Cash retention under construction contracts: short life working group final report and recommendations

4. Key Findings

30. We considered three options identified through the consultation exercise and our key findings were as follows:

Option 1 – Legislate to ban retentions

31. In considering the option of an outright ban on retentions, we recognised that this could deliver some benefits. In particular:

• retention abuses would be removed, and the payee ('payee' – the entity from whom retention is withheld (opposite of 'payer' – the withholding entity)) could avoid loss of retention money through upstream insolvency
• cash otherwise held in retentions would be unlocked and available for more productive use
• removal could drive development and expansion of the assurance market, and deliver better collaboration
• it may facilitate technological innovation such as the use of, for example, smart contracts (a smart contract is a computer program or a transaction protocol which is intended to automatically execute, control or document legally relevant events and actions according to the terms of a contract or an agreement), especially where operating alongside other technologies, such as Building Information Modelling (BIM). This could provide more efficient and secure payment mechanisms
• a ban may be consistent with, and could precipitate, the shift towards offsite manufacturing technologies and a better quality of product

32. The SLWG also recognised that a ban on retentions would be likely to raise issues of concern, in particular:

• in the absence of new and low-cost assurance products there would be a disproportionate impact on Small and Medium Enterprises (SMEs): a large proportion of contractors may not be able to get affordable alternatives
• new solutions could also be more burdensome on SMEs, reflecting the imbalance in commercial bargaining power
• the group were not confident that the assurance market would provide alternative insurance products to all clients and construction firms. It concluded that using alternative assurance products would be likely to introduce additional costs with no certainty that these would be outweighed by the losses avoided due to upstream insolvency
• an outright ban would be an unwelcome shock to the construction industry in the short and medium term
• the SLWG were concerned that a legislative ban could be circumvented by commercially driven practices. It may not stop all abuse and could trigger new forms of payment practice abuse that would be difficult to monitor
• costs of any alternative products/approach would need to be passed on or absorbed leading to a possible increase in construction costs
• it is not clear that costs of assurance would be offset by savings from monies currently lost by contractors through the use of retentions. This is likely to be a significant issue for many contractors who operate with small margins
• the variety and range of stakeholders within the construction industry and the variety of projects which they service means that a "one size fits all" approach will be difficult

33. The group considered all of these issues in full and concluded that we do not support an outright ban on cash retentions in the short or medium term.

Option 2 – Introduce Retention Deposit Scheme

34. We considered Retention Deposit Schemes which can be either custodial or insurance backed. A custodial scheme would hold retention money as cash deposited into an account set up solely and exclusively for that purpose, and which is neither designed nor intended for the money to be used as working capital by the account holder(s). An insurance based scheme would allow the retention to be held in the bank account of the payer. Retention money is deducted from payments and held by the payer, who holds a protection policy from an independent scheme for the period of the construction contract.

35. We received an informative presentation from Mike Bell and Chris Van Halewyn, who have designed the Retention Deposit Clearing House, an insurance based scheme which they intend to pilot. This scheme proposes a national statutory system utilising insurance to create a low-cost scheme to protect retention monies for the benefit of contractors (including subcontractors) in the construction industry.

36. The SLWG agreed that this was an interesting proposal although members of the group expressed concern about the impact and uncertainty of additional costs to the sector, particularly for insurance, and especially in the current economic climate. We heard that the scheme would bring an additional cost to industry estimated to be around £23 per £10,000 of contract value. Group members expressed some concern about delivery at that price and whether the insurance market would have the appetite for such a scheme. Similar concerns were raised through discussions with financial sector stakeholders (representatives of major banks, UK Finance). This scheme proposes a statutory scheme with a single provider, and members of the group had some misgivings about delivery through a single private sector provider.

37. We also heard about Tenancy Deposits Schemes (TDS) that support the private rented sector housing market in Scotland. These are custodial schemes that hold and protect private renters' deposits until they are due to be repaid. These custodial schemes have operated effectively since being introduced in 2011. The schemes include a dispute resolution service and are funded through interest earned on the funds. There is no additional cost to either landlord or tenant.

38. In April 2021, 234,064 deposits were being protected in the schemes with £165.8 million held in designated accounts.

39. We believe the TDS provides a good model of a custodial deposit scheme and, although there are many differences between construction retentions and tenant deposits, we believe the TDS provides a strong example of a custodial scheme which operates efficiently and effectively for all parties. The group favour a custodial over an insurance backed retention deposit scheme.

40. We believe there would be several benefits of introducing and utilising a Retention Deposit Scheme (RDS). Most notably:

• the money is protected, ensuring it is available and not affected by insolvency
• it should lead to greater transparency between payer and payee
• automatic release of payment would reduce incidences of "late" and "non-payment", and reduce payees' time needed to chase retention payments
• this would be likely to lead to a positive change in industry culture with more careful consideration of the use of retentions. In particular there would be no cash-flow incentive to clients or Tier 1 contractors
• although an RDS would not remove the use of retention, we expect it would reduce their use and provide security for deposits, greater certainty of cash-flow and so support business investment and confidence, particularly for SMEs

41. We concluded that:

• an effective retention deposit scheme could resolve many of the problems associated with retentions
• there is currently no operational deposit scheme which could be adopted for retentions, and therefore limited evidence is available to assess how this would work in practice. Consequently, we are not able to clearly assess the costs or determine the detailed nature of an RDS for Scotland. Further work will be required to shape and develop a business case
• an effective RDS must:
  • o include a payment release mechanism
  • o provide rapid dispute resolution
  • o be straightforward, easy to access and low cost
• the detail of any scheme must be carefully considered including clarifying role, scope and number of gatekeepers (Gatekeeper – responsible operator for overseeing funds)
• the tenancy deposit scheme, which is free to use, may provide the basis of a RDS model – further exploration is required

42. Part of the SLWG's remit was to provide (where possible) full costings associated with the recommendation considered but this has not been possible in the relatively short timescale that the group had to consider options. Costings should be properly considered through development of a detailed Business Case which should also consider legislative options for delivery.

Option 3 – Recommend an alternative mechanism of assurance

43. The SLWG considered six alternatives identified through Pye Tait research as follows:

• Performance bonds
• Retention bonds
• Escrow stakeholder accounts
• Parent company guarantees
• Project Bank Accounts (PBAs)
• Retentions in Trust

44. The SLWG agreed that whilst some of the alternative mechanisms discussed provide assurance on construction projects or provide security of payments, none appear to provide an appropriate stand-alone solution to the issues associated with the practice of cash retention. We agreed that:

• a "one size fits all" approach is not appropriate as an alternative to cash retentions and in any case none of the above mechanisms would deliver it
• although performance bonds appear to be suitable for use across the industry and are the most commonly used alternative mechanism of assurance, they are unlikely to be available to all in the sector
• the cost of alternatives, particularly bonds, are likely to be prohibitive
• other mechanisms of assurance are mostly used in addition to cash retention rather than as an alternative
• the alternatives to cash retention are already known and available to the industry. They appear to be rarely used in place of retentions
• retentions placed in trust protect them from the risk of insolvency but issues around the obligations of trustees appear to be prohibitive and need to be considered in more detail
• there was doubt about the appetite for the financial sector to provide suitable financial products that were affordable and accessible to all

Further discussion

45. Members of the group discussed their experience of good and bad practice in relation to retentions. Our discussion highlighted that the use of retentions has evolved over many years and there are no set guidelines on how the construction sector currently use retentions as a form of assurance. Group members highlighted many instances where, in addition to retentions, other forms of assurance were used to provide an additional layer of protection for clients/contractors. They spoke of the frequent challenge of securing payment of retention monies, including spurious claims of defects leading to refusal of payment and lengthy processes to secure monies owed. There is concern that adjudication of disputes has become expensive and time consuming. Some contractors and specialist organisations are choosing not to take on work where retentions are proposed. The current practice of retentions often negatively impacts business relationships whereas there is evidence that better relationships can be developed through a "no retention" approach as demonstrated by Network Rail.

46. Network Rail approach: Cash retentions are no longer used between Network Rail and its Tier 1 Capital Works suppliers, formalising the approach of the Network Rail Fair Payment Charter. Network Rail's standard terms and conditions for Control Period 6, which runs from 1 April 2019 to 2024, also prohibit the use of retentions between Tier 1 Capital Works contractors and their Tier 2 sub-contractors.

47. The Charter was drafted by the Commercial Directors Forum (CDF) established by Network Rail to promote, support and influence commercial policy in the rail industry. CDF members agreed to apply the principles of the Charter in delivering rail capital works, including:

• any withholding of payment due to defects, non-delivery or the absence of proof will be proportionate and demonstrably justified
• client arrangements for retention will be replicated via matching terms throughout the supply chain where practicable

48. The no retentions policy was part of a range of options on alternatives to retention proposed by Network Rail's suppliers and has been implemented in consultation, co-operation and collaboration with them. In order to ensure that work meets agreed standards Network Rail puts in place a cost-loaded programme and cash flow forecast for projects, including monetary amounts allocated to final delivery and project closure activities covering matters such as:

• complete and timely production of a comprehensive Health and Safety File
• compliant supply and/or fixing of final-stage and project-critical construction components

49. We heard that this approach works well, providing more clarity for businesses and building better working relationships between partners. We recognise that Network Rail has a relatively small (specialist) group of contractors from whom they procure their work, and this facilitates the 'no retentions' approach which has been adopted. Although it may be difficult to transpose this approach to all construction contracts we believe there is scope for this model to be deployed more widely, particularly in areas of specialist construction and where framework agreements are in place.

50. We do recognise that for some the current system of retentions seems to work well, particularly clients and Tier 1 contractors delivering large developments where there is less risk of insolvency. However, the problems that can arise are most acutely felt by SMEs for whom monitoring, chasing and securing payment of retentions often brings a disproportionate cost and a heavy impact on cash flow. Pye Tait highlighted that 'Qualitative evidence overwhelmingly shows that the biggest problem with the practice of retentions is the instability it creates for contractors at Tier 2 and below'. In addition, research documents that many believe retentions damage working relationships by creating an adversarial working relationship and encourage friction and disputes. This may not always be visible to clients and main contractors. We recommend further discussion with client groups, professionals (surveyors/architects etc) and the wider industry to ensure our recommendations are fully understood and the reason for each is recognised.