Construction defects – who pays when things go wrong?

In 2024, there were 2832 construction sector insolvencies, leaving large developments unfinished and families with incomplete homes. When a builder becomes insolvent, it often has flow on effects on subcontractors who are also owed money and can no longer remain solvent. It’s a further downward spiral from there, with cost cutting another response that leads to more defects.

When building defects surface, they not only pose a safety risk for occupants but also raise financial questions: who is responsible and who bears the burden of repair costs?

Typically, the entity or individual responsible for the defect is generally expected to cover the repair costs. However, determining this responsibility can be a complex process given the number of parties often involved in building construction. The contractual agreements in place can often shift the risk and responsibility between those involved.

Current pressures in the construction industry may lead to situations where the responsible party is insolvent, leaving others to bear the repair costs, often, unfortunately, the owners.

What is a defect?

Defects are a common cause of disputes between owners and those involved in the construction process, such as contractors and design consultants. 

A defect is defined as a flaw or deviation from the intended condition of a material, assembly or component that can arise during or after the completion of a building. A building defect can also be a “latent defect”, meaning it remains hidden or is not immediately noticeable upon an ordinary inspection. Defects can range from minor cosmetic issues to major defects such as structural, waterproofing or flammable cladding.

No building is perfect, and most buildings will have some minor defects. However, buildings with major defects can cause catastrophic financial consequences for its owners and have become a focus point recently. For example, the infamous case of the Mascot Towers, which had serious structural issues and was found to have suffered cracking in the primary support structure of the façade masonry, led to the immediate evacuation of hundreds of residents. The evacuation was a safety precaution due to the significant concerns that the building could potentially collapse.

The issue raised extensive discussions about building standards, regulations, and the rights of owners. We have seen a shift towards ensuring more accountability by those involved in construction works in Australia, with amendments being made to existing building legislation as part of ongoing reforms to transform the regulation of the construction industry and restore trust and confidence, particularly in residential buildings.

Changes to ensure accountability

The NSW Home Building Act 1989 was put in place to protect owners of residential property from defective building work and provides statutory warranties that are included in all building contracts. Both the builder and the developer are liable for any breaches of the statutory warranties during the warranty period, and the benefits of the warranties are passed onto subsequent owners.

The Building Legislation Amendment Bill 2023 was passed by Parliament in November 2023 and provides for further amendments to the Home Building Act. This includes the introduction of stronger powers for inspectors of the Building Commission NSW to investigate the construction of buildings covered under the Home Building Act, which include, for example, freestanding houses, duplexes and terraces (known as Class 1 buildings under the National Construction Code). Inspectors may examine, test, take samples or seize things to ascertain building compliance or if they suspect it may relate to defects in the building.

The inspector is also entitled to issue a rectification order to the contractor for any defective building work, as well as issue a stop work order to a developer where they suspect that, if the building work was to continue, there could be significant harm or loss to the public or occupiers, including future occupiers of the building. Penalties can apply for failure to comply with a rectification or stop work order.

There has also been the recent introduction of the ‘Strata Building Bond and Inspection Scheme’ under the Strata Schemes Management Act 2015 (NSW), which creates a bond that owners may be able to access to rectify defects in new buildings that are four storeys or higher. The scheme requires developers to lodge a bond equivalent to 2 per cent of the cost of the building work with NSW Fair Trading prior to the application of the occupation certificate.  

The Design and Building Practitioners Act 2020 (NSW) (DBPA) introduced a duty of care, which means that anyone involved in the construction of the building owes the owners a duty of care to avoid causing economic loss because of the defects. The legislation has been the subject of recent litigation and interpretation by the courts, including the recent Pafburn Pty Limited and Anor v The Owners – Strata Plan No 84674 [2024] HCA 49 with the majority of the High Court of Australia finding that those who delegate or subcontract work to others cannot seek to exclude or limit their liability via the apportionment regime. Owners can now potentially bring a single claim against a developer or head contractor for the entire loss arising from a breach of the duty of care under the DBPA.

What the developments mean  

The aim of these legislative changes certainly put more accountability on those involved in construction work, which hopefully will result in better quality of work to avoid defects in the first place. However, while these legislative requirements are designed to protect consumers, they also increase pressure on the construction sector, which can be unsustainable for many in the industry. Consequently, developers and contractors in New South Wales now potentially face significantly increased exposure to risks, costs, and higher insurance premiums related to construction work.

If the builder/developer does not address the rectification of defects within the relevant time period, the owners will need to commence legal proceedings if they want to preserve their rights of recovery from the responsible party. It is essential that stakeholders manage this risk by understanding the avenues for recovering those costs as soon as possible, taking the necessary steps to protect their rights, and being aware of the relevant, often strict, time limits that apply to any claim.

The construction industry is grappling with several challenges, including a labour shortage, rising costs due to escalating construction materials prices, project delays and supply chain disruptions. These issues not only affect project timelines but also increase project costs and directly impact contractors’ margins. Economic fluctuations and uncertainties, such as interest rate rises, have resulted in halted or cancelled projects, affecting the stability of the industry.

Builders have recently been operating at negative cashflows, where suppliers do not get paid, and projects are left unfinished. Problems then arise if the person ultimately responsible for the defective work is insolvent, has moved overseas or is unable to be tracked down.

In 2024, there were 2832 construction sector insolvencies, leaving large developments unfinished and families with incomplete homes. When a builder becomes insolvent, it often has flow on effects on subcontractors who are also owed money and can no longer remain solvent. This is a domino effect that usually impacts many involved in the construction process. Developers are often left to address defects that were caused by the builders they engaged to do the work. These issues often lead to cost cutting measures and shortcuts being taken to reduce expenses and minimise delays, which usually results in substandard workmanship and increased defects.

An option available is insurance. NSW has moved towards legislating that builders take out insurance, which includes an insolvency event. However, there are limitations involved. In many instances, the construction professionals involved will have professional indemnity insurance, providing owners with a greater degree of comfort that successful claims will be paid out.

Decennial liability insurance (DLI) is an insurance product that covers the common property of strata apartment buildings (known as Class 2 buildings under the National Construction Code) against defects for a period of 10 years. The developer will take out the insurance policy before occupation of the building, and it provides an alternative option to the Strata Building Bond and Inspection Scheme. DLI covers the rectification of defects up to the contract cost of the apartment building, even if the developer or builder becomes insolvent or ceases operation.

What can be done to avoid disputes arising in relation to defects:  

• assemble the right team – Developers and contractors need to ensure they research anyone that they intend to engage for construction works. Good contractors care about their brand, which usually results in those contractors attending to defect rectification and increases the chance of those contractors remaining solvent
• contractual risk transfer is important – Putting protections in place by seeking legal advice and establishing robust contracts and agreements from the outset
• due diligence – remaining diligent throughout the project to ensure detailed record management and contract administration and also to ensure defects are picked up on as soon as possible to ensure they are rectified quickly
• insurance – ensure that appropriate insurances are taken out and notification is provided as soon as possible

• obtaining early legal advice if a defect arises – seek guidance on the available recovery and ensure all rights are preserved

Determining accountability for building defects hinges on a range of factors, including the nature of the defect, the specific terms of the construction contract, the applicable legislation and the solvency of the responsible entity. What remains constant is the necessity for diligence, careful planning and clear contracts to try to prevent defects in the first place, and if they do occur, to ensure that they are swiftly addressed with minimum distribution.