Contract retention provisions



RETENTIONS ARE A HOT TOPIC at the present time with the Minister for Building and Housing, Dr Nick Smith, proposing a Supplementary Order Paper for the Construction Contracts Amendment Bill.

C_March_2015_Pg54_1Given the often large scale, complexity, cost and length of construction projects, the risk of something not going according to plan is almost certain. Accordingly, a common approach contracting parties take in order to mitigate this risk is to include retention provisions within their agreements.

Let’s consider the aspect of retentions and in some respects why we may need these and bonds in the first place. Please remember I am not a lawyer, but this column is to present the view that I have gained from my experience in the construction industry and to provide comment on the choices we have when considering the inclusion of retentions within the Construction Contracts Act.

There are two processes used to ensure performance with the intent of providing certainty to the principal and/or head contractor. There is frequently confusion between performance bonds and retentions with some suggesting they are the same thing.

First, why do we have performance bonds as there are some that confuse bonds with retentions and consider they are for the same purpose? The difference could be considered subtle.

Performance bonds are put in place when the contract is awarded with the intent that if a contractor cannot complete a contract or is in default the principal can call in the bond.

C_March_2015_Pg54_2Default by the contractor can be due to a number of issues related to failing to carry out contractual obligations but is most often due to bankruptcy, liquidation or having a receiver or statutory manager appointed.

Where the principal contends that the contractor has failed to perform its obligations the conditions of contract require an estimate of the cost be made of remedial work, work to be completed and other liabilities at the time the contractor becomes in default. It is this estimate that is used for determining the value of the bond being called in.

The value of a performance bond is not to complete the physical work but to provide compensation to the principal to have the site secured and fund the costs of finding a replacement for the original contractor.

Then of course we need to consider the issue of ‘on demand’ or ‘conditional’ bonds. It is my strong view that contractors must only provide conditional bonds which means they can be called up only if the contractor is in default under the contract. Bonds should also have an expiry date to reduce the costs of bonds that have not been released when practical completion is achieved.

Performance bonds protect the owner against defaults while retentions, unique to the construction industry, provide an incentive to the contractor or subcontractor to complete the project.

C_March_2015_Pg54_3Retentions are part carrot and part stick. Retentions are a carrot encouraging the contractor to complete the work by the required time and then to remedy any defect during the defects notification period. Conversely, retentions are a stick to punish the contractor for perceived (real or not) performance or quality issues and are withheld or payment delayed – sometimes indefinitely.

The use of retentions dates back to the construction of the United Kingdom railway system in the 1840s. In particular, retentions were used extensively by Isambard Brunel. The size of the railway projects increased demand for contractors, which led to many new contractors entering the market. These new contractors were inexperienced, unqualified and frequently unable to successfully complete their contracts.

As a result, the railway companies began to withhold as much as 20 percent of contractors’ payments to ensure performance and offset completion costs should the contractor default. The point was to withhold the contractor’s profit only, not to make the contractor, and its subcontractors, finance the project.

C_March_2015_Pg54_4Many submissions made on the Construction Contracts Act Amendment Bill suggested that provisions be included to cover off the issue of retentions and how they were applied in practice within the industry.

In response to those submissions and approaches by industry bodies Nick Smith sought Cabinet’s approval in August 2014 to draft a Supplementary Order Paper to address the issue of retentions.

In Smith’s submissions to Cabinet he provided a brief background to the retentions issue noting that subcontractors risk non-payment of retentions due to insolvency of clients or head contractors, and suggested they are not the best party to manage this risk.

He further noted that there is a high risk of insolvency in the construction market (relative to other markets), and therefore the higher risk of loss of retentions, detracts from the sector’s growth and productivity.

And finally Smith noted the use of retentions as working capital, by clients and head contractors which he says supports poor practices such as low-price tendering.

From the Cabinet Papers it is proposed to amend the Construction Contracts Act 2002 by a Supplementary Order Paper that will clarify the ban on “pay when paid” including any tactics that delay payment of retentions beyond the date specified and provide for a default rate of interest where late payment of retentions occurs.

The big issue will be the proposal to require retentions to be held “in trust” where retention monies are (there is no requirement for a formal trust to be formed) to be held in trust for the project, with the head contractor or principal owing a fiduciary duty to the subcontractors to exercise proper judgement. The primary requirement in this proposal is to ensure the funds are spent on the project that they were received for. Finally penalties will result where the fiduciary responsibilities are not met with monies being used for other purposes not related to the project.

I understand there will be transitional arrangements included because if this proposal is passed there will be costs associated with changing to the “in trust” requirements.

As an industry we need to understand both bonds and retentions and discuss how they may best be managed. We need to consider whether retentions are required or as an industry can a change in bonding arrangements provide the same surety.

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