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Negotiating Retainage

presented by Eric B. Travers. Esq.ASA Building for Profit Internet Learning Series

January 13, 2015

www.asaonline.com

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Program Goals:Reveal strategies to convince your customer to reduce or eliminate retainageDiscuss how to negotiate from a position of strength when broaching the topic of zero or reduced retainageTips and examples of how to modify your bid to eliminate or disincentivize retainage

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“The One with the GoldMakes the Rules”

+ And so it is with retainage – a word foreign to most dictionaries, but well known to subcontractors

+ Over the years, retainage has become entrenched in the U.S. Construction industry

+ For too long the construction industry has tolerated withholding retainage far in excess of current profit margins until well after work is satisfactorily performed

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What is “Retainage”?

Dictionary of Architecture and Construction, Second Edition, ed. Cyril M. Harris

“A sum withheld from progress payments to the

contractor in accordance with the terms of the owner-contractor agreement.”

“ “

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Judicial Definition

Van Knight Steel Erection, Inc. v. Hous. & Redevelopment Auth.of City of St. Paul, 430 N.W.2d 1, 3 (Minn. Ct. App. 1988)

[A] contractually created security system under which the owner retains a specified portion of earned progress payments to secure itself

against certain risks.

“ “

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Plain English Definition

The holding of otherwise due funds from a contractor after the entire contract is

complete. “ “

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Sound strange? It is.Yet that is precisely what many subcontractors have learned to tolerate.

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Justifications+ Ensures completion of the work+ Guarantees repairs+ Funds corrective repairs+ Finances the project+ It is traditional+ The Owner is withholding it

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The reality is that the Owner already has protections for the common justifications for retainage

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A201 (2007) Sec. 9.5.1

The Architect may withhold a Certificate of Payment in whole or in part, to the extent reasonably

necessary to protect the Owner, if in the Architect’s opinion the representations to the Owner

required by Subparagraph 9.4.2 cannot be made.

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ConsensusDOCS 200 (9.3 Adjustment of Contractor’s Payment Application)

The Owner may adjust or reject a Payment Application or nullify a

previously approved payment application, in whole or in part, as may be reasonably necessary to protect the

Owner from loss or damage based upon the following, to the extent the

Contractor is responsible therefor under this Agreement…

“ “

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401k+ A percentage of each payment is withheld pre-tax+ Employee sets percentage+ Possible employer matching+ Interest bearing/money generally ‘grows’+ Controlled by employee+ Paid out with “interest” to employee

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Retainage (vs 401k)+ A percentage of each payment is withheld post tax+ Someone else (Your Client) sets percentage+ No employer (client) matching+ Not interest bearing, except interest to the party

holding onto your money+ Controlled by your client+ May be paid out … may not be

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Retainage Has EvolvedThough Retainage may have originally been created to

ensure the owner that its contractors properly completed their work, it has evolved into a warranty

against faulty work and/or any other problem that might arise on a contract.

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+Retainage has outlived its purpose. Modern forms of post-contract protection such as warranties and performance bonds have eclipsed retainage.

+Worse, retainage harms both contractors and owners.

Retainage is a Dinosaur

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How Retainage Hurts Contractors

Retainage ties up company capital, sometimes for YEARS:+Some large construction projects take years to complete, yet

retainage is often held until final acceptance and sometimes longer.

+Contractors simply do not have the working capital to make up for retainage being held this long. Not when their bills for the work are due now.

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Declining Industry ProfitMargins

+ In 1972, Robert Morris Associates noted that contractors earned approx. 6% profit on each dollar of revenue.

+By 1986 the profitability rate had declined to 3%. By 2004 it fell to around 2% of revenue.

+ Retainage Practice in the Construction Industry, Dennis C. Bausman, PhD.

+A 2011 BloombergBusinessWeek article revealed that nonresidential/commercial construction contractors are at the very bottom of the 97 industries studied, with net profit margins down to 0.78% for contractors and 1.25% for material suppliers.

+ See http://images.businessweek.com/slideshows/20110118/most-and-least-profitable-business-types#slide2 and http://images.businessweek.com/slideshows/20110118/most-and-least-profitable-business-types#slide5

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How Retainage Hurts An OwnerRetainage Reduces Competition

+ASA national study indicated that 91% are more likely to bid a job with no retainage

+Many firms are reluctant to bid jobs with excessive retainage. It ties up capital and forces them to borrow money to meet expenses

+Eliminating retainage would increase bid competition (& lower prices) by bringing in more companies bidding without the retainage markup

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How Retainage Hurts An OwnerRetainage increases bid prices:

+Many contractors increase bid prices to absorb the loss of capital and to pay for the interest on the money they have to borrow

+An ASA Study indicates subs would lower bids by an average of 3.1% for projects without retainage

+A Clemson University study indicates that prime contractors increase their bids on jobs with retainage by an average of 2.2-2.4%

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Retainage Makes the Contractors Finance the Project

0%

10%

20%

30%

40%

50%

60%

70%

80%

5.1-10% 0.1-5% None

47%

37%

16%

55%

36%

9%

45% 43%

12%

73%

15%12%

% o

f P

roje

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Retainage by Occupation

Arch

CM

GC

Sub

Retainage Practice in the Construction Industry, Dennis C. Bausman, PhD

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Retainage Impacts Performance“[C]onstruction was financed bottom-up - thereforethe weakest and smallest firms (with the poorest accessto credit) bear the financial burden.”

+ The Use of Retentions in the Construction Industry, Specialist Engineering Contractors Group (2002).

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Time to Payment: Average 160 Days

+ASA surveyed 592 subcontractors from 39 states and determined that the average subcontractor was carrying $620,025 in retainage receivables on the books, for an average of 160 days after the subcontractor completed its work.

+Because these amounts typically exceed profit margins, the subcontractors are acting as a bank for the construction project. The significant financing costs associated with retainage are undeniable.

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What Can Subs Do?Negotiate elimination or reduction of retainage

from a position of strength

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How?+By understanding the common retainage myths, and being prepared to both dispel those myths and discuss how retainage hurts both contractor and owner; and then

+Being prepared to offer alternative solutions that meet the parties respective needs and address the shortcomings of retainage from your customer’s view.

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To Start

Modify your bid, proposal or quote to exclude retainage or line item closeout requirements

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Negotiation Tip #1+When addressing retainage, it is important to both understand why retainage is viewed as necessary or desirable, so you can rebut those claims

+In other words, there are some common myths supporting retainage as we know it and it is time to be dispel those myths

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Myth #1: Without retainage, subs will never finish their work+ASA’s survey found that only 17% of subcontractors believed that retainage was an effective tool in encouraging work completion.

+Such a conclusion is supported by common sense –wouldn’t a sub be more likely to finish its work in exchange for final payment while its workforce is still on site, instead of months after it has demobilized (when the final punchlist arrives) while it is working in earnest on another project?

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What is the True Guarantee of Satisfactory Completion?

The correct way to assure performance today is: 1. Through Good contract management

2. With Performance bonds and warranties

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Myth #2: The owner needs the retainage money to finance the projectA study commissioned by the Florida state legislature admitted that it would be fair to require any retainage to be repaid with interest, but rejected this because it would cost taxpayers money.

(Instead, the study recommended the line item release of retainage by trade)

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+More important, if a project has retainage the owner (public or private) is already paying for retainage in higher bids resulting in higher overall project costs

+The ASA study found that if no retainage were held –+ 91% of subs would be more likely to pursue that work;+ 69% would lower prices; and+ The average price reduction by the Subs would be 3.1%.

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The negotiation point to be learned is that owners (and gcs) will get more and better bids if they eliminate or reduce retainage,

resulting in lower overall project cost.

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Myth #3: Eliminating retainage requires tough judgment callsOwners and architects argue that institutional withholding of retainage “across the board” protects them from the consequences of their actions when making decisions about percent of completion and when a subcontractor’s scope of work is completed. Without retainage, these decisions have real consequences which cannot be masked with a pot of retainage money.

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The Federal Experience Proves Elimination of Retainage Works

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“[R]etainage should not be used as a substitute for good contract management” 48 F.A.R. 32.103.

+F.A.R. Para. 32.013 continues that “the contracting officer should not withhold funds without cause.” Thus, on federal construction contracts no funds are retained if there is satisfactory performance.

+This regulation has been in effect almost 30 years (since 1987) with no ill effect on the feds ability to get jobs completed by subcontractors.

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“[R]etainage should not be used as a substitute for good contract management” 48 F.A.R. 32.103.

+Similarly, on private work owner representatives should not abdicate their meaningful responsibilities to monitor project completion by figuring that ‘the retainage will cover it”

+Owners would still be able to hold back money for work not satisfactorily or timely performed

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Myth #4: The owner, contractor or bonding company need the retainage in the event of a default

This cynical approach was best characterized by a Past President of ASA, Floyd Warkol, who stated “The [retainage] system is antiquated and begins with the premise that the contractor won’t fulfill his obligations.”

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ASA Position on Retainage“The retainage system has become increasingly inequitable and counterproductive. ASA supports the elimination of unnecessary retainage on all construction projects. ASA [also] supports legislation to prohibit a prime contractor

from retaining a higher percentage from its subcontractors than the owner is retaining from it. Finally, ASA supports legislation that requires retained funds

to be held in escrow with interest accruing to … the party to whom funds are owed.”

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How Should Retainage be Reformed?ASA supports five reform paths:

1. Reducing the allowable amount of retainage2. Tying the amount of subcontractor retainage to the

amount held by the owner3. Charging interest on retainage4. Line item release of retainage5. Banning retainage

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AGC, ASA + ASC Joint Position on RetainageThe above trade associations have approved a ‘joint’ position concerning retainage practice as follows: +Whenever possible, retainage should be eliminated or reduced

+ If the need for retainage cannot be eliminated, an acceptable alternative form of security in lieu of retainage may be used

+ If retainage is required, the percentage retained should be as low as possible

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AGC, ASA + ASC Joint Position on Retainage+Where retainage is held, the % should be the same for subs as

for the prime contractor+Early (including line item) release of retainage should be

encouraged+Reduction in retainage and release of retained funds should

not be delayed because work under change orders has not been completed

+When retainage is used, retained amounts should be deposited in an escrow account that bears interest inuring to the contractor and subcontractor in their respective shares

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Reducing the Allowable Amount of RetainageSome states have capped the amount of retainage allowed:

+Delaware caps the amount of retainage on state work at 5%+New Mexico prohibits retainage on the majority of private

and public work, though 5% retainage may be held on road contracts

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Tying Retainage to the Amount Held by Owner+Georgia: On public work subcontractors are entitled to the

same retainage rate as the contractor+North Carolina: On public work there is no retainage for

contracts under $100K. For the rest, 5% max retainage and retainage on subs may not exceed retainage on contractor

While all these changes help alleviate the problem and keep the playing field more level, they generally do not address the underlying problem

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Charging Interest on Retainage+Michigan public work: Retained funds are placed in an interest bearing account and paid to the contractor with final payment

+The money held as retainage belongs to the subcontractor. And time is money.

+Retainage held should accrue interest since that money is being held over time from the contractor and subcontractor

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Line Item Release of Retainage+Several states require release or reduction of retainage after 50% completion

+Since subcontractors finish at different times during a project, retainage held from each sub should be released after his/her work is complete

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What Can I Do?+Sit down and determine the cost to your company ofretainage and provide an incentive to contractors andowners for paying promptly and without retainage

+This could be a discount for prompt payment, areduction off the final bill after substantial completionof your work, or something similar

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Bid Modification Ex. 1This bid is based on monthly payment in full for all work properly performed and excludes the withholding of any sums, either as a percentage of work performed or on a line item basis, pending completion of the Subcontractor’s Work on the Project. Any contract requirement for withholding of sums based on a percentage of the work performed or on a line items basis shall result in an increase in the bid price to be negotiated between Subcontractor and Contractor.

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Bid Modification Ex. 2This bid is based on monthly payment in full for all work properly performed and excludes the withholding of any sums, either as a percentage of work performed or on a line item basis, except out of Subcontractor’s final payment application, pending completion of Subcontractor’s Work or the Project. Any contract requirement for withholding of sums except out of Subcontractor’s final payment application, shallresult in an increase in the bid price to be negotiated between Subcontractor and Contractor.

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Bid Modification Ex. 3 If Subcontractor is paid in full for each progress payment application within 30 days of the date the progress payment application is submitted to Contractor, and no amounts are withheld (either as a percentage of the work performed or on a “line item” basis) pending completion of the Subcontractor’s Work, Contractor shall be entitled to a reduction in the bid price of % to be taken out of the final payment application.

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Follow Up+All the bid modification clauses do is give you the right to negotiate the terms under which retainage will be held, percentage withheld, and time of release

+ If you do not actually negotiate the additional cost (or you then sign a subcontract allowing retainage or line item closeout), then you have likely waived your right to receive additional compensation or to rely on your bid proposal

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Sample Retainage Hierarchy1. No Retainage2. Final payment application only3. Alternate security4. Interest bearing5. Limited retainage6. Equivalent with Owner retainage7. Early release

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Sample Subcontract language: No RetainageNo provision of this Subcontract shall serve to deny Subcontractor’s entitlement to full payment each calendar month for properly performed work or suitably stored materials. No amounts shall be withheld from any payment application submitted by Subcontractor based on a percentage of the work performed during the application period and no amounts shall be assigned to line items, other than as assigned by Subcontractor in its payment applications.

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Sample Subcontract language: Final Payment OnlyAll amounts withheld from Subcontractor as retainage, based on a percentage of the work completed, or as a line item tied to completion of the work shall be retained solely out of Subcontractor’s final progress payment application. Payment of any funds withheld from Subcontractor’s final progress payment application shall be released to Subcontractor within 30 days after completion of Subcontractor’s Work.

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Sample Subcontract language: Alternate SecurityThe parties agree that retainage of any amounts based on a percentage of the work completed (or as a line item tied to completion of the work) is duplicative and unnecessary if either: (i) a performance bond is in place for the Project, or (ii) Subcontractor posts alternative security in the form of a bond or letter of credit in the amount of the agreed upon retainage based on Subcontract Price. Thus, if either of the above exists, no provision of this Subcontract shall serve to deny Subcontractor’s entitlement to full payment each calendar month for work performed with no amounts withheld or deducted for retainage.

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Sample Subcontract Language:Interest BearingContractor shall pay Subcontractor interest on all funds withheld at % annual percentage rate. Final payment, including release of retainage and interest, shall be due within 30 days after completion of Subcontractor’s Work.

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Sample Subcontract Language:No Greater Retainage than withheld by Owner

Contractor shall not withhold from Subcontractor as retainage or as a line item based on completion of the work a percentage or dollar amount that is higher than the percentage or dollar amount held by Owner on Subcontractor’s Work. Final payment, including release of retainage and interest, shall be due within 30 days after completion of Subcontractor’s Work.

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Limited Retainage/CapNotwithstanding anything to the contrary in theSubcontract, Contractor shall not withhold fromSubcontractor as retainage (or as a line item based oncompletion of the work) a percentage that is higherthan ____% of the work performed, but it is agreedthat retainage shall not be withheld for any line itemsor costs of materials delivered to the site forincorporation into the Subcontractor’s work.

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Sample Language:Prompt Payment DiscountNo provision of this Subcontract shall serve to deny Subcontractor’s entitlement to full payment each calendar month for properly performed work or suitably stored materials. Payments shall be due thirty (30) days after a progress payment or final payment application is submitted to Contractor. If Contractor has paid Subcontractor in accordance with the provisions of this clause, then Contractor shall be entitled to a reduction in the Subcontract Price in the amount of $ , which amount shall be deducted solely from the amounts due Subcontractor on its final payment application.

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Other Negotiation IdeasIf retainage is going to be withheld, consider negotiating the time for release, such as at: + Line item completion+ Substantial completion+ Acceptance/completion of your work

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Other Negotiation IdeasRemember that if faced with the argument that retainage is necessary to ensure satisfactory progress and completion of the work...

+The Federal Experience negates this+And the correct way to assure performance is through good

contract management, hiring quality subs, with surety bonds, and adequate warranties for most work

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Conclusion+Being prepared to negotiate retainage through bid conditioning and contract clauses remains the best way to immediately deal with the problem.

+Use ASA resources to help build a toolbox of options you can consider and propose to help negotiate retainage for your contracts and work.

+Support ASA’s legislative state and federal retainage reform efforts.

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Thank YouEric B. TraversDirector

etravers@keglerbrown.comkeglerbrown.com/travers614.462.5473