Retainage Statute Adds Complexity, Uncertainty and (Probably) Costs to Construction Projects

The newly enacted “retainage” law calls to mind the adage about not wanting to see laws or sausage being made. The sausage, at least, is likely to be digestible and maybe even tasty. It’s not clear that either can be said about this new law.Long sought by the Associated Subcontractors of Massachusetts and ultimately supported by the Associated General Contractors, who had initially opposed it, the “Act Relative to Fair Retainage Payments for Private Construction” significantly limits the ability of the parties to certain private construction contracts to control how and when to make final contract payments to a contractor. The law specifically and severely limits the amount of “retainage” (a percentage of each progress payment the owner traditionally holds back until final completion of the construction project) the owner may require and establishes strict timetables and detailed procedures governing how and when the retainage must be released to the general contractor and its subcontractors.The new law applies to construction contracts negotiated after November 6th for projects having an original value of $3 million or more. Contracts for projects involving single-family homes and residential projects of up to four units are exempt from the new statutory limitations. Although few condominium associations undertake the large-scale ($3 million and up) construction projects covered by the new retainage law, some boards will have to deal with its effects.The new law is complicated and far-reaching; it substitutes statutory requirements, procedures and protocols for terms and conditions that were standard in the industry and that private parties (owners and contractors) traditionally negotiated and agreed upon.Construction contracts typically provided for an owner to retain 10 percent of each progress payment made to the contractor. The general contractor would similarly retain 10 percent of each payment made to its subcontractors and hold this amount until the project was fully completed. For example, at the end of a $3 million project, the owner would have paid the contractor all but 10 percent of the contract sum or $300,000.The withholding of the retainage provides insurance to the owner that:

• The contractor will complete all of its remaining tasks, including correcting improper work and completing the minor (punch list) items; and/or
• The owner will have sufficient funds to have these items completed in the event that the contractor fails to do so.

The new statute reduces that insurance by capping the amount that private parties to a construction contract can legally agree to retain at 5 percent of the contract sum. In the example above, the retainage would be reduced from $300,000 to $150,000.

Step by Step – by Step by Step

Real estate industry trade groups opposed to the law say that reducing the amount of retainage reduces the contractor’s incentive to complete some projects and leaves owners with too little in reserve to complete work should the contractor fail to do so. Subcontractors claim that the retainage cap is needed because owners often delay payments to them unfairly and for too long. In addition to limiting the amount of retainage, the new statute establishes complicated and rigid procedural requirements that specifically address the subcontractors’ concerns while apparently ignoring the effect on owners.Step 1: The process begins with “substantial completion,” which the statute defines as “sufficiently complete…so that the owner may occupy or utilize [it] for its intended use.” When the contractor thinks the project has reached this point, he has 14 days to notify the owner. The owner then has 14 days to respond – either by signing the notice (signaling agreement with it), or by rejecting it. If the latter (rejection), the owner must specify “the factual and contractual basis for the rejection” and certify that the rejection is made “in good faith.” The statute requires many of these good faith assertions ─the primary effect of which will be to allow parties to accuse each other of fraud or misrepresentation, should some assertions turn out to be incorrect.Step 2: If the owner rejects the substantial completion notice, the contractor must act within seven days to initiate a claim under the dispute resolution process specified in the contract. The law doesn’t specify what happens if the contract does not have a dispute resolution provision, but presumably, the contractor would have to file suit against the owner (or commence arbitration if that process is required by the construction contract).Step 3: If the owner accepts the substantial completion date, he/she has 14 days to submit (“in good faith”) a punch list detailing the work still to be done and the defects to be corrected. The owner must deliver the punch list within the specified time frame in order to retain any portion of the retainage after substantial completion has been achieved.Step 4: The contractor has 7 days after receiving the punch list from the owner to distribute it to each of the subcontractors from whom payments are being withheld and to detail (“in good faith”) the unfinished work or receivables not yet delivered for which the specific subcontractor is responsible. The retainage for any individual subcontractor can’t exceed: 150 percent of the “reasonable cost” of completing or correcting the subcontractor’s incomplete or defective work; or the value of deliverables the subcontractor owes, as specified in the agreement between the contractor and the subcontractor. If no value is specified, the retainage can’t exceed 2.5 percent of the total adjusted contract price for the subcontractor.Step 5: Thirty days after the substantial completion date has been established and accepted by both parties, the contractor “may” submit a written request for payment of the retainage. The owner must release the funds within 30 days of receiving that written request, with the exception of funds withheld under the procedures detailed previously.Subcontractors can begin submitting written claims for payments owed them 60 days after the substantial completion date and owners must release the portion of the retainage due them within 30 days of receiving the request.Owners cannot withhold any portion of the retainage due a subcontractor for claims unrelated to their work, unless the subcontractor has defaulted, or the owner has declared the contractor in default of the contract. Owners who miss a step in this complicated process or fail to do everything precisely as required within the time frames specified may have to release the entire retainage, even if the contractor and subcontractors have not addressed the punch list items.

Multiple Problems

There are many potential problems with this statute, not least among them, the rigid deadlines and narrow time frames it establishes. After receiving notice of substantial completion from the contractor, an owner has only 14 days to accept or reject the notice and to develop the punch list of items to be addressed. The truncated timeframes do not give architects, engineers, and other design professionals on the owner’s construction team much time to complete the inspections and analyses required to adequately respond to the notice of substantial completion and to protect the owner’s interests.The statute gives subcontractors control they did not previously have over the “retainage” process, but it also makes owners, rather than the contractor, potentially responsible for paying them. If the contractor fails to pay subcontractors who have completed their share of the work, the owner may have to release retainage funds to compensate them, even if the contractor or other subcontractors still have work outstanding.In this scenario, the statutory retainage cap may be problematic for owners. Using the previous example of a $3 million project with a $150,000 retainage: Releasing funds to subcontractors entitled to payment under the statute may deplete the retainage or eliminate it entirely, leaving the owner with no leverage over the contractor and without the funds needed to complete the work. For that reason, among others, lenders may require developers and owners to have more equity in a project (a larger down payment) to compensate for the lower retainage. Lenders may also require performance bonds and other forms of security from contractors. Subcontractors argued that the new statute will reduce the cost of construction projects, but it is more likely to have the opposite effect.An equally disturbing aspect of the statute is its tilt toward litigation, arbitration or other binding dispute resolution proceedings. The tight deadlines and rigid procedures leave little room for owners and contractors to resolve problems informally; the good faith assertions required seem to assume that owners and contractors will sue each other; and the statute itself encourages, even requires them to do so.For example, if the owner rejects the substantial completion date, the statute requires the contractor to initiate the contractual dispute resolution process within seven days. Contractors who might prefer a less adversarial solution will conclude, rationally, that negotiation isn’t an option; they must pursue either binding arbitration or litigation to protect their interests. Filing suit is likewise about the only means available to owners to slow a timetable that puts their interests at risk. While it is too early to predict the law’s impacts on construction projects, increasing the chances of more litigation begun earlier in the process will almost certainly be among them.

Reducing the Risks

Condominium associations with construction projects subject to the retainage statute should take several steps to protect themselves. These include:

• Rewrite construction contracts to reflect the statutory notice requirements and time frames. Any contract provisions contrary to the statute are unenforceable.
• Review the terms of any construction loan. Some lenders may not approve loans if the retainage is less than 10 percent; others may insist on a larger down payment.
• Have your engineer or other design professionals monitor the construction work closely to track progress and identify potential problems early on, so you can more easily meet the deadlines for assessing “substantial completion” and producing the punch list of work to be completed.
• Stay tuned. It is likely that the new retainage statute will spur more litigation between contractors, subcontractors and owners over many aspects of construction projects to which it applies. Disputes that might have been resolved informally may instead be decided by a judge or an arbitrator –at great expense to all parties involved. And lawmakers will almost certainly be asked to revisit the law, to answer the questions it doesn’t answer and to address the problems, anticipated and unexpected, that it creates.