REUTERS | Toby Melville

Payment, retention and risk: shuffling the deck

Increasingly, the construction industry model that we know so well – based on layers of contractors and sub-contractors – is being called into question. In the last six months various failures (including Grenfell, Scottish PFI-built schools and Carillion’s collapse) have prompted questions about construction industry outsourcing and transfer of risk.

Queries have been raised about the potential for “passing the buck” and lack of accountability when things go wrong. On major construction projects, typically the large majority of the workforce are sub-contractors, sub-sub-contractors or workers employed on a daily or hourly basis, rather than being directly employed by the contractor. Does this model enhance the risk of non-payment, safety issues and reduced acceptance of responsibility for such issues?

A responsible approach to payment?

The government is currently assessing responses to its recent consultation (which closed on 5 June) on Prompt Payment by Government Suppliers. Following Carillion’s collapse, it floats the idea of excluding suppliers from major government procurements if they cannot show “a fair, effective and responsible approach to payment in their supply chain management”.

This is the government’s latest measure to clamp down on poor payment practices in the construction supply chain. It is light on detail as to how the exclusion might be applied in practice, but it suggests that an appropriate benchmark would be paying 95% of undisputed invoices within 60 days, over two consecutive six month periods.

It remains to be seen what changes will be implemented as a result and whether any such changes will filter through the industry as a whole.

Retentions

Retentions are one of a number of measures used to provide the employer with security in respect of contractor performance. Retention monies under construction contracts are typically between 3% and 5% of the contract price and 50% is commonly retained until the end of the defects rectification period, usually one year after completion of the works. However, there are instances of all or some retention monies being retained for far longer periods.

Retentions are by far the most readily accessible form of performance security. Retention bonds can be used in lieu of a cash retention, although these are less common. A retention bond would need to be on-demand to make it as good as cash, which is likely to have cost implications that may well be prohibitive to procuring such a bond. It is also likely to require cash collateral from the contractor, so tying up its working capital and limiting the benefit that it will derive from the early release of retention.

More complicated and risky projects are likely to require additional performance security, especially if funded through bank lending. Types of security may include:

  • Performance bond: provided by a surety to ensure that the works are performed in accordance with the contract. The surety undertakes to pay a sum of money if the contractor defaults. The industry norm is for a performance bond to be set at 10% of the contract sum, but recently we have seen bonds provided for higher amounts.
  • Parent company guarantee: provided by the contractor’s parent company, who guarantees that the contractor will perform its obligations. The strength of such guarantees obviously depends on the covenant of the parent in question.

There is a risk that the contractor (or surety/guarantor) may challenge a call under the bond or guarantee, potentially leading to lengthy proceedings. This risk is reduced if an on-demand bond is provided, but on-demand performance bonds are rare in the UK construction market.

Payment security

An increasing number of contractors are looking up the chain for ways to maintain cash flow and obtain security of payment. Common forms of payment security that we are currently seeing in the market include:

  • Payment guarantee: provided by a group company of the employer or another provider of sufficient covenant strength.
  • Advance payment. The employer pays an amount to the contractor on entering into the building contract, to be used in carrying out the works. This is repaid once a certain amount/percentage of the contract sum has been paid to the contractor. An on-demand bond is often provided in return for an advance payment.
  • Escrow account: a sum of money is deposited with an escrow agent, with instructions to pay the contractor in the event that the contractor is not paid under the building contract. The employer must have access to the necessary funds and be willing to set these aside. The City of London Law Society’s (CLLS) Construction Law Committee has recently published a model form of escrow agreement, together with explanatory notes, providing a useful standard form for contractors.
  • Letter of credit (LC): provided by a surety in favour of the contractor for an agreed sum. The contractor may only call on the LC if there is a payment default under the contract. A surety will most likely require cash collateral and/or an indemnity.

Retention deposits bill

A Private Members’ Bill introduced by Conservative MP Peter Aldous, the Construction (Retention Deposit Schemes) Bill (also known as the “Aldous Bill”), has had its second reading postponed again, now to 26 October 2018. It proposes to amend the Housing Grants, Construction and Regeneration Act 1996 to include two new sections (ss. 111A and 111B) requiring Ministers to introduce regulations to protect retentions in the construction industry.

In summary, it proposes that all cash retentions under construction contracts be retained in a secure trust fund, using a similar system to the tenancy deposit scheme. However, the details of the “Aldous Bill” are vague and offer little clarity as to the types of contracts and monies to which it will apply, nor as to how the scheme will work in practice.

A similar Private Members’ Bill addressing retentions failed to make progress in 2017. The Aldous Bill has garnered some high-profile support, but it has also attracted opposition from bodies such as Build UK and Civil Engineering Contractors Association (CECA). That being the case, it seems likely that the deferral is only a prelude to its being kicked permanently into the long grass.

What next?

Industry responses to issues such as security of payment suggest that some action is inevitable. What that will be remains to be seen. The deck of cards is still being shuffled, but we can expect a tightening of government policy as a first step forward.

Bryan Cave Leighton Paisner LLP Elizabeth Stonebank

One thought on “Payment, retention and risk: shuffling the deck

  1. Retention is a percentage (often 5%) of the amount certified as due to the contractor on an interim certificate, that is deducted from the amount due and retained by the client. The purpose of retention is to ensure that the contractor properly completes the activities required of them under the contract.

    Retention can also be applied to nominated sub-contractors, and the main contractor may also apply retention to domestic sub-contractors.

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