Cash retention under construction contracts: consultation

Consultation on the Practice of Cash Retention Under Construction Contracts

Scottish Government Consultation

The practice of cash retention under construction contracts

1. Consultation Overview

There is evidence that some payment practices prevalent in the construction industry are a barrier to investment, productivity improvements and growth.  Cash retention, where the process is misused or abused, can be one such practice.

The retention system is a long-standing practice in the construction industry throughout the UK. A retention is money withheld from payment of a construction project. The purpose of a retention is to mitigate the risk of a failure to complete a construction project or a failure to rectify defects. The part of the contract sum which is held back is intended to provide a means of incentivising contractors and subcontractors to return to correct any defects during a specified period of time or to provide towards a means of funding the procurement of another contractor to do so if necessary, as outlined in contract terms and conditions. In most cases a retention is imposed by the client employing the main or Tier 1 contractor and this is mirrored in all subsidiary contracts throughout the supply chain.

Following concerns expressed by parts of the industry, the Scottish Government agreed to undertake a review of retention payments. To support the review, the Scottish Government commissioned independent research from Pye Tait and that research is published alongside this consultation. It illustrates the challenges with retentions - in particular understanding the extent to which this practice has a negative impact and what solutions would be effective and proportionate in addressing this.

2. Why we are Consulting

The purpose of this consultation is to seek information on the practice of cash retention in public and private sector construction contracts in Scotland and to gather views on the findings of the supporting documentation.

In addition to asking questions about the Pye Tait research “Retentions in the Scottish Construction Industry” we are also asking for views on the potential impacts of introducing legislation in this area.

3. Executive Summary

There is evidence that some payment practices prevalent in the construction industry are a barrier to investment, productivity and growth. Cash retention, where the process is misused or abused, can be one such practice.

As a sum of money withheld from the contractually-agreed amount due on a construction project, the purpose of a retention is to mitigate risk should some of the work not be completed satisfactorily, or any resulting defects not be rectified by the contractor.

To support this consultation, the Scottish Government commissioned independent research from Pye Tait Consulting. The report they produced - Retentions in the Scottish Construction Industry, is published with this consultation. It illustrates the challenges with retentions - in particular understanding the extent to which this practice has a negative impact and what solutions would be effective and proportionate in addressing this.

A number of key issues were identified by the research:

• Evidence suggests that a significant proportion of companies say they deliberately avoid business in which retentions are involved
• It suggests that the current system operates to the advantage of clients and Tier 1 contractors but to the disadvantage of medium and smaller companies, particularly where a contractor insolvency might occur.
• Qualitative evidence suggests that late and non-payment of retention monies is a significant issue for some contractors; and
• There is a need to investigate a fairer, more neutral and more protected approach to assurance in construction contracts.

Unjustified late and non-payment of a retention or any other amount owed is unacceptable.

This consultation aims to gather views and information on:

• the effectiveness of existing prompt and fair payment measures for retentions;
• views on the Pye Tait independent research on retentions in the construction industry;
• late and non-payment of retentions;
• the effectiveness of existing alternative mechanisms to retentions; and
• the benefit of holding retentions in a retention deposit scheme or trust account.

4. Current Policy Landscape

The Scottish Government is responsible for setting official policy on performance assurance mechanisms in construction contracts for in-scope organisations, including cash retentions. “In-scope organisations” are those bodies for which the Scottish Public Finance Manual is applicable guidance (paragraph 7 et seq). Organisations which are out of the Scottish Government’s administrative scope include, for example: local authorities; the higher education sector; and housing associations. Such bodies are therefore free to implement their own requirement for performance assurance mechanisms, or indeed none, as they think appropriate.

The Scottish Government’s performance assurance mechanism policy is set out below. In summary, it encourages contracting authorities to consider assurance methods, including the use of retentions, on a project-by-project basis: the use of retentions is not the default position.

Current Scottish Government Policy on Performance Assurance Mechanisms in Public Works Contracts

5. Need for assurance

Realistically, defects occur in most construction works and project owners therefore need to be assured by measures designed to protect the public purse from becoming liable for defective or sub-standard work and to ensure their projects are completed as contractually-specified. An evaluation of the options among available assurance mechanisms should be conducted in respect of strategic factors, including the specific nature of a project’s value, procurement method and market conditions.

6. Assessment of assurance

Scottish Government does not prescribe particular assurance processes. Decisions should be project-based and processes should be proportionate to the specific circumstances of the project. Wherever possible, they should also be applied consistently along the supply chain. In most cases, professional advice and specialist input will be required to help fully inform decisions. Cash retentions or other traditional means of assurance should not prevail purely by default or without adequate analysis. “Custom and practice” is not of itself adequate justification for the implementation of any performance assurance mechanism. Hence, Scottish Government does not prescribe the use of cash retentions.

7. Cash retentions - principles

Project assurance mechanisms which utilise cash retention are permissible where an evaluation of options identifies them as offering the best overall value for money (rather than a retention bond or parent company guarantee, for example). Clients should ensure they receive advice from professionals, having regard to project circumstances. Whilst Scottish Government does not prescribe the proportion, or amount, of cash to be held, it should be reasonable and commensurate with strategic project factors, as should the triggers for its release.

Any costs associated with properly establishing and monitoring the retention fund should be compared with the benefits of minimising scope for abuse along the supply chain. Retention monies should not be unjustifiably withheld at any point along the supply chain on Scottish Government projects, those holding monies should observe the associated fiduciary duties (where applicable) and the relevant clauses in conditions of contract should be adhered to at all times.

8. Alternatives to cash retentions

Alternatives include the following:

Retention bonds - under a typical retention bond, the contractor’s performance of its obligations to complete the works as contractually-specified is guaranteed by a third party, or surety, which undertakes to pay damages sustained by the employer in the event of any default on the part of the contractor. Normal practice is to provide conditional retention bonds that increase in value as payments are made (in full i.e. no cash retentions applied) in accordance with the contract. The surety’s liability is limited to the sum which would otherwise have been held by the employer by way of cash retention at the time of any breach and is automatically reduced by half upon issue of the certificate of practical completion.

Performance bonds - the contractor may be able to give a “default” (or “on default”) bond to the public authority. This type of bond is conditional on performance of the contract or payment of damages by the bondsman if the contractor defaults. This bond is a guarantee because the bondsman assumes a secondary obligation to pay if the contractor fails to perform. The amount of the bondsman’s liability is proportional to the damages sustained by the employer. Another type of performance bond is an “unconditional on demand” bond: however, it is Government policy not to use these. “Maintenance” bonds are also available, which provide limited security for performance of the contractor’s obligations during the defects liability period. These can be of use where there has been a performance bond which has expired on practical completion or the works comprise a specialist installation demanding a high level of care after practical completion.

Parent company guarantees - This form of guarantee is given by a parent company (or holding company) to guarantee the proper performance of a contract by one of its subsidiaries (the contractor), and can only be given where the contractor is owned by a parent company or is the subsidiary of a larger group. Because the financial strength of the parent company may be linked to that of the contractor, a parent company guarantee will be acceptable only if the parent company (or holding company) is financially strong and its financial resources are largely independent of those of the contractor.

Such a guarantee is free of cost to the client, but may give less certainty of redress than a bond because it is not supplied by an independent third party. However, whilst accepting less independence, parent company guarantees for the proper performance of the contract can be more advantageous than bonds. The conditions of a parent company guarantee will usually give the parent company the opportunity to remedy any default within a period of notice before the guarantee is called. Rather than the client receiving a fixed amount in compensation, the parent company is obliged to complete the contract. The way in which this is done can, to some extent, be at the discretion of the parent company. Costs for completion are borne by the parent company - and these costs may be significantly more than the compensation provided for in a bond.

Escrow

Being in escrow is a contractual agreement in which a third party (the stakeholder or escrow agent) receives and disburses money or property for the primary transacting parties. The disbursement is dependent on conditions agreed to by the transacting parties.

Assurance drivers and constraints

Contracting authorities should seek appropriate professional advice when considering the use of bonds and guarantees on public works contracts, to clarify their practicalities, technicalities and legalities, and also their overall value for money compared with other performance assurance mechanisms. The use of bonds transfers some of the project financing cost from the contractor to the public client and will pass cashflow benefits to the contractors. Their use should result in a lower overall cost to the client if the contractor is prepared to reduce its tender price accordingly. Only one type of performance assurance mechanism should be deployed by the client at any time on a single project: for example, retention bonds should not be supplemented by the withholding of cash retentions. There can be greater scope for implementing alternatives to cash retentions on longer term contracts, framework agreements or serial contracts in which teambuilding and collaborative working practices can be more readily introduced.