Retention: Is it Really that Bad? An Owner’s Perspective

Over the last several years a common trend has emerged among state and local governments – enacting new legislation that limits and restricts the amount of retention that can be withheld on a construction project.[1] The cause of this recent trend to legislate retention limits is unknown, whether it be increased lobbying by contractors or subcontractors, labor shortages, or support for small business. Whatever the reasons may be, it is not clear that retention practices are unscrupulous enough to warrant legislative intervention. Are there that many owners that withhold excessive amounts of retention to trigger legislative action? Do we need state general assemblies to restrict the private contracting ability of owners and contractors on a construction project? Retention has an important purpose on a construction project and while restricting retention may be popular from a general public policy position, it may not be wise to impose such limits for every project. This article discusses the purpose of retention, two recent laws limiting retention, one in the private sector and one in the public sector, and how retention can be misused.

The Purpose of Retention

Retention on a construction project is a contractually agreed upon percentage of payment withheld from each progress payment to protect an owner from a failure by a contractor to complete the contractor’s work in accordance with the contract. Each month during the course of a construction project an owner withholds such agreed upon percentage from payment amounts otherwise due contractors. The owner then typically releases some of the retained amount at substantial completion, releases more as items on the punch list are completed, and the remaining upon final completion. Retention is the owner’s security for a contractor’s timely and efficient completion of the work and punch list, and a contractor’s incentive to complete such work timely and in accordance with the contract documents. If the contractor fails to complete the work timely and in accordance with the contract documents, the retained amounts can be used to complete the project, so that, at least in part, the owner is not forced to seek out-of-pocket funds to pay for defects and incomplete work.

Until this recent trend of governmental constraints on the ability of construction industry participants to freely-contract and determine the proper amount of retention, owners and contractors were able to creatively determine how best to structure retention in their construction contracts. Some contractors and owners contractually agreed to a 10% retention on each progress payment so long as retention is not withheld on the contractor’s material suppliers, general conditions costs, and/or fee. Other contractors and owners agreed to 10% retention on each progress payment until 50% completion of the work, at which time owners would reduce retention to 5% or no longer withhold retention. At times, reduction of retention was linked to performance factors such as on-time and on-budget work. Still other owners required 10% retention throughout the entire construction project due to restrictions placed on retention by project lenders.

However, due to recent changes in the law, governmental entities are hampering the ability of parties to create retention requirements that meet the specific needs of a project and, at times, lender requirements.

Illinois Law and Revisions to the Municipal Code of Chicago

Two relatively new laws restricting retention are particularly relevant to the construction industry in Illinois: (i) revisions to the Illinois Prompt Payment Act, 815 ILCS 603/20 (2019); and (ii) an amendment to the Municipal Code of Chicago (passed by the City Council, June 28, 2017).

The revisions to the Illinois Prompt Payment Act provide that:

“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.”

This revision prohibits owners and their downstream prime contractors from holding greater than five percent (5%) retention on any construction project in the State of Illinois. While this restriction supports an owner’s desire to include retention as a contractual requirement, it prohibits any ability to cater retention to the needs of the project or lender requirements. Assuming this statute cannot be waived by contract, the owner may no longer be agreeable to alter retention provisions to include requests by the contractor to further limit retention as the statute has already limited retention to a level that is only acceptable to the owner because it is required by law. Instead of adhering to newly enacted retention provisions, contractors may prefer 10% retention be withheld on the entire project if that means the owner will agree to not withhold retention on general conditions costs or contractor’s fee or to release retention prior to substantial completion for early completion subcontractors (i.e., demolition, excavation, foundation, etc.). It is unclear why the Illinois General Assembly chose 5% as the limitation. What is clear, and as will be discussed below, is that the government mandates have been set primarily to protect contractors with a disregard to whether owners or their lenders or the specifics of a project require more retention or other creative practices to protect the efficient and effective completion interests of the owner and even the contractor.

In addition to the state law, the City of Chicago’s amendment to the Municipal Code prohibits retention on certain city-funded construction projects. In enacting this amendment, the City remarked that withholding retention alleviates a significant burden on small contractors, particularly small minority and women-owned businesses that cannot absorb the burden retention places on such businesses. The City also stated that eliminating retention would simplify its administration over projects as employees would no longer need to track retention. [2]

By enacting this ordinance, the City potentially has eliminated an incentive for such contractors to complete the punch list in accordance with contract documents. While supporting small businesses, especially women and minority-owned businesses, should be of utmost importance to the City, project completion costs should also be a consideration. Eliminating retention in its entirety constrains the City’s recourse against contractors who fail to complete a punch list timely and/or in accordance with the contract documents. Essentially, as a result of this ordinance, the City’s recourse for contractors who fail to complete their work in accordance with contract documents is limited to (i) chasing such delinquent contractors through claims or litigation; or (ii) paying for the correction of incomplete and/or defective work through a third-party contractor; both of which would likely increase overall project costs.

Limitations on Retention Prevent Economic Disadvantages and Abusive Practices

Despite the arguments above, laws limiting or prohibiting retention are based on solid public policy and unfortunate market conditions. First, as prudently noted by the City of Chicago as public policy for eliminating retention, without certain restrictions on retention, construction projects could be limited to those larger contractors whom have abundant cash flow. Many smaller and/or cash-strapped contractors simply cannot make payroll or maintain their business if too much or even any retention is withheld. Second, contractual retention may cause contractors to not even consider a bid for the work, thereby further prohibiting the growth of their business, eliminating competition, and allowing for only a select few contractors with the ability to secure new work.

Legal restrictions on retention may also help to prevent or limit: (i) an unequal position at the bargaining table; (ii) owners from refusing to release retention, withholding retention until completion of all work, regardless of whether an individual contractor has completed its work on-time and in accordance with the contract documents, or using one contractor’s retention to pay for another contractor’s defects; and (iii) damage to contractors in the event an owner becomes insolvent or abandons a project. With the passage of laws regulating retention, all parties negotiating a construction contract, regardless of bargaining position, know at least, for retention, that an owner can only withhold what is allowed by law or at least can refuse to waive by contract the legal limit on retention. Further, government restrictions on retention may also provide remedies to contractors who are faced with owners who do not comply with statutory retention requirements or fail to release retention timely or not at all. Finally, limiting retention amounts reduces the damage inflicted upon contractors in the event an owner cannot complete the project due to insolvency or abandonment.

Conclusion

If all contractors and owners, regardless of size and bargaining power, treated each other equitably and in good faith, governmental regulation of retention would not be necessary. Unfortunately, such equitable treatment is not always implemented when negotiating a construction contract. As a result, some legislative oversight of retention may be necessary, especially to protect smaller contractors and support a more open and competitive market. However, overly intrusive legislative interference in contract negotiations may hinder the parties’ ability to customize contractual provisions for individual projects. Retention is not inherently bad and neither are the restrictions placed on retention; so long as such restrictions contemplate and carefully consider the purpose and critical incentive retention plays on a construction project.

[1] See, for example, N.M. Stat. Ann. Section 57-28-5 (2011) (no retention may be held on any construction project, public or private in New Mexico)

[2] See press release from the Office of the Mayor, City of Chicago, “City Council Approves Measure to Alleviate Financial Burden on Construction Subcontractors” (June 28, 2017)

Retention: Is it Really that Bad? An Owner’s Perspective

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