Canada: Mind The Gaps: Top 5 Things Lenders Should Know About The New Construction Act

The new Construction Act is now here.

Broad, numerous and significant amendments to the Construction Lien Act (now called the Construction Act) came into force in Ontario on July 1, with more coming on October 1, 2019. These changes will bring about a real culture shift in the construction industry.

Are lenders ready for it?

While there are many, many changes, here are the five most important and impactful on lenders, with the greatest potential for gaps and risk, whether they provide project financing or lend operating funds directly to general contractors and trade contractors.

1. Mind the (New) Gaps

The changes in the Construction Act bring many changes to the payment process on construction projects. Some of these came into effect on July 1, 2018, such as mandatory payment of holdback, longer lien periods and later dates for release of holdback. Much more significant changes are coming in October 2019 with statutory payment periods (28 day prompt payment) and fast track binding dispute resolution (adjudication).

These changes are being imposed on owners, contractors and subcontractors, but not lenders. They are likely to create funding gaps and stranded risk on projects. For example, it will be possible for an owner to have to pay the construction holdback at the end of the lien period, but not be able to draw from its lender. An adjudicator could require the owner to pay for a change or an invoice that a lender has not approved. Interest, at mandatory legislated rates, will be incurred for late payments. Sometimes this will be a matter only of a short timing gap. Sometimes it will be a block on access to funds.

Where will borrowers get their funds? Is a higher reserve required or prudent? If they have to borrow to cover these gaps, does the credit agreement allow that? Does that impact financial ratios and covenants, and borrowing base calculations?

2. All About the Flow

Most of the amendments are designed specifically to ease and expedite cash flow from the owner to the trade contractors and suppliers. Longer lien periods, prompt payment, mandatory holdback, forced payments on adjudication will all have an impact on cash flows on a project. Provisions allowing for earlier release of holdback will also have an impact in some cases. This also likely means a reduction in the borrowing needs of trade contractors and suppliers in their operations, but also a possible increase in needs by owners.

Do lenders' lending and cash flow models need to be updated?  This is especially important for dealing with prompt payment next year. Do credit procedures allow for the release of funds for when owners (and, to a lesser extent, contractors) will now be obliged to pay under the Act?

3. Update Your Documents

There are many, many changes in the Construction Act. Many of these will require lenders to revise and update their credit documents, and even their procedures and some practices.

The lien period is extended from 45 days to 60 days. The financial thresholds for the substantial performance test are now $1,000,000 from $500,000. Approval by owners of draft invoices or pre-certification of invoices by the payment certifier will no longer be permitted after October 1, 2019. Regular progress payments and payment of the holdback will happen much more quickly. The Construction Act incorporates 18 new forms, updates others, and generally imposes more procedure, formality and complexity on construction projects.

While being more rigid and formal, the Construction Act  also allows for some new flexibility that borrowers may want. In specific circumstances, owners will be allowed to accept a bond or letter of credit instead of retaining a holdback, to release holdback early on a phased basis or on an annual basis, or to treat separate "sub-projects" as separate contracts. But only if the construction contract expressly allows it. Will lenders' credit documents and procedures permit this?

Lenderss' credit documents, policies and procedures will need to catch up to the new regimes, or else risk conflicting with borrowers' statutory obligations and restrictions, or with borrowers' construction contracts.

4. Trust in Trusts

The Construction Act now requires contractors to deposit all trust funds in an account in the trustee's name, and to apply trust accounting rules by keeping separate books and records for this (or these) accounts. This is to enable that all construction trust funds are traceable and not commingled with operating funds or other trust funds.

For lenders that loan to contractors, the use of ARs that include any trust funds will be more difficult. Will this have an impact on your borrowers' borrowing base? Are additional reserves required?  Do your borrowers keep proper books for their trust funds?

For lenders that loan to owners, there is a more remote connection to the contractor's trust fund obligations, but the health and strength of successful projects often relies on the discipline and diligence of the lender. Do you need to require your borrowers to confirm their contractors' practices?  Should all trust funds go into a separate account from general reserves?  What are the new best practices lenders will require on a project?

5. Timing - When does all this take effect?

Some technical and translation changes of Bill 142 came into force immediately on December 12, 2017. However, most of the substantive changes will be proclaimed and come into force in two stages:

  • On July 1, 2018, all of the substantive changes, regulations and forms, other than those relating to prompt payment and adjudication, came into force
  • On October 1, 2019, the prompt payment and adjudication provisions will come into force

As we have noted previously, the Act will grant grandfathering of existing projects/improvements/contracts. But these grandfathering rules are more complicated than they appear. The rules of the old Construction Lien Act continue to apply with respect to an improvement if:

  • a contract for the improvement was entered into before the date of proclamation, regardless of when any subcontract under the contract was entered into;
  • a procurement process, if any, for the improvement was commenced before the date of proclamation by the owner of the premises (including the making of a request for qualifications, a request for proposals or a call for tenders); or
  • the premises are subject to a leasehold interest, and the lease was first entered into before the date of proclamation.

It is very important for lenders to note that the date of the credit agreement has no bearing. It is entirely possible for a loan to be established assuming the old rules apply (e.g. 45 day lien period), but for the new rules to be binding on the owner and contractor.

This is made even more complicated by the fact that the prompt payment and adjudication rules, which come into force in 2019, have different grandfathering rules. Prompt payment and adjudication will be binding on all construction contracts signed on or after October 1, 2019, regardless of when the procurement process was commenced or if there was a lease.

During this transition time, it will be very important to be clear about which regime applies, or risk creating gaps and conflicts on the project.

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