RETAINAGE – WHAT CONTRACTORS SHOULD KNOW!

The following article addresses retainage in the context of the owner-contractor relationship. Subcontracts often have similar retainage provisions. The same principals discussed herein are generally applicable to the contractor-subcontractor relationship.

Retainage is a term of art in the construction industry. It consists of contract funds earned by a contractor for work performed on a project that the owner is entitled by contract to withhold from payments to the contractor until some specified time or event occurs to trigger the owner’s obligation to pay the contractor some or all of the retained funds. The amount of retainage the owner is entitled to retain is typically defined in the construction contract as a percentage of progress payments periodically due for completed work. Conditions to the contractor’s entitlement to payment of the retained funds are likewise typically defined in the contract, being usually tied to the occurrence of a particular event(s) (e.g. substantial completion) or stage of the project (e.g. when the work is 50% complete). Contractors constrained by such retainage provisions in their contract with the owner will typically reserve the right to withhold funds earned by their subcontractors in the same, or in some cases greater percentage as the owner is permitted to withhold funds from the contractor. In all cases, however, the purpose of retaining funds earned under the contract is to protect one contracting party from the inability or unwillingness of the other contracting party to remedy defective work, discharge liens filed against the property, or otherwise comply with its obligations under the contract.

On large construction projects retainage can result in millions of dollars earned for work performed (and frequently paid for by the contractor) being held by the owner for extended periods of time. Whether the project is large or small, retainage can be a major issue when significant funds are retained, delays in payment of retained funds occur, or cash-flow problems exist on a project. Even with the nearly universal problems prolonged retaining of earned funds causes for contractors, the contract terms dealing with retainage frequently receive little attention in construction contracts. While contracts nearly always stipulate the percentage of retainage to be withheld and the stage(s) in the project the retained funds will be paid, there is seldom anything describing the obligations the owner has with respect to the retained funds. For instance, typical retainage clauses seldom stipulate how the owner must hold the retained funds (interest bearing or not) and who gets benefit of interest earned on retained funds, under what circumstances the retained funds may be used by the owner short of termination for cause, what conditions must be met before the owner may apply retained funds in the event of a dispute without termination, what circumstances justify an owner’s use of retained funds to discharge a lien, or how the retained funds may be used if the owner identifies some deficiency in the work or other non-compliance by the contractor that does not result in termination of the contract.

Each of these issues merit consideration in the construction contract. After all, the funds being retained are funds already earned by the contractor and, in theory, the debts owed by the contractor with respect to the work performed have already been paid by the contractor.

Following are some frequently asked questions about retainage and our answers to them. Each of these issues should guide contractors in addressing retainage provisions in their contracts.

Who owns the retainage held by the owner? Courts have concluded that the contractor’s interest in retained funds is only a contingent interest. In other words, the extent to which the contractor is entitled to the retained funds is dependent upon the contractor fulfilling certain contingencies to payment. Those contingencies typically require the contractor’s full and satisfactory completion of its obligations under the contract. While there may be terms in the contract that require partial release of retained funds to the contractor at various milestones (e.g. 50% completion, substantial completion, etc.), the contingency to the contractor’s right to release of retained funds in those instances is full and satisfactory achievement of the stipulated milestone, just as full and satisfactory completion of all the contractor’s obligations under the contract is a predicate to the release of all remaining retained funds.

Is the contractor entitled to interest earned on the retained funds? Because the contractor only has a contingent interest in the retained funds, any interest earned on those funds does not inure to the benefit of the contractor unless the contract so stipulates. This is one area where simply modifying the construction contract to require the owner to hold retained funds in an interest bearing account with interest earned inuring to the benefit of the contractor, would prove beneficial to contractors and of little detriment to owners.

So what are the contractor’s rights with respect to retainage when the owner breaches the contract, thereby preventing the contractor from completing the project and fulfilling the contingency to the contractor’s absolute right to payment of the retainage earned for work performed? Under Oklahoma law, and unless the contract otherwise requires, if the owner prevents the contractor from completing the project through no fault of the contractor, whether by way of the owner’s breach or otherwise, the contractor is entitled to payment of the retainage held by the owner. E.V. Cox Construction Co. v. Brookline Associates, 1979 OK CIV APP 66, ¶ 17, 604 P.2d 867.

Does the owner have an obligation to pay retainage to the contractor if the contractor breaches the contract or otherwise fails to fulfill the contingency that entitles the contractor to receive retainage held by the owner? In Oklahoma, and unless the contract provides otherwise (and they very seldom do), failure of the contractor to satisfy the contingency that entitles the contractor to payment of retainage from the owner, negates the owner’s obligation to pay the retainage to the contractor until the owner determines whether the cost of completing the portion of the project left unperformed by the contractor exceeds the unpaid balance of the contract price, including the retained funds withheld. Mid-Continent Cas. v. First National Bank & Trust, 1975 OK 18, ¶¶ 27-35, 531 P.2d 1370.

Can retainage be treated by the owner as liquidated damages in the event the contractor breaches or otherwise fails to perform under the contract, and in so doing fails to fulfill the contingency entitling the contractor to payment of retainage from the owner? In Oklahoma, and unless the contract provides otherwise (and they very seldom do), the owner is entitled to retain only so much of the retainage withheld as is reasonably necessary to complete the unperformed portion of the contractor’s obligations under the contract. Mid-Continent Cas. v. First National Bank & Trust, 1975 OK 18, ¶¶ 27-35, 531 P.2d 1370; Professional Const. Consultants, Inc. v. State ex rel. Grimes, 1982 OK 61, ¶¶ 6-7 , 646 P.2d 1262.

What costs are reasonably necessary to complete the unperformed portion of the contractor’s obligations under the contract? What qualifies as “reasonable costs of completion” is a question of fact dictated by the particular circumstances and, frequently, the terms of the construction contract. The fact question is most often answered between the owner and contractor (or the contractor’s bankruptcy trustee or performance bond surety) through an accounting by the owner of the “reasonable costs” incurred and an evaluation of those “costs” by the contractor. To aid in this process, construction contracts often include language that permits the owner’s costs of completion to include, in addition to the actual cost of completion, the owner’s overhead incurred with respect to taking over the contractor’s work, attorneys fees and costs associated with completion, reallocation charges, storage charges, architectural and consultants fees, inspection fees, and other fees that would not have been a part of the contract sum had the contractor completed its obligations under the contract.

May an owner use retained funds to discharge lien claims or cure other deficiencies in the contractor’s work? The owner’s right to use retained funds is dependent on (a) a failure of the contractor to fulfill some obligation under the contract, (b) the contractor’s refusal or unreasonable delay in fulfilling its obligation under the contract, and (c) the owner’s good faith belief that the contractor will not fulfill the particular obligation within a reasonable time after becoming aware of the non-performance. In general terms, in order to use retained funds to remedy some failure by the contractor to fulfill some obligation under the contract, the owner must act in good faith and in a reasonable manner. For instance, if a contractor refuses to discharge a subcontractor lien asserted against the owner’s property on grounds the lien is invalid, the owner need not wait for a judicial determination of the validity of the lien before using retained funds to discharge the lien. United Parcel Service, Inc. v. Weben Industries, Inc., 794 F.2d 1005 (5th Cir. 1086). Similarly, an owner may withhold the payment of retained funds to cover a contractor’s underpayment of mandatory minimum wages, but may not withhold a large amount of retainage due to the contractor’s modest underpayment of wages. Appeal of BECO Corp., IBCA No. 1795 ,Nov. 16, 1984); Columbia Engineering Corp., IBCA No. 2351 (March 7, 1988).

Must the owner release a stipulated portion of retained funds at a milestone date stipulated in the contract? Construction contracts sometimes include terms whereby the owner is required to release a stipulated portion of the retainage at a particular stage or milestone of the project (e.g. substantial completion). The answer to this question is best answered by the terms of the subject construction contract. If the contract requires a stipulated reduction in retainage at a specified milestone, the owner is required to comply with those terms by releasing the stipulated amount unless the owner has some reasonable justification for its non-compliance. If there is no language in the contract requiring a stipulated reduction at substantial completion, the owner may be entitled to retain only so much of the retainage as may be reasonably necessary to complete the punch list and remaining items of work, and paying the balance to the contactor. State of Louisiana v. Laconco, Inc., 430 So.2d 1376 (La.App. 1983). Conversely, if the contract permits the owner to withhold some multiple of the projected costs of completing the project (including punch list), or permits the owner to withhold some or all of the retainage through the warranty period, such provisions of the contract are generally upheld by the courts barring a state or federal statute prohibiting such excessive or prolonged holding of retainage. Economy Forms Corp. v. City of Cedar Rapids, 340 N.W.2d 259 (Iowa 1983); Appeal of B.F. Carvin Construction Co., Inc., VABCA No. 3224 (September 18, 1991); The Baldwin Co. v. Rainey Construction Co., Inc., 280 Cal.Rptr. 499 (Cal.App. 1991).

Steven K. Metcalf