ENSURING CREDITOR PROTECTION IN ASIA PACIFIC CONSTRUCTION PROJECTS

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1 Asia Pacific Projects Update ENSURING CREDITOR PROTECTION IN ASIA PACIFIC CONSTRUCTION PROJECTS PART I: THE NEW AUSTRALIAN PERSONAL PROPERTY SECURITIES LAW KEY CONTACTS Jane Hider Partner T jane.hider@dlapiper.com Peter Faludi Special Counsel T peter.faludi@dlapiper.com Many construction projects are funded using third-party finance. Repayment of the debt associated with such finance is often secured by real or personal property. Where this security interest can be registered, financiers can obtain greater certainty and lend more cheaply. The Australian Personal Property Securities Act 2009 (Cth) (PPSA), which commenced on 30 January 2012, introduced a national regime for the perfection, priority and enforcement of security interests in personal property and established an online register which replaces many existing state and Commonwealth schemes. The stated purpose of the PPSA is to "establish a single national law governing security interests in personal property [that] would result in more certain, consistent, simpler and cheaper arrangements for personal property securities for the benefit of all parties". 1 When compared with secured transactions law in other Asia Pacific jurisdictions, the PPSA generally has furtherreaching application. Accordingly, it is important for parties contracting in Australia to get advice on and develop a business strategy for managing and registering securing interests which might arise in the course of their business. This article looks in particular at the application of the PPSA to construction projects in Australia. Part II of this series will discuss the application of secured transactions law to construction projects in other Asia Pacific jurisdictions. 1 Explanatory Memorandum, Personal Property Securities Bill 2009 (Cth), paragraph 10.

2 THE PPSA The PPSA aims to meet its objectives to provide more certain and cheaper arrangements for personal property securities through: Its application to any interest in personal property, whether tangible or intangible (collateral), that secures payment of a debt or the performance of an obligation, regardless of the form of the transaction (security interest) The introduction of a single online register dealing with registration of all security interests over personal property in Australia, with the implication that parties need only review one register in order to understand what registered security interests exist over collateral. THE IMPACT OF THE PPSA ON CONSTRUCTION PROJECTS IN AUSTRALIA The commencement of the PPSA in Australia introduced additional considerations for investors in the Australian market which may not be present in other markets. This is because the Australian focus on the substance of the security interest, as opposed to the focus in most other Asia Pacific jurisdictions on the form of the transaction, has broadened the application of secured transactions law in the Australian context. It also impacts on the construction industry by expanding the range of security interests in an Australian construction project that may require registration in order to retain priority. Impact of a failure to register The implications of a failure to register include: The potential for a security interest holder to lose priority against other registered security interest holders The potential for a security interest holder to become, in effect, an unsecured creditor, if a grantor becomes insolvent or goes into administration The greater risk of extinguishment rules applying against a security interest holder if personal property is transferred by the grantor to a third party. Below we highlight instances that may give rise to registrable security interests under the PPSA and discuss the impact of a failure to register. Security interest holders may want to consider registering these security interests or think through alternatives. Suppliers and contractors Lease of equipment and temporary works The PPSA has introduced a new type of security interest, the PPS Lease. A PPS Lease arises from certain leases or bailments of personal property where the lease or bailment is generally either for an indefinite period, for a term exceeding 12 months, or in the case of items which may be described by serial number (such as a motor vehicles) for a term of 90 days. A PPS Lease will not arise, where (amongst other things) the lessor or bailor is not regularly engaged in the business of leasing or bailing goods, and in the case of a bailment, where the bailee does not provide value. The introduction of the PPS Lease, and the deemed security interest provided to the lessor or bailor of such personal property, has the potential to impact the construction industry in the following ways: Where owners of leased equipment (such as scaffolding) may previously have relied on their legal title for protection, an owner's rights may now be at risk where these rights in the leased equipment are not registered under the PPSA, particularly in the rare circumstance where the lessee or bailee is in the business of selling or leasing personal property of that kind, due to the "take free" provisions. Take free provisions allow a party to take certain personal property free of a security interest if the personal property was sold or leased in the ordinary course of a business of selling or leasing personal property of that kind. This is also relevant if the lessee or bailee has itself granted a security interest over all of its assets to a third party which has registered such security interest on the PPS Register. Similarly, a bailment (which might create a deemed security interest under the PPSA) may arise where a subcontractor leaves tools or equipment on a site which is controlled by a contractor. Note that the bailor must be engaged in the business of leasing or bailing goods. Equally, a contractor who leaves temporary works on a principal's site (for example, scaffolding or site sheds) and which previously would have relied on the nemo dat rule (under which a party cannot assign a greater interest than the interest they possess) to protect it, may now also be at risk where it has not registered a security interest in the temporary works. Performance security Notwithstanding its name, performance security (which in a construction contract is usually provided in the form of an unconditional bank undertaking or insurance bond or in the form of retention of monies otherwise payable) will not generally be covered by the PPSA by virtue of the fact that there is no personal property to which a security interest can attach. 2 Ensuring creditor protection in Asia Pacific Construction projects

3 Despite this, there are some circumstances in which performance security may fall within the ambit of the PPSA. These include: Where retention moneys are retained in a separate bank account Where a principal draws on the entire amount of a bank guarantee but does not require the entire amount to rectify a contractor's default and is required to set the remainder aside in a separate trust account. In such circumstances, the contractor may have a security interest capable of being registered under the PPSA. Retention of title or "Romalpa'" clauses In its most basic form, a construction project will generally consist of a contract between the principal and head contractor to construct the works (head contract) and then several subcontracts between the head contractor and subcontractors, suppliers and consultants (subcontracts) to perform works, supply goods (which may include plant materials and equipment) and design elements of the works. This means that the issue of ownership of and interests in goods can be quite complex as it is being dealt with in at least two contracts: the head contract and the relevant subcontract. Generally, title to goods under a supply contract passes from a supplier to a purchaser when the parties intend for this to occur. 2 Accordingly, the supplier (or the head contractor under the head contract) may require the inclusion of a "retention of title" clause, commonly known as a "Romalpa" clause, such that title in goods does not pass to the purchaser (or the principal under the head contract), and hence is "retained" by the supplier, until the price for the goods has been paid to the supplier, notwithstanding that the goods may not have been delivered to the purchaser. In circumstances where title in the goods lies with the supplier but the goods have been delivered to the purchaser, the supplier will have a security interest in the goods to secure the payment of the purchase price, until such time as the purchase price is paid. In order for the supplier to obtain the protection of the PPSA, the supplier will need to register this interest in accordance with the registration requirements of the PPSA. Alternatively, in circumstances where parties intend for title to pass upon delivery, the supplier will ordinarily require payment for such goods from the purchaser prior to delivery to the purchaser in order to protect its interest in the value of the goods supplied. This raises an issue for the purchaser in that the purchaser will have paid for such goods prior to obtaining possession. A purchaser will, 2 See, for example, Goods Act 1958 (Vic), section 22 (1) and Sale of Goods Act 1923 (NSW), section 22 (1). therefore, look to options to protect its interests. These options are discussed in greater detail below. As between the supplier and the head contractor at the subcontract level, a similar issue will arise. In order to protect its interests, and depending on how the head contract deals with title in goods, the supplier may require the inclusion of a "retention of title" clause. Alternatively, the supplier may require payment for such goods prior to delivery to the head contractor. In circumstances where the head contractor has received payment from the principal for such goods, it should not be problematic for the head contractor to pay the supplier prior to delivery. Purchasers and principals Security for unfixed plant and materials As noted above, it is also not unusual for construction contracts to provide that, subject to certain conditions being met, the principal will make payment to the contractor for goods (for example lifts or transformers) that are off-site or on-site but unfixed (generally referred to as "unfixed plant and materials"). As the principal has made payment for the unfixed plant and materials, but the unfixed plant and materials are in the possession of the contractor, the principal may wish to register a security interest in the unfixed plant and materials to secure the performance of the contractor's obligations under the construction contract. Registration of such interests will be important for principals wishing to maintain priority over other interested parties in the event of contractor insolvency. Principals wanting to register their security interest in unfixed plant and materials might like to consider including drafting that makes registration a condition precedent to payment for unfixed plant and material. As a partial alternative to registering a security interest, and particularly in circumstances where unfixed plant and materials can be easily and quickly replaced, a more practical approach for a principal might be to accept another form of security, such as a bank guarantee. By accepting a bank guarantee for the full value of the unfixed plant and materials, the principal will be able to recover any amounts paid with respect to the unfixed plant and materials. Principal's "step-in" rights Construction contracts often provide that in the event of the contractor's default or insolvency, the principal or the head contractor (as the case may be) may end the contract, take the works out of the contractor's or subcontractor's hands and have another party complete the works. Large infrastructure project documentation also often gives a principal or financier the right to step in on default (and then step out when the default is remedied). Such 3 Ensuring creditor protection in Asia Pacific Construction projects

4 provisions will generally include a right for the principal or head contractor to use the contractor's or subcontractor's plant and equipment following such default or insolvency and are of particular importance where such plant or equipment is either difficult or timeconsuming to obtain. The principal's or head contractor's interest in this plant and equipment may constitute a security interest for the purpose of the PPSA as this collateral secures the performance of the contractor's or subcontractor's obligations. While registration of such interests may seem onerous, particularly for head contractors who will have multiple contracts with multiple "step-in" rights, registration is important to ensure that the interests of other parties, such as financiers, suppliers (especially those with retention of title clauses in their contracts, see "Retention of title or "Romalpa" clauses", above) or lessors of the plant or equipment, do not have priority over the interests of the principal or head contractor, in circumstances involving contractor or subcontractor insolvency. Accordingly, in relation to the majority of fixed plant and equipment, registration should occur as soon as the security interest arises. Such registration can be made less onerous if proper internal processes are in place. Alternatively (although not preferable), principals and head contractors may elect only to register interests in circumstances where the equipment cannot be easily replaced due to scarcity or long lead times on production (for example tunnel boring equipment). The principal or head contractor may require the contractor to use only unencumbered plant or, to use encumbered plant or equipment only on the basis that the party with the competing security interest in the plant or equipment enters into an agreement with the principal or head contractor that would allow the principal or head contractor to use or retrieve the plant in the event of the contractor's default or insolvency. Free issue materials On some construction projects, a principal may elect to procure certain materials from the supplier directly and "free issue" them to the contractor to install. Instances where a principal may elect to do this include, for example, where the procurement of the materials may otherwise hold up construction or where the principal can buy materials in bulk for a number of projects, thereby reducing the costs associated with procuring the materials for an individual project. Previously, a principal electing to "free issue" materials to a contractor could rely on its title to the free issue materials to protect its interests. Following the introduction of the PPSA, a principal can no longer rely on its title, particularly in circumstances where a contractor with possession of the materials becomes insolvent. Accordingly, principals will need to ensure that the drafting of any free issue material clause creates a security interest in any materials owned by the principal and not in the principal's possession, for example as a consequence of being stored on the contractor's site. The principal will then need to perfect that security interest in accordance with the PPSA in order to protect its interest in the materials. While the timing for protection will depend on the nature of the materials, it will generally need to occur when the security interest is created. Commingled goods and accessions Principals and suppliers of goods will also need to take note of the priority rules under the PPSA associated with commingled goods. Commingled goods include goods that are mixed with goods of the same kind and become part of a product or mass so that the individual identity of the goods is lost in the product or mass (eg steel reinforcement in concrete). The security interest in the goods remains in the product after the manufacturing process. A failure to register a security interest in goods that are later commingled may be problematic in circumstances where, for example, a principal has a security interest in unfixed plant and materials as a consequence of having made payment for these materials, and then those materials are commingled with materials over which a supplier has a security interest by virtue of a retention of title clause in a contract. In these circumstances, a failure by one of the parties to register its security interest would result in that party's security interest being subordinated to the security interest of the other registered party. Even where registered (and assuming that one party does not have super priority by virtue of having a purchase money security interest as opposed to a general security interest) the parties' entitlements to the materials will be apportioned according to the ratio that each party's obligation secured by the perfected security interest bears to the sum of the obligations secured by all perfected security interests in the same materials. In addition to commingled goods, suppliers should also take note of the priority rules with respect to accessions. Accessions are goods that are installed in, or affixed to, other goods without losing their identity (eg a new motor installed in a piece of plant). A security interest in goods that become an accession to other goods continues in the accession. The default rule on priority with respect to accession is that a security interest in the goods to become an accession that is attached at the time when the goods become an accession has priority over a claim to the goods as an accession made by a person with a security interest in the whole of the goods. 4 Ensuring creditor protection in Asia Pacific Construction projects

5 The rules dealing with accessions may have implications, for example, for suppliers supplying component parts in plant or equipment required for a construction project. Failure to register a security interest in goods which become an accession prior to installation and affixing will mean that the supplier's security interest in the accession is subordinated to any registered security interest held by another party in the whole of the goods. CONCLUSION There are different forms of secured transactions law across different jurisdictions. This article discussed Australia s unitary system, which focuses on the substance of the security interest. Other countries base priorities rules on the form of transaction document. Part II of this series will discuss the systems in other Asia Pacific jurisdictions. Australia s unitary focus has resulted in a broader application for secured transactions law in Australia and specifically in construction contracts. As a consequence of the introduction of the PPSA, parties to construction contracts in Australia should seek legal advice regarding how to best protect their security interests in personal property. THIS UPDATE WAS AUTHORED BY: Kylie Fitzpatrick Solicitor T kylie.fitzpatrick@dlapiper.com Celeste Koravos Solicitor T celeste.koravos@dlapiper.com DLA Piper is a global law firm operating through various separate and distinct legal entities. For further information, please refer to Copyright 2012 DLA Piper. All rights reserved This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication 5 Ensuring creditor protection in Asia Pacific Construction projects