What is retainage?
Anyone in the construction industry should be familiar with the term “retainage.” While it’s a mildly controversial practice, retainage prevalent in the construction industry. Retainage is the practice of withholding a percentage of payments until the end of the project. The average percentage withheld from payments hovers around 5% to 10% depending on the work being performed.
The reason for retainage is two-fold:
- it’s meant to act as an incentive for the contractor to successfully finish the project; and
- retained funds act somewhat like an insurance policy in case defects or other financial issues arise.
What’s the problem with retainage?
Retainage creates serious cash flow problems for those who aren’t receiving “full” payments. Contractors are uniquely susceptible to cash flow headaches. On any given project, contractors, subcontractors and suppliers eat project costs up front in promise of repayment later on. So not only are these businesses required to cover the cost of construction up-front, but they’re also asked to forgo some percentage of retainage until completion.
Lower-tiered project participants find themselves floating initial material and equipment costs right from the get go, before a single progress payment is even made. On top of that, profit margins have historically been slim and getting worse. The average margin falls within the 2% to 5% window. So, that 5% to 10% retainage may be well beyond the profit margin on the job. If a construction business never gets their hands on retained funds, they may end up working a job just to break even.
How retainage is abused
As one contractor said, “Retainage in our industry is a way for companies to take an extra 10% off the top. They will make up reasons not to return it—despite having done the work they requested.”
This is the most common way retainage is abused. Since retainage doesn’t become due until the project is substantially complete, lower-tiered parties tend to lose leverage. This is particularly problematic for early phase subcontractors doing work like excavation, framing or pouring foundation. Depending on the size of the project or schedule, they may find themselves waiting months or even years to collect the remaining contract balance. And the longer the delay between performing work and payment, the more difficult it becomes to get ahold of the contractor and convince it to release payment.
Lawsuits and collection services can cost precious time, money and resources. Frequently, subcontractors or suppliers will be asked to accept a lower amount. By that point, some would rather get some money back, than none at all.
How to proactively protect retainage payments
The federal government and many state governments regulate retainage through prompt payment laws rather aggressively on public projects. This is done by capping the amount that can be withheld, establishing deadlines for payment and imposing interest penalties for late payment.
Private project are less regulated. Many of the state retainage laws that apply to private projects establish the same kinds of limitations. However, many states with these regulations also include the unfortunate caveat of “unless otherwise agreed.” Meaning, the parties can still agree to contractual terms that would supersede prompt payment requirements.
Most of these regulations are reactionary, imposing penalties after the fact. These penalties—like interest penalties—can only be collected by filing a lawsuit, which adds more time and cost. Proactive measures need to be taken before the project even begins. Here’s where it’s time to flex negotiation skills.
Negotiation tactics regarding retainage
It all starts with the contract. If retainage isn’t specifically addressed in the contract, it doesn’t exist. This is why it’s so important to read the contract carefully and negotiate fair and equal terms, particularly when it comes to retainage.
Here are some retainage provisions that construction businesses can negotiate into their contracts:
- Variable retainage. First and foremost, identify and clarify the amount of retainage being withheld. Variable retainage can mean one of two things. The first is a sliding scale, not unlike a lot of state statutes. Many states provide for retainage at a certain percentage, that’s then reduced at the 50% completion mark. This is a great way to control cash flow when nearing the end of the project. Another type of variable retainage is to limit it just to labor costs. Floating material costs can be a heavy financial burden at the outset of a project. By carving out materials from retainage, there is the security of knowing all material costs have been covered.
- Substitute security. This requires some money up front, but at least the money is there and can be collected at the end of the project. The security can be letters of credit, certificates of deposit or surety bonds. A lesser-known retention bond can also take the place of retainage. This route makes sense if the premiums is less than the retainage being withheld and is a safe option to ensure the retainage can be recouped at the end of the project.
- Deposit funds separate accounts. Another option is placing retained funds in a secure account, such as an escrow account, trust fund account or separate bank account. The limited access to funds will prevent the money from being diverted for other purposes. This also protects the funds against creditors should the prime or owner face some financial difficulties. In some cases, the account may accrue interest that is paid out on project completion.
- Get creative. There are many ways to structure a favorable retainage clause. Work with the other party to find terms everyone can agree on. One example is a line-item or phase/milestone releases. The point of retainage is to ensure successful completion. If a certain portion of the work or line-item is complete, why not release retainage as each is completed and approved? Another tactic is to offer two different contract prices. A higher price if retainage is included and a lower price if not.
How to recover retainage
Recovering retainage payments is not easy. Whether a contractor pursues them or hands the debt to a collection agency, it does not guarantee payment. Before resorting to the courts for help, it’s important to maximize mechanics lien rights from the outset of the project. They are the single most powerful tool for leverage in the construction industry. Liens are the best was to ensure payment what has been earned.
This requires being proactive. No one expects problems on a job, but it’s better to be safe than sorry (and broke). Sending a preliminary notice is the first step towards protecting against nonpayment. Some states, such as Texas, even require preliminary notices specifically for retainage (Notice of Contractual Retainage).
This isn’t an aggressive move that will anger the customer. It’s just safe business practice. If things go south, or continue to go south, then begin to progressively tighten the screws. It usually starts with a preliminary notice, then invoice reminders followed by payment demands. If those don’t work, it’s time to increase the pressure with a Notice of Intent to Lien and lastly a mechanics lien.
Admittedly, in some states timing is tricky. Mechanics liens only cover unpaid amounts that are owing and due. If the deadline to pay retainage falls outside of the lien filing deadline, there may be no recourse. If not, retainage can assuredly be included in a lien claim. However, any accrued interest or attorney’s fees can’t be included in the claim itself.
Bottom line
Retainage isn’t going away any time soon. Contractors should know their rights, use the law and remedies where applicable, and negotiate the best terms possible. When all else fails, don’t be afraid to leverage lien rights. After all, not only has this money been earned, but it potentially represents the entire profit margin for the job.
