One of the most difficult aspects of contracting for an Employer is in dealing with defects following taking over. At this point the Contractor is likely to have demobilised from the site and moved on to the next project, the Employer will have his new plant and for the most part will be relying on the plant performing as he thought it would. Common experience tells us that things aren't always this smooth, however. Problems can arise after taking over and when they do, it can be hard to get the Contractor back to fix them. This is where retention rights come in.

In order to give the Employer some assurance that he will not be left high and dry with a plant that is defective, the Employer will often insist on some form of retention entitlement in the contract that extends past the time of taking over. This entitlement usually permits the Employer to retain part of the final contract payment (as retention monies), or be given a retention bond, up to the end of the warranty period.

As convenient and effective as this is for the Employer, retention entitlements can cause problems for the Contractor. Where the retention entitlement stated in the Contract permits part of the contract sum to be withheld, it can cause cash flow problems for the Contractor – particularly if it exceeds the Contractor's margin on the project. Just as the Employer is exposed to the risk of defective work without retention entitlements, the Contractor is exposed to the risk that the retention sums may not be released in time in accordance with the terms of the contract, or worse, that the Employer becomes insolvent.

In light of these issues, this month we take a look at ways that the Contractor can minimise the impact of retention entitlements, and steps the Contractor can take in the event that problems arise in recovering retention sums.

2. Steps to take in negotiating the contract

Most standard form contracts outline some form of retention entitlement. For example the FIDIC Red Book provides that the Contractor shall issue a statement at the end of each month showing in detail the amounts the Contractor considers himself entitled to. This statement is to include a deduction for retention monies, calculated by multiplying the percentage stated in the 'Appendix for Tender' by (roughly) the value of the works executed under the contract, as varied.1 This deduction is continuously made until it reaches the retention cap or limit stated in the Contract.

The release of retention money is also governed by the Contract. All of the FIDIC contracts provide for the retention money to be released in two stages. The first half is released when the Works – or that part of the Works that the retention relates to – has been completed. Typically, the event that triggers the payment is the issue of a taking over certificate or its equivalent, and in some cases (such as the Silver and Yellow Books) the passing of all tests, such as the 'Tests on Completion'.

In relation to the second half of the retention money, a proportion of this money is released at the end of the defects notification period for the section of work it relates to, with the balance released after the expiry of the defects notification period for the project.2

Against this framework, a number of choices will arise for the parties at the negotiation stage.

  1. How much is to be retained? This will vary depending on the type of project, the country where the project is to occur, and the extent of other securities that are being given (performance bonds, warranty bonds etc). Sometimes the limit may be expressed as a dollar amount, while on other occasions it may be a set percentage of the contract sum. A limit of between 5% and 10% is common for most projects. What is imperative is to ensure that a limit is clearly stated and that its application is clear. What will happen in relation to variations or scope increases: will the retention sum increase? While issues of this kind are often plainly resolved in standard international contracts, the position can sometimes be unclear in bespoke contracts.
  2. How is the money to be held? The second issue relates to what the Employer is permitted to do with the money it is holding. The biggest risk is that the Employer becomes insolvent before the Contractor's entitlement to repayment of the retention money arises. In cases of this kind, unless the money is kept separate and treated as trust money for the benefit of the Contractor and Employer, it will become money that can be divided among all unsecured creditors of the Employer. This usually means that the Contractor will then only receive a small fraction of the amount retained. Some standard form contracts contain a requirement to keep retention money separate3 and this is usually the preferable position. Where this cannot be negotiated, a common alternative is to negotiate a parent company (or bank) guarantee to secure contractor payments.4
  3. What happens to interest on the retention money? On large value contracts, retention money can be a sizeable sum. Given that the value of money may depreciate over time, who is to obtain the benefit of that money while it is held under the Contract? While many standard international contracts do not permit interest to accrue on retention money in favour of the Contractor until they become entitled to it, the establishment of joint interest bearing accounts (with interest to be divided in some manner) can be negotiated in bespoke contracts. Alternatively, a similar effect can be achieved if the Contractor is able to substitute a bond for the early payment of any retention money.
  4. Can the Contractor substitute the retention money for a retention bond? Given that the retention money is likely to constitute a substantial portion of the Contractor's margin on the project the Contractor will commonly want the ability to provide a retention bond in lieu of the money being retained. Some international contracts provide for this as the default position,5 while others permit it as an option the parties can select.6
  5. When can the retention money be withheld? Many of the standard international contracts permit the Employer to withhold payment of retention monies in some circumstances. For example, under all of the FIDIC contracts, where defects have surfaced in the defects notification period, the Employer is entitled to withhold the release of retention monies to cover the estimated costs of carrying out repairs. Disputes can arise over the value of the repair works, or indeed whether the work is defective at all. In bespoke contracts, it is imperative to make clear what events will permit retention money to be withheld, and how the amount withheld is to be calculated. If possible, it is preferable that the value of any withheld amounts can be subjected to prior expert determination or, at least is assessed by someone other than the Employer (such as the Engineer).
  6. How will disputes over retention money be resolved? Your contract is only as good as your ability to enforce it. Accordingly, any entitlement to retention money must be backed up by a process that presents a fair chance of recovery. For this reason it is particularly important to negotiate a dispute resolution clause that provides for arbitration in a neutral jurisdiction.

3. When problems arise

Once the contract has been negotiated, a number of problems may arise with the release of retention monies. All of these potential problems stem from the risk that: a) the contractual process will not be followed, or b) differences will arise as to what the contract requires.

In situations of either kind, there are a number of steps that a Contractor can take to improve its position.

  1. The importance of records. The first and most important step is for the Contractor to have organised its records properly so that it can identify when the work was performed (and therefore when the defects period expired, or whether the alleged defect falls within the scope of the warranty), what variations were made to the works allegedly affected, to what extent claims may be passed on to other parties (e.g. component manufacturers, subcontractors), and so on.
  2. Follow notice requirements in the contract. If notices are given under the main contract, Contractors must ensure that any requisite notices are given under any sub-contract in a timely way.
  3. Investigate and keep track of potential defects. Where issues are first brought to your attention which may suggest a defects claim, investigate them quickly and thoroughly. This not only reassures the Employer that the Contractor is properly attending to its contractual obligations, but will also ensure that the Contractor maintains a chain of contemporaneous evidence if a dispute later arises (i.e. if the Contractor concludes that there is no defect or the matter falls outside its contractual obligations).
  4. Persist. Even if the Employer is not following the proper process under the Contract, or is delaying in making payment, be persistent.
  5. Follow dispute processes. Once it becomes clear that a solution will not be reached in relation to a disputed defect, consideration should be given to starting the dispute process. While there is not one hard and fast rule for how this should be progressed, the Contractor must bear in mind that the longer a dispute is delayed, the harder it will be to win. For example, evidence to support your position becomes harder to preserve, key witnesses leave organisations or move on to other projects, records are destroyed or misplaced and so on. In addition to this, following the dispute process early ensures that pressure is maintained for the parties to negotiate an outcome. The Contractor must remember that while the Employer holds the retention money, the default position – which is that the Employer keeps the money – will become harder and harder to change.