Payment retention: impact and alternatives

Don't hold back

1 November 2018

Although well established, payment retention in the construction industry is a contentious practice. Chris Green assesses its impact in the light of Carillion’s collapse, and considers some alternatives

Retaining cash in the construction industry supply chain is a long-established practice that has often come under scrutiny. Questions were raised over the practice as early as 1994, when the late Sir Michael Latham’s report Constructing the team was published; while more recently, the Department for Business, Energy and Industrial Strategy commissioned Pye Tait Consulting to prepare a specific report, Retentions in the construction industry, that was published in October 2017. In response to this, the Construction (Retention Deposit Schemes) Bill 2017–19 is now being considered by Parliament.

Retention rationale

Retentions were introduced to the UK construction industry during the development of the railway system in the 1840s. This national undertaking proved too painful for many construction companies and the insolvency rate along the supply chain was high. The railway companies responded by withholding 20 per cent of the value of all contracts, which was repaid to the contractors on satisfactory completion. This fund also enabled railway companies to procure a replacement contractor to finish the work if necessary.

Since then, the practice of retention has become commonplace in the industry, with 3 to 5 per cent of contractual value typically withheld until completion of works. Retentions now also provide security for contractors’ completion of defects, with half of the retained amount continuing to be withheld until the expiry of the defects liability period.

Current practice

Retentions are withheld throughout the supply chain. Many clients require cash to be withheld from the tier-one contractor, which in turn withholds money from the tier-two subcontractors and suppliers, which then impose retentions on any tier-three sub-subcontractors and suppliers. The RICS guidance note Retention details the methodology for applying retentions, as set out in the common forms of construction contract that are in current usage.

The recent failure of Carillion is an example of just how much money can be lost by the industry’s supply chain in retention alone

A retention provides a fund to meet any costs arising from the contractor’s failure to perform their duties, and thus the construction process is somewhat de-risked from a client’s perspective. The fund also offers a degree of peace of mind that the contractor will endeavour to complete works on time and attend diligently to defects.

However, retentions present a risk to tier-one contractors because the 3 to 5 per cent rate is roughly the same as their anticipated profit margin, and this profit may be lost if the client becomes insolvent during the construction period. The money is also vital to cash flow, which ensures the health of the organisation and its supply chain. If the client becomes insolvent during the construction period, the retention may be lost. Unduly long defects liability periods can even result in the retention being overlooked altogether. Consequently, it is common practice for tier-one contractors to replicate the client’s retention throughout the supply chain, thereby protecting their own cash flow.

Contracts undertaken before October 2011 often required the supply chain to wait until completion of the main contract before their retention was released. The revisions brought in under the amendments made to the Construction Act in 2011 outlawed this practice; however, the change is still not widely observed, and many tier-two and tier-three contractors and suppliers view the retention as a cost that is unlikely to be recovered. Some then price it into their works, thus artificially increasing the cost paid by the client.

It can be argued that a well-established business should no longer feel the impact of retention, as currently withheld monies are offset by the release of previous retentions. However, this does not hold true when organisations are growing, as the releases from previous work are less than the retentions on the increasing volumes of new work. Retentions hamper such development by restricting their working capital.

The most significant risk, though, arises with a tier-one contractor’s or client’s insolvency. The recent failure of Carillion is an example of just how much money can be lost by the industry’s supply chain in retention alone: a significant portion of the company’s supply chain will have lost the retentions that were withheld under its subcontracts and supply contracts. The impact of such an insolvency is therefore widespread.

Following the publication of the Pye Tait report [...] the government is currently considering the whole issue of retentions

In the infrastructure sector, given the scale of projects, cash retentions can distort the market. For example, a 5 per cent cash retention on a £1bn infrastructure project would require the tier-one contractor to have a working capital of £50m to undertake the works, restricting the number of eligible tenderers to just a handful worldwide. Defects liability periods in this sector are typically longer as well, often ranging from 2 to 10 years in duration. As a result, cash retentions have become far less common in the infrastructure sector.

Alternatives

Since the Latham report, the industry has developed alternative strategies to ensure the security of completion and defects correction without introducing the full risk of a straight cash retention. For instance, there are several ways to ring-fence cash so it is visible and secure.

  • Project bank accounts: all payments are made through an account specifically set up for the project. This has the added advantage of ensuring transparent payments to the entire supply chain, and is therefore often mandated on large government contracts. It does however cost to set up and administer and requires its own finance system, and training costs are also incurred.
  • Escrow accounts: these are held by third parties, often legal advisers, that keep project funds both visible and separate from the client organisation.
  • Retentions held in trust funds: trust funds allow money to be secure and visible to the organisations offering cash retentions. Project bank accounts and escrow accounts can both be set up as trust funds that ring-fence the retained monies from the assets of the client, so, in the event of an insolvency, they are safeguarded from other creditors of the insolvent entity. There are also alternatives to cash retentions, such as the following.
  • Retention bonds: the client and contractor enter into an arrangement with a third-party surety or bondsperson, who agrees to pay the amount of the retention should the contractor default – typically 5 per cent of the contract price, and reduced by half on completion of the works. This provides clients with the benefits of retentions without introducing burden to the supply chain. However, clients may resist retention bonds as they can be difficult to call, and require legal action to prove default. They may therefore be provided as on-demand bonds, alleviating the difficulty of calling them; but this usually directly restricts the contractor’s working capital, having the same impact as a cash retention.
  • Performance bonds: these are similar to retention bonds, but usually amount to 10 per cent of the contract price. They are also more expensive as they do not reduce on completion of the works. They come as performance or on-demand bonds and share the characteristics of retention bonds, although on-demand bonds are preferred by clients as no conditions are attached to calling them, giving instant access to monies should they be required. However, contractors generally refuse to give on-demand bonds for the same reason, as unscrupulous clients may call them on completion of works to gain unfair commercial leverage in negotiation of the final account.
  • Parent company guarantees: these are guarantees entered into as deeds by the parent company of the contracting organisation to ensure the contractor’s performance. However, many organisations do not have a parent company and are therefore unable to offer this type of guarantee. There is also a risk to clients that the parent company may become insolvent.

Current initiatives

Following the publication of the Pye Tait report, and in light of the Carillion failure, the government is currently considering the whole issue of retentions. MP Peter Aldous, a former chartered surveyor, put the Construction (Retention Deposit Schemes) Bill before Parliament, recommending the mandatory use of such schemes to protect monies from misuse or insolvency.

The bill does not seek to ban cash retentions, but aims to give greater protection for the retention monies. This is at second reading stage in the House of Commons at the time of going to press; however, many industry professionals do not support the bill and are instead seeking to ban cash retentions outright.

Chris Green is Group Commercial Director at J. Murphy & Sons Limited

Further information

Download a complete “Payment retention: impact and alternatives” PDF