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Published 29 May 2018
Government Consultations, proposed parliamentary bills and the collapse of Carillion have put cash retention in the construction industry firmly in the spotlight. This article by Adam Jason and Ashley Simpson of DAC Beachcroft review its purpose and future.
Department of Business, Energy & Industrial Strategy's consultation and the draft Aldous Bill which is due for second reading in June has focused attention on the practice of cash retention on construction contracts. Similarly, the financial position of the UK's largest contractors is now under scrutiny in the wake of Carillion's high profile insolvency. Cash retention impacts on cash flow and working capital throughout the entire supply chain and Carillion's liquidation has further brought these issues to light with an estimated 30,000 creditors and £800m of retention payments held on the date of liquidation. A number of industry bodies have called on the Government to abolish retention and to implement cultural change throughout the industry.
A key recommendation of the Aldous Bill is the creation of a retention deposit scheme, similar to that in place for residential tenancies; with the retention held in an independent scheme until it contractually falls due for payment. Such a scheme may protect the interests of those at every level of the supply chain, but it still does ignore the crucial issue of liquidity within the construction sector at the moment.
Construction projects are procured with increasingly tight margins, sometimes yielding lower levels of profit for the contractor than the retention percentage, leaving absolutely no room for error on projects that often carry significant risk. Conversely, the practice is well established and gives employers and funders comfort that the project will be delivered on time and within budget. The Aldous Bill is addressing how to ensure retentions are released appropriately; it would also be timely to examine if the practice of cash retentions is benefitting the industry as a whole.
As we know, the objective of cash retentions is to provide a contingency pot should the contractor become insolvent during the construction phase of a project or refuse to remedy defects in accordance with its obligations pursuant to the building contract.
From the contractor's perspective not only is it having to wait to realise its profit on a scheme, the contractor is exposed to the employer's insolvency. Although the JCT retention provisions state that the employer has a fiduciary interest in the retention as trustee for the contractor giving the contractor the right to request that the funds are ring-fenced in a separate bank account (thereby ensuring contractors have recourse to their retentions in the event of the employer's insolvency) it is universally accepted that these provisions are always deleted. This means that the employer can use the retention money to help its own cash flow. The problem is that in the event of employer insolvency, the contractor's right to the retentions are lost other than to be claimed as an unsecured creditor. Added to the contractor's risk profile is that its liability for defects to any interested party who had received a collateral warranty persists. While the Aldous Bill seeks to protect contractors in such instance, the industry would do well to consider whether there is any way to make alternative methods of protection more viable for employers and contractors alike.
From an employer's perspective, using a £20m pound project procured using the default JCT D&B 2016 retention percentage of 3% as an example, the employer could have around £600,000 of the contractor's money in its bank account just before practical completion. Even after practical completion, the employer would have a stick weighing £300,000 to use against the contractor in respect of failure to remedy snags and defects. However, because the retention is taken against interim payments, any amounts retained during the early to middle stages of the development are unlikely to be sufficient to protect the employer against the additional costs to the project arising due to contractor insolvency during the early or middle stages of construction. Had the contractor become insolvent with only £5m worth of work paid for, the employer's contingency pot would be £150,000 which is 0.75% of the total £20m contract sum. Even if we only attribute extra costs in achieving completion of the works to inflation and put to the side the other usual additional costs of completing a half built development (such as paying another contractor a premium to warrant work already done and/or paying subcontractor monies due to them but not paid by the original contractor), the employer is already paying more than the original £15m for the remaining works and the £150,000 contingency pot is only half of the revised cost to completion (based on inflation being around 2%). Once you add in the prospect of paying another contractor a premium and having to pay subcontractors a ransom to stay involved in the project, the costs start to stack up. And in the meanwhile, the prospect of the developer having to pay delay damages to third parties starts to become a real possibility. Some may argue that every little helps in these circumstances but retention in itself has not substantively helped the developer. Rather had the retention not been deducted on this contract, and several more this contractor may have been delivering simultaneously, the issue of insolvency may never have arisen.
The deficiencies in relying on the retention described above are well understood, which is why there is a market for retention bonds and performance bonds which are sometime used in combination with parent company guarantees, but is it not time to discuss whether the industry and its financiers could make bond products much more viable in order to adequately protect the employer whilst not unduly harming the industry's contractors. Given that the primary reason why performance bonds are called upon is contractor insolvency, it must be in the industry's interests to help contractor liquidity and cash flow by encouraging employers not to deduct retentions by making bonds more attractive to employers (whether in price or in the amount the bond covers)?
As this brief articles suggests, the practice of cash retentions may well be disproportionally harming contractors compared to the benefit it provides to employers. Although the retention deposit scheme proposed by the draft Aldous Bill would undoubtedly help protect contractors and its supply chain whilst maintaining the limited protection already available to employers, it is by no means a silver bullet by which to improve the cash position of UK contractors and secure the delivery of UK construction projects. If you are interested in receiving advice and assistance on your contractual arrangements and how best you can mitigate any risks on a construction project, the team at DAC Beachcroft would be delighted to hear from you.
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