In Confidence

Office of the Minister for Building and Construction

Cabinet Economic Growth and Infrastructure Committee

Building Act review: Regulation of guarantee products and services

Proposal

1 I propose the Department of Building and Housing be directed to provide homeowners with information and guidance on guarantee products and services and also publish this paper on its website.

2 The Minister Responsible for the Law Commission has referred the issue of joint and several liability (dealt with in a companion paper to this paper) to the Law Commission for further consideration as part of a broad review of joint and several liability. The issues dealt with in this paper are linked to the review of joint and several liability and will also be considered by the Law Commission as part of its review. The Department of Building and Housing will provide information and guidance on guarantee products in parallel to the Law Commission review.

Executive summary

3 The Building Act reforms agreed by Cabinet in August 2010 propose changes to the building regulatory system that seek to contribute to a more productive, efficient and accountable building and construction sector [Cab Min (10) 27/10 refers].

4 In terms of accountability within the residential construction sector, the aim is to create a system in which legal roles and accountabilities of different parties for building work are clearly defined and to ensure these accountabilities can be managed and enforced in practice. The reforms include:

amendments to the Building Act 2004 to clarify responsibilities of building practitioners, building consent authorities and consumers

a move to risk-based consenting

mandatory written contracts and disclosure by building contractors

improved dispute resolution, especially planned changes to the Construction Contracts Act 2002

clearer implied warranties and direct remedies where those warranties are breached.

5 When the Building Amendment Bill (No 4), introduced on 6 September 2011, is passed and comes into force, building practitioners will be required to disclose what (if any) surety backing they have available before entering into contracts with

homeowners. It is estimated around 50% of new builds are covered by one of the two main surety products or services currently in the market. Enhanced disclosure is expected to drive demand for, and supply of, surety products and services on a voluntary basis.

6 The new requirements will encourage building practitioners, who do not currently offer guarantee products, to seek out ways to provide guarantees/surety.

7 Guarantee products and services are one type of surety. The products can help homeowners manage their losses when building work is defective and a building contractor defaults on obligations to remedy (including warranty obligations under the Building Act 2004). These products can also help building practitioners to manage their own risks and liabilities and reduce the impacts on territorial authorities from defective building work.

8 There are several risks for homeowners associated with guarantee products. It may be difficult for consumers to fully understand the guarantee product or service they are purchasing. In theory, a range of other risks for consumers also exist with these products that may result in a loss of cover. However, homeowners are not unprotected from these risks.

Building Act reforms, which promote greater accountability, provide remedies where implied warranties are breached, and include an effective licensing scheme for building practitioners, should help to reduce risks associated with guarantee products (for example, by helping to improve skill levels in the sector).

General consumer and insolvency law also applies. For example, the Consumer Guarantees Act and Fair Trading Act apply, and new regulatory requirements in the Consumer Law Reform Bill will soon apply which should help owners better understand the limitations and risks of these products.

9 There is no evidence of the risks, other than in theory, resulting in a loss of cover occurring at the present time (eg, a ‘run’ on a product). In light of the possible risks associated with guarantee products (and available evidence), the current regulation of these products is considered sufficient at the present time (taking proposed consumer law and Building Act reforms into account).

10 Rather than moving to any further regulatory intervention now, I propose the Building Act reforms be given time to ‘bed in’ so their impact can be properly monitored, considered and evaluated. A monitoring and evaluation plan is being developed by the Department of Building and Housing and the issue of guarantee products and services will be considered as part of that work. The plan will include a rolling consumer survey and a watching brief on any new products that may enter the market.

11 In the meantime, it is proposed that the Department of Building and Housing, in consultation with other relevant agencies, be directed to provide additional information and guidance to help homeowners understand and manage the risks associated with the current suite of guarantee products and services in the building sector as part of the Building Act review.

12 Following discussions between myself, the Attorney-General and the Minister of Justice, the Minister Responsible for the Law Commission has referred the issue of joint and several liability to the Law Commission for further consideration as part of a broad review of joint and several liability. The issues dealt with in this paper are

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Background

13 In August 2010 Cabinet agreed to building regulatory reforms to support improvements to the productivity, efficiency and accountability of the building and construction sector (Cab Min (10) 27/10 refers):

changes to the Building Act to clearly signal roles and accountabilities for building work and Building Code compliance between designers, builders, building owners and building consent authorities

new legislative provisions to enable residential consumers to better hold building contractors to account through contract

changes to the Building Act and regulations to exempt a broader range of low risk work from consenting requirements, and to provide for a risk-based approach to building consent and inspection requirements, so that the requirements are proportionate to the risks and consequences of building defects and the skills and capabilities of those doing the work

further advice on improvements to the administration of the building regulatory system.

14 The reforms under the Building Act are being implemented as a package. This includes both an information campaign to communicate with consumers about their rights and obligations when undertaking a building project, and information to the sector to support policy and regulatory changes. A monitoring and evaluation plan to assess the impact of the reforms is also under development.

15 As part of the Building Act review, Cabinet directed officials, led by the Department of Building and Housing and the Ministry of Economic Development, to report back to the Cabinet Economic Growth and Infrastructure Committee on:

the risks associated with guarantee products and services in the building sector

whether any changes to the way that these products and services are regulated would be cost-effective [Cab Min (10) 27/10 refers].

16 On 27 June 2011 Cabinet considered my proposal for the Department of Building and Housing to provide information and guidance to help homeowners understand and manage the risks associated with guarantee products and services in the building sector. Cabinet referred the proposal (contained in this paper) back to EGI for further consideration and invited me to discuss the proposal with the Attorney-General and Minister of Justice [CAB Min (11) 24/9B refers].

17 In this paper the term ‘warranty’ refers to a promise or obligation made by one party to another. Guarantee products and services are one form of ‘surety’ that a promise or obligation made by one party to another will be met if the party making the promise or obligation defaults.

18 A companion paper considers the issue of joint and several liability in the building sector and notes the issue has been referred to the Law Commission to be reviewed in a wider context.

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Comment

Guarantee products and services in the building sector

19 The Registered Master Builders Federation of New Zealand (RMBF) and Certified Builders Association of New Zealand (CBANZ) both offer guarantees backed by financial surety. These are the two main products in the sector. Both are funded through premiums paid by consumers. Both products provide cover for non-completion as well as latent defects for several years after construction (generally up to seven to ten years for certain defects) – with limitations and exclusions. In both instances, the building contractor has the primary obligation to repair the damage and the guarantor has a secondary obligation. [two sentences withheld under section 9(2)(b)(ii) of the Official Information Act 1982] Both products have been in the market for several years.

20 In addition to the guarantees offered by RMBF and CBANZ there are also other options available to consumers to protect themselves when undertaking building work. For example, BuiltinNZ Ltd provides guarantees for work undertaken by builders who are not members of CBANZ as long as they meet certain risk-based criteria. In addition, one major group builder holds a deposit with a bank to provide surety for its guarantee.

21 Alternative products such as escrow account options (eg, ‘Buildsafe’ and ‘Safekiwi’) are also available. These options are not directly comparable to the guarantee products described in paragraph 19. While they provide some protection to homeowners during the construction phase, they provide negligible protection for homeowners from losses due to latent defects.

Risks associated with guarantee products and services in the building sector

22 During the Building Act review, questions were raised about whether current regulation adequately protects consumers from the risks associated with existing guarantee products, and products that may enter the market in the future.

23 Anecdotal evidence suggests it may be difficult for consumers to fully understand the product or service they are purchasing, including the amount of financial backing each product or service has and the potential number of claims that may depend on that backing.

24 In theory a number of other risks for consumers associated with these products also exist, including:

the guarantee company becomes insolvent because of a ‘run’ on the product leaving homeowners without cover

non-coverage of latent defects if a guarantee company is wound up (in accordance with the Companies Act 1993) and defects become apparent at a later date

the guarantee company may attempt to retrospectively decline cover for specific kinds of building defects should they become widespread.

25 Should these risks eventuate, homeowners could potentially suffer significant financial losses. The magnitude of any losses suffered will depend in part on the

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26 The Building Act reforms (which promote greater accountability, provide remedies where implied warranties are breached, and include an effective licensing scheme for building practitioners) should help to reduce risks associated with guarantee products, for example, by helping to improve skill levels in the sector.

The regulation of guarantee products and services in the building sector

27 Homeowners are not unprotected from the risks associated with guarantee products and services. General consumer law applies (discussed further below), and in the case where a guarantee company has become insolvent, general insolvency law applies (potentially allowing homeowners to recover some costs as a creditor).

28 Guarantee products are primarily regulated through general consumer law (the Fair Trading Act 1986 and Consumer Guarantees Act 1993). The legislation includes requirements around fitness for purpose of products and services and false and misleading claims. General business law requirements also apply to the entities offering these products (eg, the Companies Act 1993). Additional consumer disclosure requirements will also apply to these products when the Consumer Law Reform Bill currently before Parliament is passed and comes into force – it includes a requirement for ‘plain language’ which should help owners better understand the limitations and risks of these products.

29 At first glance, guarantee products would appear to have many of the characteristics of insurance products and in practice consumers who purchase these products have an expectation of there being sufficient financial backing, some years in the future, to fulfil a legitimate claim. This raises the question, should guarantee products and insurance products be regulated in the same way?

30 Insurers are regulated under the Insurance (Prudential Supervision) Act 2010. This Act requires insurers to be licensed, with a key aspect relating to insurers’ capacity to meet future claims. By contrast, guarantee products and services are specifically excluded from the definition of a ‘contract of insurance’ under section 7 of the Insurance (Prudential Supervision) Act 2010.

31 There are important reasons for this different treatment.

The first is there are legal differences between a contract of guarantee and a contract of insurance. The key difference is in relation to who owes a primary obligation to the homeowner. In a building guarantee, the homeowner must look to the builder first. If the builder cannot or does not remedy the defect, the homeowner can then look to the guarantor for remedy.

A second and perhaps more compelling reason for the different treatment of the two products is the potential harm caused by the failure of a general insurer is much greater than the harm caused by the failure of a building guarantee company. The costs of prudential regulation of this type may be out of proportion with the risks associated with guarantee products.

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Next steps

32 There is no evidence of the risks, other than in theory, resulting in a loss of cover occurring at the present time (eg, a ‘run’ on a product). In light of the possible risks associated with guarantee products (and available evidence), the current regulation of these products is considered sufficient at the present time (taking proposed consumer law and Building Act reforms into account).

33 Rather than moving to any further regulatory intervention now, I propose the Building Act reforms be given time to ‘bed in’ so their impact can be properly monitored, considered and evaluated.

34 A monitoring and evaluation plan is being developed by the Department of Building and Housing and the issue of guarantee products and services will be considered as part of that work. The plan will include a rolling consumer survey and a watching brief on any new products that may enter the market.

35 The issues dealt with in this paper are linked to the operation of joint and several liability. A companion paper to this paper discusses current issues with how joint and several liability affects the building sector. I have agreed with the Minister responsible for the Law Commission to refer the issues on joint and several liability to the Law Commission for a broader review (not limited to the building sector). Accordingly, the contents of this paper will also need to be covered by the Law Commission’s review.

36 If the outcome of the Law Commission’s review of joint and several liability includes further regulation of guarantee products, some of the possible regulatory options that could be considered are as follows:

Table 1: Indicative range of options that could be considered further if required

Level of intervention (likely cost / impact)

Indicative range of options

Lower

Higher

Additional financial reporting + disclosure requirements for guarantee companies (regarding financial soundness)

Negative licensing of guarantee companies (banning etc)

Government licensing of guarantee companies (eg, this could be similar to that for insurers)

Provision of surety, options could include the following: - Establishing a Government surety product to compete

with current providers and products - Mandatory industry wide surety (eg, a fidelity fund

financed by a levy on building consent applicants).

37 Pending completion of the Law Commission’s review, I propose the Department of Building and Housing, in consultation with other relevant agencies, be directed to provide additional information and guidance to help homeowners understand and

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Consultation

38 This paper incorporates advice from the Department of Building and Housing and the Ministry of Economic Development.

39 The following government agencies were consulted on this paper before its first consideration by EGI. This version of the paper was sent to them for their information:

The Treasury, the Department of the Prime Minister and Cabinet, the Ministry of Justice, the Department of Internal Affairs and the Ministry of Consumer Affairs.

40 The Officials Committee for EGI was consulted on this amended paper and had no comments on the paper.

41 To inform the contents of this paper, discussions were held with a range of stakeholders. These include Consumer NZ, the Registered Masterbuilders Federation, the Certified Builders Association of New Zealand, the Building Research Association of New Zealand (BRANZ), the Homeowners and Buyers Association of New Zealand, the Insurance Council of New Zealand, the Bankers Association of New Zealand and various individual banks.

Financial implications

42 There are no financial implications for the Crown associated with the proposals in this paper.

Human rights

43 The proposals in this paper are not inconsistent with the New Zealand Bill of Rights Act 1990 or the Human Rights Act 1993.

Legislative implications

44 There are no legislative implications associated with the proposals in this paper.

Regulatory impact analysis

45 A Regulatory Impact Statement is attached to this paper.

46 The Department of Building and Housing confirms that the principles of the Code of Good Regulatory Practice and the regulatory impact analysis requirements, including the consultation RIS requirements, have been complied with.

Publicity

47 Any publicity associated with the proposals in this paper will be undertaken as part of the Government’s wider communications strategy on the Building Act review. A

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Recommendations

48 The Minister for Building and Construction recommends the Committee:

1 note that on 2 August 2010 Cabinet directed officials, led by the Department of Building and Housing and the Ministry of Economic Development, to report back to the Cabinet Economic Growth and Infrastructure Committee on:

the risks associated with guarantee products and services in the building sector

whether any changes to the way that these products and services are regulated would be cost-effective

2 note Cabinet considered a report from the Minister for Building and Construction on 27 June 2011 and referred the matter back to EGI for further consideration [CAB Min (11) 24/9B refers]

3 note the Minister for Building and Construction discussed the previous report with the Attorney-General and Minister of Justice and the Ministers agreed the report needs to be considered as part of a wider review of the joint and several liability rule

4 note the Minister responsible for the Law Commission has referred the joint and several liability rule to the Law Commission for review and the Minister for Building and Construction agrees with that approach

5 note the Department of Building and Housing intends to monitor the impacts of the wider building sector reforms on building guarantee products and services as part of the monitoring and evaluation plan for the Building Act review

6 direct the Department of Building and Housing, in consultation with other relevant agencies, to provide additional information and guidance to help homeowners understand and manage the risks associated with the current suite of guarantee products and services in the building sector as part of the Building Act review

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7 agree this paper, and the minute related to it, can be published by the Department of Building and Housing as part of the wider communications plan for the Building Act Review.

Hon Maurice Williamson

Minister for Building and Construction

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