The Government’s proposed measures to improve business cashflow includes a ban on cash retentions in construction contracts. The move is intended to protect the industry – especially small and medium-sized enterprises (SMEs) – however it will be interesting to see what impact the outlined changes might have on the surety industry and what alternative solutions could be adopted.
What are retention payments within construction contracts?
Cash retention is a simple concept – from the typical monthly valuations of construction work on a project, a small percentage is deducted and held by the employer as security. The retention is then usually released in two stages: half on “practical completion” of the works and the balance at the end of the (typically 12 months) “defects liability period” once any notified defects have been rectified.
The intention is to motivate the contractor to rectify defects post-completion, and to provide cash to the employer if the contractor fails to do so. However, these payments are often unprotected, despite JCT contracts trying to impose duties on the retention sum.
Background to the need for change
Factors including cashflow pressure – especially in relation to SMEs – have been identified as a root cause of the UK’s construction industry having the highest insolvency rate, accounting for 17% of corporate failures. Late payments also play a significant part, along with materials cost inflation and fixed-priced contracts.
There is a competing background – post-Grenfell cladding issues have highlighted poor build and design practice. The extent of historic defects – particularly in relation to cladding and fire safety – would see employers and developers looking to better protect their position, rather than potentially reducing any financial security measures, at a time when it’s needed most. So, this is a potential key area which would need reviewing, should the proposed cash retentions ban go ahead, to minimise any possible consequential effects.
Consultation outcome
Responses to the Government’s Department for Business and Trade consultation indicated that retention is a recurring cause of cashflow pressure, particularly for SMEs. The sums withheld can materially reduce working capital, constrain investment in other projects and leave contractors less able to manage short-term cash flow difficulties.
The options consulted on were: (i) a simple ban on retention, or (ii) a more compromised position providing more of a balance between employers and contractors by means of protecting the retention money in a ring-fenced account with controls to ensure fair and prompt release. Alternative insurance or bond retention arrangements were also considered.
Industry expectation in most quarters was a compromise position but, to some surprise, the Government announced a simple ban on construction retention as part of a raft of other measures to protect SMEs (mandatory interest on late payment and 60-day terms cap). The driver for this is the simplicity of the approach to implement and enforce.
Implementation of proposed changes
Details have not yet been announced on exactly how the ban will be implemented by legislation. However, there is form in the approach taken under the Housing Grants, Construction and Regeneration Act 1996, which banned “paid when paid” clauses i.e. the sub-contractor isn’t paid by the main contractor until the main contractor has been paid by the employer.
Some main contractors tried to get round the new regime, for example, by “paid when certified” clauses. This practice was subsequently banned when the 1996 Act was (eventually) amended in 2011.
One option might be to utilise the flexibility of the payment regime under the 1996 Act to use agreed milestone payments similar to retention at equivalent times – this is one area where the drafting of a ban may need to consider wider legislation.
Successfully banning retention will, therefore, require very careful drafting and to consider possible avoidance strategies.
Sureties and retention
Retention bonds, as an alternative to cash retention, are not new; however, they have been generally reserved for larger projects. There will be an additional cost to the contractor in procuring the bond and this will be added to the contract sum. This cost may be mitigated in part by slightly better pricing by the contractor in return for a better cash flow.
One issue for contractors is the limit of capacity on their credit lines to be able to procure bonds, and that will likely be more of an issue for SME contractors – the main beneficiaries of the retention ban.
If retentions are banned outright, then the contractor will be paid in full for each interim application and, by the time of practical completion, there will be no remaining ‘fund’ held by the employer to deal with rectification of defects. This may remove part of the incentive for some contractors to return to rectify defects.
From a surety perspective, the proposed changes could mean there will no longer be a requirement for retention bonds and that element of surety business might disappear going forward. In relation to bond claims arising from contractor failure, the employer will not be holding any retention monies which would be held to the notional credit of the contractor and available to fund completion works. This slightly increases the risk for the surety when providing performance bonds.
Retention bonds are not the only surety solution relevant here – performance bonds (whether default bonds, or on-demand) have long been a feature of UK construction contracts and provide security to the employer (and extendable to their funders) typically guaranteeing an amount payable of up to 10% of the contract sum. The bond is there to cover contractor insolvency and compensates the employer for the extra-over cost of bringing in a replacement contractor to complete the works. They can also serve as protection against the cost of defect rectification.
One response may be a drive by employers to extend the value and/or duration of the performance bond to provide additional security to cover the gap of cash retention. However, this approach has pros and cons – this would be at additional cost to the employer and may restrict the capacity of SME contractors in terms of how much security they would have available.
How effective is retention anyway?
Historically, retention practices led many contractors to expect that retention would not be released by some employers, regardless of whether the works were complete or free from defects. Even after the introduction of adjudication in 1996, challenging non release was often not cost effective.
Some contractors would respond to this by pricing the retention into the tender process, and so even though the employer had the benefit of the security, they had in effect paid for it themselves. While this contributes to construction inflation, there is an argument that banning retention could reduce the pressure to price in this way.
Alternative options for the construction industry
Parent company guarantees may be an option for some contractors as an alternative security, and they have the advantage of not having a tangible cost attached. However, they do not provide the same level of security for the employer/developer as a bond from a regulated financial institution.
Holding the retention on trust, or in a dedicated account with some form of independent control may be workable alternatives. However, these options were rejected following the consultation due to being overly complex. Given the legislative need to ensure an effective retention ban, it is likely these approaches would be unlawful.
Watch this space
So, the industry continues to wait for further detail on the proposed statutory drafting and guidance on how the ban will be implemented. How the construction and surety industry reacts to this policy development should be an interesting tale.