Retention Regimes at what cost to our clients?
Retentions are thought of as a safeguard against over-paying for work before it is completed and proven to be defect free. This is partly true. But take a closer look at the rules for calculating and releasing retentions and you will also find in part it’s a con job rife with abuse.
How Subcontractors Retentions become Main Contractors working capital
With the sliding scale retention formula, if a main contractor with a $10 million contract has eight $1 million subcontracts, the owner can progressively retain up to a maximum of $200,000 from the main contractor's payments. In turn, the main contractor will progressively retain from subcontractors up to 8 × $60,000 = $480,000. This means the main contractor has a positive bank balance of $280,000 of subcontractor retentions in excess of the fund held on them by the owner at the end of the project.
The sliding scale retention formula can result in an average positive cash flow benefit to the main contractor of approximately double what the client holds on the main contractor. This retention cover factor is predicted to be between 1.4 and 2.8 times what the client holds on the main contractor. The liquidators for the Mainzeal liquidation (2013) reported it was 1.6 times ($18.3m/$11.3m) and 2.6 times ($1.53m/$0.6m) for the Alliance (2012) liquidation.
How we Manage and Mis-Manage Cash Retentions
In a perfect world, the main contractor makes enough profit for the extraneous subcontractor retentions to sit safely in the bank earning interest until, at the end of the project, the time comes to collect retentions from the owner and release retentions to the subcontractor. When practical completion is achieved, all contracts have 40% or 50% of the retention fund released, and the remainder is released when the defects liability period ends.
When a crash hits the market, profit margins shrink, retentions from a larger turnover progressively roll out of the account and are replaced with retentions of a smaller turnover rolling in. This transitional negative cash flow can only be maintained if the business has retained all the funds gathered previously and is earning enough profit to cover operating overheads or has the ability to inject new capital.
Problems arise when the main contractor uses the extra cash flow in their business and then goes into liquidation owing current account sums as well as long-term retention sums as unsecured credit.
The Idiocy of Arbitrary Cash Retentions to guard against defects
ONE - The Arbitrary formula fallacy
Holding arbitrarily retentions against all subcontractors is sending out the message “We’ll pay at the end of the project whether you fix it up your defects promptly or not”. We are allowed to delay payment and we will let you delay performance.
When the defect liability period ends, this is what we do;
NZS3910:2013 clause 12.3.2 explains that before the remainder of retentions is paid after the end of the Defects Notification period, an amount will be deducted and withheld on the Engineer’s assessment of the value of the contract works remaining to be completed, being the assessed Cost to the Principal of making good those omissions and defects being undertaken by others per 11.2.3.
Now if we can measure what is not done correctly and value it accurately to make sure we hold the right amount at the END of the project, after we pay consultants to inspect quality and value the works all the way through the job, why don’t we just START the project payments with this method of calculation?
TWO – the Balance Sheet Backfire
Poor quality usually follows a cheap price, from a under resourced contractor lacking capability who doesn’t make much money with their cheap prices and is typically under-capitalised. The kind of contractor who will leave you with defects and only turn up at the end of the maintenance period to fix them so they can get paid. These are the people you are holding money from for performance, but by holding money you are hastening their demise. And when liquidation hits, you will use the retention cash to finish the job at a premium price, negating the cheap price to start with.
The alternative is to hire a capable, well resourced contractor with a healthy balance sheet and pay them the real cost up front. The bonus is you hand over to your client a company who’s warranty is worth something in the future.
THREE – Retentions are no longer FREE CASH
Before the introduction of CCA Trust provisions, retentions were all cash and no responsibility. Now with tighter controls coming, the end of free cash will be upon us.
Once we protect the cash retentions with trust certainty, we have to consider that the cash retention game is over, done, finished, dying a slow heavily administrated death. Retentions are no longer free cash because;
1. Cash retentions are about to be ring fenced, locked off and subject to mandatory administration responsibilities that cost money to administer;
2. Retention bonds are not cash and also cost money to setup and administer;
3. A complying instrument releases cash retentions for use but complying instruments also cost money to setup and administer.
Have you got a big one?
Cash Retention, Retention Bonds and Performance Bonds are all about performance and balance sheets. The bigger the balance sheet the less of an issue having or not having a bond or retention mechanism matters. But with small balance sheets, having a bond or retention mechanism can mean recovery of a loss when the performance is poor or the balance sheet is liquidated.
Retentions and performance bonds are a poor substitute for a large balance sheet. Large Balance sheet organisations need not be subject to any form of retention scheme. Industry efficiency will be improved by removing the inefficiency of managing any retention or performance bond schemes. Balance sheet capacity should be used to minimise the use of such schemes and reserved for managing the risks of small balance sheet organisations only.
Retentions are Dead.
We are now paying to kill them off and keep them buried by adding additional admin costs onto projects for our clients to pay for the privilege of treating everyone as if they have a small balance sheet. It’s time to focus on proven quality performers underpinned by an appropriately sized balance sheet. Use retentions and bonds only as trial for unproven performers. Cease wasting clients money administering blanket systems of little value.
100% Quality = Zero Retentions
Why did we stop caring about quality work, delivered right first time, before it was paid for?
A sustainable industry requires a minimum amount of capital reserves built up over time on the balance sheet. If you seek a sustainable industry, you must perform your promises with a positive cashflow netting to a measurable profit margin.
Low ball prices from Small balance sheets, subject to retention Cashflow restrictions, does not spell the formula for a sustainable industry.
Deliver quality on time, assured to stand the test of time.
There is no future for the use of retentions. Focus on delivering quality and its timely measure to ensure cashflow. DO NOT allow defects to creep into the project. Clear them as the job progresses. Pay fully for work done to the correct standard.
Make precision payments, for measured quality, to a balance sheet organisation capable of responding to its warranty obligations when called upon, and they will deliver quality on time with assurance it will stand the test of time.
“Celebrating 50 years of New Zealand Building Economist 1972 to 2021”
By Matthew Ensoll
Life Member NZIQS. Reg.QS.
Editor New Zealand Building Economist.
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