PayingMoneyUpfront

Paying money up front – the risks and the safeguards

Commerical lawyer, Geoff Hardy

Payments in advance (otherwise known as deposits or down-payments) are common in the construction industry.

Sometimes they are needed because building materials have to be ordered and the supplier insists on some kind of payment up front. Sometimes the builder has to do a lot of preparatory work like pricing, design, or consent applications, and he wants to be sure he is going to be reimbursed once that is done, in case the project doesn’t proceed.

It is not uncommon in a building contract for a deposit to be payable that is not even the first instalment of the contract price at all; it is a form of security that remains in place throughout the project to ensure the customer never leaves an invoice unpaid.

There is an obvious risk when you are paying in advance, that you won’t end up getting what you have paid for. In extreme cases that could happen if the builder or fabricator, or building materials merchant (in this article
I call them the “supplier”), simply takes the money and runs.

In more common situations it could happen if the supplier has a stroke or a heart attack and there is no-one else in the company with the necessary skills or expertise to do the job. You would like to think that they would refund your money in that instance, but it is surprising how often that doesn’t happen. And of course it is never going to happen if the supplier has gone bust.

Although the risk may be small, it can be financially crippling if the down-payment is large enough and you are faced with the prospect of having to pay it all over again to another supplier.

If the original supplier is simply mucking you around, then you can go to court to either force them to honour the contract (in which case you will eventually get what you ordered), or sue them for damages (in which case they owe you money instead).

But either way, that involves expensive and protracted litigation with no guarantee of success, against a supplier who might well go bust in the end, so you would generally be better off just terminating their contract, grabbing what you can off them and finding a replacement supplier.If the original supplier has already gone bust, then neither of those options is available to you because you are not allowed to sue them (at least without the liquidator’s consent) and you simply have to hope that you get something out of the insolvency after the secured and preferential creditors have had their fill.

 

What precautions can you take?

Neither of those scenarios is an exciting prospect so understandably people look for ways to protect themselves from the risk.

There are a couple of approaches you can take. One is to make sure you get your money back if the supplier doesn’t deliver. But that just puts you back to square one, having to find a substitute supplier, when you are already way behind schedule.

The second option is to at least get hold of the raw materials and the partially-completed work, so you could hand those over to the replacement supplier, and  offset the amount that you owe for those things against the down-payment you have already made.

Of course that assumes that the raw materials and partially-completed work  are worth having, and the replacement supplier has the technology licences, the plant and equipment, and the expertise to finish the job.

Getting your money back can be achieved in a number of ways. The standard approach is to have a third party promise to repay you if the original supplier defaults.

For example, you could insist on a personal guarantee from one or more of the directors or major shareholders of the original supplier. Or you could insist on a bond from a bank, or an indemnity from an insurance company.

All those options depend on you having enough bargaining power to extract those concessions. When the supplier is in high demand or everyone has plenty of work because the construction industry is in a boom cycle, you may be out of luck. In that case you might even arrange your own insurance policy to cover the risk that one of your down-payments might be lost.

A classic example of such an insurance policy are the guarantees that members of the Certified Builders or Master Builders Associations can offer their customers. They protect those customers against the risk that they might have paid more than they received in return.

In fact, it is the answer to any concerns expressed by the customer about being required to pay up-front in the first place, although the extent of the protection depends on the wording of the individual guarantee. But in general terms, if the  builder gets run over by a bus or elopes to Venezuela with his mistress, without having refunded the down-payment, the guarantee is there to ensure the owner doesn’t end up out of pocket.

 

Keeping the money safe

If you can’t get a guarantee or a bond, or an insurance policy to protect you in case your down-payment is lost, then a compromise arrangement is to at least put the money somewhere safe so that you can retrieve it if the supplier becomes insolvent or goes out of business before completion.

For example, the money can be held in trust by a solicitor or an escrow agent who is under instructions to pay it to the supplier if all goes according to plan, but to return it to the client if the supplier defaults. That at least gives the supplier the comfort of knowing that the money is safe and won’t be withheld for capricious reasons, and it gives the client the comfort of knowing that it is not at risk.

The only downsides to this arrangement are that it involves a third party who will want to document the arrangement and to be paid a fee, and it means that the supplier can’t use the money to buy raw materials that he has to pay in advance for.

Unfortunately that requirement is all too common, particularly with expensive building components such as designer joinery, appliances, or finishes that are frequently obtained from overseas.

 

Owning the work in progress

I mentioned above that instead of just getting your money back you might prefer to get hold of the raw materials and the partially-completed work.

To do that you need to show that you, not the supplier, own the items in question, or you have some other security interest in them that prevails over the rights of the supplier’s liquidator or other secured creditors.

Under our sale of goods laws you might be able to establish that ownership has already passed over to you. If not, then  you can accelerate the process by agreeing with the supplier that you have ownership  of the items as soon as you pay in advance for them.

Some of our standard-form building contracts, such as NZS 3910, already provide for such an arrangement (it is called an “agreement for off-site materials”), but it involves getting the supplier to sign a separate contract, it usually requires you to register your interest on the personal property securities register, the supplier’s bank might have to consent to the arrangement, and it comes unstuck when the supplier doesn’t own the items in question because ownership of the raw materials is still retained by its own suppliers.

If all that sounds too complicated, then you might just consider transferring the risk of loss of the down-payment to the building owner, rather than the head contractor.

If the building owner agrees to this then it is simply a matter of ensuring that the head contract reflects this arrangement. And once again you would need

 

Geoff Hardy has 44 years’ experience as a commercial lawyer and is a partner in the Auckland firm Martelli McKegg. He guarantees personal attention to new  clients at competitive rates.
His phone number is (09) 379 0700, fax (09) 309 4112, and e-mail geoff@martellimckegg.co.nz.  This article is not intended to be
relied  upon as legal advice.

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