Retentions


Posted on 23rd April, by JimYoung in Blog. Comments Off on Retentions

To an increasing extent we are outsourcing project work – maybe our entire project or at least part of the work is given over to a contractor to complete who in turn may contract out packages of their work to subcontractors or subbies as we call them.  Thus contracts between the client and the principal contractor and between the principal contractor and their subcontractors are commonplace.  A practice, particularly in the construction industry, is for the client or principal contractor to have a provision in their standard contract that allows them to retain a portion of payments until both parties agree that the work is properly completed.  So retention or retainage in this sense has nothing to do with improving customer loyalty, reducing customer defections or even a medical complaint, but everything to do with creating an incentive to retain a contractor’s attention until all work has been properly completed.

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Such retentions are a safeguard against fully paying for work before it is properly completed and defect free.  To pay the full amount regardless of defects, risks worker desertion or at least drawn out arguments and delays.  Have you ever paid a tradesman in full and then found they’re very elusive when it comes to putting defects in their job right?

The standard current retention formula for our local construction industry is:

  1. 10% of the first $200,000 of the value of work completed to date.
  2. 5% of the next $800,000 of the value of work completed to date.
  3. 1.75% of any amount in excess of $1 million with a maximum sum retained of $200,000 (default) or other specified.

Using this formula, what total retention sum would apply to a $2,000,000 job?  And what would be the retention sum at a flat rate of 5% as some experts advocate?

Should a subbie have a previous incident of unsatisfactory performance and/or the work possess considerable uncertainty, they may be expected to accept a retention rate greater than 10% – perhaps up to 20%.  Conversely, a subbie of proven ability may be able to negotiate a very small retention rate or have no retention at all, particularly if there are no others who can do the work to the required standard.  A subbie might delete (tag) the retention clause from the proposed contract or submit two quotes – one including retentions and one excluding retentions.

Ordinarily, following project completion, there is a period commonly known as the “defects liability period”.  This is usually 12 months.  During this period the principal contractor and therefore the sub-contractors have to make good any defects to the project deliverable, appreciating that some defects only become apparent during the operational life of the deliverable.  There are different contractual provisions but release of the first portion of retention (typically 50%) is normally linked to completing the work on site, the stage commonly referred to as “practical completion”, which recognises that the job has been satisfactorily completed except for minor omissions and defects, if any.

Thus, retention monies represent a percentage of the total value of the contract and have long been an important safeguard for employers against the threat of defects and omissions. Unfortunately, retentions are sometimes used as an excuse to withhold or avoid paying contractors, which of course is illegal, but nevertheless happens all too frequently.  And where there is no suspicion of latent defects and withholding retention is merely an insurance in case of latent defects, then the client or contractor has no authority to do this.

The recent liquidation of various Mainzeal companies has drawn particular attention to the retention issue.  Mainzeal went into liquidation owing about $18.3 million in retention payments to subcontractors.  Retentions can be used by principal contractors as cashflow, rather than as a security, and subcontractors have to claim retention payments back. They are not simply handed back at the end of a job.  Anyway, since this money was not secured there is little or no chance of these subcontractors recovering their money.  So as unsecured creditors, subcontractors are very unlikely to recover this debt.  It is therefore understandable why retention is a dirty word for subcontractors.  In an ideal world, subcontracts would not contain retention clauses, all work would be perfectly completed, and payment of subcontractors’ invoices would be paid on time and in full each month.

Thus, the basis for holding retentions is that they are an incentive for the contractor to properly complete any remedial work that may be required after substantial completion of the project. If the contractor is unable or unwilling to complete remedial work in a timely manner, the client is in possession of funds to enable that work to be carried out by others.  So, it’s a financial incentive to ensure the subcontractor’s performance of their contractual obligations and to ensure the subcontractor completes remedial work in a timely manner.  Subbies widely accept the retention system, but mostly because there is a major imbalance in negotiating power and they want future work.

Retentions might be applied differently to different subcontractors, depending on the relative power of the subcontractor.  Yet, subcontractor retentions are a significant factor in enabling financially-challenged principal contractors to continue trading.   But with the tight margins many subbies often work to, we can be assured that most (if not all) of the subbies’ profits are tied up in retentions. This means subcontractor profits cannot be realised for about one year after practical completion. While, the whole widely abused  “pay when paid” or “pay if paid” principle was removed by the NZ Construction Contracts Act 2002, it is still in effect for retentions.

In our relatively small market, many subcontractors rely on the same principal contractor for their future work and, if they make too much fuss, they may risk being stigmatised in our local industry as troublemakers.  And legal action is usually not an option because lawyers are expensive and will argue about whether a job was completed satisfactorily or not forever and a day, and the big building firms aren’t afraid to use them.  So when things go wrong in our local building industry and there’s not enough money to go around, one thing seems certain – the subbies are screwed.

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Thus, the four main concerns with retentions from the subbies’ perspective are:

  1. Retention is often not released on time and in accordance with the contract. This is a problem for all parties in the contractual chain. In a typical construction contract, the level of retention can often be more than the level of profit margin; therefore, until retention is paid, it means that the party having their retention withheld may be in a financial loss situation.
  2. In the case of subcontracts, the release of retention may be dependent on circumstances outside of the subcontractor’s control, such as the remedying of defects under the main contract by other parties.
  3. Retentions may help to keep financially troubled, unsound and unethical contractors in business.
  4. Subcontractor retentions are a real cost that eventually find their way through to the clients.  They are a cost that provides only doubtful benefits.

So subbies argue that if retentions were abolished, we might expect:

  1. Inadequately financed contractors to be forced out of business.
  2. Contractors would be inclined to award subcontracts considering more than just the lowest cost conforming tender.
  3. Contractors would be keen to engage sound and competent subcontractors.
  4. Less financial damage from construction company failures.

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A subbie can refuse retention clauses and perhaps negotiate a bond or a discount instead, but in the interests of both parties the best solution would be to amend current legislation, just as the Construction Contracts Act was amended to abolish the “pay if/when paid” clause.  At the very least, legislation could require that retention amounts and periods for them to be held be subject to justification for each specific subcontract, rather than to be held to the end of the head contractor’s maintenance period. This would require parliament to amend the Construction Contracts Act 2002 to help ensure that retention payments are better protected, with retention payments held in a trust as successfully practised in NSW and now advocated by Clayton Cosgrove NZ Labour Party’s commerce spokesman.  These funds would then not be available for every day use by either party. In this situation the subcontractor’s bank would provides a bond to the principal contractor for the total amount of the retention payment.  Such an amendment to our Construction Contracts Act is due to be debated in our Parliament during May or June 2004.

Subcontractors are the backbone of our building and construction industry and are critical to the country’s economic growth and the Christchurch rebuild.  So hopefully the whole issue is sorted soon.  And for a detailed explanation about retention accounting please go to: http://myobnz.custhelp.com/app/answers/detail/a_id/33479.

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