Retention money - a necessary evil or a pernicious device?

It was to address this issue that at the beginning of the year, and after a brief inquiry, the House of Commons' Trade and Industry Committee (the Committee) published a report on: "The use of Retentions in the UK Construction Industry". The inquiry looked at the advantages and disadvantages of the retention system and reported that: "Given the doubtful benefits and the clear disadvantages of retentions, it would obviously be in everyone's interest for such an inefficient - and frequently harmful - practice to disappear"

The advantages

The advantages of the practice of retaining money are clearly on the employer/client’s side and some of the perceived advantages are as follows:

• It provides a fund for rectifying defects.
• It provides an incentive to the contractor to complete the project on time and without defects.
• It provides an incentive to the contractor to return to site during the defects liability period to remedy any defects or deal with snagging items.
• It offers the Employer some protection against the contractor’s insolvency.

The Committee considered the views and heard evidence from a cross section of organisations involved in the construction industry. It reported that there was little, if any, evidence that retentions actually resulted in fewer defects. Conversely there was some evidence that on projects where retention money was not held there were fewer defects (this could be because the projects were carried out on a partnering basis).

The disadvantages

The disadvantages of the retention system are almost invariably suffered by the contractor (and, often more so, by sub-contractors). Some of the disadvantages are as follows:

• The contractor is not paid in full for work which is carried out satisfactorily.
• If margins are low and the payment schedule stacked in favour of the employer it can mean that in the early stages of a job the contractor is not being paid sufficiently to cover his costs.
• The usual 5% retention can represent a large proportion, or all, of the profit on a job.
• A sub-contractor who executes a small part of a large contract may complete his obligations early on, and to a high standard, and yet not be paid his full entitlement for some time to come because the overall project has months or years to go until completion.
• The cash flow, particularly in small businesses, is restricted often to the extent that contractors have to borrow money to cover the gap in their finances caused by earned money being withheld from them.
• As a matter of practice it tends to be the contractor who has to apply for the return of retention money and therefore bears the administrative burden.
• Whilst the retention system offers some protection up the line in the event of contractor or sub-contractor insolvency no such protection is offered down the line. Therefore if the party holding the retention money becomes insolvent the party entitled to repayment of the retention simply becomes an unsecured creditor.

So it appears that retention money is a pernicious device and the merits of the arguments against retention money are with the contractor. Having formed this view the Committee looked at alternatives to retentions and the possibility of abolishing the practice altogether.

The alternatives

The issue of whether legislation could be introduced to abolish the retention system was considered and decided against. The main reason why the Committee was opposed to legislating against retention money is that it would interfere with the parties rights to contract on whatever basis they chose to. In any event presumably payment mechanisms could be altered and drawn out to such an extent that in effect money was still being withheld.

The practice of retaining a percentage of the money due to a contractor originated in the Victorian era during the railway construction boom. Money was retained to protect against the frequent occurrence of contractor insolvency. Of course, today, bonds and guarantees are used to protect against insolvency but retention money is still held to protect against defects or at least to provide a fund for rectifying defects. The Committee considered the use of bonds and warranties as alternatives to the retention system but reported that the general view was that, in reality, a bond would probably cost the contractor as much as retention money.

The report refers to the British Construction Steelwork Association (BCSA) which introduced a system of retention bonds rather than money. In fact the BCSA had prohibited its members from entering into contracts that required retention money to be held. The Construction Confederation complained about this to the Office of Fair Trading (OFT) who decided that this prohibition was anti-competition and as a result of this intervention the BCSA has revoked the rule and members are now free to enter into contracts on terms they choose.

In fact the Federation of Piling Specialists (FPS) and the Precast Flooring Federation (PFF) had also prohibited the use of retentions and, as with the BCSA’s rules, the OFT ruled that this prohibition was anticompetition. In compliance with the OFT the FPS has removed its prohibition on retentions however, its members are apparently determined to stick to their no retentions policy. The FPS Chairman was quoted recently as saying:

“Our members have become used to the right to be paid in full for the work they have completed and will not return to a situation where payment of 3-5 per cent of their turnover is withheld and at risk”.

This is a sentiment understood amongst contractors and is fuelling their collective resistance to retention.

Another alternative that was briefly considered by the Committee was insurance. On balance, insurance is probably not going to persuade the industry to discard retentions because it can be expensive and difficult to claim. The ultimate alternative is to abandon and not replace retentions and in circumstances where the employer is entitled to set-off or abate, in the event of actual defects, there is little justification for withholding money due to a contractor once the project is complete unless it is genuinely attributable to defects.

The future

Despite the fact that the Committee undoubtedly was in favour of abolishing retention it came to the conclusion that the practice could not be outlawed and would not disappear – well not yet anyway. Notwithstanding the fact that retentions do not necessarily reduce the occurrence of defects or that the amounts retained are insufficient to cover major defects or that alternative measures may in fact provide more protection, the majority of employers are very reluctant to lose their pot of ready money. The short term conclusion seems to be that whilst parties who regularly contract should probably learn to live without retentions it is understood why smaller, less experienced or infrequent employers require retention money. Equally it is probably more acceptable to hold retention money when contracting with an unfamiliar contractor.

Furthermore, where a sub-contractor has completed its section of the work satisfactorily there seems little reasonable justification for retaining money properly due to the sub-contractor. The new JCT Domestic Form of Sub-Contract provides for half of the retention to be paid on practical completion of the sub-contract works and the other half to be released when any defects under the sub-contract have been rectified. As long as an equivalent amount of the main contractor’s retention is released by the employer this would appear to be a move in the right direction.

The public sector

As it was an accepted principle of the Committee that retention money is a contractual matter and the terms of a contract are (largely) for the parties to agree, perhaps the real ambit of a House of Commons’ Committee is to make recommendations to the public sector. Although there are exceptions, retention money is still held across the public sector. However the Committee recommended that:

• The government departments and agencies should be taking the lead in phasing out retention practices.
• By 2007 government departments should have phased out retention in their procurement contracts.
• In the negotiation of PFI contracts the government should insist that its principal contractors agree not to require retentions.
• Local government and local authorities should be encouraged to adopt a similar policy.

Conclusion

The overall aim of the Strategic Forum for Construction (chaired until recently by Sir John Egan) is to promote better practice and trust within the industry. A measure of whether this is being achieved is the extent to which employers insist upon withholding retention money. Eventually it is hoped that better working practices will render retentions redundant, but it would appear that for the time being retention money survives as a necessary evil. However with the public sector being expected to lead by example in phasing out retentions and groups of contractors resolving to resist retentions, clearly there are increasing efforts to eradicate the practice of retaining money.

For further information please contact Tania Maycock at [email protected] or on +44 (0)20 7367 2299.