How to Avoid Retainage in the Construction Industry?
Retainage is a process of holding back a certain percentage of money from a subcontractor or contractor while the construction project is in the progressive stage. Restricted only to the construction industry, the practice has been extremely popular with both public and private projects for over 200 years.
Under this, construction contracts are designed to withhold a certain percentage of the total contract price until the project goals are achieved. Though the practice seems to be favorable for the project owners investing loads of money to the projects, it becomes difficult for contractors and subcontractors to upkeep the cash flow, especially when there are so many existing regulations that complicate the construction process.
Before we get to our objectives on how retainage in the construction industry can be prevented, it is critical to know the history of retainage, the various regulations surrounding the retainage process, and the challenges they pose to contractors.
Invented in the 1840s in Great Britain, Retainage was started as a practice to avoid the risk of poor workmanship during the project lifecycle. Even though the practice has faced always faced criticism, withholding contractor's payments were subjected as a financial incentive to the contractor for completing a project, while the amount withheld can also be used as insulation against any risk or incapable performance shown by the contractor.
With time, the practice of retaining money has become part of the industry's culture, with different laws framed around it. Retention these days has turned to be a vital part of contractual provisions on which an agreement is required from the contractor before the work is started. However, most of these regulations and laws were designed to promote fair use of Retention practice and avoid any kind of abuse with contractors or subcontractors.
Besides all these regulations made to protect the rightful payments of the stakeholders, subcontractors and other lower-end participants of the construction process are mostly affected by Retention related norms. This is why many contractors, subcontractors, and construction service providers demand an international abolishment of the retention practice, as the entire process of tracking and managing withheld money is highly consuming.
Even though the retention practice involves so many queries and questions related to the money withheld from the contractors, the two most important concerns that contractors need to face in routine include:
- The percentage amount that should/will be withheld?
- The time for which the particular percentage amount needs to be withheld.
Basically, all these questions signal the need for clear retainage rules for all the contractors, subcontractors, and other participants involved in the project.
The Retainage Rules
Whether you lead a project or you are a general contractor who needs to use retainage to keep your money protected, or you are a contractor or subcontractor who needs to save the retainage amount to avoid any issues with cash flow during the development stage of the project, there are certain rules that you need to understand and follow to avoid any disadvantage retainage could bring to your business.
Mutually Defining the Retainage Amounts & Timetables
The "Retainage" process for both the retaining party and the party whose payment is withheld begins with a contract or mutual agreement. Though every state or federal laws surrounding retention are different, most of them function as a limitation to retention. This is why both parties who are planning retainage agreements have to consult an expert to know what they need to agree as a part of the process.
If not addressed in the project contract specifically, retainage is no longer exercised to the project. This means the project owner or the general contractor is left with no right to withhold any money on the job. However, a retention agreement is a common practice for both parties who agrees on a construction contract in the form of the most popular form of contracts like AIA documents & Consensus DOCS.
Research made in 2004 at Clemson University found that every construction job contract contained a norm for retainage, and for private projects, at least 5 percent is held in 85 percent of projects.
However, the burden of this retention mostly lay upon subcontractors as every 2 of 3 subcontractors have to deal with a 10 percent retention amount while one of them had to have the maximum burden. The average percentage was 7.59%, 5.56%, and 3.26% for private, state, and federal projects, respectively.
The major concern associated with these figures was not the percentage of retention, but the time it took to collect the retainage money after the contract ends or a project is completed.
Are you surprised? There is more to come. According to another research made in the UK, the average waiting period for collecting the payment withheld is around 99 days for general contractors, and it goes up to 167 days for subcontractors, while 25 percent of them never received the retained amount.
What should be the percentage amount that should/will be withheld?
The percentage amount that needs to be withheld usually depends on the agreement between the parties. Therefore, the amount of retainage could vary as per the mutual contract between the parties. But the standard or average amount of retainage is usually kept at 7.59%, 5.56%, and 3.26% for private, state, and federal projects, respectively.
The time for which the particular percentage needs to be withheld.
The time for retainage again depends on the agreement between the two parties. Most of the time, the money is withheld until the end of the project. However, the average time of retention for general contractors is measured to be around 99 days, while it was 167 days for subcontractors.
Guidelines on Federal Public Projects
Once the parties involved in a project come to a mutual agreement, it is considered as a contract for holding back money. Since the government has recognized the various disadvantages related to cash flow for the parties whose money is withheld, the need for legal limitations around the retainage process was identified.
Furthermore, the Office of Federal Procurement Policy asked Federal and State Governments to pass laws governing the retainage process, starting in 1983. On this, the Federal Government made the first response ever limiting the percentage of retention for contractors who get to work on federal public projects.
Prime contractors were allowed to withhold subcontractor money while keeping the bills to the government exclusive of the retention amount. The law framed under Federal Acquisition Regulation (FAR) allowed the primary contractor to retain payments for the subcontractors based on the mutual agreement and contract terms between the two, even if there is no retainage done by the government.
Since the government does not validate including retention amount into bills shared by general contractors, this gives way to a new provision that only Government Agency can practice retainage with the general contractor when they have a "Cause."
The federal government policies related to retention needs contractors to prevent retainage when not necessary, i.e., either they should have a cause to retain money, or it is a case selective decision. In legal language, it says, "The Contracting Office has complete discretion to decide whether or not to withhold retainage" based on a past assessment of the performance of the sub pursuant.
As per the FAR Guidelines, if the contractor is not able to show satisfactory progress with the project, the government agency that has the project gets the right to hold 10 percent of the payment at max. However, the usual retainage percentage lies between 5 to 10 percent, which keeps on reducing as certain project milestones are achieved.
Guidelines on State/County or Municipal Projects
Retainage is not just limited to Federal projects but can also be exercised on public projects that fall under state, county, and municipal jurisdictions. Actually, there are only a few states that show agreement with retainage; at least one of 50 states show favor to retention on public projects. Yet, every state has its own rules and laws that govern the practice, as some states even consider Retainage as a requirement for contract and not a choice.
There are certain states that consider the retainage money as the percentage on the contract price and are something not applicable to every progressive payment. For instance, if a project is designed for ten different goals of the project lifecycle, and each progressive payment includes 5 percent retainage, the total retention amount is maxed out at the 6th payment, making all four final payments retention-free.
However, certain states do not allow retention after 50 percent of project goals are achieved. But still, this needs contractors operating in different regions to verify that what laws and jurisdiction apply to their project and contract.
Guidelines on Private and Commercial Projects
When it comes to private projects, every project has scope for withholding money. However, the laws and the rules defined by state governments still apply to the terms of the contract, such as time of retention and recovery. This helps subcontractors or other pursuant to get protection against abuse as laws enforces punishments in the form of interest penalties.
Though there are so many laws, regulations, and limitations on private projects, the retainage is only defined by the terms of the contract between the Construction Company, contractors, and subcontractors.
Retainage as a Challenge for Subcontractors
If it comes to the construction project stakeholders that are most affected by the retainage, then it is the subcontractors. Subcontractors often have to deal with the loss of practicality in business relationships due to Retainage when the accounting and payment system is already very complicated.
Even a report published by American Subcontractor Association in 2004 found that the maximum of the subcontractor abuse happens only due to retainage. The report had some shocking revelations to make:
- Subcontractors said they receive a lesser amount than the actual retainage amount for more than 10 percent of projects.
- For normal projects that do not involve any disputes, subcontractors have to wait for a period of 30 to 900 days to get the retained amount. The average time for collection lies around 167 days.
- When asked for the longest retainage, it came out to be the wait time of 60 days to 2500 days, with an average time ranging at 567 days for worst cases.
Apart from this, the report showed a list of strong beliefs that subcontractors have developed due to retainage practices adopted by contractors or project owners. Many subcontractors claimed that primary contractors often held a bigger amount of money than the actual retainage percentage they agreed on contracts with project owners.
Secondly, some had a belief that retainage is done purposely to make the subcontractors go weaker with their finances and had it had nothing to do with performance. Besides this, it was majorly believed that primary contractors use retainage as a financing mechanism to keep their operations moving without any use of personal business cash, bringing all the burden to the secondary tier of stakeholders.
And after all these questions and queries are left unanswered, retainage is still considered an essential part of contracts and agreements.
How Retainage Dampens The Cash Flow?
When it comes to the reason for failure for any business, it always ends up in finances and cash. Since the construction industry is dealing with cash flow issues even before the concept of retainage came into existence, the failure rates are even higher for businesses.
Though there are so many reasons for the potential loss of cash flow, extensive retention time is one of them. Most construction firms and subcontractors who invest all their resources to sustain their operations and expenses are more vulnerable to collapse that may happen due to delayed payments on Retainage.
Especially when the construction industry is one of those areas that have notoriously thin profit margins with the projects, a long-withheld payment due to retainage turns to be much greater than the expected profit margin when not retained amount is not received on time.
Consider a situation where a contractor signs a project for an 8 percent profit margin with the total amount of the project. However, the retainage done at 10 percent could leave the contractor at a loss of 2 percent even after the critical project requirements are achieved.
Above that, if the retention amount is not paid to the contractor or a subcontractor on time, it would need them to continue their other projects for that time on their own cash, degrading their financial statements. In short, retainage, if not practices based on laws and regulations, could create serious business complications for the contractors and subcontractors.
The Conflict between Retainage, Lien Rights, & Payments Rights
To keep the payments protected for the contractors and subcontractors, the mechanic lien rights were formed. Regarding the viability of these rights, they appear to be highly contradictory to the purpose of their creation.
The retainage laws provide contractors the right to hold the money until the project is completed or reaches a specific stage allowing the total retention period to go up to months or years. On the other hand, the contractors or subcontractors who need to take benefit of lien rights to claim their payments have a very small window to file their claim.
This means if a project has a long-extended timeline, it is very likely that the subcontractor's access to lien rights may expire long before the time for which retainage is kept due. So, here comes the question of what can be done by contractors to get over such a situation. Do contractors need to use their lien rights at the early stage of projects? And if so, would it be of any benefit to them?
The truth is Mechanic Lien Rights don't wait for retainage, and even the State or Federal laws have never shown any support to the contractors on the issue. However, the only state that has managed to take the right action on protecting the lien rights of the contractors related to retainage is New York, as it has made amendments to its lien laws.
In contrast, there are states like California, Illinois, Louisiana, Massachusetts, and Utah, that calculate the date of lien filing based on project completion date as a whole and not the last furnishing date for a particular company. Even though the solution does not rectify retainage issues, it gives enough time to contractors to take benefit of their lien rights, minimizing chances of delay or loss.
Do You Need To Raise Mechanics Lien Claim Including Legally Withheld Money?
Since the state laws surrounding retainage and mechanics lien rights are highly contrasting and unclear, most contractors and subcontractors are stuck with the question of whether or not to include retainage in their lien filing.
Still, the decision to include retainage money in the lien claim is entirely the decision of the contracting firm as every firm has its own financial needs and considerations. Also, when state rights empower contractors to file a claim for the full due amount they owe to a general contractor or project owner, it is always a good idea to go for mechanic lien rights.
The lien claim actually works as the total value of work and other resources that the filing contractor or subcontractor has completed. Filing a mechanics lien works as a process that gives you the right to get paid for all the efforts that you put in to meet the construction contract terms, irrespective of the retainage.
How Lien Rights Work When Dealing With Retainage
Sending Preliminary Notice
When need to make potential lien claims, it is vital to send a preliminary notice as it helps to validate the mechanics' lien and have the ability to file. In most states, the process of sending the preliminary notice is sufficient to protect what is owed by the contractor, including the amount of retainage. In short, preliminary notices should be sent within the subject time to keep retainage and other payments protected.
However, certain states have different retainage practices and exceptions. For instance, Texas is one such state that needs contractors and subcontractors to process a specific notice for contractual retainage, which is usually done in addition or instead of monthly notices. These notices, at most times, are limiting to protect the ability to claim retention money.
Understanding Mechanics Lien Deadlines
First of all, it is crucial for contractors to understand that retainage does not extend your lien filing deadline. In most cases, the lien claim that includes the retainage withheld is a good decision to make.
Quick Tips to Manage the Impact of Retainage
Here is some practical advice to help deal with the potential impact of retainage on a project.
- Learning the State and Federal Laws Work along with the Contractual Details
Retainage is controlled on government projects in comparison to private projects. However, the only issue that contractors working on private projects had to face is the lack of finances to fight for penalties against private project laws.
This is why it is crucial for contractors or subcontractors to check all the terms of the contract, as it helps to learn how the retainage process works. Moreover, any percentage mentioned in the contract should be confirmed.
Some other questions that you need to ask should include:
- Any provision to hold retainage in escrow
- Provision to withheld interest and the entity that get the benefits
- Using retained funds to discharge mechanic lien claim by the project owner
- Any retention clause made to compensate the workmanship deficiency
1. Negotiating on the Retainage
If the company, contractor, or subcontractor is about to get bound into the project contract, one thing that can always be an advantage is the time for which the firm is in business. If the firm has a proven track record, then having a negotiation on retainage can be a great idea.
In certain cases, contractors could even go for a surety bond or letter of credit to meet the retainage requirements of the project owner. However, these negotiations are not very usual in the industry and only work on goodwill. But still, exploring the ways to negotiate on the bills is always a good idea to keep the payments protected.
2. Plan Ahead To Protect Cash Flow
When done with all the alternatives and practices to protect the retainage percentage, the next thing contractors should do is plan cash flow accordingly. This needs to reckon the finances of the firm and work on some accounting to ensure the project can be floated without any monetary complications.
3. Using Lien Rights
Last but not least, if the firm had to deal with some circumstances of financial stress, the mechanic lien should be exercised immediately to secure all payments. However, working on mechanic lien rights should be done after careful consideration of the state laws, federal laws, and contract policies.
How can Construction Software Help with Retainage?
As we know, the best construction software are designed to bring efficiency to the construction business. And, with the complexities in the construction industry, contractors and sub-contractors need management software that can best optimize the process right from project approval, digital invoicing to client management and paying retainage. Construction management software can automate invoicing with specific line items for retainage, standardize their forms across all projects, and pay subcontractors on time, thus reducing errors and risk. Construction management software, when integrated with financial management software, can help navigate the nuances of retainage, including managing complex retention structures.
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