July  28, 2000



Bulletin #38: Retainage -- Playing Project Banker

ZZZ Sheet Metal had been seeking larger projects to help the firm pay for its new office and fabrication facilities. Firm management also believed that it would be more profitable and efficient to participate in a few large projects, rather than the numerous smaller jobs that had been the firm’s specialty. When a bid package arrived for a high-rise office tower, ZZZ management was ecstatic.

The HVAC component of the project would involve at least $7.5 million. The project schedule contemplated completion more than two years after breaking ground. From the ZZZ perspective, the project could not have been more perfect. The subcontractor’s bid was accepted, and a contract form arrived several days later. The printed form looked like a standard document, and after review of the price, schedule and scope of the work, the subcontractor signed and returned the document. The ZZZ contract administrator did not focus on the retainage provision. It had been the subcontractor’s experience that retainage was not negotiable and that subcontractor retainage requirements tended to track with the retainage terms between the owner and general contractor. However, within the benign-looking form, the following language was included:

The rate of retainage shall be 10%, and such amount shall be withheld from each progress payment to be made to the Subcontractor. The Contractor may set-off the retainage against any claims of the Contractor against the Subcontractor, and Contractor shall be under no obligation to release all or any part of the retainage until Subcontractor shall have completed the Subcontractor’s Work in a manner acceptable to the Contractor (including repair or replacement of any faulty or defective work and the completion of any punch list items) and the completed Project has been accepted by the Owner.

The financial impact of the retainage provision revealed itself, in stark terms, when the first ZZZ progress payment application was processed. The subcontractor had submitted an application for approximately $400,000 but received only $360,000. Since the entire $400,000 amount was needed for payment of labor, materials, insurance, engineering and other project costs, the subcontractor found itself on the phone with its friendly banker. To keep the project moving forward, it borrowed the $40,000 shortfall on its line of credit at 12% interest. As each pay period passed, the financial gap widened, the draws on the line of credit grew, and the company’s banker became increasingly nervous. When the balance on the line of credit reached $500,000, the bank scheduled a meeting with the principals of ZZZ. The bank would only continue to fund the line of credit if the principals each signed personal guarantees, and pledged stock or other assets. Reluctantly, they did so.

As the project neared completion, the retainage amount had grown to $800,000, and the company line of credit balance to nearly the same level. The strain on the company’s credit resources from the one project was also making it difficult for ZZZ to secure credit from its primary suppliers and lenders on other projects. Obtaining full payment of the retainage was becoming a “make it or break it” issue for the subcontractor.

The testing of the HVAC system revealed some issues that had to be addressed. ZZZ asked that the retainage be released, with the exception of an amount necessary to address the final issues. The contractor refused the request. When the subcontractor offered to provide a bond or letter of credit for the remaining cost, this was also refused. Desperate to close out the project, the subcontractor incurred extensive overtime costs to resolve the remaining issues. Finally, the project architect signed off on the system. The ZZZ project manager offered to stop down to the general contractor’s office to pick up the check for the retainage, only to be told that it would not be released until the overall project had been completed. The owner and general contractor were still working through some fire safety code and communication system issues, and the owner was not willing to acknowledge project completion. The ZZZ project manager was told that the company would have to wait for the retainage, and referred to the language in the subcontract document on “project acceptance.” Four months later, a check arrived for most of the retainage. The general contractor had withheld approximately $100,000 for alleged delays, additional testing costs and “miscellaneous expenses.” The cover letter with the check indicated that if the subcontractor accepted the payment, it would be deemed an acknowledgment that the payment represented a full and final settlement of the contractor’s obligations. With the banker calling twice a day, ZZZ viewed itself as having little choice, accepted the check and delivered it to the bank. Due to the accrual of interest (running at $8,000 per month), and the general contractor’s holdback, the company was still several hundred thousand dollars short of paying off the line of credit. For the following year, most of the profits from other jobs were needed to pay off the remaining line of credit balance.

While any retainage is a negative from the perspective of a subcontractor, it is also a fact of life in most of the construction industry. The subcontractor’s challenge is to minimize the negative impact of retainage on the economics of a project and to minimize any undue leverage the retaining of funds gives to the general contractor. The following are some suggestions to achieve those objectives:

1. As a general rule, the subcontractor should familiarize itself with retainage laws of the jurisdiction in which the project is to be completed. Certain states require the deposit of retainage in interest bearing escrow accounts or permit the posting of other security (i.e., a letter of credit) in lieu of retainage.

2. The subcontractor should review the subcontract form carefully to make certain that it provides for only the same level of retainage from the subcontractor that the owner is imposing on the general contractor. Five percent (5%) retainage is fairly standard.

3. The subcontractor should negotiate contract language eliminating retainage once a project is 50% complete. At that point, the general contractor would be holding a substantial sum as security for the subcontractor’s performance, and the subcontractor would have demonstrated that it is willing and able to complete the work.

4. The release of the retainage should be tied to the substantial completion of the subcontractor’s work, rather than the completion of the overall project. The contract should also provide that once the general contractor has received the release of retainage related to the subcontractor’s work, the retainage would be delivered to the subcontractor.

5. The subcontractor should verify that the contract form permits (or should negotiate for) the right to substitute a bond or other security for retainage if its work is satisfactory, and a specified percentage if the project has been completed. If that is not acceptable to the general contractor, the subcontractor should seek the right to provide a bond in lieu of retainage at the time the project is nearing substantial completion.

6. The contract should provide, at the point of “punch list,” for the release of all retainage funds other than the amount necessary for completion of the punch list work.

It is unlikely that the concept of retainage will disappear in the foreseeable future. Until that occurs, the subcontractor must focus carefully on how retainage is structured under each contract, and attempt to negotiate to minimize the financial impact. Without attention to this issue, the subcontractor can easily find himself involuntarily functioning as a project banker.

 

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