CONSTRUCTION JOURNAL

What are the alternatives to retention?

Legal attempts to abolish the practice of retention have made slow progress – so what other contractual approaches are available, and how effective are they?

Author:

  • Roland Finch FRICS

12 April 2023

Overhead picture of high rise construction site

In November 2022, NEC and the Construction Leadership Council published guidance on the topic of retention. However, by its nature the guidance only refers to the NEC suite.

Other standard forms deal with the issues related to retention in different ways. What alternative approaches are available?

Understanding practical problems of retention principle

The principle of cash retention is relatively simple: one party to a construction contract can hold on to a proportion of the money due to be paid to the other until such time as that second party completes the work to the satisfaction of the first, or attends to any defective work that appears during a stipulated time after construction has finished.

Typically, this may be an employer or client holding retention for a main contractor, or between a main contractor and its subcontractor. That retention is supposed to cover the cost of putting things right in the event that the contractor, say, doesn't meet its obligations under a contract. The amount is usually a percentage of the contract sum.

The main advantage of cash retention is that, despite being a fairly crude method, it is relatively easy to calculate and administer. But over the years it has been the source of many arguments, with retentions being withheld for longer than was stipulated, or in disproportionate amounts.

For example, a subcontractor that undertakes groundworks on a large project could find its retention is not released until the whole job is signed off by the employer under the main contract, and that might be years later. Similarly, where there are only very small items of snagging to attend to, the amount held may be disproportionate to the cost of the outstanding work.

Either way, the result is that cash flow is restricted, and this can be potentially harmful for businesses. In an industry where typical profit margins are currently less than 3%, it is easy to see how a loss of 5% retention money could have serious consequences.

Related article

NEC guidance aims to reduce need for retentions

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Consultation pinpoints pitfalls and alternatives

Retention monies ultimately belong to the party carrying out the work, and in the normal course of events should be paid in full. However, this is not always the case, so there is a continuing fear that if the party holding retention becomes insolvent then the cash could be lost.

The Housing Grants, Construction and Regeneration Act 1996 (as amended) outlawed so-called 'pay when paid' clauses, so in theory it shouldn't be the case that a subcontractor is denied payment of its retentions until they are released under the main contract. However, it still happens from time to time, potentially leading to financial difficulties for the subcontractor.

In 2017, the Department for Business, Energy and Industrial Strategy – now part of the Department for Business and Trade – commissioned consultancy Pye Tait to report on the subject as part of a broader consultation into the use of cash retentions in the construction industry.

The report concluded that among other things, the use of retentions resulted in higher costs for clients, poorer relationships in the supply chain and constraints on business growth. It identified some alternatives to retention, including:

  • project bank accounts (PBAs)
  • retention bonds
  • performance bonds
  • parent company guarantees
  • escrow stakeholder accounts
  • retentions held in trust funds.

 

The JCT contract suite offer some examples of how these items work.

PBAs not fulfilling potential

Essentially, PBAs comprise a dedicated trustee account from which contractual payments are made to the contractor and members of the supply chain. They may be subject to single or dual authority, depending on who initiates the payment. Significantly, though, they are not held solely by one party in isolation.

The first PBAs were trialled by the Ministry of Defence in 1999. However, their use is still unusual outside the public sector, where they are often mandated. JCT contracts have offered them for some considerable time, with the most recent version of PBA documentation published in April 2022.

Several high-street banks offer these types of account for use in construction, but they still do not appear to be as widely used as they might be, despite extensive promotion in the industry.

Project Bank Accounts are now mandated by the devolved administrations in Scotland and Wales for construction projects with a value of £2m and above, and the policy in Northern Ireland is to include them for projects over £1m.

Meanwhile, the UK government introduced the Public Sector Supply Chains (Project Bank Accounts) Bill in 2019. However, there is still some resistance to PBA implementation outside the public sector, on the grounds of cost and complexity of administration.

Retention bonds reflect retention practice

A retention bond is a form of insurance-backed guarantee. Instead of holding on to cash, one party receives an undertaking that a payment – equivalent to the amount of retention that would have been held – will be made in the event that the other party defaults on its obligation to make good any defects.

While NEC uses secondary option X16, JCT has a dedicated enabling clause in most of its standard-form contracts, originally introduced in the 2005 edition, and has published template bonds for this purpose.

The amount of the bond can be reduced on practical completion, mirroring the process under which the retention percentage would also be reduced at that stage.

Performance bonds can strain supply chain

Perhaps the most familiar of all the alternatives to retentions, performance bonds and parent company guarantees have been used in construction for decades. They seek to guarantee the performance of the work rather than focusing on retention, notwithstanding that the means of compensation in the event of failure is usually financial.

One major problem with the use of performance bonds, however, is the wording of the bond itself. In recent years, there has been a client-led move towards on-demand bonds. These routinely allow the bond to be called in without necessarily having to prove breach of contract, only that there are defects – which may not even be the fault of the contractor. Moreover, in some cases there is no opportunity to challenge the call.

Like all products of this nature, there is also a premium to be paid to the guarantor, and this additional cost is usually borne by the contractor. Obviously, this can affect relationships between the parties.

JCT deals directly with performance bonds, guarantees, collateral warranties and third-party rights in section 7 of its standard, intermediate and design and build contracts, introduced as part of the 2016 update. While JCT don't recommend a specific bond, they do offer some guidance on the topic.

It is perhaps fair to say that in isolation, performance bonds and parent company guarantees are not in themselves a direct replacement for retention – clients will often ask for both a bond or guarantee in combination with retention, but when attempting to secure performance, the terms of a bond or guarantee are usually more precise.

'In recent years, there has been a client-led move towards on-demand bonds. These routinely allow the bond to be called in without necessarily having to prove breach of contract'

Escrow and trustee accounts aim to safeguard funds

Retention money is deposited in these third-party accounts so that if, for example, the paying party becomes insolvent then the retention itself is safe.

Although these are not a standard feature of NEC contracts, the JCT suite includes an obligation in most of its standard forms that imposes a fiduciary duty on the employer to use the retained funds in the best interests of the contractor, while stopping short of requiring them to invest.

Many other standard form contract publishers propose alternatives to retention. UK government GC/Works contracts (now withdrawn) included these as long ago as 1998, while the Association of Consultant Architects (ACA) PPC family contains options for bonds dealing with retention and performance. The Infrastructure Conditions of Contract (ICC) suite also allows for similar choices.

Likewise, the RIBA Concise and Domestic Building Contracts have provision for an optional insurance-backed guarantee.

In 2018, the International Federation of Consulting Engineers (FIDIC) published a briefing note: Guarantees, Bonds and Retentions. Although aimed principally at professional services, the principles can be applied equally to construction contracts. And, of course, where the contract contains clauses for retention, there is always the ability to set the figure to zero.

Public-sector policy overtakes slow legislation

The Construction (Retention Deposit Schemes) Bill was introduced in 2018. While it would not if enacted present an alternative to retention in itself, it aims to ensure that retained monies are safeguarded by making it a legal requirement to hold them with an independent third party.

The same year, after the consultation into cash retentions, Build UK, the Civil Engineering Contractors Association and the Construction Products Association together called for legislation to abolish retention by no later than 2025, following an industry-led roadmap.

In 2022, the Construction (Retentions Abolition) Bill took a further step towards this target, by proposing amendments to the 1996 Act. However, both bills have suffered from a lack of parliamentary time and are still some way from becoming law.

Meanwhile, many public-sector bodies, including the UK government and devolved administrations, have made the removal of retention a policy objective. Organisations such as Network Rail, the Highways Agency and HS2 have mandated zero retention on their projects.

The government has also declared that it is actively exploring possible solutions and is committed to improving payment practices and working with the construction industry to take this forward.

For its own part, RICS supports moves to simplify and reform retention policies, with the aim of improving performance in the industry and supply chains. The RICS Rules of Conduct – particularly the explicit requirement that members and firms do not take unfair advantage of others – also clearly preclude any abuse of the retention system.

'Many public-sector bodies, including the UK government and devolved administrations, have made the removal of retention a policy objective'

Disadvantages of system outweigh simplicity

Cash flow is the lifeblood of any business activity. But in construction it is stemmed by the abuse of retention and payment.

While contracts can contain provisions that appear equitable, seeking to promote fairness and collaboration between parties, there is still the opportunity to amend standard terms and make use of dominant position to abuse the system. If retention is abolished will we still see the routine undervaluation of work, which would effectively lead to the same result?

The construction industry has worked hard to improve its performance and its image in areas such as health and safety and the environment, recognising the business benefits of adopting appropriate strategies. It is perhaps a little strange, therefore, that it has yet to acknowledge the difference that cash flow makes.

Retention continues to be used because it is simple to understand and administer; yet many studies have demonstrated that the disadvantages in terms of business performance and working relationships far outweigh the perceived benefits.

Perhaps regulation is the way forward. But it would be nice to think that the industry could sort out this perennial problem itself.

Roland Finch FRICS is a quantity surveyor and arbitrator with over 30 years' experience in construction

He is the author of the NBS Guide to Tendering for Construction Projects, and BIM for Construction Health and Safety both published by RIBA Publications.

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