Editor’s Note: This article was originally written by Don Gregory, Director of the Construction Law practice at Kegler, Brown, Hill + Ritter. It’s reprinted here with his permission.
Why Does Retainage Exist?
As subcontractors know all too well, retainage is an owner’s or higher-tier contractor’s practice of holding a predetermined percentage from each progress payment to the next-lower tier of subcontractors, and releasing the retained amounts only when a milestone such as “substantial completion” is reached. This practice has a dramatic effect on subcontractors, because the financial restraints caused by retainage often trickle down from the contractor to the subcontractor. Retainage creates a problem for subcontractors, because even if a particular subcontractor is finished with its portion of the project, it will often not be paid its retainage until completion of the entire project.
The main purpose of retainage is to ensure that subcontractors satisfactorily and completely finish their work, but by definition retainage is withheld on work satisfactorily performed. Not only is the practice often ineffective at ensuring project completion, but it causes a significant amount of financial problems for subcontractors, and the industry as a whole.
Why Should the Practice of Retainage Be Either Reformed or Eliminated Altogether?
According to an article written by Ted Garrison of New Construction Strategies, retainage creates a number of financial burdens on subcontractors that essentially increases the costs of construction projects in general. One of the main problems with retainage is the burden on the subcontractor to advance money for labor and materials. Subcontractors must pay their labor every week and their material invoices monthly and wait to be reimbursed. This negative cash flow becomes worse when retainage in excess of the subcontractor’s expected profit is withheld.
A study performed by the Foundation of the American Subcontractors Association (“ASA”) illustrates that retainage adversely affects the industry and may lead to higher construction costs. The study found that retainage reduces competition and increases the costs of the project, thus causing contractors to increase contract prices by an average of 2.2% and subcontractors to increase prices by an average of 3.6%. So, not only does the retainage adversely affect subcontractors, but it has a profound effect on the industry as a whole.
The financial crunch that retainage places on subcontractors not only increases costs overall, but has the potential to run subcontractors out of business. Retainage can be held up for years, and hurts the capital of companies who must wait a significant period of time for retainage to be released. An ASA study determined that the average subcontractor was carrying $620,025 in retainage receivables on average of 160 days after the subcontractor had successfully completed its work.
Not only is retainage financially burdensome, it does not effectively ensure good performance by subcontractors. In a study performed by the ASA in 2001, 4 out of 5 subcontractors said that retainage was not a motivating factor in getting the job done correctly. Furthermore, according to the study “Retainage Practice in the Construction Industry,” 65% of subcontractors are less likely to pursue a project where retainage is required.
If retainage is not an effective tool guaranteeing performance by subcontractors and escalates costs, what is the purpose of having retainage at all? ASA believes retainage is an archaic practice that does not have a legitimate purpose in the construction industry. For that reason, ASA has worked to initiate changes throughout the country to reform retainage law.
What Significant Changes in Retainage Law Have Occurred?
Kentucky: In 2007, Kentucky enacted a Fairness in Construction Act. Under this new legislation, the maximum rate of retainage is 10% until 50% of the contract has been completed. Once the contract is 50% complete, the rate of retainage reduces to 5%. Because of these changes, Kentucky has improved its ranking from being one of the worst states to being one of the best states on retainage policies.
New Mexico: New Mexico has become the only state to completely prohibit retainage. New Mexico is now listed as the best state for retainage policy in the country.
North Carolina: In 2007, North Carolina passed legislation that added a cap of 5% maximum retainage for contracts exceeding $100,000. For contracts valued below $100,000, no retainage may be withheld. In addition, when the project is 50% complete, if the work is deemed satisfactory, no retainage may be withheld.
Tennessee: Amendment 1 to the Prompt Pay Act passed in 2007 added a new provision that effectively limits the rate of retainage to 5%. According to ASA’s report, Tennessee is the third best state on retainage policy.
The Rest of the Country: While Kentucky, New Mexico, North Carolina and Tennessee have significantly improved their retainage policies within recent years, many other states have also changed policies over the past decade. For example, some states limit the amount of retainage held between contractor and subcontractors to the same percentage or amount held by the owner. However, the vast majority of states are still failing on retainage reform. Alaska, Illinois, Kansas, New Hampshire, South Dakota, Texas, Vermont and West Virginia have not codified a maximum retainage rate at all. Every other state generally has a maximum retainage rate at 10% or below for public contracts. Although strides have been made, most states still have a long way to go to dramatically reduce or eliminate retainage.
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What Are the Alternatives to Traditional Retainage?
There are a few different alternatives that can be used to replace or reform traditional retainage practices. Some of the alternatives suggested through the industry are: allowing bonds instead of retainage, line item releases, charging interest on retainage withheld and focusing on hiring high-quality contractors and subcontractors.
Allowing bonds to be used in lieu of retainage is an effective way to guarantee good work while not unduly burdening contractors and subcontractors. If a bond is in place, retainage need not be withheld. Currently, about half of the states allow bonds to be substituted for retainage.
Line item releases also mitigate the harmful effect of retainage. A line item release occurs where the retainage is released upon the completion of specific divisions of work. Line item releases are beneficial to subcontractors, because a subcontractor need not wait until the completion of the entire project, but only its work, in order to receive its retainage. This alternative is especially beneficial to early finishing trades.
Another alternative to retainage is the release of a portion of the retainage upon a certain percentage of completion of the project. For example, in 19 states, the law has either provided for a reduction in the rate of retainage after a certain amount of completion of the project (usually 50% completion), or the elimination of retainage all together.
Another reform requires interest be paid on retainage earned by the contractor, but held by the owner. There are 13 states that require the money be placed into an interest-accruing account or require retainage interest be paid to the contractor. However, many of these states do not require that the interest be shared with subcontractors.
Finally, one interesting article suggests that the only real solution to the retainage problem is to hire high-performing subcontractors. By using this approach, owners would have the security that the job would be done correctly, because high-quality contractors are incentivized to utilize high-quality subcontractors. This also may well reduce overall project costs as contractors and subcontractors do not have to cushion their bids with the hidden cost of financing the retainage.
While the debate about retainage reform continues to persist, subcontractors will continue to be burdened, and owners will be subject to higher costs, because of traditional retainage practices. Although the industry continues to make strides limiting retainage, much reform remains before the states catch up with the federal government and eliminate retainage altogether.