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Step-in rights in construction contracts can give rise to security interests
The High Court of New Zealand recently handed down a judgment confirming that ‘step-in’ rights in construction contracts can constitute a security interest.
As a result of this case, principals are even more likely to want to register security interests against contractors on the personal property securities register (PPSR) when entering into construction contracts containing step-in clauses.
Mainzeal Property and Construction Limited (Mainzeal) entered into a standard construction contract with Hobson Gardens to carry out remedial works on an apartment complex.
The contract contained a clause that allowed the principal, Hobson Gardens, to take over the contract work if Mainzeal went into receivership. That clause entitled the principal to:
- use Mainzeal’s materials, fittings and construction machinery to complete the contract work
- recover from Mainzeal reasonable costs incurred in completing the contract works, and
- sell any surplus materials, fittings and construction machinery and apply the net proceeds towards meeting Mainzeal’s liability to Hobson Gardens.
Hobson Gardens did not register its interest under the construction contract on the New Zealand PPSR and Mainzeal subsequently went into receivership. Hobson Gardens sought to rely on the step-in rights in order to take over the works and claim possession of Mainzeal’s construction machinery on the site.
The Bank of New Zealand (BNZ) had previously registered three security interests on the PPSR against Mainzeal in relation to general and specific security agreements with Mainzeal. A dispute arose between the receiver appointed by BNZ and Hobson Gardens over the right to two hoists owned by Mainzeal.
The court ultimately found in favour of BNZ on the basis that Hobson Gardens had not perfected its security interest in the step-in rights either by:
- registering it on the New Zealand PPSR, or
- possessing the hoists prior to BNZ registering its security interest on the New Zealand PPSR.
Importantly for Australian construction contracts, the court confirmed that the step-in clause constituted a security interest because it secured payment or performance of Mainzeal’s obligations to Hobson Gardens.
What does this mean for construction contracts in Australia?
While this is a New Zealand case and is not binding in Australia, it does provide some guidance on an area of law which is yet to be properly judicially considered in Australia.
Impact on Principals and Contractors
If a principal does not register a security interest on the PPSR, it runs the risk that the rights, materials and equipment secured by the step-in clause may be lost upon the insolvency of the contractor or to secured creditors who have registered security interests on the PPSR against the contractor.
Contractors should also consider registering their rights under step-in clauses where principals have an obligation to return the contractor’s materials and equipment once the step-in ends.
Most standard construction contracts contain step-in clauses (e.g. AS 4000-1997 General conditions of contract and AS 2124-1992 General conditions of contract), so parties should give serious consideration to registering security interests when entering construction contracts.
Seizure does not equal possession
Under the Personal Property Securities Act 2009 (Cth) (PPSA), a security interest can be ‘perfected’ in a number of ways, including by registration on the PPSR or by possession.
Parties should be aware that seizure or repossession of goods on enforcement does not amount to perfection by possession and so will be insufficient to defeat a prior registered security interest. Given the difficulties in determining timing of possession, we recommend that parties register security interests on the PPSR rather than seek to rely on seizing back goods at the relevant time.
Parties registering security interests under step-in rights may take their interests subject to prior registered security interests. Therefore, we recommend that parties search the PPSR to confirm if there are prior registered security interests that may require consent (e.g. from financiers). This may necessitate priority arrangements.
Registration – don’t get caught short!
Parties must ensure that registrations are accurate and capture the correct assets and collateral classes. We have seen circumstances where principals have registered inaccurately or over a broader class of collateral than the security interest created under the relevant construction contract entitles them to. This has created unforseen complications for contractors (e.g. potential breach of banking covenants) and necessitated amendments to the register to clarify the position. There is also some case law that indicates that registrations that are too broad or are inaccurate risk being ineffective.
There are also strict timeframes for registration of security interests on the PPSR. As a general rule, registrations against companies must occur within 20 business days of the date of the security agreement, however there are some shorter timeframes (e.g. 15 business days from the time of possession) for purchase money security interests (PMSIs). PMSIs include interests such as retention of title clauses and may include bailments and leases. Adverse consequences can result if time limits are not met, including enforceability of the security interest on the insolvency of the other party.
For contracts which existed prior to the commencement of the PPSA, secured parties have a 2 year transitional period (Transitional Period) to review those contracts and determine whether registration is required on the PPSR. The Transitional Period ends in January 2014. If a security interest is not perfected (e.g. registered) by the end of the Transitional Period, the security interest will be subordinated to any security interests that are perfected.
The PPSA is a new area of law and as with any new area of law there is a degree of uncertainty as to how some concepts (such as step-in clauses) will be interpreted. There is considerable debate as to whether certain interests will (or will not) amount to ‘security interests’ for the purposes of the PPSA. This will only be resolved by court consideration and legislative clarification as the PPSA scheme progresses. Until this doubt is resolved, there is an inherent risk that if you have a ‘security interest’ and you do not adequately protect it under the PPSA you risk losing your interest in the goods to others who do protect their interests under the PPSA.
We can assist your business with PPSA audits and implementation plans particularly as you plan for the end for the Transitional Period in January 2014.
Focus covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. Focus is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.