The most ignored set of laws in Tennessee that impact commercial developers and their lenders are the construction “retainage” laws. Typically during a commercial project, once a draw is approved/funded by the lender, the owner withholds from every approved contractor’s pay application a percentage of the application, commonly called “retainage.” Under the construction contract, retainage is then released to the contractor at the successful completion of the project.

These laws have been revised over the years to favor contractors and previous changes were significant—and still ignored: (1) retainage cannot exceed 5 percent of any pay application; (2) if retainage is withheld and the construction contract exceeds $500,000, it is mandatory that the owner, every time retainage is withheld, place the retainage into a separate, interest-bearing escrow account with a third party; and (3) when deposited, the retainage becomes the “property” of the contractor.

Typically, the lender serves as the escrow agent and creates the escrow account under a third-party escrow agreement between the lender, the owner, and the contractor. It is an open legal question whether without the contractor’s agreement, the monies placed in the retainage account, when again funded become the contractor’s legal property, can be subject to the lender’s prior security interest.

To be clear, banks are not subject to the retainage laws, but a loan can be put in jeopardy if the borrower/owner chooses to ignore the laws. “Ignorance of the law” is no excuse. Failure of an owner to comply with these laws is not only a criminal violation (a Class C misdemeanor), but if the escrow mandate is ignored, the owner has to pay the contractor a daily penalty of $300—from the very first day that retainage was withheld and not escrowed. In a recent case, an owner who did not escrow $50,000 in retainage for 1,000 days was forced to pay the contractor a $300,000 penalty. The escrow laws were given teeth by the Legislature because of instances—arising out of the 2008 collapse—where projects and single-use developers went belly up; lenders foreclosed and wiped out any mechanics liens; and the earned, approved but un-escrowed “retainage” was part of the “unfunded” (and defaulted) loan. The contractors and their subcontractors were then left out in the cold. Their retainage was lost even if a third-party purchased the property and improvements from the lender after foreclosure.

The most recent development will not be believed by lenders and developers. In their minds, the sole purpose of withholding retainage is to protect the project, so that if there is a dispute with the contractor, whether it is defective/incomplete work, or the project is late—assessment of delay or liquidated damages—retainage can and will be withheld from the contractor, used as leverage. Most every construction contract’s retainage and payment provisions provide this protection. However, a 2016 decision of the Tennessee Court of Appeals calls this common sense “purpose of retainage” into question.

The retainage laws have always contained a provision that specifies when retainage has to be released to the contractor. Retainage must be released 90 days from the earlier of: (1) when an owner begins to use the project; (2) when the codes department issues a certificate of occupancy; or (3) when the project architect signs a typical “certificate of substantial completion.” However, no one ever believed that this provision could prevent owners from withholding retainage when there is a dispute with their contractor.

The Court of Appeals ruled that, regardless of what the contract says about an owner withholding retainage, even if there is serious defective work which far exceeds the retainage amount, retainage must be released to the contractor within the 90-day period. To make this even clearer, assume there is $100,000 in properly escrowed retainage, but it is discovered near the end of the project that the entire roof is defective, needs replacing, and will cost $300,000 to repair. Assume further that the owner and lender did not require a performance bond. Under this new case, even if the contractor is financially unstable, or even out of business, the owner is required to fork over the $100,000. This Court of Appeals case is now used by lawyers for contractors in hotly disputed state court lawsuit to recover their withheld retainage.

What’s the bottom-line lesson for lenders and their lawyers? (1) Know what’s required of their borrowers under the retainage laws; (2) protect the lender’s rights to escrowed retainage by drafting sound retainage escrow agreements; and (3) be aware that even if there is a failed project, caused by the contractor, withheld retainage may have to be paid to that contractor.

Republished with permission. This article, "What lenders need to know" first appeared in The Tennessee Banker March/April 2017 edition.