David K. Taylor
Bradley Arant Boult Cummings, Nashville, TN
There have been debates for years about the pros and cons of owners withholding retainage (usually 5% or 10%, depending on each state’s retainage laws or local “industry standard”) from prime contractors. Typically, the primes will, in turn, withhold retainage from all subcontractors. However, in these crazy times, when the future of private and public projects is unknown and profit margins are in question, it might be a good time to revisit this issue. Everyone in the business remembers the post-recession days of 2009-2010 when projects were slashed, many companies went under, and the construction industry lost an entire generation of workers. Do the current economic conditions merit asking whether retainage is an old, used-up concept that should be modified or jettisoned entirely?
To understand the arguments, a history lesson may be helpful. The origins of retainage stretch back at least to the 1840s during what has been called “railway mania.” Railroad track construction exploded across the United Kingdom. Then there was an economic crash. Many owners were left with incomplete projects, as well as instances of bankrupt contractors and unpaid laborers. Someone (unknown) then came up with the idea (completely unique) that for the sole protection of owners, a certain percentage of approved work should be withheld until the project was complete – and the concept of “retainage” was born. This concept was then “imported” to the United States soon thereafter, where it has been in use ever since. Retainage has traditionally been a sacred cow for public and private projects until the last 20 years when several factors and events came together to cause those in the industry, as well as their elected officials, to reevaluate the use of retainage.
These factors and events included plummeting profit margins for both primes and subcontractors. Many times, the amount of retainage equaled profit margins. Over time, some prime contractors self-performed less of the work and instead subcontracted out most of the work to subcontractors. As a result, as far as retainage is concerned, the burden fell on the subcontractors who built the project and hoped that retainage withheld for approved work would filter down to them from the lender to the owner then to a prime at the tail end of a project. Other times, owners, architects, and primes have wrongfully withheld retainage, using it as improper leverage.
There has been a recent trend to get away from the use of retainage. The federal government took the lead when in 1986 it enacted a federal regulation that stated retainage is discretionary but that “retainage should not be used as a substitute for good contract management” (F.A.R. 32.103). The Department of Defense, the General Services Administration and the United States Department of Transportation now have a zero-retainage policy. While many state agencies have followed the federal lead, private commercial projects still frequently use retainage and lenders require that their borrowers withhold retainage. The economic events of 2008-2010 also resulted in state legislatures (aided by lobbying groups) wading into the area of regulating retainage by statute. Foreclosures resulted in the wiping out of liens and leaving subcontractors holding the retainage “bag.” Historically, retainage was normally the subject of contract negotiations between sophisticated players in the commercial construction industry. Most of these new laws have been passed for the protection of subcontractors. Some states have reduced the maximum amount of retainage that could be withheld. Some have required that a “project retainage escrow account” be set up and funded. Any contract provision to the contrary is void and against public policy. Some states, such as Tennessee, have criminalized retainage violations and provided a hefty civil penalty ($300 a day) for an owner or contractor that did not properly escrow retainage. Bankruptcy protections are statutorily created by stating that any escrowed retainage upon payment into the account is the “property” of the prime or subcontractor to whom it is owed. Tennessee statutory law even regulates when retainage must be paid by an owner to a prime, regardless of any contrary contract provision.
Because of these considerations, even on private projects, more discussions about retainage are occurring on the “front end” of a project. Can the lender be convinced to allow an owner to reduce the retainage amount or not to withhold retainage at all, especially if it must be escrowed (and thus interest paid)? If payment and performance bonds are obtained, why is retainage necessary? If the purpose of retainage is to provide security to the owner, and not necessary for leverage over a prime (and in turn a subcontractor), would not bonds better secure the owner? In many states, payment bonds can be used to discharge mechanic’s liens without a prime having to use bonding capacity to obtain a lien bond (which in some states must be double the amount of the lien amount). What about thinking creatively? The parties can agree to allocate a small percentage of the contract amount at the tail end of a project, not call it retainage, but allow for withholding of a small amount for completion of a punch list or close-out documents? Will an owner get better prices from primes, and attract better primes (as well as subcontractors who are building the project), if the bid documents state that there will be no retainage withheld?
The bottom line is this: There should be an independent evaluation on the front end by the major players (developer, owner, architect, lender, prime) as to whether “retainage” should be withheld on a commercial project. Each state’s retainage laws should be reviewed by counsel. Think through what is at stake in the project and what needs to be done to protect all players and encourage primes and subcontractors to bid on any project. If the legislative trends continue, there may be states that ban any retainage. In any event, assuming retainage as a “given” on any construction project may not be the norm and should be carefully considered.