s proposed vocational education system reforms. Some are applauding the fixing of a broken model. Others have concerns about the proposed system and the risk of “Wellington bureaucracy” driving training without industry involvement. 

Member feedback was critical in the development of our submission. There was universal agreement the vocational education system is under achieving and not delivering the industry training employers or learners expect or require.

 I’m adamant we cannot continue to have a system where:
the current competitive funding model has a perverse outcome where polytechnics base course decisions on funding rather than learners’ and sector needs
polytechnics are teaching the same courses, often at standards below what industries require
some industry training organisations look after training across a vast range of unrelated sectors
There are 4 training organisations responsible for construction sector learning, this reduces integrated sector thinking.

We support the merging of the polytechnics. One new institute provides an opportunity to get better investment outcomes by streamlining courses, focusing on quality education-not “bums on seats” and aligning courses with regional needs and aspirations. We recommended keeping the industry training organisations, but reducing them to six, reflecting the existing vocational pathways. We also supported giving them the additional functions of setting vocational education standards, moderating end of study assessments and contributing to course developments. This approach would strengthen the role the sector plays in training learners, which we believe will assist in improving education outcomes. 

We are working with other associations and organisations to ensure the reforms do not compromise the education of the 27,000 construction sector learners or hinder businesses who take on apprenticeships. 


Credit crunch makes banking relationships the new health and safety

By Kirdan Lees, Sense Partners
Construction is booming. But just as additional projects are needed, both bank and firm-level data show credit conditions are tightening, putting the boom at risk. Regulators could do more to lift competition in loan markets but don’t expect government to take on banks’ credit intermediation role. Companies need to plan access to project finance and working capital to ensure they can continue to operate effectively. 

Access to credit limiting efforts to meet demand

It’s a paradox. Construction is booming – more sites, more projects and more investment than ever. But many construction firms report difficulties accessing both the project finance needed to get new projects off the ground and the working capital to keep existing efforts ticking over. The issue is not new. Survey data – both from lenders and borrowers – show a general decline in access to credit over the past five years, with a marked tightening over the past two years. Figure 1 shows bank managers’ assessment of general conditions. Figure 2 shows construction firms’ reported difficulties accessing credit. 

Question: “How has the availability of commercial property credit from your institution evolved over the past six months?  Do you expect any changes over the next six months?


*Responses are a weighted average across banks (i) tightened significantly (=-100); (ii) tightened somewhat (=-50), (iii) broadly unchanged (=0), (iv) eased somewhat (=50), (v) eased significantly (=100).

The construction sector is not alone. Other sectors face similar difficulties accessing credit (see Figure 3). And Figure 4 (construction or building loans) and Figure 5 (real estate or property development loans) show finance is still available for the sector.


But unlike other sectors, finance is the life-blood of construction. Below we dig a little deeper on the nub of the problem, the outlook and what might be done to improve access to finance.

A tricky problem to resolve

From the firm side, demand for construction projects has caused input prices to surge as suppliers and contractors struggle to keep pace with demand. Prices have jumped but have also been volatile. 
This has made it hard to accurately price projects, increasing variability into bid pricing so more low-price and high-price bids are on the table. 

Poor procurement practices add to the problem. Lower price bids with higher default risks have won out over higher price bids, with procurers paying insufficient consideration to the risks associated with bids with razor sharp margins in such a volatility pricing environment. When unforeseen events force firm closures, the supply chain suffers.

From the bank side, managers don’t just see a firm-specific construction project, they run through how the new project affects their entire portfolio of loans. 
Banks are unwilling to double-down on firms that have:
smaller balance sheets
poor internal processes or a lack of managerial experience and expertise
limited track record in trading through a variety of market conditions
concentrated activity in a particular sector of the market
concentrated activity in a particular location of the market.

One unintended consequence for New Zealand from the Hayne Royal Commission into misconduct in the banking, superannuation and financial services industry, has been a general tightening in lending right across the economy. Recent firm failures only incentivise bank managers to run the ruler even more carefully over new projects. 

The credit crunch has different impacts that depend on the scale of firms:
Larger firms with established track records can access some finance but find marked reductions in the quantity of finance available that takes big projects off the table
Mid-size firms that don’t own land require an ever-increasing fraction of pre-sales to access financing for multi-home projects
Small regional builders use their residential mortgages as a line of credit.

Construction credit can be available but it’s not all about each individual construction project – it’s what best fits the lender’s portfolio requirements and overall risk appetite. The construction sector tends to have larger projects that come under more scrutiny than other sectors with small- to mid-size projects – projects for which banks can diversify away the risk. So what to do? The economy and New Zealand’s under-served infrastructure are the poorer in the absence of a well-performing construction sector.

What can government do?

Banks are extremely useful intermediaries, transforming many short-term liabilities (deposits) into assets (the loans that fund productive enterprises). That makes it easier to match people with funds to invest with projects that need investing. And banks’ experience means they are more adept than others at sorting good loans from bad. So, don’t expect the government to step in and back the sector carte blanche. That sets up all the wrong incentives. Taxpayers effectively end up underwriting contracts with no accountability mechanism to differentiate between viable projects and projects that use resources poorly. 

But the Reserve Bank of New Zealand has a governance role here acting as Tāne Mahuta – the big tree of the banking system. They need to balance the stability that comes with conservative lending practices against the need to create the space for firms to flourish by accessing credit. And regulators could do more to improve the intermediation of funds by:
Improving information: We know a little but not enough about the loans that don’t get funded and the loans that comprise the $110 billion worth of construction and property development loans on banks’ books. More detailed size and regional information would shine a light on credit availability – without which it’s simply too easy for banks to make blanket statements about idiosyncratic risks and limit credit.
Lifting competition: Under UK legislation, banks that turn down loan applications are required to pass the application on to a competitor, applying some heat to the market. Introducing additional funding channels, such as project bonds, large savings and investment funds, or international investors, into the market would also help. 
Promoting technology, such as open banking, where information on clients is standardised and shared, could be used at the smaller end of the market.

These improvements could help free up access to finance, offsetting the trend towards reduced lending due to higher capital requirements for our banks. Figure 6 shows the Reserve Banks’s proposed path to higher capital requirements against current capital ratios.

Lending to the construction sector stand today at about $106 billion. Without change in practice, increased capital requirements imply banks need to reduce lending by $17 billion given their leveraged position. But as the Reserve Bank points out, banks could retain earnings or raise more capital, reducing the impact on lending.

* Systemically important banks.

What can construction firms do?
With a trend toward tighter credit constraints, firms need to keep on top of financing. The trend is for tighter constraints, but firms have time to get their ducks in a row before the impact of tougher capital controls start to bite.

Understanding how specific construction projects fit the bank portfolio of lending will be crucial so talk with bank managers. Those with stronger balance sheets, well-known assets, smaller, diverse liabilities and experienced well-regarded directors will have greater chances of accessing the credit needed. 

This all points to the importance of proactively building relationships with lenders. Getting close to bank managers and understanding risk from their viewpoint will be critical. Raising capital can be a tiring exercise. Hiring in external advisors for a helping hand may be rewarding. See this as a medium-term investment in your future operations, rather than a short-term operating cost. 

Overall, the key message here is that a business-as-usual approach will not be enough when it comes to addressing your financial health. Just as health and safety requirements have transformed the industry, you will need to devote greater resources to securing credit and working capital in the next few years. Otherwise access to finance risks being the one thing that trips you up.


Reckless trading- the Mainzeal judgment

Sarah Martin Solicitor and Andrew Hazelton - Partner Hazelton Law 

The recent judgment in Mainzeal Property and Construction Ltd (in liq) v Yan [2019] NZHC 255 involved 12 causes of action and a complex factual background.  This article focuses on just the first cause of action: the allegation that the directors breached their duty under s 135 of the Companies Act 1993 not to trade recklessly.  This was the only cause of action where the Court made comments about the construction industry in general. 

Mainzeal was a part of the Richina Pacific Group and allowed companies in the Group to extract funds from it on a number of occasions to acquire lucrative assets overseas.  Mainzeal was therefore owed significant amounts of money by other companies in the Group.  It continued to trade in this state, using the funds paid to it by principals before paying its subcontractors. 

Mainzeal relied on assurances from the Group that financial support would be provided if needed. However, these assurances were vague, infrequent and not legally enforceable. The Group also went through two restructures, one in 2008-09 and one in 2012. These restructures separated the New Zealand and Chinese divisions of the Group and meant that the loans given by Mainzeal were owed by New Zealand entities that did not have the means to pay them back.  The Group still did not provide a legally enforceable assurance that the loans would be paid.  Furthermore, stringent Chinese regulations meant it was unlikely that the Chinese entities could have provided financial support to Mainzeal.

In 2012, Mainzeal began to experience significant cash flow issues due to disputes over a large construction contract with Siemens.  Around this time, it was also involved in several leaky building claims.  Mainzeal continued to trade until BNZ suspended any further advances on its facilities.  It was placed into liquidation on 28 February 2013.

The Liquidator claimed that the directors were in breach of their duty under s 135 of the Companies Act 1993 not to trade recklessly. The Act requires a director not to agree to carry out business in a manner likely to create a substantial risk of serious loss to the company’s creditors or cause or allow the business to be carried out in this way.

The Court emphasized the following features of s 135:
Merely trading while the company is insolvent does not breach s 135. Nor is it concerned with normal business risks taken by a company. There must have been substantial risk of serious loss to its creditors.
A “substantial risk” to the creditors means a major or large risk of the company going into liquidation with a deficiency. Furthermore “serious loss” requires there to be a serious deficiency in liquidation rather than a minor or modest loss. This is a reasonably high threshold.
Section 135 is concerned with the risk to creditors, not the company. A substantial risk of serious loss to creditors will arise when potential insolvency is in issue. When this occurs, any risks the directors take risk the creditors’ funds rather than the shareholders’ capital.
When the company enters a difficult period, the directors must make ongoing sober assessments of the company’s likely future income and prospects.
There must be a causal link between the manner of trade and the substantial risk of serious loss to the creditors.
Section 135 is assessed objectively.

The Court summarized this section by stating:
The manner of trade must give rise to a substantial risk of company failure causing a deficiency in liquidation resulting in serious loss to creditors. Alternatively, the section can also apply if failure is already likely, but the manner of trade creates a substantial risk of additional serious losses to creditors on the liquidation.

There were three key factors which led the Court to decide the directors had breached their duty not to trade recklessly:

Mainzeal was trading while balance sheet insolvent as it was owed significant amounts of money and was unlikely to be able to recover these debts;
The directors could not reasonably rely on the assurances of Group support; and
Mainzeal’s financial trading performance was generally poor and, as it was a construction company, prone to significant one-off losses. This meant that, to avoid collapse, it had to rely on a strong capital base or equivalent backing. It had neither.

The Court noted that while the directors’ decision to trade while insolvent is the source of their breach, this would not have been as problematic if Mainzeal had reliable Group support or a strong financial trading position. However, it had neither.

The first key factor was the directors’ policy of trading while insolvent. The Court accepted that Mainzeal was balance sheet insolvent from as early as 2005. Balance sheet insolvency is when a company’s liabilities are greater than its assets. Mainzeal was owed substantial amounts of money by other companies in the Group. However, the Group had been re-structured so that the companies that owed the debts were unable to re-pay them. Furthermore, the Group had never given any legally-enforceable commitments to repay the loans.

The Court emphasized that continuing to trade while balance sheet insolvent does not necessarily establish a breach of this duty. The directors could be satisfied that the creditors were properly protected by other means while the company was trading in this position.

However, Mainzeal traded using their creditors’ funds. The Court stated that it is a:
“recognized feature of the construction industry that companies are able to obtain payment from contractual principals in advance of paying sub-contractors. This very significant cash flow advantage existed for Mainzeal and gave it what was effectively working capital. But this working capital comprised creditors’ funds – Mainzeal was literally trading with the sub-contractors’ money. This money was at risk in place of share capital.” 

The second factor which led the Court to find a breach of s 135 is the reliance that Mainzeal placed on the Group for support.  The Court stated that a company may place reliance on the support of the wider Group. However, whether this constitutes a breach of s 135 depends on the circumstances. In the present case, Mainzeal’s reliance on the Group was inappropriate. The expressions of support were unclear, conditional, not legally binding and limited by stringent Chinese regulations.

The third factor which established a breach of s 135 was Mainzeal’s trading performance.  The Court described this as “unpredictable and generally very poor”. In assessing this, the Court focused on Mainzeal as a construction company. It noted that “construction was a difficult business” and that companies operate on very small margins. They are also susceptible to large one-off losses. When a problem arises with one contract it can put significant financial pressure on the whole company. Also, by 2010, there were a number of significant leaky building claims made against Mainzeal. Significant liability can arise for companies involved in these claims and Mainzeal had not adequately provided for the potential associated costs.

The Court also touched on a few additional factors that were relevant to a breach of s 135.  While directors may rely on their auditors’ advice, there are limits on how much they may do so. The directors did not take external legal advice even though they were facing a number of legal issues. They were also too focused on how the company’s business operations were progressing and did not give the same attention to its structural and governance risks. Lastly, Mainzeal’s creditors would not have understood the vulnerable position the company was in. It was a well-established company, chaired by a former New Zealand Prime Minister and part of the Richina Pacific Group. The creditors would have viewed that it was at low risk of failure.

In summary, directors of construction companies should be aware of the following points coming out of the Mainzeal judgment:
In considering whether a director has breached its duty not to trade recklessly, a court will objectively assess whether there has been a substantial risk of serious loss to creditors.
Trading while insolvent does not necessarily constitute a breach of this duty. A company could do so while also providing adequate protection to its creditors. However, the Court decided that Mainzeal had not done this as it was trading using the funds it owed its subcontractors.
The Court also noted that construction companies operate on very small margins and are susceptible to large one-off losses. These factors contributed to the Court’s finding that Mainzeal’s trading performance was poor and unpredictable, thus causing a substantial risk of serious loss to creditors.

The directors have stated they are appealing the judgment, so the Court of Appeal will revisit the matter next year.

*this article is not intended to be legal advice nor is it a substitute for taking your own legal advice, no liability is accepted by the authors or RMBA for anyone relying upon the information in this article.

Feedback and content suggestions are always welcome

Please contact Alex Voutratzis
Registered Master Builders Policy and Advocacy Manager 04 385 8999, 0800 762 328

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