ACLN· Issue #45 36

1--------------- Insolvency------------------I

Construction Contracts and Insolvency ­Problems, Effects and Answers

- Pamela Jack, Partner,Phillips Fox, Solicitors, Sydney.

CONSTRUCTION CONTRACTS AND INSOLVENCYThe primary concern of any party engaged in

commercial activity is to ensure that they are paid.The financial viability of those with whom we do

business is crucial to our financial success. So how can weprotect ourselves, or at least insulate our businesses fromthe financial difficulties of others?

Certain methods have been developed in theconstruction industry to deal in some way with financialinstability such as:

• rights of termination;• payment for and rights to unfixed materials;• title retention clauses;• security for performance.

1. TERMINATION CLAUSESMost standard form construction contracts used in

Australia contain provisions which enable either party tothe contract on the other becoming insolvent, to terminateor take some other step which may bring the contract to anend.

It is useful to examine some of the standard fonncontracts to see the provisions relating to insolvency.

JCC-D 1993Under the standard JCC-C&D 1993 contracts, specific

provision is provided for determination of insolvency.Clause 12.01 provides that if a party:• has an execution levied against that party;• is made bankrupt;• enters or attempts to enter into composition or

arrangement with that party's creditors;• has a winding-up or dissolution order made;• except for the purposes of reconstruction, passes or

attempts to pass a resolution for winding-up ordissolution;

• has a provisional liquidator appointed;• becomes a party to the appointment of or has a

manager or receiver appointed for the whole or anypart of that party's property or undertaking; or

• becomes a party or attempts to enter into any

composition or scheme of arrangement,

then the other party may at any time, by written noticedelivered by hand or sent by Certified Mail, determine thebuilder's employment under the agreement.

The provisions of this clause do not deal with thesituation of appointment of a voluntary administrator.Such an appointment would not entitle the other partyunder this contract to terminate.

Contractor's InsolvencyUnderClause 12.05, the consequences ofdetermination

by the Proprietor are listed. The following rights andliabilities are of note:

• the Proprietor may employ and pay other persons,whether in the employment of the Builder or not, tocarry out and complete the works (Clause 12.05.01);

• the Proprietor or architect may require the Builder,within 10 days from determination, to assign to theProprietor without payment, the benefit of anyagreement for the supply of any materials or goodsand/or for the execution of any work under thecontract (Clause 12.05.02); and

• until the completion of the works, the Proprietorshall not be bound to make any further payment tothe Builder. After completion, the Architect shallascertain costs incurred by the Proprietor incompleting the works, the amount ofloss or damagecaused to the Proprietor by the determination, andany other liability of the builder to the Proprietorunder the agreement. These amounts are then addedto the moneys paid to the Builder before the date ofdetermination. If there is an excess between thoseamounts and the amounts which the Builder was tobe paid under the agreement, the difference shall bea debtdue to the Proprietorby the Builder. However,if the amounts result in a lesser total than thatspecified in the agreement, the difference shall bedue and payable by the Proprietor to the Builder.

The provision reserving to the Proprietor the benefit of

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subcontracts by virtue of the assignment of sub-contractsand supply agreements is an important one. It enables theProprietorto complete the work withthe benefitofexistingagreements. This assists in minimising the otherwisesubstantial increases in costs likely to be involved inretaining the services ofreplacement contractors or projectmanagers, to complete the works.

Proprietor's InsolvencyClause 12.07 lists the consequences of determination

by the Builderfor the Proprietor's insolvency. The relevantprovisions are as follows:

• the Builder shall remove from the site all histemporary buildings, equipment and plant, tools,etc, and shall give facilities for his sub-contractorsto do the same. Any loss, damage or expenseincurred by reason of that removal shall be paid bythe Proprietor to the Builder;

• the Proprietor must pay to the Builder the contractvalue ofwork executed at the date ofdetermination,costs or materials for which the Builder has paid orlegally bound to pay (property in the goods, vestingin the Proprietor); or

• the Builder may take possession of, and have a lienupon, allunfixedmaterialsand goods until all moneysdue to the Builder are paid by the Proprietor.

The consequences ofdetermination by a Builderfor theProprietor's insolvency provide littlecomfortto theBuilder.An entitlement to payment ofall moneys due and owing atthe dateofdetermination is oflittlecomfort, ifthe Proprietoris insolvent.

Similarly, the lien which the Builder has by virtue ofClause 12.07.03 over all unfixed materials and goods maybe defeated by the very circumstances which entitle theBuilder to determine the contract; that is the appointmentof a Liquidator, or Receiver. As the appointment of theLiquidatorwould necessarily occurpriorto the termination,the Liquidator's claim to any unfixed material wouldgenerally take priority over the lien of the Builder.

AS2124-1986 Standard Form ContractUnder the AS2124-1992 standard form of contract

which in relation to these issues is in the same terms asAS2124-1986, Clause 44.11 covers the rights andobligations of the parties in the event of insolvency. Whatconstitutes insolvency is similar to that defined for theJCC-type contracts above.

Contractor's InsolvencyIf the insolvent party is the Contractor, the Principal

may exercise its rights under Clause 44.4(a), and by noticein writing, may take over the work.

In taking over the work the Principal may take thewhole or part ofthe work remaining to be completed out ofthe hands of the Contractor. Clause 44.11 does not allowthe Principal to terminate thecontractunderClause44.4(b).The Contractor shall not be entitled to any further paymentin respect of work taken out of its hands unless a payment

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becomes due under Clause 44.6. It would appear that thePrincipal is only able to terminate the contract for a defaultby the Contractor under Clause 44.2. Note that insolvencydoes not constitute such a fault.

If the Principal takes over the work of the Contractorunder Clause 44.4(a) he may, without payment orcompensation, take possession of such plant or otherthings as are ownedby the Contractorwhich are reasonablyrequired by the Principal to facilitate the completion ofthework. Such plant must be maintained by the Principal andreturned to the Contractor on completion of the work.

The cost incurred by the Principal in completing thework shall be determined by the Superintendent and acertificate shall be issued certifying that cost. If thecertified cost is greater than the amount which would havebeenpaid to the Contractorunder the contract, thedifferenceshall be a debt due from the Contractor to the Principal. Ifthe cost certified is less, the difference shall be a debt dueto the Contractor by the Principal.

If the Contractor is indebted to the Principal, thePrincipal may retain plant or other things taken underClause 44.5 unless that debt is met. Such plant may besold, if after reasonable notice, the debt is not paid and theproceeds of sale may be applied to the debt, and the costsof sale. Any excess would be paid to the Contractor.

The right to deal with any plant of the Contractor willbe subject to the rights of a Liquidator or Receiver as thecase may be.

Principal's InsolvencyIf on the other hand the insolvent party is the Principal,

the Contractor may exercise its rights under Clause 44.9,where the Contractor may by notice in writing, suspend thewhole or any part of the work under the contract.

Such suspension shall be lifted ifthe Principal remediesthe breach within 28 days, following which if noarrangement satisfactory to the contractor is made,. theContractor may terminate the contract.

The Contractor shall be entitled to recover from thePrincipal any damages flowing from the suspension. Clause44.10 provides that where a contract is terminated underClause 44.9, the rights and liabilities of the parties shall bethe same as they would have been at common law if thePrincipal had wrongfully repudiated the contract and theContractor had elected to treat the contract as at an end andrecover damages.

UnderAS2124 one ofthe triggerevents for terminationfor insolvency is the placing of the company inofficialmanagement, orresolving to do so. This somewhatdefeatsthe purpose ofthe legislature in providing a "moratorium"by the voluntary administration procedures to allowcompanies to assess their financial position.

NPWC3 (1981)The NPWC3 (1981) form of contract, has similar

provisions dealing with the bankruptcy or insolvency ofthe contractor, although the circumstances giving rise totermination are more limited than those in the ICC orAS2124 Contracts.

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Clause 44.7 of the NPWC contract provides that if theContractor commits an act of bankruptcy, is presentedwith a petition in bankruptcy, enters into a scheme ofarrangement or compromise of creditors, or is placedunder official management, the Principal may invoke theprovisions dealing with the default ofthe ContractorunderClause 44.1(a) or (b).

Under Clause 44.1(a), the Principal may-• take over the whole or any part of the work to be

completed, and for that purpose exclude from thesite the Contractor and any other person concernedin the performance of the work under the contract,or

Under Clause 44.1(b), the Principal may-• cancel the contract, and in that case, exercise any

of the powers of exclusion referred to in sub­paragraph (a) above.

In Thiess Watkins White Construction Limited vCommonwealth ofAustralia (unreported, 23 April 1992)Giles J considered the implications in Clause 44.1 of theNPWC3 contract.

At page 41 of the judgment, His Honour found that ifthe Principal elected to take over the contract, Clause 44.3and Clause 44.4 came into effect, and on completion oftheworks the extra cost to the Principal to complete the worksand any liquidated damages become payable by theContractor. It was only after the completion of works thatthere was an accounting between the Principal and theContractor.

However, ifthe Principal elected to cancel the contract,as happened in this case, Clause 44.6 provides that themoney and security to which Clause 44.6 refers is forfeitedto the Principal. The effect is that forfeiture brings to anend the Principal's claims upon the Contractor. HisHonour further found that whilst cancellation may work tothe advantage of the Principal, because of the forfeiture itwill work to its disadvantage if the Principal finds that theextra cost of completing the work exceeds the amountforfeited.

At page 42 His Honour stated:"In this way the principal and the contractor agreeupon a means by which there can be an immediate endto their relationship. There will be a clean break inwhich the contractor knows where it stands and theprincipal takes the risk that it will be worse offthan ifit had taken over the work rather than cancel thecontract. "

If the Principal elects to take over the works underClause 44.1(a), the Principal may make contracts for thework remaining to be completed, and employ any personsother than the Contractor to carry out that work. ThePrincipal may take possession and permit use of anymaterials, plant or other things on the site owned by theContractor necessary for the purposes of such contract ofunemployment.

The Contractor shall have no right to compensation for

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any action taken by the Principal, other than a right torequire the Principal to maintain the plant in good workingorder. On completion of the work, the plant and surfacematerials will be handed over to the Contractor, withoutpayment or allowances for fair wear and tear they mayhave sustained.

On completion of the works, the Superintendent willascertain the costs ofcompletion. If that amount is greaterthan the amount due under the original contract, thedifference shall be a debt due from the Contractor to thePrincipal. Such a debt may be satisfied by deduction fromany moneys which may become payable to the Contractorby the Principal under the contract.

If the Principal elects to cancel the contract underClause 44.1 (b), the provisions ofClause 44.6 are invoked.Under that clause the Principal must pay over to theContractor any sums that are at that date payable to theContractor under the contract. However, any of thefollowing:

• sums in the hands ofthe Principal which are not thenpayable to the Contractor;

• the whole or part of any security; and• all sumsnamed in thecontractas liquidateddamages

occurring to the Principal,

may be forfeited to, and vest in, the Principal. Uponcancellation, all sums paid or payable to the Contractorshall be deemed to be in full satisfaction of all claims theContractor may have under the contract.

The final words ofClause 44.6 provide that all moneyspaid "together with all moneys then payable" shall bedeemed to be in full satisfaction of all claims of theContractor.

In the TWW case the Referee had found that theContractor was entitled to be paid some amount in excessof $400,000.00 at the time of cancellation of the contract.As that amount was "then payable" it remained payable insatisfaction of the claims of the Contractor and was notforfeited to the Commonwealth of Australia under theprovisions ofClause44.6. This position was notchallengedin the action on adoption of the report.

2. RIGHTS TO UNFIXED MATERIALS OR GOODSRights relating to unfixed materials and goods are dealt

with specifically in some of the standard forms.As we have seen, the JCC-D Contract seeks to give to

the Builder a lien over unfixed materials and goods whichhave become the property of the Principal. This lien maybe of little or no benefit. The nature of the lien is that it:

• arises by virtue of the contract;• arises on tenninationofthe contract. The termination

itself is triggered by some act of insolvency such asappointment of a Liquidator;

• will not defeat the claims ofa Liquidator unless it isa registered charge.

One would expect that the Liquidator would havealready taken possession of any unfixed materials andgoods which were the property ofthe Principal inpursuance

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of his duty to satisfy the claims of creditors.The only way in which the Builder would defect the

claims of the Liquidator would be to register a floatingcharge over any unfixed materials and goods. The chargewould become fixed in the event ofthe termination. Giventhe difficulties of assessing and quantifying and costingthe value ofany unfixed materials which may be on the sitefrom time to time, it is reasonably unlikely that the Builderwould seek the registration of a charge as an appropriateoption.

The issue of unfixed materials was dealt with by theSupremeCourtofQueenslandin the matterofOtisElevatorCompany Pty Limited v Girvan (Qld) Pty Limited & Ors,unreported, Ambrose J, 21 August 1990.

The case involved a contract between Girvan (Qld) PtyLimited and Otis Elevator Company Pty Limited for thesupply and installation oflifts in a hotel and office complexin Brisbane.

The subcontractor, Otis, made progress claims, thethird ofwhich was not paid. A Receiver and Manager wasappointed to the Builder in about January 1990 andsometime thereafter a Receiver and Manager was alsoappointed to the Principal of the development.

By this time Otis had delivered certain materials to beused in the lift installation.

Otis then requested permission to remove certainmaterials from the site. Otis was then prevented fromremoving the materials by the Receiver of the Principal.

Otis asserted that it was entitled to take possession ofthe materials and equipment delivered to the site but notyet incorporated in the works and also asserted that theReceiver and Manager of the Principal was not able tohinder the retaking of that possession.

The parties accepted that where the materials had beenincorporated into the project then property had passed inthe materials to the Principal.

The Court characterised the contract as being one forwork done and materials supplied and not separateagreements for the supply of material, and its subsequentinstallation.

His Honourconcluded that the property in the materialsdelivered to the site but not installed had not passed to thePrincipal and, accordingly, the subcontractor was entitledto re-take possession of the equipment and materials.

A similar result was reached in the decision of MrJustice Jacobs in Aristoc Industries Pty Limited v R AWenham (Builders) Pty Limited [1965] NSWR 581.

The issue is, ofcourse, whether the property has passedin the material. Clearly, if the material or goods have beenincorporated in the building and have become a "fixture",then property has passed.

Where goods and materials belong to a subcontractor,the subcontractor will not want property to pass in respectofgoods whichhe owns, merely becausethe head contractorhas been paid. The subcontractor will look for some otherassurance of security of payment.

Generally, the value ofa subcontractor's materials willbe included in application for payment, on the basis that themain contractor may have asserted that he is entitled to

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pass title in the material.In the English case ofDawber Williamson Roofing Ltd

v Humberside County Council (1979) 14 BLR 70, thePlaintiffcommenced proceedings for the return ofroofingslates or damages.

The contract· provided that where there were unfixedmaterials and goods delivered to the site, they should notbe removed except for use upon the works, unless consentin writing was given, and when the value ofthe goods hadbeen included in any interim certificate which had beenpaid, such materials should become the employer'sproperty.

The Plaintiffs haddelivered the roofing slates to site inNovember· 1976, a certificate was issued under the maincontract which included an amount for the value of theslate which was paid by the Defendants, but the maincontractor did not pay the Plaintiffs. The main contractorwent into liquidation in January 1977. The Plaintiffssought to retrieve the slates.

It was held that title in the slate had not passed to themain contractor as there had been no payment by the maincontractor to the supplier. The provision in the maincontract which soughtto transferproperty was noteffectivebecause the main contractor had no title. Accordingly, thePlaintiffs were entitled to judgment for the value of theslates.

Suppliers ofgoods and materials may be able to protecttheir possession by the use of what has become known asthe "romalpa" clause or "reservation of title" in a contract.

3. TITLE RETENTION (ROMALPA) CLAUSESThe term "Romalpa" originated from the case of

Aluminium Industries Vaasen BV v Romalpa AluminiumLimited (1976) 1 WLR 676. In that case, the Plaintiff soldaluminium foil to the Defendent, who in tum sold the foilto third parties. Whilst being indebted to the Plaintiff, areceiver was appointed to the Defendant.

The Plaintiff successfully claimed entitlement to boththe proceeds of sale of the foil, and the unsold foil whichhad fallen into the hands of the receiver under theReservation of Title clause in the contract.

In Borden (UK) Limited v Scottish Timber ProductsLimited (1981) 1Ch 25, the Plaintiffsupplied resin used bythe Defendants in the manufacture ofchipboard. Once theresin had been mixed with other substances in order toproduce chipboard, it became impossible to identify theresin separately from the end product.

After the Defendant became insolvent and a receiverwas appointed, the Plaintiff sought repayment of moneyowed. In this case it was held that, although the sellerretained property in the resin until it was used, once theresin was incorporated into the chipboard, the seller's titleto the resin vanished as did their security.

In Re Bond Worth (1980) Ch 228, acrilan yam was soldto a company to be made, together with other fibres, intocarpeting. The contract of sale of the yam contained aretention of title clause retaining to the sellers "equitableand beneficial ownership" of the yam and the proceeds ofany goods made out of the yam. It was held that the clause

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was intended only to be a security right, and not a retentionofownership to the seller, and consequently as the securityhad not been registered, it was void.

A further case in which retention of title clauses wasconsidered was Re Peachdart Limited (1983) 3 All ER204. In this case leather, which was to be made intohandbags, was provided by the Plaintiffs under contractwhich included a retention oftitle clause providing that theleatherremained the property ofthe sellers until ithad beenpaid for orused in a manufacturing process, but in addition,the ownership of the goods made out of leather was to vestin the Plaintiffs.

Furthermore, the contract provided that the sellerswere to have the right to trace the proceeds of sale of thehandbags. Despite such clear language in the contract, itwas held that the intention of the parties that ownership ofeach piece of leather should pass to the buyers as soon asthey commenced work upon it.

In Hendy Lennox (Industrial Engines) v GrahamePuttick Limited (1981) Ch 25, the Plaintiff supplied dieselengines to the Defendants under contracts containingretention of title clauses. The Defendants' product was adiesel generator set, in which the supplied engines werebolted to a skid-mounted chassis and connected to otheritems, such as a fuel tankandradiator. When the Defendantswent into receivership, the Plaintiffs claimed part of theproceeds of the sale of the engines on the basis that thePlaintiffs had a proprietary right to those engines by virtueof their power ofrepossession under their retention of titleclause. Staughton J found for the Plaintiffs, distinguishingRe Bond Worth and Scottish Timber on the basis that theengines simply remained engines, albeit connected toother things.

In the construction industry, generally, the materialsand goods will be incorporated into the structure. In thatevent, title to the goods will pass to the owner of the land.In Trust Bank Central Ltd v South Down Properties Ltd(1992) Conv R257, a Mortgagee successfully sued aContractor who attempted to remove timber joinery fromthe site. The timberjoinery was the subjectofa "Romalpa"clause.

The effect of "Romalpa" clauses in Australia is furtherlimited by the provisions of the Corporations Law,particularly the amendments introduced in 1992relating tovoluntary administration.

4. VOLUNTARY ADMINISTRATIONThe provisions of the Corporations Law, particularly

in the voluntary administration provisions of Part 5.3Ahave restricted the effect ofretention oftitle clauses. Oncean administrator is appointed to a company, the owner ofany property that is used by or in the possession of thecompany cannot take possession of the property unless ithas the administrator's written consent or the leave of theCourt. Accordingly, any supplier who has the benefit of aretention oftitle clause would not be able to retrieve goodsonce an administrator was appointed to the company inpossession of those goods. (Section 440C of theCorporations Law.)

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The administrator of a company is also prohibited,under Section 442C from disposing of property that issubject to a charge, or where the owner of the property issomeone else. However, the prohibition does not effectdisposal in the ordinary course of business or with thewritten consent of the charge or owner.

5. PROTECTIONThere are some methods which can be adopted which

will ensure some additional level of protection than thatwhich may be provided in the standard form contract orstandard structures for contracting in the industry. If acontractor can have security for the moneys payable to itin respect of the work done and materials to be supplied,then that security can be made available to the contractorin the event of the other parties' insolvency.

ChargeSecurity can be obtained by a charge either over assets

or over land. A charge over land can only be obtained byexpress written agreement, unless there is specific statutoryright, such as the Sub-Contractor's Charges Act inQueensland. There is no such Act in New South Wales.

Many standard form residential contracts contain aprovision by which the land on which the building iserected is charged with the payment ofany moneys due tothe Builder under the building contract. Such chargingprovisions have been considered and the provision upheldas creating a proper caveatable interest (Griffith & Hodge(1979) 2 ACLR 68).

The issue ofa caveat registered over land to protect theamount payable under a building contract was consideredby the Supreme Court of Victoria in the matter of HeneryProperty Development Pty Limited v James DibbenMcLennan (1993) 12 ACLR 28. The Builder hadsubstantially completed the construction of a project buthad not been fully paid. The Builder lodged a caveat overthree residential units of the Plaintiff. The relevant clauseof the building contract provided that:

"The Principal hereby charges the parcel of land onwhich the works are to be erected the due payment tothe Builder ofall moneys that may become payable tothe Builder by virtue of this contract or otherwisearising from the carrying out ofthe works. "

The Court held that the provision in the buildingcontractcreateda propercaveatable interestand the Builderwas entitled to maintain the caveat until he had recoveredthe moneys payable to him under the building contract.Such charging provisions will clearly only benefit to theextent that there is appropriate equity ·in ·the land socharged.

RetentionMost standard form contracts require the Contractor to

provide either cash retention or bank guarantees to securethe performance of the works required to be undertakenunder the contract. Generally, such security is provided forapproximately 5% of the contract value. Often for

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subcontractors, security for their performance is requiredby the head contractor in the form of cash retention. Thestatus of cash retention moneys was considered by theSupreme Court of New South Wales in the KBHConstruction Pty Limited vLidcoAluminium Products PtyLimited, unreported, Giles J, 27 June 1990. His Honourconsidered the provisions ofthe JCC-A subcontract and in I

particularClause 10.24.05 ofthat contract which provides:"The interests ofthe Builder in the amount so retainedshall be fiduciary as trustee for the subcontractor butsubject to the provisions ofClause 10.26 and withoutany obligation on the part ofthe Contractor to investthe same or account for any advantage that he mayderive from the moneys so retained. "

His Honour held that the contractor held the retentionmoneys on trust for the subcontractor and was obliged toset aside the retention moneys and not mix those fundswith the funds of the Builder or of other subcontractors.

It has been suggested that these provisions could applyto payments to subcontractors generally (see article"Structuring Contracts to Protect Against Insolvency", DS Jones (1992) #21 ACLN p34).

Bank GuaranteesSecuritycan alsobe providedby way ofbankguarantee,

generally by a head contractor to a Principal, or by asubcontractor to a head contractor again to secureperformance. A bank guarantee payable on demand is anunconditional promise to pay by the bank issuing theguarantee. The nature ofbank guarantees was consideredby the High Court in the matter of Woodhall Ltd v ThePipeline Authority (1979) 141 CLR443. TheHighCourtheld that bank guarantees were unconditional and theCourt would not require any enquiry to be made by thebank ofthe presenter, but confIrmed the holder's right thatthe bank should pay on demand.

This issue has been subsequently considered in variouscases, particularly where an injunction is sought to preventthe calling up of a bank guarantee. Unless there is somespecific contractual provision limiting the circumstancesin which the guarantee can be called upon, the holder oftheguarantee is entitled to be paid on demand. See HughesBros Pty Ltd v Telede Pty Ltd, unreported, NSW SupremeCourt, Cole J, 15 February 1989, and Sabemo Pty Ltd v

Malaysia Hotel (Aust) Pty Ltd, unreported Hodgson J, 21June 1990.

Security for payment and protection from insolvencyare matters of considerable concern to the industry. Thestandard form contracts alleviate the problem only in avery minor way and commercial concerns dictate thatoftencontractors are not ina position tonegotiate favourableterms upon which to undertake work. Awareness of theproblems, however, and pursuit of any opportunity tosecure payment can assist. Amendment of contract terms,entering collateral agreements,securing personalguarantees, or associated or parent company guaranteesand other such means are not only appropriate but makecommercial good sense. If those involved in the industry

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continually require appropriate mechanisms to providesome security for payment, thosemechanisms will becomeaccepted and common place, to the benefit of all.

Firstpresented ata Phillips Fox/Ernst & Youngseminar.