Do We Still Need Retainage?

David K. Taylor | BuildSmart

There have been debates for years about the pros and cons of owners withholding retainage (usually 5% or 10%, depending on each state’s retainage laws or local “industry standard”) from prime contractors. Typically, the primes will, in turn, withhold retainage from all subcontractors. However, in these crazy times, when the future of private and public projects is unknown and profit margins are in question, it might be a good time to revisit this issue. Everyone in the business remembers the post-recession days of 2009-2010 when projects were slashed, many companies went under, and the construction industry lost an entire generation of workers. Do the current economic conditions merit asking whether retainage is an old, used-up concept that should be modified or jettisoned entirely?

To understand the arguments, a history lesson may be helpful. The origins of retainage stretch back at least to the 1840s during what has been called “railway mania.” Railroad track construction exploded across the United Kingdom. Then there was an economic crash. Many owners were left with incomplete projects, as well as instances of bankrupt contractors and unpaid laborers. Someone (unknown) then came up with the idea (completely unique) that for the sole protection of owners, a certain percentage of approved work should be withheld until the project was complete – and the concept of “retainage” was born. This concept was then “imported” to the United States soon thereafter, where it has been in use ever since. Retainage has traditionally been a sacred cow for public and private projects until the last 20 years when several factors and events came together to cause those in the industry, as well as their elected officials, to reevaluate the use of retainage.

These factors and events included plummeting profit margins for both primes and subcontractors. Many times, the amount of retainage equaled profit margins. Over time, some prime contractors self-performed less of the work and instead subcontracted out most of the work to subcontractors. As a result, as far as retainage is concerned, the burden fell on the subcontractors who built the project and hoped that retainage withheld for approved work would filter down to them from the lender to the owner then to a prime at the tail end of a project. Other times, owners, architects, and primes have wrongfully withheld retainage, using it as improper leverage.

There has been a recent trend to get away from the use of retainage. The federal government took the lead when in 1986 it enacted a federal regulation that stated retainage is discretionary but that “retainage should not be used as a substitute for good contract management” (F.A.R. 32.103). The Department of Defense, the General Services Administration and the United States Department of Transportation now have a zero-retainage policy. While many state agencies have followed the federal lead, private commercial projects still frequently use retainage and lenders require that their borrowers withhold retainage. The economic events of 2008-2010 also resulted in state legislatures (aided by lobbying groups) wading into the area of regulating retainage by statute. Foreclosures resulted in the wiping out of liens and leaving subcontractors holding the retainage “bag.” Historically, retainage was normally the subject of contract negotiations between sophisticated players in the commercial construction industry. Most of these new laws have been passed for the protection of subcontractors. Some states have reduced the maximum amount of retainage that could be withheld. Some have required that a “project retainage escrow account” be set up and funded. Any contract provision to the contrary is void and against public policy. Some states, such as Tennessee, have criminalized retainage violations and provided a hefty civil penalty ($300 a day) for an owner or contractor that did not properly escrow retainage. Bankruptcy protections are statutorily created by stating that any escrowed retainage upon payment into the account is the “property” of the prime or subcontractor to whom it is owed. Tennessee statutory law even regulates when retainage must be paid by an owner to a prime, regardless of any contrary contract provision.

Because of these considerations, even on private projects, more discussions about retainage are occurring on the “front end” of a project. Can the lender be convinced to allow an owner to reduce the retainage amount or not to withhold retainage at all, especially if it must be escrowed (and thus interest paid)? If payment and performance bonds are obtained, why is retainage necessary? If the purpose of retainage is to provide security to the owner, and not necessary for leverage over a prime (and in turn a subcontractor), would not bonds better secure the owner? In many states, payment bonds can be used to discharge mechanic’s liens without a prime having to use bonding capacity to obtain a lien bond (which in some states must be double the amount of the lien amount). What about thinking creatively? The parties can agree to allocate a small percentage of the contract amount at the tail end of a project, not call it retainage, but allow for withholding of a small amount for completion of a punch list or close-out documents? Will an owner get better prices from primes, and attract better primes (as well as subcontractors who are building the project), if the bid documents state that there will be no retainage withheld?

The bottom line is this: There should be an independent evaluation on the front end by the major players (developer, owner, architect, lender, prime) as to whether “retainage” should be withheld on a commercial project. Each state’s retainage laws should be reviewed by counsel. Think through what is at stake in the project and what needs to be done to protect all players and encourage primes and subcontractors to bid on any project. If the legislative trends continue, there may be states that ban any retainage. In any event, assuming retainage as a “given” on any construction project may not be the norm and should be carefully considered.

Illinois’ New Retainage Law

James Rohlfing | Saul Ewing Arnstein & Lehr | September 3, 2019

Effective August 20, 2019, Illinois law provides that a maximum of 10 percent retainage may be withheld from payments under private construction contracts and, after the contract is one-half complete, retainage must be reduced to 5 percent and kept at 5 percent for the remainder of the contract.  With this new law, Illinois joins the vast majority of states that have enacted laws pertaining to retainage on construction contracts.  Like almost every other state, Illinois’ retainage restrictions are unique to Illinois and, therefore, parties to Illinois construction contracts should understand how the new law will impact their projects.  This article will explain the law, discuss how to comply with it and give an example of its application.

When Governor J.B. Pritzker approved SB 1636 it become effective immediately as Public Act 101-0432.  It is an amendment to a law known as the Contractors Prompt Payment Act, 815 ILCS 603/1 (“CPPA”), which governs the timing of payments to contractors on private projects in Illinois.  The new law applies to contracts entered into after August 20, 2019, but not to contracts made before that date.  Public Act 101-0432 provides:   

No construction contract may permit the withholding of retainage from any payment in excess of the amounts permitted in this Section. A construction contract may provide for the withholding of retainage of up to 10 percent of any payment made prior to the completion of 50 percent of the contract. When a contract is 50 percent complete, retainage withheld shall be reduced so that no more than 5 percent is held. After the contract is 50 percent complete, no more than 5 percent of the amount of any subsequent payments made under the contract may be held as retainage.

The above provision can only be understood within the context of the CPPA.  Moreover, the CPPA incorporates definitions from the Illinois Mechanics Lien Act (770 ILCS 60/0.01) (the “MLA”) and, should be applied consistently with the MLA.  The CPPA, including the new retainage section, applies to construction contracts with general contractors as well as those with subcontractors.  It does not apply to contracts for the construction or improvement of residential properties of twelve or fewer units.  Also excluded from its reach are contracts that require the expenditure of public funds, which, consistent with Section 23 of the MLA, should be understood as public improvements for either the State of Illinois or a local government.  The CPPA provides that if full payment is not timely made, including retainage, ten percent interest is due on unpaid amounts, and the contractor is entitled to stop work until proper payment is received.  Importantly, the CPPA raises a presumption that invoices are valid if not objected to in writing within 25 days of receipt.  The provisions of the CPPA are incorporated by law in all Illinois construction contracts to which it applies, even if its terms are not be expressly included in the written contract.    

The CPPA, which governs the timing of payments under construction contracts, apparently takes the view that 50 percent completion of a contract occurs when half of the price of the contract has been earned.  The requirement under Section 5 of the MLA, as well as the common practice in Illinois, is that contractors must furnish sworn statements to owners before receiving payments.  Among other things, the statements set forth the contract price, the amount paid to date, the amount being requested as part of the current payment application, and the amount that remains due to complete work under the contract.  The same information must also be furnished for subcontracts.  Sworn statements will be useful in determining when a contract is fifty percent complete, thereby requiring a reduction of retainage to five percent under the CPPA.  Other evidence will be required for non-fixed price contracts or in situations when substantial and unpredictable change orders greatly increase the difficulty of measuring the 50 percent threshold.  Careful contract drafting should lessen potential conflicts over inevitable  unusual situations. 

Consider the following hypothetical to illustrate how the law should work in practice:

1) an owner contracts with a general contractor to construct a commercial building for a fixed price of $900,000, with payment applications to be submitted on the tenth day of every month until completion;

2) to date, the general contractor has submitted payment applications totaling $400,000 and the owner has approved those applications;

3) retainage of $40,000 (10 percent) has been held from approved payments, so the owner has made net payments totaling $360,000 to the contractor; and

4) now, the general contractor is submitting a payment application with a sworn statement requesting an additional interim payment in the amount of $100,000, less retainage.

Under this hypothetical, the general contractor’s contract with the owner is now more than 50 percent complete ($500,000 of work completed on a total contract price of $900,000), so retainage must be reduced to 5 percent or a total of $25,000, and a maximum of 5 percent retainage may be withheld from all future payments. 

Therefore, the owner may withhold up to $5,000 from the newly submitted payment application and credit the contractor $20,000 for previously held retainage which is in excess of 5 percent.  Thus, the owner would pay the contractor $115,000 ($100,000 minus $5,000, plus a credit of $20,000).  The owner would then be holding retainage of $25,000 (5 percent of $500,000).

Each subcontract is considered separately for purposes of triggering 5 percent maximum retainage upon fifty percent completion.  Thus, a general contractor typically will be restricted to withholding a maximum 5 percent retainage from payments to its demolition and excavation subcontractors before the general contractor reaches 50 percent completion under its own contract with the owner.  In addition, the CPPA requires a contractor to remit to a subcontractor monies received from an owner for that subcontractor’s work (including retainage), within fifteen days of receiving payment from the owner.  Thus, a contractor might request a provision in the general contract that the owner will not withhold retainage from the contractor money the contractor is by law required to pay to its subcontractors.  If an owner is satisfied with a contractor or is otherwise secure that the contract work will be satisfactorily completed, reducing overall retainage to five percent would simplify the project accounting.

In practice, many Illinois commercial construction projects already have reduced retainage to less than 10 percent, and some large public projects in Illinois hold no retainage or a straight 5 percent retainage.  In many other states, retainage is restricted on public and private contracts to amounts less than the maximum permitted by Illinois’ new law.  Some contractors and subcontractors believe the new retainage law does not go far enough, while some owners believe it does not allow them the security they require to guarantee job completion.  Owners, lenders, title companies, contractors, subcontractors, sureties, and other participants in the industry all will need to grapple with the new law, and reach accommodations in the process.