Here’s the Scenario: Try explaining the concept of “retainage” to a businessperson unfamiliar with the construction industry at your next holiday party. Here’s the typical response as she spits out her eggnog: “Wait a minute: are you telling me that when work and materials timely supplied on a private commercial project are approved, the contractor and subcontractors have (depending on the state) 5%-10% withheld every month until the very end of a long project? That’s just nuts!” You respond: “Crazy, but this is standard in the industry, even when profit margins are getting smaller and smaller.” And the businessperson then says: “Where is this ‘retainage’ during this time, in a safe in the Grinch’s cave? Your response: “Well, while its mostly the subcontractors’ retainage, since most prime contractors don’t self-perform, maybe the retainage is with the owner or even the lender and it may not be actually set aside.” The businessperson does her best Santa “Ho, Ho, Ho,” shakes her head, heads back to the bar for more eggnog, and strongly suggests you should get yours spiked.
If you do historical research to find out where the heck the concept of retainage came from, you have to go back in England in the 1840s during a boom in railway construction called “railway mania.” With not enough competent contractors, and then a crash in the market, the railway companies began to withhold up to 20% to make sure that the work was properly and timely done. This concept somehow filtered over to the United States during the industrial revolution and has been in use ever since. The idea of “protecting” retainage reached a legislative peak after the series of failed projects and bankruptcies that followed the 2008-2010 financial meltdown. Lenders foreclosed, wiped out any lien rights and then sold the projects without having to pay a dollar to the construction companies that built the half-completed projects. And where was the subcontractor retainage for approved work on these failed projects? Most of the time, it did not exist and had not been funded to the owner by the lender as set forth in a loan agreement. Poof, an invisible lump of coal shoved down your financial throat. Recall from the previous post, the “owner” on any prime contract is typically a “limited liability” company whose only asset is the heavily mortgaged land. Who may be holding the empty retainage bag when all the subcontractors all gather around the Prime office trailer tree with their hands out? Yep, prime contractors.
So, what can a prime contractor do?
- Know the Retainage and Prompt Pay Laws in the Project’s state: Some states (like Tennessee) have mandatory requirements and severe civil penalties if retainage on a commercial is not paid into an interest-bearing escrow account during the project. These laws can also limit the % of retainage which can be withheld and even when and how retainage is released. Most of these laws also cannot be “waived” by contract. To be clear, there can be consequences not just for the owner for not following the retainage laws, but also to the prime contractors which have in turn withheld retainage from their subcontractors. In Tennessee, due to a very active subcontractor’s lobbying efforts, as an example, the failure to establish a retainage account after written notice can even be a criminal violation. Don’t get bad news after the fact from your Chief Legal elf.
- Can you get the owner to not withhold retainage? Because of the perceived unfairness of retainage and the possibility of retainage abuse, there is a trend for owners (mostly state and federal agencies) not to withhold retainage. Why should retainage be withheld if there is a payment and performance bond required of the prime contractor? The primary problem is still on commercial, financed projects where the status quo is for lenders to demand that retainage be withheld and even make retainage, even if escrowed, part of the security for the loan (think the Grinch in his cave hiding the Whoville toys) in the event of an owner default (which may be a violation of a retainage laws). The argument is that the owner can properly manage a project through the ability to withhold payments from monthly pay applications if there’s an issue with the work. When quality and loyal subcontractors are sometimes hard to find, what better way to ensure loyalty than to tell a subcontractor, like an ecstatic toddler Christmas morning, that for approved work, it will get paid 100% of a pay request?
- Can there be creative ways to benefit all sides and not hold retainage? Put on your Santa thinking hat. Can the owner be protected, and the prime contractor and subcontractors benefitted, by not withholding “retainage” but placing some monetary value on some aspect of the work or requirements for final payment such as project close out? But be careful if the goals are to avoid retainage laws. Again, many of these laws cannot be waived by contract, and if some withholding of monies looks and sounds like retainage (looks and quacks like a duck), it may be deemed by a judge or (in many cases) an arbitrator as retainage.
- Be smart about retainage provisions in contracts. Be like Cindy Loo Who ferreting out her toys and the Grinch. Don’t sign a prime contract that calls for retainage until you have some reliable information about how “your” retainage is located/held. More importantly, look carefully at the retainage provisions. Going back to the lender issues, many loan agreements provide that if there is an owner loan default, over which a contractor has zero control, retainage will not be released but used to cure any owner default. Scrutinize the contract provision for “final” payment, which normally includes retainage. Are there unacceptable conditions, such as lender approval? You don’t want to be left with an empty bag like Santa at 11:59 pm on December 25th.
- Check your own “form” Subcontracts. While most prime contracts are heavily negotiated, many prime contractors have their own “form” subcontracts. Again, every state’s lien, retainage and prompt payment laws are different. An effort needs to be made to modify that form, just like Santa continues to update his naughty and nice list.
The Bottom Line
What’s your profit margin? Think through how retainage impacts your bottom line during your projects. Even Santa has to feed and water his reindeer before, during and after Christmas. In 98% of your projects, the retainage will flow down to you and in turn you are handing out retainage checks like candy canes at a holiday parade but be prepared if you see a big fat retainage lump of coal coming to the stocking on your mantle.