Retainage uses and abuses

Retainage is not a word found in standard dictionaries. It is a concept peculiar to the construction industry. Try to purchase an airplane ticket and hold back 10 percent until the pilot gets you safely home on time. Ask to drive that car off the lot after paying only 90 percent of the purchase price. While no other industry must deal with retainage, contractors must cope with it every day.

Purpose of retainage

The legitimate purpose of retainage has always been to ensure owners that the contractors properly and timely complete the work. To the extent retainage is used for purposes inconsistent with its legitimate purpose, retainage is being abused. Seasoned contractors will tell you that retainage was historically withheld at 10 percent to match the contractor's anticipated profit. Retainage is not intended as a tool to aid the owner's ability to finance the project. Contractors should insist that all of their progress payments be at least large enough to cover their costs for the period covered. Otherwise, they are helping to finance the owner's project. By limiting retainage to no more than anticipated profit, there will be less reason for the contractors to engage in 'front loading.'

Retainage is not a tool for controlling faulty work. Owners should maintain rights that go far beyond retainage to protect themselves in case of performance-related problems. If there is a problem during construction, owners should have contractual rights to withhold more than retainage. In instances where defects are discovered after the completion of construction, performance related warranties may come into play to render a contractor liable for correction or completion.

Protection of the fund

Earned funds that remain in the pocket of the owner represent a source of real costs to contractors.

There are far too many instances of owners running out of money or even going bankrupt while still holding retainage. That means that contractors may never get paid what they have earned, or they may get involved in costly litigation with third parties, e.g., the IRS, lenders, bankruptcy trustees, surety companies and others, over entitlement to the retainage. Contractors need to have contractual or statutory protection that declares retainage to be a trust fund for their benefit so that, for example, if the IRS attempts to levy on the owner's funds, those dollars will be set aside for the benefit of the contractors who earned them outside the reach of the IRS.

Retainage reform

Interestingly, the federal government is the leader in retainage reform. To its credit, the federal government has declared 'retainage should not be used as a substitute for good contract management, and the contracting officer should not withhold funds without cause.' 48 F.A.R. 32.103. Other ways to reform retainage while still providing necessary protection for the owner include the following:

• Cap. Since most contractor's profits are below 5 percent, retainage should be capped at 5 percent. Some owners arrive at an overall 5 percent cap by using 10 percent retainage for the first 50 percent of the job and then zero retainage for the second half. This system, however, is of no benefit for the early trades unless caps are applied on a line-item basis.

• Time limits. Perhaps the greatest abuse of retainage is holding too much money too long. Many contractors could live with retainage, even at the 10 percent level, if they knew that they would get all of their retainage (less an appropriate amount for punch lists) upon substantial completion of their work. To protect the owner, it is not necessary to hold $1 million if the reasonable value of the punch list is only $150,000. Upon substantial completion, all of the retainage should be paid except for an amount, say 150-200 percent of the value of the punch list.

• Escrow. Placing retainage in an interest-bearing escrow account for the benefit of the contractors and subcontractors is consistent with the owner's goal of having security to assure timely and proper performance. The interests of both parties are served because the owner is withholding the funds while the contractor knows that upon completion, the funds (plus interest) will be there.

• Substitute security. Cash is king. Why not allow contractors the option of providing owners certain safe negotiable instruments, e.g., certificates of deposit, treasury bonds or notes or a letter of credit or retainage bond as a substitute for retainage. Upon receipt of safe substitute securities, the owner would release the cash to the contractor. This option affords owners protection without tying up the contractor's cash. The substitute security alternative is consistent with the purpose of retainage, especially when it is remembered that it is not the purpose of retainage to provide the owner with extra cash during construction.

• Line-item release. Line item release is especially helpful for early subcontractors such as the excavator. Many subcontractors' work is completed months or even years before the overall project is complete. Because the goal of retainage is to ensure completion of the project, there is no reason to withhold retainage on the completed subcontractors' work. Is it fair to withhold funds earned by the excavating subcontractor who has successfully completed all of its work to cover the defects of the painter?

Lessons learned

Retainage is a controversial subject, whether viewed from the perspective of owners or contractors. Legislatures around the country are listening to the contracting community regarding the uses and abuses and are enacting reform. Next month's article will discuss some of the recent laws which have been enacted around the country attempting to reform retainage, notably New Mexico, Montana, Maryland, Arizona and Utah.