Australia has a structure of regulatory oversight in the construction industry that is designed to fail, (Melbourne residents evacuated from extreme-risk cladding building, AFR 23 Aug 2019), but the problems go deeper than the surface cracks currently identified.
The introduction of private certification dates from the era when public policy viewed governance of markets in terms of a false dichotomy – inefficient government bureaucracy or unfettered free market. Building standards governance demands a more nuanced, hybrid policy approach.
Our current system involves builders (or developers) engaging private certifiers who then verify compliance with building regulations. This is a structure that creates a market dynamic that dictates a competitive ‘race to the bottom’ where diligent private certifiers are forced to bid against each other in a downward spiral of standards. Any opportunities for ‘interpretation’ of the letter of the law create opportunities for error or manipulation that must be exploited to remain competitive. ‘Putting the fox in charge of the hen house’ is therefore not an apt analogy – you can’t blame the fox if the only thing he can eat are the hens he is supposed to watch!
The tragedy is that with a minor modification, these unintended consequences could be averted. If private certifiers were engaged by local government (instead of builders or developers) the competitive race to the bottom of regulatory oversight would not arise.
But response of regulators has not been reform of the process for certification – it has been to implement reforms that iteratively shift ever-more contractual and statutory responsibility to designers, builders, certifiers, and other construction industry participants. Consultants generally insure against these risks, but builders are unique in being subject to statutory and/or licensing requirements to maintain asset backing in their trading vehicle. Small builders are literally required to ‘bet their house’ on their future financial performance.
The builder is also unique in that they achieve very low margins on a relatively high but erratic cashflow. And they are often contractually responsible for many events over which they have little control, such as an unexpected failure of a subcontractor. Builders therefore bare financial responsibility for events where there exists little ethical basis for holding them contractually liable.
As a result, builders’ cashflow (and therefore liquidity) is almost always precarious and outside of their control. The upshot is that carrying on a business as a builder literally involves being required by statute to bet your house ‘against the house’ that you will somehow dodge the ubiquitous risks that beset the industry. It is therefore no wonder that the response of the construction sector has been one of managing risk through formal asset protection structures. This explains the construction sector experiencing the highest rate of bankruptcies, and the frequent accusation that the sector is rife with ‘phoenixing’.
And here we come to yet another well-intentioned but potentially disastrous public policy intervention – the proposal to fight phoenixing by introducing cascading statutory trusts. (WA draws up trusts plan to protect subcontractor payments, AFR 11 Jun 2019.) This proposal attacks the dynamic growth-engine of the economy, which relies on companies dealing with each other through mutually agreed terms, including extending each other trade credit.
The drive toward statutory trusts stems from a fundamental misunderstanding of their economic implications for the sector. The idea that builders will respond by increasing their capitalization is fanciful – small builders are already required to maintain asset backing for licensing purposes. Ask any small builder – their growth is constrained by their access to capital. Also, statutory trusts will not attract additional ‘passive capital’ to the sector – small businesses are too dependent on an owner operator, so are rarely a viable candidate for passive investment.
Large builders, on the other hand, typically maintain minimal asset backing, and are able to contract around the proposed statutory trust legislation through establishing related-party subcontracted service providers. The real targets of the ‘statutory trust’ regulations – those at the ‘sharp end’ of current trade practices – will simply structure their activities to avoid any impact.
The inevitable response of the industry to statutory trusts will therefore not be the desired increase in capitalization of builders, nor improved payment terms. It will simply trigger a greater reliance on the already widespread adoption of formal asset protection structures, and an increase in ‘phoenixing’ particularly amongst smaller contractors. The cascading network effects of this predictable increase in failure of otherwise viable small businesses could well be disastrous.
Rather than introducing rigidity to cashflow through the sector with statutory trusts, the goal of equitable access to fair progress claims could be achieved through introducing a quick and efficient tribunal process for resolution of progress claim disputes, that has real teeth.
And if regulators want to stop the misuse or manipulation of liquidation processes through deliberate ‘phoenixing’, that could be addressed directly by introducing a limited ability for trade contractors (and employees) to secure priority of payment (ahead of secured creditors) in the event of an ‘engineered’ liquidation.