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What Is Retainage?
Retainage (also called ‘retention’) is a portion of the agreed-upon contract price that is withheld by the party making payments on a construction project until the completion of the work.
Retainage was first invented in Britain back in the 1840s to ensure that construction projects were completed fully, and to manage the risk of poor workmanship which was very common at that time.
Now, almost two centuries later here in the US, the stated aim of retainage is the same as it was way back when. Retainage practices have now been built into federal law (as well as many state laws) to both promote its fair use and to prevent its abuse.
However, many businesses in the construction industry — especially subcontractors and other project participants that are on the lower end of the payment chain — are adversely affected by the way that retainage functions in the industry today.
There are different aspects of retainage that will come into play on any construction project, but perhaps the 2 most important considerations are:
- 1) How much retainage can be withheld?
- 2) How long the retainage can be withheld?
And as you can probably imagine, the rules are pretty complicated.
Is Retainage Allowed on Federal Public Works Projects?
There are 2 main scenarios where retainage is held.
Scenario 1: The Prime Contractor Is Holding Retainage on a Subcontractor
In short, yes — under the Federal Acquisition Regulation (FAR), a prime contractor may withhold payments from their sub pursuant to the contract between the parties. So, if the contract between them provides for retainage, they are allowed to do so under the terms set forth, even if the government is not withholding retainage from the prime.
There’s a very important note to make here though: If the prime is withholding retainage, they cannot bill the government for the retainage. This basically results in the government holding the retainage on those particular federal projects.
Scenario 2: The Government Agency Responsible for the Project Is Holding Retainage on the Prime Contractor
The federal government’s policy on retainage states that funds shall not be retained “without cause,” and should be determined on a “case-by-case” basis. The legal translation of that is, the Contracting Officer has complete discretion to decide whether or not to withhold retainage based on their assessment of past performance and likelihood of continuing performance.
According to the FAR, if “satisfactory progress has not been made, the Contracting Officer may retain a maximum of 10% of the amount of the payment until satisfactory progress is achieved.” However, in practice, it is usually between 5-10% with a gradual reduction once certain milestones are reached.
Is Retainage Allowed on State/County or Municipal Public Works Projects?
Just like with federal projects, the answer here is yes — every single one of the 50 states allows retainage to be withheld on any public works project they control. However — and this is important — each state has different rules that govern how retainage works on public works projects.
In fact, in some states, retainage isn’t a choice — that is, withholding retainage on state/county public works projects is actually required.
In a number of states, the retainage withheld is a percentage of the total contract price, not a percentage of each progress payment. (For example, if you’re working on a project with 10 progress payments and 5% retainage, and the 5% retainage is maxed out with the 6th payment, that means that no more retainage can be withheld for the final 4 payments, 7-10.)
In other states, the normal practice is that no more retainage can be withheld after 50% of the project has been completed. Consult the retainage law in the state where your projects are located and confirm that the retainage in place on your project is allowable according to the law.
Is Retainage Allowed on Private / Commercial Construction Projects?
No surprise here — the answer is yes with one notable exception: the state of New Mexico forbids retainage on all private construction projects.
The retainage laws of each state laws don’t usually require a party on a private project to hold back retainage. Most retainage statutes for private construction will serve the sole purpose of preventing the abuse of retainage. Typically, they’ll provide punishments (in the form of interest penalties) if retainage is held without authorization or if an unreasonable amount of retainage is withheld.
On private/commercial construction projects, the single biggest factor in determining how retainage will work is what’s allowed by the project contract.
Retainage Is a Huge Financial Challenge, Especially for Subcontractors
Subcontractors and other down-the-chain participants have gripes about retainage – with good reason. Retainage practices are problematic because they cause practical issues and business relationship issues within the already-complicated accounting and payment systems of the construction world.
According to a 2004 report published by the American Subcontractors Association, the majority of subcontractors believe that “[prime] contractor abuse of their retainage” is a widespread problem.
Some of the data shared in the report are troubling:
- Subcontractors say that they end up receiving less than the full amount of retainage withheld on more than 10% of their projects.
- On normal projects with no major disputes, subs had to wait anywhere from 30 to 900 days after completion to collect the final retainage due to them, with an average wait time was 167 days.
- Asked about the single longest retainage wait they had encountered during their careers, subs reported that the worst cases ranged from a low of 60 days all the way up to 2500 days (that’s almost 7 years!), with an average wait time of 567 days for each sub’s worst-case scenario story.
But that’s not all. Here are a few common sentiments that we’ve heard from talking to subcontractors and others in the industry:
- There is a widespread belief among subs that prime contractors often withhold a greater amount of retainage on them compared to what is withheld by the project owner on the prime contractor.
- Many in the industry believe that retainage is used not so much to ensure subcontractor performance, but rather as leverage, forcing the project subs into a weaker financial position (by withholding money from them).
- Many in the industry also believe that GCs and owners use their withheld retainage as a free financing mechanism, shifting the borrowing costs of project finance onto the smaller players further down the payment chain while they have an interest-free pile of money they can use to fund their own operations and business cash needs.
Yet, even with all of these potential problems, retention clauses in construction contracts are rarely questioned or even thought about very much, at all.
How Does Retainage Hurt Your Cash Flow?
At the end of the day, there’s really just one reason why a business — any business — fails. The reason? A business fails when it runs out of cash.
Unfortunately, it’s clear that cash flow is an issue in the construction industry, and that’s even before retainage enters into the picture. Construction businesses fail faster and more often than any other industry, as highlighted in the industry’s failure rates.
There are many reasons for this — perhaps chief among these is the incredibly long time it takes to it takes to get paid in the construction business. Many construction businesses are expected to float all of the costs and expenses associated with their jobs and projects up front, all while hoping that payment comes eventually, if at all.
On top of that, the margins in the construction industry are notoriously slim. And that’s where the problem lies because it’s not uncommon for the amount of retainage withheld on a project (as a percentage of the total contract value) to be greater than a construction company’s profit margin on that same project.
For example, let’s assume that ‘ACME Plumbing’ is a subcontractor on a project where retainage of 10% will be withheld from their payments. However, ACME Plumbing’s profit margin on this project is only 7%. In this scenario, ACME is going to be in the red on this project to the tune of -3% until they finally receive their retainage withheld.
This also means that ACME is going to have to have enough cash on hand (or the ability to secure financing) to fund that loss for as long as it takes for them to finally receive the retainage withheld. The longer that takes, the more money ACME will need to keep their business going.
Thus, it’s easy to see how retainage only makes a bad problem worse for many contractors.
How Does Retainage Affect Your Payment Rights?
It appears that the laws on retainage and the laws on mechanic’s lien rights were written in 2 different universes and 2 different eras. Simply put, these 2 sets of laws could not be any more contradictory.
On the one hand, owners and others are allowed to withhold retainage until the very end of the project. On some projects, that time period could stretch from weeks, to months, and even to years for the largest projects.
On the other hand, subcontractors and others that want to leverage their mechanic’s lien rights in order to resolve a payment issue on a project typically only have a small window of time allowed to file their mechanic’s lien claim. For projects with extended timelines, it’s quite possible that the mechanic’s lien deadline may expire long before the retainage is actually due.
So, what should a contractor or supplier do in that situation? Is filing a mechanics lien before the retainage is due even allowed? And if a mechanics lien before the retainage is due is allowed, is it a smart move to do so?
How Does Retainage Affect the Mechanics Lien Process?
Unfortunately, most states’ laws are silent on this issue. One notable exception is the State of New York which amended their lien laws to make sure that those forced to file a mechanics lien would not lose out on their rights to the portion of the payments withheld as retainage.
In a few other states including California, Utah, Illinois, Massachusetts, and Louisiana, the lien filing deadline is calculated from the completion of the project as a whole instead of an individual company’s last furnishing date. While this does not address the retainage problem head-on, it does minimize the problem significantly since the completion of the project will also trigger the retainage payment.
Should You Include Retainage Withheld in a Mechanics Lien Claim?
The previous section addressed whether a mechanics lien filing could include retainage (and in many states, the answer is unfortunately unclear). The next question is whether the withheld retainage should be included in a lien filing. Here’s one thing to consider before taking this step: many general contractors, owners, and lenders would consider filing a lien for retainage before the retainage is due to be a pretty adversarial step. While retainage withheld can amount to a considerable amount of money, filing a preemptive lien before the retainage is actually due might be too much (especially if the project is otherwise free of payment issues).
Bottom Lien: Retainage Can Almost Always Be Included in a Lien Claim
If a mechanics lien claim is being filed, most states empower the party making the claim to file for the full amount of what they’re owed against the project. The lien claim, in other words, is equal to the total value of the work, labor, and materials that the filing party furnished to the job (less any payments received). The fact that some of this money may be held as retainage is usually irrelevant — basically, if you earned the money fair and square, and if your lien rights are intact, then you’re allowed to file a mechanics lien.
How to Leverage Your Lien Rights When Dealing with Retainage
1. Always Send Preliminary Notice to Secure Your Lien Rights
Preliminary notices are a common requirement in the majority of states for a potential lien claimant to remain in a protected position and retain the ability to file a valid and enforceable mechanics lien.
In most cases, sending the required preliminary notice for the project’s state is sufficient to protect the potential claimant with respect to all s/he is owed on the project, including retainage. In other words, if you send the required preliminary notices within the time they need to be sent, then you are protected — and that includes any retainage withheld.
However, in rare situations, a different, or additional retainage notice is required, but that is the exception.
[Texas contractors take note: Texas is a state where there is a specific “notice for contractual retainage” that can be provided “instead of or in addition to” the regular monthly notices that Texas requires – but which is limited to protecting the ability to make a claim against the retained amounts.]
2. Understand that Mechanics Lien Deadlines Won’t Be Extended Just Because Retainage Is Still Withheld
First off, as we discussed above, ALL construction companies need to know the following:
RETAINAGE DOES NOT EXTEND YOUR LIEN FILING DEADLINE.
However, in most cases, including the retainage withheld in the lien claim is the wise move.
Other Tips to Help Manage the Impact of Retainage
Here is some practical advice to help deal with the potential impact of retainage on a project…
1. Learn How the State and Federal Retainage Laws Work and the Contractual Details of the Project You’re Working On
On government projects, the retainage is usually pretty controlled. However, on private projects, the retainage is less controlled. The challenge with the private project laws is that those who need the retainage money the most won’t have the cash to fight for the penalties.
When you’re entering into a contract for a project where there will be retainage withheld, make sure you examine the terms to find out everything you possibly can about how the retainage will work. Confirm the percentages that will be withheld.
Additionally, you should ask questions such as:
- Will retainage be held in escrow? (A number of states require this, so be sure to check for your state.)
- Will retainage that’s withheld earn interest? And who is entitled to that interest?
- Can a project owner use retained funds to “discharge” a mechanics lien claim?
- Can a project owner (or another project participant – like the GC) use retained funds as compensation for workmanship issues or deficiencies?
2. Ask Your Customers to Negotiate on the Retainage
The old adage “It never hurts to ask” applies here. Has your company been in business for a long time with an equally long track record of success? Does your business have a stellar reputation? Then ask to negotiate the percentage of retainage withheld.
Perhaps you can offer a letter of credit or a surety bond to substitute for the retainage requirement. This type of negotiation is probably going to be difficult, but it never hurts to ask, and your company’s goodwill has value.
3. Plan for the Retainage’s Impact on your Cash Flow
Once you know what you’re getting into, and once you’ve exhausted all of your alternatives, then you can plan for the cash flow reality. You need to KNOW YOUR FINANCIAL NUMBERS. Do the math (i.e., do a project cash flow forecast) and make a plan to have access to the working capital required to “float” the withheld retainage.
4. Don’t Be Afraid to Leverage Your Lien Rights in Order to Get Paid
We can’t stress this enough. Mechanics liens are the most powerful tools available to construction companies to secure all of their payments, including withheld retainage. If you want to find out more about how mechanics lien rights can help your company, get in touch with us.