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Retainage is a portion of the agreed upon contract price deliberately withheld until the work is substantially complete to assure that contractor or subcontractor will satisfy its obligations and complete a construction project.
The practice of retainage dates back to the construction of the United Kingdom railway system in the 1840s. The size of the railway project increased demand for contractors, which led to the entrance of new contractors into the labor market. These new contractors were inexperienced, unqualified and unable to successfully complete the project. Consequently, the railway companies began to withhold as much as twenty-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.
Given 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 retainage provisions within their agreements. The concept of retainage is unique to the construction industry and attempts to do two things: (1) provide an incentive to the contractor or subcontractor to complete the project; and, (2) protect the owner against any liens, claims or defaults, which may surface as the project nears completion. Incidentally, and more so now than ever, owners and contractors use retainage as a source of financing for the project, contractors in turn withhold retainage from subcontractors, frequently at a greater percentage than is being withheld from them.
If there is to be retainage on the construction project, it is set forth in the construction contract. Retainage provisions are applicable to subcontracts as well as prime contracts. The amount withheld from the contractor or subcontractor should be determined on a case-by-case basis by the parties negotiating the contract, usually based upon such factors as past performance and the likelihood that the contractor or subcontractor will perform well under the contract.
One can structure retainage arrangements in any number of ways. Subject to state statutory requirements, 10% is the retainage amount most often used by contracting parties. Another approach is to start off with a 10% retainage and reduce it to 5% once the project is 50% complete. A third approach is to carve out material costs from a withholding requirement on the theory that suppliers, unlike subcontractors, may not accept retainage provisions in their purchase orders.
Retainage clauses are usually found within the contract terms outlining the procedure for submitting payment applications. A typical retainage clause parallels the following language: "Owner shall pay the amount due on the Payment Application less retainage of [a specific percentage]."
Retainage is generally due to the contractor or subcontractor once his work is substantially complete. Determining just when substantial completion occurs is usually litigious. The standard analysis finds the event triggered when the owner can occupy a structure and use it for its intended purpose.
Subcontractors tend to bear the brunt of retainage provisions, especially subcontractors performing work early on in the construction process. The main reason for this, is because many contractors pass down the owner's right to withhold retainage to the subcontractor, but frequently withhold more than is being withheld from them. For example, a subcontractor performing site work may complete its work in the first few months of the construction project, but generally is not allowed to recover the amount withheld from the owner and contractor until the project is "substantially complete," which could take a few years depending on the size of the project. Coupled with a contingent payment clause, the retainage can cause significant financial distress to a subcontractor.
Another problem arises when the contractor withholds from its subcontractors at a greater percentage than the owner has withheld from them. The owner is to pay retainage to the contractor when substantial completion has occurred, however, in this abusive, over-withholding scenario, the contractor will already have been paid a portion of the subcontractors' funds, meaning that the contractor will have to fund the balance of the payment from its own cash flow. This could cause a delay in the project closeout. The contractor may feel that it is more advantageous to keep the project incomplete, than by never being paid its retainage and making the argument that the subcontractors are therefore not due their portion of the retainage.
In 1974, Congress established the Office of Federal Procurement Policy to provide a uniform government-wide procurement policy. Since the mid-1970s, there has been an overall trend in the reduction of percentage withheld on federal construction projects. The current Federal Acquisition Regulation (F.A.R.) continues to support this trend. Paragraph 32.103 of the regulation states, " . . . Retainage should not be used as a substitute for good contract management, and the contracting officer should not withhold funds without cause. Determinations to retain and the specific amount to be withheld shall be made by the contracting officers on a case-by-case basis. Such decisions will be based on the contracting officer's assessment of past performance and the likelihood that such performance will continue." Currently, Federal agencies such as the Department of Defense, the General Services Administration and the US Department of Transportation have 'zero' retainage policies.
Several alternatives exist to standard retainage provisions that provide the same benefits and protections. For example, parties can agree to establish a trust account. A trust account provides the contractor with some control over its money, even if it is being held by the owner. In a trust account, retainage is withheld by the owner, placed in a trust account with a trustee that has a fiduciary relationship to the contractor. The trustee can invest the retainage at the contractor's direction, thereby allowing the contractor to "use" the retained funds that normally would sit idle in an escrow account.
Other alternatives to retainage are to allow the contractor to supply substitute security to the owner in the form of a performance bond, bank letter of credit, or a security of, or guaranteed by, the United States, such as bills, certificates, notes or bonds.