Types of payment and payment risks

There are three types of payments to be considered when focussing on payment risks through bankruptcy: The first relates to interim payments (i.e. for work done during a particular period, say a month). The second relates to payments made for materials (either on or off site, or on order) and finally, the third relates to sums of moneys retained from interim payments generally as a protection against poor workmanship. However, according to Hughes [12], such sums are held partly as security in the case of non-performance, and partly as leverage to persuade them to come back and complete the final few items of work after practical completion. The actual intentions may need to be gleaned through contract provisions and statutory provisions. The type of payment risk with respect to the contractual relationship is shown in Table 1.

Table 1- Payment risks

Relationship Community at risk Defaulting party Payment risk Principal-Contractor Contractors Principal (P)/

Funding Institution (FI)

Interim payments Retention moneys Payment for materials (on or off site, or on order)

Principal Contractor Advance payment#

Contractor- Subcontractor

Subcontractor Contractor Interim payments Retention moneys

Contractor Subcontractor Over payment

Contractor – Supplier

Supplier Contractor Materials on credit # Rare in New Zealand; hence, not discussed.

perhaps to secure the services of a top quality provider in times of high demand. Moreover, principals have different risk profiles; some more risky than others. For example, when the government commissions projects, it is rare for them to go into liquidation or fall short of funds for payment. Whist this may be the case in New Zealand (or for that matter in the developed world), it is not an uncommon in developing countries to fall short of funds as they sometimes budget for more projects than for which funds are available (in order to counteract underperforming projects), or when funds already pledged do not materialise. On the hand, private sector clients, especially property developers in comparison with government clients, are considered to be less trustworthy at least on the face of anecdotal evidence. Thus, there is a need to understand the payment risk profile of principals in order to make decisions on strategies for dealing with payment losses (described earlier).

5.2 Construction sectors

Main contractors operate across many sectors of the industry from residential, commercial to infrastructure. Clearly, the risks of working across these different sectors are not the same. For instance, there is anecdotal evidence that those who work in the property development sector are exposed to a greater level of payment risk than in other sectors. Such differences need to be understood before any attempt is made to promote solutions to payment risks. The situation is much the same when it comes to subcontractors with further differences depending on the type of work they do (say different trades in building projects) and also depend on whether it is labour only, or a full contract, or whether nominated or otherwise.

5.3 Project characteristics and interim payments

Big or small, projects vary in length. Interestingly, the size of the projects and its duration is linked with the nature of the payment risk. Interim payments of a project which is 10 months long would roughly be 1/10th of the contract sum which appears to a large sum of money to lose when compared with general profit margins; and in the case of a 5 month long project, this may be roughly 1/5th. Clearly, the nature of the payment risk would be higher in the latter than the former for projects of similar value. On the other hand, the payment risk in a larger project with the same duration would be comparatively larger than a smaller project. In other words, larger the rate of turnover, larger appears to be the payment risk (in relation to interim payments). However, as for retentions, the risk would appear to be different with larger and longer duration projects (with longer defects liability periods) having a larger risk. Thus, with such different profiles of payment risks, applying a single PB seems unsuitable, unless of course the PB is geared to reflect the nature of the risk that is currently being understood.

5.4 Types of work and nature of trades

First consider the case of the subcontractors in the building industry. According to the findings of a study by Abeysekera and Soysa [13], contractors do not view all trades as equally risky which would

5.5 Type of sub-contract and the time lag

The type of sub-contract seems to have an impact on payment risk. For example, if the work is labour- only, it is usual (in NZ) to receive payments on a fortnightly basis but given that the first payment is received only after about a week or two, the payment risk period is approximately 3 to 4 weeks. When compared with work involving ‘labour and material’ there is a significant difference as payments for such work are made usually on a monthly basis which amounts to a payment risk period of around 2 months. If this period can be reduced, then the risk involved could also be reduced.

The question of whether this period is either too long or too short may depend partly on whether the principal is seen as creditworthy; in other words, the risk profile of the principal. Thus, in order to understand the issues at stake, it appears necessary to investigate how businesses assess creditworthiness of their customers (which may also impact on the price-discounts they may or may not secure for say material purchases). However, in the case of construction contractors (or subcontractors as the case may be), they may not have much of a choice other than to make a decision whether or not to take the job depending of course on market conditions. If so, they would have to accept the risk which may have unfortunate and debilitating repercussions in the event the risk eventuates.

5.6 Retention regimes

Take the case of retention regimes imposed by clients on main contractors. Examinations reveal that the commonest regime used in NZ is a sliding one as shown in Table 2. Accordingly, as the contract price increases, the effective rate of retention reduces. Of course, this is not the only regime used. Other examples are given in Table 2. It appears that there isn’t a rational explanation as to why such regimes are being used.

In formal construction, it is common for main contractors to enforce back to back terms on subcontractors; in essence, smaller the value of the subcontract, larger is the rate of retention. For example, if the value of the subcontract package is less than $ 200,000, the applicable retention rate would be 10%. This creates a retention differential as noted by Abeysekera [14] which in essence creates a surplus of cash for the main contractor. This is indeed the case if main contractors adopt the same retention release mechanisms that are applicable to them. However, examinations show that this is not the case always as some trades, particularly the front end trades in the building industry have been able to get their retentions released after a stipulated period from their practical completion as against main contractor’s practical completion [13]. It is not clear whether this is a common practice or not. Nevertheless, what is clear is that subcontractors are exposed to a comparatively higher financial risk than main contractors, and if the main contractor goes bankrupt, the amount of retention moneys held by clients may not be sufficient to meet subcontractors’ retention monies, particularly after taking into account of other debts a contractor may have when they liquidate.

The contractor-friendly sliding-scale retention regime used in New Zealand

125,000; Defects liability retention 50%

B $25M; Retention rate 10%; Limit of retention

5%; Defects liability retention 50% from last separable portion

C $ 100M; 10% on first $15M + 5% on next 30M +

2.5% thereafter; Limit of retention $3.5M; Defects liability retention 50% from last separable portion