The impact of Construction Lien Act amendments on PPP/AFP infrastructure projects

25 minute read
10 August 2017

Public-private partnership (PPP) infrastructure projects sit uncomfortably alongside provincial construction lien legislation, hopeful that parties do not look too closely at the technical definitions and procedures of statute and compare them to the actual workings of a public infrastructure project. In Ontario, this is changing.

On May 31, 2017, the Ontario government introduced Bill 142, the Construction Lien Act Amendment Act, 2017. It contains many changes that impact the infrastructure and the PPP or alternative financing procurement (AFP) sector.

Bill 142 introduces many amendments to the Construction Lien Act, including a renaming of the Act to the Construction Act in order to reflect that the statute deals with more than just lien rights.

The Province had three primary objectives in amending the Act:

  1. Modernize the Construction Lien Act
  2. Introduce a mandatory prompt payment regime
  3. Introduce adjudication of construction disputes

Many of the changes are simply modernizing and updating a very old piece of legislation which has not been significantly amended since it was first enacted in 1983. However, many of the changes are very impactful, including on infrastructure projects. These changes will have a direct impact on infrastructure projects in Ontario, and will need some adjustment in how infrastructure projects are managed, modeled and documented. Some of the principal changes are summarized in this article.

1. Modernize the Construction Lien Act

Recognizing the PPP/AFP Delivery Model in Practice

Currently, the Construction Lien Act in Ontario, like other provinces, does not recognize or properly address the structure and the practice of a traditional public-private partnership project. For example, an "owner" is defined such that it is a party required to have an interest in the lands on which or on whose behalf the improvement is being performed. This means that a consortium partnership or "Project Co" is not, technically, an "owner" under the Act, but is considered a "contractor". As a result, among other things, typical lien rights cannot be enforced against Project Co, Project Co is not technically allowed to release holdback until full completion of a project and not earlier for some subcontractors, and so on. Substantial performance under the Act is a concept that applies only to the contract between an owner and a contractor; whereas, between a contractor and subcontractor, work must be fully completed before holdback can be released. Lien rights also expire on the completion of work under the contract, not on substantial performance. The facilities management work of a project agreement, if included in a project, is not clearly included as part of the project at all, raising some uncertainties.

For the most part, this and other similar "fixes" catch up with standard practice and contract terms rather than introducing new obligations for contractual arrangements.

Bill 142 introduces a new Section 1.1 which applies "if the Crown, a municipality or a broader public sector organization, as the owner of a premises, enters into an agreement with a special purpose entity that requires the entity to finance and undertake an improvement on behalf of the Crown, municipality or broader public sector organization, as the case may be, and, for the purpose, to enter into an agreement with a contractor in respect of the improvement." In other words, these new rules apply to a traditional public-private partnership (PPP) or alternative financing procurement (AFP). A "broader public sector organization" has the same meaning as in the Broader Public Sector Accountability Act, 2010.

For improvements financed under a PPP/AFP model, the special purpose entity (Project Co) will now be deemed to be the owner of the premises in place of the Crown, municipality or broader public sector organization, and the agreement between the special purpose entity and the contractor is deemed to be the "contract" and is therefore not a "subcontract". This applies to Part I.1 (Prompt Payment), Part II.1 (Adjudication), Section 32 (Rules Governing Certification or Declaration of Substantial Performance), and Section 39 (Right to Information). It also will apply to any other portion or provision that may be prescribed in regulations.

The implications of exempting the Crown, municipality or broader public sector organization from the application of the prompt payment regime and adjudication regime creates some potential issues for PPP projects. For one, while the new prompt payment regime and adjudication regime will be binding between Project Co and the design-builder, Project Co cannot enforce them against the government authority or against the lenders on the project. This creates a potential stranded risk, at least at temporal stranded risk. These concerns are discussed below in more detail.

It is important to note that, other than those specifically enumerated sections, the Crown, municipality or broader public sector organization continues to be the owner of the premises under the Act. For the purposes of statutory holdbacks calculated under section 22, the amount to be held back is determined in reference to the agreement between the contractor and the SPE. Also, for the purposes of priorities on insolvency under section 85.1, the agreement between the contractor and the special purpose entity is deemed to be a public contract

The definition of "subcontractor" in subsection 1 (1) of the Act is also amended by adding "and includes a joint venture entered into for the purposes of an improvement or improvements" at the end. For a traditional PPP/AFP project, this will recognize that the subcontractors are typically themselves special purpose entities or joint ventures.

Bundling and Phasing

In order to reap the benefits of a PPP/AFP model, a certain economy of scale is required. Often, the governmental authority will bundle multiple smaller projects into one much larger project or include different phases in a larger project. Bundling and phasing in projects are not recognized under the current Construction Lien Act.

The Act defines an improvement, and the holdback and lien rights that flow from a project, based a single improvement under a single contract. In other words, if there is only one contract, then there is one improvement (all of the work contemplated under the contract), one project, one substantial performance date, one date for release of holdback and one date upon which lien rights expire.

This is addressed in Bill 142 by allowing bundling or phasing of projects and treating each portion of the project, if it is sufficiently separateable, like a separate sub-project within the one contract. As a result, where an authority, such as a school board, bundles the design and construction of several schools under one project agreement, there can be a separate holdback release date and lien period for each school if they are defined as different phases or milestones, provided the phases are sufficiently clear and defined in the contract. This will facilitate cash flow on projects.

Similarly, if the contract provides for a completion schedule that is longer than one year, and the contract price exceeds the prescribed amount (not yet established), then holdback can be released on an annual basis and not simply at the end of the project, provided that the contract expressly provides for a payment of accrued holdbacks on an annual basis. This will greatly facilitate the flow of cash on large and long term projects.

Updated definitions of substantial performance and completion

The financial threshold tiers for determining when an improvement under a contract is substantially performed has been increased from $500,000 to $1,000,000 to reflect inflation since the Act was passed in 1983. The financial threshold for determining when a contract is deemed to be fully completed and services and materials deemed to be last supplied has also been increased, from $1,000 to $5,000.

Mandatory release of holdback

Under sections 26 and 27 the basic 10% holdback and the 10% finishing holdback, respectively, must be paid on the day after the holdback period expires. The basic holdback period has not changed and remains 45 days after the publication or declaration of substantial performance. However, it is important to note that the lien period has been extended, and holders of lien rights will have 60 days from the publication or declaration of the substantial performance to file their lien claims. In other words, the holdback must be released before the lien rights expire. Further, a payer must provide a notice to a payee 10 days before the end of the holdback period if any amounts are to be withheld on the release of the holdback.

Longer lien preservation and perfection periods

As noted above, contractors and subcontractors will have a longer lien period. They will have 60 days from the publication or declaration of the substantial performance to preserve their lien rights, and, if they have preserved their lien rights, a further 90 days to perfect their lien claim. The objective is to provide parties with more time to resolve disputes.

Bonding required for all public projects

A new Part XI.1 (Surety Bonds) will be added to the Act. Section 85.1 of the Act will create a requirement for a contractor who enters into a "public contract" (i.e. a contract with the Crown, a municipality or a broader public sector organization) to provide the owner with a labour and material payment bond, and with a performance bond, if the contract price is above the amount set out in the regulations. These regulations have not been drafted yet so we do not yet know the applicable thresholds. The public contract bonds will need to meet the requirements that will be specified in the Act and regulations.

For PPP/AFP projects, the contract between Project Co and the design-builder is considered a "public contract" and so the design-builder will be required to provide these bonds in addition to any security dropped down from the project agreement or credit agreement. This will not be waivable and the bond will be in a prescribed form, so it is likely that this will be additional security, along with standard security and bonding that government authorities and lenders already require.

What is not as clear is whether or how this public sector contract bonding requirement will apply to the operation and maintenance contracts, particularly those that include lifecycle replacement.

Security allowed instead of holdback

Bill 142 will allow parties to agree to different forms of security which satisfy the 10% holdback requirement on all payments. Instead of cash, the parties may agree to a letter of credit or demand-worded holdback repayment bond, each in a form to be prescribed by regulations.

Proliferate use of standardized forms

Bill 142 proposes to standardize a number of forms that are typically used on a construction project, including notices of lien, notices of non-payment, and so on. On large PPP/AFP projects, typical template forms will either have to be adapted or contracts will need to contemplate two forms.

Definition of "capital repairs"

Under the current Act, an "improvement" includes "repairs". Case law has provided some guidance as to what is a repair that attracts lien rights and to which the Act applies, and maintenance type repairs to which the Act does not apply. Bill 142 attempts to clarify this line of distinction by establishing that an "improvement" includes only "capital repairs". "Capital repairs" are defined mean any repair intended to extend the normal economic life of the land or of any building, structure or works on the land, or to improve the value or productivity of the land, building, structure or works, but does not include maintenance work performed in order to prevent the normal deterioration of the land, building, structure or works or to maintain the land, building, structure or works in a normal, functional state.

It is not clear whether this will provide sufficient clarity of definition to avoid disputes, but it does provide some helpful guidance and clarity that applies to the operation, maintenance and lifecycle phase of a PPP/AFP project.

Trust provisions

Bill 142 also makes someone significant changes to the trust requirements of the Act. Following the example of the State of NY, the trust provisions will be amended to attempt to make trust funds more traceable and, it is hoped, more immune from the grasp of a trustee in bankruptcy.

Trustees will be required to deposit project trust funds into a trust account in the trustee's name. This does not need to be a separate, project-specific bank account, but separate written records must be maintained in respect of each trust for which the trustee is responsible.

On PPP/AFP projects, there is typically already a great deal of rigorous accounting and record-keeping discipline, as well as separate bank account requirements, imposed by the authority or the lenders. The new trust provisions should not require any major change by project parties.

2. Prompt Payment

When Bill 142 becomes law, Ontario will have a mandatory prompt payment regime.

The prompt payment regime will apply to every size or type of project, and apply at the level of the owner-general contractor, general contractor-subcontractor, and downwards. However, prompt payment will not apply to "the Crown, a municipality or broader public sector entity" on a PPP/AFP project. Project Co is deemed to be the only "owner" under Bill 142 as currently drafted. The prompt payment provisions of the Act (to be sections 6.1 to 6.8) apply to all payments made under contracts entered into on or after the day the prompt payment provisions come into force.

In brief, in the new payment regime, an owner on a project will have 28 days from the delivery of a "proper invoice" to pay their contractor. On PPP/AFP projects, this means Project Co, and not the Authority. The contractor will have a further 7 days from receipt of payment from the owner to pay its subcontractors, and so on down the contractual chain.

These are mandatory provisions and parties may not contract out of them. However, parties will be free to contract in respect of payment structures and other payment terms, for example by adding milestones, phases. a payment schedule (including completion or phase completion payments), or other requirements for payment. In the absence of milestone or other payment schedule in the contract, Bill 142 will deem a monthly progress payment structure.

Payers will be permitted to withhold or dispute invoices; however, in order to do so, they will be required to deliver a formal notice of non-payment in prescribed form within the prescribed time period. The notice of non-payment must be delivered within 14 days following receipt of a "proper invoice", in the case of an owner, and within 7 days following receipt of an owner's notice of non-payment, in the case of a contractor or subcontractor. There are no restrictions on the grounds for not paying, but the notice of non-payment must set out "all of the reasons for non-payment".

A definition of a "proper invoice" will be defined in section 6.1 of the Act once amended. The definition will specify what details must be in the invoice to constitute a "proper invoice". In addition, the Act will prohibit parties from including contractual provisions that make the giving of a proper invoice conditional on the prior certification of a payment certifier or on the owner's prior approval.

When discussing prompt payment, the Province indicated there would be a true "pay when paid" provision. However, Bill 142, as drafted, provides only a conditional "pay when paid" clause. If the owner does not pay a contractor, the contractor may still be under an obligation to pay its subcontractors unless (1) the contractor disputes the owner's non-payment and commences adjudication, or (2) the contractor delivers to the subcontractor a notice of non-payment disputing the subcontractor's entitlement to be paid.

If a payer disputes only part of an invoice, Bill 142 will mandate payment of the entire undisputed portion of the invoice.

If a party is entitled to be paid, but is not paid, Bill 142 will impose a mandatory interest charge on the amounts required to be paid on late payments. The rate will be the greater of the pre-judgment interest rate in the Court of Justice Act or the contractual rate of interest. PPP/AFP financial models may need to be adjusted to account for these payments as they may not be recoverable from the Authority or be advanced by lenders.

In addition, a contractor which is not paid or a subcontractor which is not paid after an adjudication decision will have a statutory right to suspend work, which will not be waivable and for which there may not be immediate relief under the project agreement.

3. Adjudication

Bill 142 also introduces a new, mandatory interim dispute resolution process referred to as "adjudication". This is based on the UK adjudication model that was introduced there over two decades ago.

Adjudication is intended to provide a fast, perhaps "rough", justice resolution of disputes, and expedite cash flow on projects. These will be mandatory and parties may not contract out of them. They will apply to all contracts entered into on or after the date that the adjudication provisions come into force. As with prompt payment, the Crown, municipalities and broader public sector entities will be exempted from adjudication proceedings on PPP/AFP projects. Project Co will be considered the only "owner" for the project.

A decision by an adjudicator will be binding on the parties, but are said to be binding only on an interim basis, meaning that the parties must follow the decision immediately and the decision may not be appealed except on some few, narrow grounds. A party may still re-dispute the original underlying matter in court (or through arbitration if required under the contract), but until resolution of that dispute, the adjudicators decision is binding on, and must be followed by, the parties.

Adjudication will only apply to disputes relating to specific issues, including: the value of services or materials, payment (including change orders), a notice of non-payment, set-offs, release of holdback, and any other matter that are set out in regulations or to which the parties agree may be submitted to adjudication.

The Act, mostly through regulations that have not yet been drafted, will set out how adjudicators are chosen, and what minimum rules of procedure must be followed. Essentially, the aim is to have adjudicated disputes resolved within one payment cycle of 30 days; or a bit longer if the parties agree to extend.

The adjudicator's decision cannot be appealed, although the subsequent determination of the same matter by a court or arbitrator is not bound by the adjudicator's decision. A party required to pay money by the adjudicator's determination must make payment within 10 days, failing which the payee may suspend work. A party can also have the adjudicator's decision enforced by court order.

Each party must bear its own costs and the adjudicator's fee is to be divided between them. The adjudicator may only award costs to a party if the conduct of the other party is considered frivolous, vexatious, constituted an abuse of process, or was not in good faith.

4. Implications and Issues for the PPP/AFP Industry

The changes in the Act are, in many respects, welcome in the PPP/AFP industry, especially by bringing PPP/AFP projects out of the shadows of the Act. However, as currently drafted, Bill 142 raises many questions and issues, even problems for the sector. Some of these may be resolvable by revising standard project agreements, but some may require other adjustments in project management and administration if Bill 142 is not changed.

Possible Stranded Risk - Prompt Payment Gaps: The true owner of the land - the Crown, Municipality or broader public sector entity - will not bound by the prompt payment and adjudication regimes. Nor will lenders. This creates a number of concerns. If the Authority on a PPP/AFP project delays a payment to Project Co or provides for pre-certifications or other conditions to payment, there may not be able to be dropped down and Project Co may still be obliged to pay the design-builder on a project. If Project Co does not pay when required under the Act, it will face interest charges that may not be recoverable from the Authority under the project agreement. To a certain extent, it will be possible to align contracts to the payment conditions of the project agreement, but the 28-day payment period cannot be waived and will not bind the Authority. If it is not paid, interest will accrue. Where will this money come from? The same issue arises with lenders which are also not bound by the prompt payment requirements and restrictions. Will financial models need to factor in this potential stranded risk? Will additional reserves be required? What impact will this have on bidders' pricing of AFP/PPP projects?

Possible Stranded Risk - Adjudication: Similarly, neither the Authority not the lenders will be bound by adjudication requirements. Since adjudication is designed to flow funds quickly on a project, Project Co could easily be squeezed with an obligation to pay a contractor, but without timely recourse to funds from the Authority or lenders. These concerns are particularly acute given the potential size of delayed or disputed completion payments. Again, where will this money come from and what impact will this have on bidders' pricing of AFP/PPP projects? In addition, what impact will an adjudication proceeding have on standard notice, reporting and default provisions in project documents and lending documents?

Consecutive Adjudication: Currently, there is no requirement for adjudications to run concurrently. This raises the possibility of different adjudication decisions at different tiers of the project pyramid in an adjudicated dispute between Project Co and design-builder, and between design-builder and subcontractor.

Adjudication Readiness: Adjudication is meant to be an extremely rapid dispute resolution process limited to one payment cycle; however, many invoices will be very large and very complex on large PPP/AFP projects. Will consultants and technical advisors have sufficient time to properly evaluate the merits of a dispute? Project Co is by definition a special purpose entity and the disputing party will have had as much time as it wants to prepare before commencing an adjudication: will Project Co (or the design-builder) be primed and ready for the speed at which a disputing party can commence an adjudication proceeding (2 days), including copies of records, experts, etc.?

Timing of Subcontracts: Bill 142 stipulates that the new prompt payment rules apply only to contracts that are entered into on or after, and the new adjudication rules apply only to contracts and subcontracts signed on or after, the day those sections come into force. This creates the possibility of some contracts and subcontracts on a project falling inside the regimes, and some outside the regimes, since there can be a significant gap in time between agreement signings. We understand that the Province is considering addressing this in grandfathering clauses, but it is certainly an issue of which project parties should be aware and should monitor.

Bonding: As noted above, it is not likely that the Authority or lenders will modify their standard project security requirements, which will among other things provide much more liquidity than a bond. So the additional bonding requirements will increase costs on projects. In addition, it is not clear how the bonding requirements will apply to What is not as clear is whether or how this public sector contract bonding requirement will apply to the operation and maintenance phase of an AFP project where the payment structure includes payments for construction work (capital and possibly lifecycle replacement) but is not necessarily aligned with the timing of the actual construction work. How is the bond amount calculated? When does it need to be provided? These will need to be worked out once Bill 142 and the related bonding regulations and exemptions are finalized.

Adjudicators: AFP/PPP projects are very complex and have complex payment and change procedures. The regime for qualifying and selecting adjudicators on AFP/PPP projects raises some concerns. Will they be sufficiently qualified to understand the AFP/PPP structure and procedures? Will there be sufficient numbers of sufficiently qualified adjudicators, especially bearing in mind that such projects are very long and would consume the time of many adjudicators? Finally, with so many parties on an AFP/PPP project and therefore so many potential adjudications, how will these be consolidated, decisions made consistent at each tier of contract and over the course of the whole project?

A change to any law will always raise questions and concerns. A major change to a significant statute will inevitably raise many questions and concerns. Much of this will be worked out over time through the administration and management of projects. But much of this will create real issues and problems for AFP/PPP projects, the solutions for which will not be found until after Bill 142 is enacted fully, and parties are able to start modeling the new financial risks and attempt to address those risks in negotiated contracts.

Gowling WLG has been deeply immersed in the reform process. We have held several events and published several articles since the first reading of Bill 142, and will continue to monitor its progress through the Legislature. We are planning several educational events and workshops, and additional analysis of the impact of Bill 142, over the coming months to help educate and inform parties about these changes to our industry. This includes a unique work shop program on adjudication on September 18 at which some of our UK partners will discuss the UK experience with adjudication.

Please visit our Construction Lien Act Reform "hub" for information and dates about all of our events and activities.

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