Many debate the pros, cons and claims of retainage—when one party to a construction contract withholds a percentage (typically 5%-10%) from an otherwise approved contractor pay application, and which typically is not paid until a project is substantially complete. If an owner withholds retainage from a prime contractor, typically the contractor will in turn withhold retainage from its subcontractors.

While retainage has been part of the construction industry for decades, its concept, use (and abuse) have been under more discussion during the past 10 years.

Based on heavy lobbying from primary subcontractor groups, state legislatures have passed laws to regulate retainage in commercial projects. Lenders have become more careful about loans and are frequently involved in retainage discussions. Bonded projects are subject to criticism when a surety does not step in and, like the mythical insurance company, write a check.

The question is very simple: Is it time for retainage to go?

To understand the arguments, one must go back in history. The origins of retainage stretch back to the 1840s during what has been called “railway mania.” Throughout this time, railroad track construction exploded across the United Kingdom, there was an economic crash, and many owners were left with incomplete projects, as well as instances of bankrupt contractors and unpaid laborers. As a result, the unique idea was born that for the sole protection of owners, there should be withheld a certain percentage of approved work until the project is completed, and the concept of “retainage” emerged. This concept was then “imported” to the United States.

Retainage had traditionally been a sacred cow until industry professionals, as well as their elected officials, began to reevaluate its use in commercial and public projects.

These factors and events include plummeting profit margins for both general contractors and subcontractors. Many times, the amount of retainage was equal to profit margins. More prime contractors jettisoned performing work in-house and instead subcontracted out most of the work to subcontractors. As a result, as far as retainage is concerned, the burden fell on the subcontractors to complete the work and hope that retainage withheld for approved work would filter down to them at the tail-end of a project.

“Pay if paid” clauses also may mean that subcontractors must wait for the payment of retainage when there are disputes unrelated to their work. And in some instances, owners, architects and primary or general contractors have improperly withheld retainage, using it as leverage.

Steps to Eliminate Retainage

In 1986, the federal government took the lead to get away from retainage when it passed F.A.R. 32.103, stating that retainage should not be used as a substitute for good contract management, the contracting officer should not withhold funds without cause and determinations should made on a case-by-case basis. The Department of Defense, the General Services Administration and the Department of Transportation now have a zero-retainage policy. While many state agencies have followed the federal lead, private commercial projects still frequently use retainage.

Probably the most significant event that impacted the discussion of the use and abuse of retainage was the 2008 financial meltdown. Many states already had retainage and escrow laws requiring that retainage be escrowed on the books. The problem was that most laws did not have any teeth for violations.

Of course, who went belly-up in the 2009-2011 timeframe following the financial crash? Not only scores of prime contractors and subcontractors, but single-use development limited liability companies, bonding companies and even lenders. And what happened to those subcontractors whose non-escrowed retainage was withheld, and theoretically was accounted for in some construction loan, for approved work?

Lien rights were wiped out with a lender foreclosure. Bankruptcies wiped out debt and owed retainage. Purchasers—who still had credit—of half-completed projects after a foreclosure got great deals from lenders without having to pay one dollar for owed retainage, and more and more construction companies went out of business. As a direct consequence, the construction industry lost a generation of workers.

The events resulted in state legislatures (aided by lobbying groups) wading into the area of regulating retainage, which is normally the subject of contract negotiations among sophisticated commercial construction industry players. Most of these laws have been passed for the protection of subcontractors. Some states have reduced the maximum amount of retainage withheld from the standard 10% to 5%. Some have required that a project retainage escrow account be set up and funded with actual dollars. Any contract provision to the contrary is void and against public policy.

Some states, such as Tennessee, have criminalized retainage violations and provided a hefty civil penalty (e.g., $300 per day) for an owner or contractor that did not properly escrow retainage. Bankruptcy protections are statutorily created by stating that any escrowed retainage upon payment into the account is the “property” of the prime or subcontractor to which it is owed. Tennessee statutory law even regulates when retainage must be paid by an owner to a prime contractor, regardless of any contrary contract provision.

Important Questions

Because of these considerations, even on private projects, more discussions about retainage are occurring on the front end of a project.

• Can the lender be convinced to allow an owner not to withhold retainage, especially if it must be escrowed, and thus interest paid?
• If payment and performance bonds are obtained, why is retainage necessary?
• If the purpose of retainage is to provide security to the owner, and are not necessary for leverage over a general contractor and, in turn, a subcontractor, are security bonds the better option?
• In many states, payment bonds can be used to discharge mechanics’ liens without a prime contractor having to use bonding capacity to obtain a lien bond. What about thinking creatively?
• Can the parties agree to allocate a small percentage of the contract amount at the tail-end of a project, sans retainage language, allowing, however, for withholding of a small amount for completion of punch list or close out documents?
• Will an owner get better prices from primes, and attract better primes and/or subcontractors, if the bid documents state that there will be no retainage withheld?

The bottom line: An independent evaluation should take place on the front end by the major players (i.e. developer, owner, lender, general contractor) as to whether retainage should be withheld on a commercial project. Each state’s retainage laws should be reviewed by counsel.

Gone should be the days when, as a matter of course, in any form loan agreement or construction contact, retainage is always withheld.

Think through what is at stake in the project, and how to protect all players while encouraging primes and subcontractors to bid on any project.