February  16, 1996

Bulletin # 5: Payment and Retainage

When The Payments Stop Coming

There are few businesses tougher than subcontracting. The bidding can be cut-throat. A project schedule can be thrown off by something out of the subcontractor’s control. Additional work may be forced on the subcontractor under its bid because of errors of other parties in defining the scope of work. However, when the dust settles and the work is done, at least the subcontractor always gets paid. For those who believe that, there is a very nice bridge for sale in Brooklyn.

Acme Sheet Metal has gone to work on a large shopping center project. The developer/owner is an out-of-state retail firm that is rapidly expanding across the region. Acme has worked with the general contractor a few times before and signed what it believed to be a "standard" subcontract.

Acme’s first application for a progress payment is rejected due to what the architect calls "inadequate documentation." By the time Acme resubmits the application, it is too late for that payment cycle. Acme has two months of work into the project before it ever receives a payment. When that payment does come, Acme discovers that ten percent of each progress payment is being withheld as a retainage, even though the subcontractor understands that the general contractor is only subject to a five percent hold-back. Acme’s applications for payment based on materials and equipment stored on the site are being rejected. Progress payments are routinely twenty to thirty days late and Acme has been forced several times to threaten to leave the job.

Well into the seventh month of its work, Acme receives no progress payment at all. There are rumors on the job site about disputes between the developer/owner and the general contractor over structural and completion schedule issues. When Acme contacts the general contractor, it is notified that the general contractor has also not been paid and that Acme will only be paid when the general contractor has received payment for Acme’s work. Acme refers back to its subcontract and finds a "pay when paid" clause entitling the general contractor to withhold payment under these circumstances. Acme gives oral notice to the general contractor that it will perform no further work without getting paid and leaves the job site. It is owed for all of the work performed during the sixth and seventh months of the project, as well as retainage on the first five months’ work. Before Acme can commence an arbitration action under the subcontract for unpaid amounts, it is served with an action by the general contractor and the owner demanding breach of contract damages related to Acme’s leaving the job site. Acme’s conduct, when faced with a non-payment situation, has only made its situation worse.

Some Factors Contributing to Subcontractor Non-Payment

Every subcontractor has run into payment issues at some time. There are almost any number of problems that can arise. The developer may be undercapitalized or have other claims against it that cause it to withhold payment or to seek bankruptcy protection. The project lender may stop funding because of a developer default, an environmental concern, government regulatory action, or some other factor. The general contractor may get involved in a dispute with the owner over its work, the project schedule, or escalating costs, with the owner holding back payment as a result. The general contractor may take advantage of an unfavorable subcontract form to unilaterally withhold amounts or to impose an unreasonable retainage on the subcontractor. A construction manager may reject payment applications due to minor defects in the documentation, in order to have the use of the subcontractor’s money for an extra month.

The subcontractor’s assessment of the risk of non-payment on a project will vary with the size of the project and other factors. The subcontractor should certainly verify whether or not a payment and performance bond is in effect for the project. The existence of a bond provides significant assurance to the subcontractor that it will get paid. If there is no bond, the subcontractor should attempt to get what information it can on the owner and the project, including whether committed financing is in place to allow project completion. Is the developer/owner considered financially sound? Is the general contractor generally viewed as stable and well-capitalized, or in some financial trouble? Is the subcontract large enough that delays in payment or non-payment for several months’ work could seriously damage the subcontractor’s business?

Considerations in Reviewing Your Subcontract

Along with its inquiry about the project, the subcontractor must carefully review the proposed subcontract agreement. Is the retainage level set artificially high? Is the subcontractor’s retainage percentage set higher than the general contractor’s percentage? Does the retainage step-down once a substantial portion of the work has been completed? Does the subcontract contain the "pay when paid" language? Is the subcontractor entitled to be paid for materials and equipment stored on site, upon notification to the owner and proper verification that the materials and equipment have arrived at the site? Does the subcontract provide for an equitable adjustment to the contract price if the subcontractor leaves the site due to nonpayment and must come back later? Is interest to be paid to the subcontractor on late payments? Is the subcontractor asked to waive its mechanic’s lien rights? Is release of the subcontract retainage tied to completion of the entire project or just acceptance of the subcontractor’s work? Is the subcontractor permitted to walk off the job within a reasonable period of time after a progress payment is due and not paid? Does the general contractor have a unilateral right to withhold payment, without advance notice, if it believes the subcontractor’s work is defective? If such a payment is withheld, does the subcontractor have a quick and efficient remedy to enforce its rights under the subcontract?

Subcontractor Payment Rights Under the AGC/ASA/ASC Subcontract Form

The subcontractor does have some control over the form of subcontract it signs. The AGC/ASA/ASC Standard Form Construction Subcontract approved in 1994 is a carefully thought-out attempt by the construction associations to address payment issues. The general contractor is only entitled to reject a payment application under limited circumstances. As to non-conforming work, the contractor must provide the subcontractor with advance notice, providing the subcontractor the opportunity to cure before payment is withheld. The subcontractor is specifically permitted to apply for payment on materials and equipment not incorporated into the subcontract work, but delivered to and suitably stored at the site. The contractor is required to pay the subcontractor "within a reasonable time" even if it has not received payment from the owner, so long as the subcontractor’s fault was not a cause of the non-payment to the contractor. The subcontractor may stop work: (i) if it does not receive a progress payment within seven days of the due date or within fourteen days after payment was due from the owner to the contractor and (ii) the subcontractor has given an additional seven days’ notice to the contractor before it leaves the job. The subcontractor is entitled to be compensated for the reasonable cost of shutdown, delay, and startup. The subcontractor is to be paid interest on delinquent payment amounts. The subcontractor can terminate the subcontract if work has been stopped for thirty calendar days because the subcontractor has not received progress payments. It should be noted that the subcontract form is silent on whether all subcontract retainage is released as part of the "final payment" process on the subcontract or whether it is withheld until the end of the project. The answer to that question is likely to be dependent upon whether the prime contract permits line item release of retainage and should be clarified as to each project.

The AGC/ASA/ASC Subcontract also caps retainage at a maximum of ten percent. The percentage of subcontract retainage is to be equal to the percentage imposed on the general contractor. If the contract provides for reduction of the contractor’s retainage upon completion on a certain portion of the work, the subcontract retainage will also be reduced upon completion of an equivalent percentage of the subcontract work.

What Acme Should Have Done

In the Acme hypothetical, a lot of things went wrong for the subcontractor. However, assuming that it signed a subcontract like the AGC/ASA/ASC form, Acme might still have influenced the course of events by promptly giving the required default notice to the general contractor concerning non-payment, when its progress payments first started arriving more than seven days late. By giving the second notice after the first seven-day default period had run, Acme could justifiably have left the job site on the fifteenth day after its progress payment was due. It could (and should) have filed a mechanic’s lien on the property for the unpaid balance it was owed. When it was called back to the job site, it would have had a valid claim for its unpaid billing interest on those unpaid amounts, and an increase in the subcontract price to take into account the delay, shut-down and start-up costs. However, by failing to comply with technical notice requirements in the subcontract and by leaving the job site too quickly, it placed its legal position in serious jeopardy, while still remaining unpaid.

Review your subcontract and follow its payment application procedures carefully. Document your payment requests as the subcontract requires and confer with the architect to verify that the information submitted meets the subcontract requirements (especially on the first several draws). Make certain that your payment requests are submitted on time. Monitor dates and notice periods carefully and send your notices of non-payment promptly. If you keep a careful eye on the payment process, you may end up spending more time with your accountant and your banker, rather than with your lawyer.


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