One year following the introduction of the construction retentions regime, many large developers and head contractors report they have successfully transitioned their practices to comply with the regime’s requirements. However, there is a feeling that some smaller to mid-sized head contractors and developers may not fully understand what the regime requires of them. This article provides a brief background to the retentions regime and summarises the two options that are available for holding retention money.
Background to the Retentions Regime
Retentions are commonly included in commercial construction contracts by a developer or a head contractor as a form of security to ensure that the party they employ will perform all of its obligations.
A retention clause typically provides that a principal (which includes a head contractor engaging sub-contractors) will withhold a percentage from each progress payment that is due to their contractor (or sub-contractor as the case may be). If the contractor meets all of its obligations, and there are no defects in their work, then half of the retention money will typically be released upon practical completion, with the remainder released at the conclusion of the defects notification period. On the other hand, if there are defects in the contractor’s work, and the contractor fails to remedy those defects, the retention money may be used to rectify those defects.
In the wake of the Mainzeal collapse five years ago, it emerged that Mainzeal had spent millions of dollars’ worth of retention money that rightfully belonged to sub-contractors. For many of the sub-contractors who never received their retention money, the financial hit proved fatal. Largely in an effort to avoid a repeat of the Mainzeal collapse ripple effect on sub-contractors, Parliament introduced a mandatory retentions regime into the Construction Contracts Act 2002 (“Act”).
The regime came into effect a little over a year ago. It strengthens a contractor’s position by first prohibiting any “pay-when-paid” provisions for retention money, and secondly by ensuring that if a principal becomes insolvent, retention money will not form part of the liquidation pool. Thirdly, the regime requires that principals comply with one of the two arrangements for holding retention money that are discussed below.
The Default Arrangement: Holding Retention Money “On Trust”
The regime’s first and default arrangement provides for a principal to hold retention money “on trust” for their contractor’s benefit. This retention money can be held in the form of cash or other liquid assets that can easily and quickly be converted into cash. Restrictions and responsibilities apply to holding money on trust. These include that the principal must:
have the retention money available to pay to the contractor in cash when it is due;
maintain proper and auditable accounting records of all retention money, including records of all transactions regarding retention money; and
not use retention money to pay its debts.
Provided a principal has the retention money available to pay to the contractor when it is due, the above restrictions and responsibilities do not prevent the principal from prudently investing the retention money and keeping any interest earned on the investment. Similarly, a principal does not need to hold retention money in a separate trust account, and retention money can be kept in an account with the principal’s other funds. However, storing retention money held on trust in a separate trust account is best practice.
If a principal holding retention money on trust fails to pay the retention when due, they will be liable to pay interest for late payment. Further, while the Act does not include penalty provisions, a principal who fails to meet its obligations could be liable to pay damages to their contractor. If the principal is a company, directors could potentially be personally liable for breaching trustee obligations.
The upshot for principals is that, if they elect the retention regime’s default arrangement and hold retention money on trust, it is crucial that they (including each director in the case of a company) understand and fulfil their obligations. It is also important that principals understand the retention regime includes an alternative to holding retention money on trust.
The Alternative Arrangement: Retention Financial Instruments
The alternative retention arrangement is for a principal to hold a financial instrument issued by a bank or an insurer confirming that, if the principal fails to pay retention money when it is due, the financier will make the payment. Acceptable forms of financial instruments include insurance, guarantees or bonds (though not to be confused with bonds in lieu of retentions). Whatever form the instrument takes, the principal must ensure that:
the instrument complies with all of the requirements set out in the regime;
the instrument is specifically issued in the contractor’s favour;
the instrument requires the financier to pay retention money if the principal fails to do so when required by the contract;
the instrument is enforceable by the contractor;
proper and auditable accounting records are kept, firstly of all retention money protected by a financial instrument, and secondly of all dealings regarding the instrument itself; and
the premium or other cost of the instrument is maintained by the principal so that it remains in effect.
If a principal decides to provide a financial instrument and that instrument meets the above requirements, then the retention money the principal holds will not be held on trust. The principal will in this scenario have more freedom to choose how it holds the retention money.
Following the introduction of the retentions regime, there has been a decline in the number of construction contracts that provide for retentions to be withheld. Instead, many principals are using alternative mechanisms to secure performance, including contractor’s bonds in lieu of retentions.
Where contracts do provide for retentions, an increasing number of principals are favouring the use of retention financial instruments over the burden of having to hold money on trust. One benefit of this arrangement is that a principal’s directors will not be exposed to the risk of personal liability from the trustee obligations attached to holding retention money on trust.
Similarly, many contractors prefer retention financial instruments over a principal holding money on trust. The reason is that, in the event of a default by the principal, the contractor can make a claim directly to the financier for their retention money.
Retention financial instruments do come at a cost. However, this is a cost that can be shared by both parties, for example when a contractor is pricing a project. In theory bonds/financial instruments should provide the same protection as retentions held in trust.
It is important that all principals and contractors operating in the construction industry understand and comply with the retention regime. If you have questions about your rights or responsibilities under the regime, then you should take legal advice.