Retention: How and what to put in place

Retention in the UK dates back to the 1840s where it was used as security against contractor insolvency through the boom of railway expansion in the Victorian era. The rising demand for contractors was met with a growth in new business formation, which often meant that quality standards were not met, and with it the risk of contractor insolvency, hence the practice was to withhold twenty percent of the contractor’s payment to ensure completion.

This practice expanded across the entire construction industry, but rather than holding retention until completion, it was extended to include defects that occurred post completion, usually for a period of twelve months; the defects liability period. Once these defects were corrected, the final release of all retention monies would, in theory, be made.

The concept of retention is such that contractors and subcontractors are driven to improve quality across their works to minimise defective works and therefore receive retention monies back in full at the end of the defects period. However, there have long been claims that contractors hold on to retentions past this point and there are even claims that the money is used to finance the business and other projects, or just generally as working capital.

The practice of holding retention is not uncommon, but the process to go through in order to see it released is much maligned by the supply chain, which has lead to numerous government reviews on the subject and recommendations to improve the situation. For context, the construction industry is estimated to be worth approximately £400 billion per year, contributing around 9% of the entire UK GDP. It is estimated by the BEIS that at any one time, the value of retention held has a range of £3-£6 billion per annum.

What is a fair retention?

After conducting a study on retention in the UK construction industry, the Government made a recommendation that three percent to be held as retention was a fair balance, as stated in amendments to the Construction Act in 2011, but this can and often is varied on a contract by contract basis. Also, in terms of how the money is held, the recommendation was made that this could be via a designated project bank account or trust.

To expand on the point above, prior to the construction act amendments in 2011, it was common practice to link the final release of retention in a subcontractor’s contract to the end of the defects liability period under the main contract. The contractor, wishing to spread their liability such that any defects notified during their defects liability period could in turn be instructed for correction through their supply chain, drove this practice. Also, in the event of subcontractor insolvency, the contractor held monies that could be used to offset the cost of rectification works.

The amendments sought to make this fairer through legislative changes, meaning the release of retention can no longer be linked to an act occurring on another contract i.e. the main contract completion which is in effect a ‘pay when paid’ clause. It must therefore must be linked to an event occurring under the subcontract.

Clearly, how contracts are drafted becomes more important. Contractors are likely to simply extend the subcontractors defect liability period such that it coincides with the main contract one in order so they can retain an equal level of liability. The question as to what is fair is therefore wide ranging and subject to opinion, but generally reflective as to what the parties can agree between themselves.

How should I structure a retention?

The percentage stated as standard in the JCT Design and Build contract is three percent, but typically across many contracts this is increased to five percent as contractors do not believe that three percent is enough of an incentive for subcontractors to come back and complete outstanding defects.

Whatever the agreed percentage, it’s usually linked to a half release upon completion of the subcontractor’s works and the remainder released at the end of their defect liability period.

For example, in order to be construction act compliant, JCT subcontracts are structured in such a way that retention is released at practical completion and the remainder linked to a retention release date in the contract. However, if one is not stated, it defaults to six months after the main contract defect period ends. The benefit here is there is clear process and trigger for entitlement to claim payment and timescales are stated in the contract within which payment must be made.

Ideally, any retention obligations under the main contract should be stepped down through the supply chain, but you will need to stay construction act compliant whilst doing this. In the event you do not then both adjudicators and courts will likely strike them out and replace them with the process stated in the Scheme for Construction Contracts.

If you are a main contractor drafting contracts, it’s ok to state a date far in the future that will be the retention release date on the basis you might want to wait until after your own defects period has elapsed, but you must not include a clause that directly links the two.

Should every trade have a retention?

It does not make sense for labour only contractors to have retention for a number of reasons, namely they are operating under the direction of a directly employed foreman or ganger, therefore from a liability perspective you will struggle to hold them directly responsible for defects.

Also, any permanent works will require labour, plant and materials, but as labour only, you make up just one of the components for this, so it’s difficult to accurately state that the labour only element is reason that a defect has occurred or there are just general quality issues.

Equally, if the main contractor or subcontractor is dictating the level of labour only on site, and therefore the progress of the works, it is difficult to make case for them to be held liable for retention until practical completion has occurred when they are not in direct control of the rate of progress.

Notwithstanding the points above, for minor trades and low value works you have to question if the administration involved in managing retentions is worth it for the value held. Another way to consider this is to question whether the amount held is enough of an incentive for the supplier to return to site and correct a defect. The JCT subcontract retention amount is set at £250 and above but even this is only nominal.

Should I disregard a tenderer that refuses to accept retention?

This is always a difficult decision to make, but look at all mitigating circumstances e.g. if there is no retention requirement under the main contract, could you manage without it? Also, there may be other options, such as a retention bond that operates in a similar way to an on demand bond, which can be called upon in the event a defect is not corrected or works are unfinished. No retention monies are held, but the bond can reflect the amount of retention that would have been held if the traditional approach were taken. In the event the bond is invoked, the guarantor, usually a bank, will pay out the amount and then take action to recover the amount from the supplier.

Another alternative, albeit it dependent on the supplier’s set up, is a parent company guarantee. Similar to a bond, but arguably less effective and more of an administrative burden, the parent company agrees to step in and make good if the subsidiary company defaults on its contractual obligations.

If you are faced with a new supplier and you do not have any direct history in which to consider the quality of their workmanship or approach to quality management, you may need to remove them from your tender list in the event they do not accept retention, but it’s good practice to explore alternative options first.

What are the negative implications of incorporating retentions?

For those holding the retention, your risk profile is going to be fairly small, as in the event of an issue linked to a defect or failure to complete works, you already have the capital available to deal with it yourself or the risk to the supplier of withholding the monies such that it acts as an incentive for them to deal with it.

However, from a supplier’s perspective, they may argue they were not responsible for the defect and therefore should not be held to ransom in dealing with the issue at hand. Many of the most common forms of contract used in the industry contain clauses whereby contractors or subcontractors can be instructed to search for a defect, but if one is not found, they are compensated for the time and cost incurred in the search.

For subcontractors, the practice of handing over up to five percent of every contract with no guarantee you will ever see the money again can be a drain on your finances, and with increased costs for overdraft facilities and an increased cost of the time it takes to chase the release of retention, it is easy to see the downside of retentions for SMEs.

Considering latent and patent defects, at what point should you release retention?

Patent defects should be addressed at the time they are found or as instructed by adherence to the timescales stated in the contract. Good practice is to ‘snag’ works as you go, meaning that when you arrive at the point of completion, there is not a long list of outstanding finishing works to carry out before your client will acknowledge completion.

As completion typically triggers a release of half of the retention, the works should be inspected at this point and any patent defects that can be identified should be notified to the contractor or subcontractor for them to correct. Only at the point these are closed out should half of the retention monies be released.

Once you have acknowledged completion, the defects liability period starts and dependent on what is entered into your contract e.g. twelve months or longer is the norm, then you will have to inspect the works again, identify any additional defects and again notify the supplier, ensuring they are complete before making the final payment of retention.

For latent defects, these are defects in the design, workmanship or materials that may not manifest itself until years later, therefore if one such defect occurs, it is likely there will not be retention to call on or that any retention held will be sufficient to cover the cost of correction.

Instead, as a client, you should consider if there is latent defects insurance, a collateral warranty or any form of guarantee first. If there is not then you will likely have to launch legal action for breach of contract, ensuring that you check the limitation period of your contract before notifying your intent.

Is there a better way to encourage good workmanship?

Ensuring that you have formal structures in place to manage quality, as opposed to relying on supervision on site to check for defects, is the right way to drive improvements in quality. When tendering for works, make sure that all companies have ISO9001 Quality Management. This is a standard attained by organisations that are able to provide quality products and services that meet regulatory requirements and have a system in place allowing them to strive for continuous improvement.

On a project by project basis, the supplier will provide you with a quality management plan informing you how they will ensure a right first time approach to delivery is adopted on your project, and in instances where quality does become an issue, how they will deal with it and ensure it does not happen again.

Image credit: iStock.com/ChrisGorgio

About Dean Suttling

A member of the Royal Institution of Chartered Surveyors, Dean has twenty years of experience in commercial management and quantity surveying, undertaking roles for contractors, clients, and consultants.