Retentions: get rid or retain?

by Claire King, Partner

During the course of the last year, Claire King had the pleasure of working on the NEC and CLC Guidance Note for dealing with retention payments under the NEC3 and NEC4 Contracts with a team from within the industry.1 Unlike the JCT standard form, the NEC has made retention an “opt-in” rather than “opt-out” option in its contract suite with the aim of making those entering into construction contracts think twice before defaulting to what they have always done (i.e. provide for a retention).

One of the key issues repeatedly raised whilst speaking on the topic of retentions was what the alternatives to retention are in practice. This is obviously crucial because, in the absence of active legislation on this issue, those who are used to providing for retention need to be persuaded that there is an alternative solution to retentions to achieve the express goals of retention.2 In this article, we look at the industry-wide reasons for moving away from retentions and then review the possible options for alternatives that are available.

What is a retention?

The BEIS Report, “Retentions in the Construction Industry”3 (“BEIS Report”) defines a retention as:

“a sum of money withheld from the payments for construction section projects in order to mitigate the risk that such projects are not completed either at all, or to the required quality standard.  Retentions are mainly used as a means of incentivising contractors and sub-contractors to return to correct defects during a specified period of time, as outlined in the Contract Terms and Conditions”. [Emphasis added]

The BEIS Report also notes that the average retention is 5% of the contract value. From the definition above, two key reasons given for taking a retention can be discerned. These are:

Quality (specifically encouraging the return to fix defects during the retention defects liability period); and

Mitigating against the risk a project is not completed at all. 

These two purposes obviously need to be borne in mind when considering alternatives to retentions. 

Why does the discussion on retention matter? 

The answer to this is fairly simple. The evidence available demonstrates that there are considerable downsides to retentions. Many of these are particularly pertinent when the economy is in a downturn. Some particularly alarming statistics from the BEIS Report include:

  1. 44% of contractors had lost retentions due to upstream insolvencies;
  2. 71% of contractors experienced delays in receiving retentions back;
  3. The average delay is significantly longer for tier 2 and 3 contractors compared to tier 1 contractors; and
  4. Between £3.2 and £5.9 billion is retained annually (this was in 2018).

There were also strong suggestions that retentions were being used as working capital by firms holding them. Finally, there were clear indications that tender prices were often increased because of an insistence on retention. In other words, contractors were assuming they would not get their retention back (at least not for a long time) and pricing their works accordingly.

Perhaps the most spectacular and depressing example of the impact of retentions on the supply chain when there is an insolvency was seen when Carillion collapsed. Then, it was estimated that £800 million was being held in retentions by Carillion. This collapse had a devastating impact on Carillon’s supply chain, causing a domino effect. 

So, what are the alternatives?

The first question for an employer to ask when deciding whether a retention is actually required is whether retentions achieve their two goals in the first place. First, in reality, a 5% retention provides very little security for completing a job if a contractor becomes insolvent unless that insolvency occurs very late in the day. Second, as the NEC Guidance points out, and at least in theory, if quality is being monitored properly then retention should not be required to ensure the quality of the work undertaken. 

With that in mind, the key alternatives to retention are broadly divided into two camps. These are namely:

  1. Alternatives seeking to provide security for performance; and
  2. Alternatives focused on protecting the retention funds to ensure those monies are kept safe and paid out in a timely fashion as provided for in the underlying contract.

The key alternatives that are generally recognised are as follows:

  1. Project Bank Accounts;
  2. Retention Bonds;
  3. Performance Bonds;
  4. Parent Company Guarantees; and
  5. A retentions trust fund.

The first two options are those options aimed at ensuring that retention funds are protected. The last three focus on security for performance. All of these alternatives have pros and cons to them. 

What does the rest of the world do?

Perhaps the most popular alternative seen in other common law jurisdictions seems to be retentions held in a trust scheme in separate accounts. New pieces of legislation have, for example, been recently passed in New Zealand with the aim of ensuring that retention funds are protected following an insolvency.4 In Ontario, a 10% retention hold back is mandatory, but a lien is then put over the property that the retention relates to in order to secure that money.5 Both solutions provide security for the retention funds. 

What is available in England and Wales?

In the continued absence of legislation on the topic of retention (despite draft bills being put forward), options remain limited to those that do not involve further legislation. These are summarised below. 

Protection of retention funds

The options for Project Bank Accounts (“PBAs”) and retention-specific trust accounts offer a degree of security for funds should an insolvency occur. Indeed, protection is provided for both the employer and the contractor. The idea is that monies are held on trust for identified beneficiaries.

PBAs have been used in public contracts since 2007 and are, indeed, primarily used in that sector. The NEC4 provides Option Y(UK)1 for PBAs. A trust deed is required, and monies are held on trust subject to the rules governing the trust and the PBA. As noted in the BEIS Report, PBAs have had some success but tend to be limited to the upper tiers of the contractual chain due to the administration involved in setting them up and the education process involved in teaching people how to operate them properly. 

PBAs are increasingly widespread in government-led projects. For example, National Highways has publicly announced that they are trying to ensure that the set-up costs and administration burden for PBAs is lessened so that parts of the supply chain lower down the chain can access them.6 Parties need to make sure they know how monies (and interest) are dealt with in the context of an insolvency. That means paying enough attention to the contractual documents governing the PBA at the time they are entered into – before it is too late to change their meaning.

Retention being held in trust accounts is another option reviewed in the BEIS Report. The idea being that the money is ringfenced and housed in a separate fund so that, if someone in the supply chain goes insolvent, those monies are protected. Despite the BEIS Report concluding that this was a viable alternative for cash retentions, these are rare in practise. Lessons may also need to be taken from New Zealand where legislation was specifically enacted to ensure insolvency practitioners did not manage to keep hold of retention funds notwithstanding there being a trust in place. 

Security for Performance

Alternatives to cash retention which provide security for performance are arguably more obvious. However, most of them come with a cost attached. As such, the cost of the alternatives is a key factor in determining whether it is viable. In the current environment, where bonds are ever more expensive, these may not be viable alternatives for contractors whose credit rating is not ideal. 

A performance bond7 can ensure performance, albeit the grounds on which you can call them need to be carefully reviewed to ensure that pay outs are made upon insolvency and/or when the quality of the works undertaken is insufficient. However, generally, performance bonds are used in addition to retention, merely as the burden on the contractor or subcontractor in question and are likely to be added straight back onto the cost. 

Another alternative is a retention bond and, again, these are provided for in the NEC4 as well as the JCT Forms of Contract. These bonds are linked specifically to retention monies and are for dealing with the same issues (i.e., defects emerging after completion). They can be recorded in the terms at the outset or during the project to get the retention, i.e., the cash released. There is obviously an upfront cost but, otherwise, they result in improved cashflow and can be made payable on demand. However, the wording of the retention bond needs to ensure that it is linked to the purpose of retention (i.e., defects) rather than wider breaches such as delay. 

Finally, a Parent Company Guarantee (“PCG”) may be an option where the company (perhaps a special-purpose vehicle) entering the contract has a parent company with a strong balance sheet.8 Those accepting them as alternatives to retention need to be aware that delays can occur meaning that claims for defects have to be established and ascertained first. It is also important to establish the domicile of the parent company. 

Some jurisdictions are known for being harder to trace assets than others. As such, whilst PCGs can be very effective performance for security performance, they need to be checked carefully and are only applicable if there is a suitable parent company to offer the guarantee in the first place.  

Summary

In summary, then, there are alternatives to retention which should actively be considered as alternatives as opposed to additions. However, they all have their own disadvantages and advantages. Perhaps the most obvious alternative could be retention trusts, but these may require further legislative action (as seen in New Zealand) to ensure that the protection of having the monies in those trusts is adequate.  

From a personal perspective, however, there is no doubt that action needs to be taken on retentions. Too often, parties hold onto retentions for as long as possible and without sufficient (or any) justification. In the current economic conditions, this is particularly alarming as those having to use retentions for cashflow are normally those more at risk of insolvency. 

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Claire King

Tel: +44 (0)20 7421 1986
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