Exploring possible changes to construction retentions and the HGCRA 1996

Following a consultation process on retentions in the construction industry, and on the 2011 amendments to the Housing Grants, Construction and Regeneration Act 1996 (HGCRA 1996), Francis Ho, partner at Penningtons Manches, considers the possible changes that could be made to the law around retentions, payment and adjudication.

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What were the consultations about?

The Department for Business, Energy & Industrial Strategy (BEIS) ran two parallel consultations from 24 October 2017 to 19 January 2018. The first focused on the long-standing practice of clients and contractors holding cash retentions from their supply chains. The second was a review of the impact of the amendments to HGCRA 1996, Pt II, brought in from October 2011 through the Local Democracy, Economic Development and Construction Act 2009 (LDEDCA 2009).

 

Retentions

The retentions consultation followed detailed research commissioned by BEIS in England into businesses’ experiences with cash retentions, their disadvantages and possible alternatives. Cash retentions have long been a prickly issue within the construction industry. Clients and main (Tier 1) contractors typically hold back 3–5% in retention from any payments due to their own contractors, primarily to incentivise them to remedy any defects in construction works that come to light during the defects liability period. Half of this sum is usually returned to contractors at practical completion, with the remainder being paid at the end of the defects liability period (generally lasting for 12–24 months), subject to any set-offs the payer is permitted to make.

These retained funds can be abused, with those holding them either releasing them late or even not at all. Furthermore, those funds, if not ringfenced from the payer’s other monies, could be lost to the payee in the event of the payer’s insolvency. While Carillion’s long-standing financial problems would not have been a consideration for introducing the consultation, the recent collapse of the giant Tier 1 contractor into liquidation will only intensify focus in this area. Notably, the consultation did not cover construction contracts between homeowners and contractors.

The consultation was the first time the government has looked specifically at retention monies, although the subject was touched upon in separate House of Commons’ Select Committee reports in 2003 and 2008.

The government is concerned that, despite several initiatives in recent years such as the Construction Supply Chain Payment Charter, the Prompt Payment Code and project bank accounts, legislative reform may ultimately be needed to improve the situation—hence the consultation. Its research found delays in releasing retentions to be commonplace, with second-tier (Tier 2) and third-tier (Tier 3) contractors more vulnerable. Leaving aside the payer’s insolvency risk, this can lead to a weakening in relationships between payers and payees, as well as increasing payees’ overheads.

LDEDCA 2009

The consultation on LDEDCA 2009 is less unusual. The government commonly assesses changes in law after a few years to understand what has worked and what can be improved. LDEDCA 2009 was meant to refine the original legislative provisions—it has now had sufficient time to bed in that we can better understand its impact. There may also be subsisting issues arising from the original legislation, which the consultation should shed light upon.

Each consultation may lead to legislative change. This would likely be carried out through further amendments to HGCRA 1996, Pt II, in England, Wales and Scotland and to its Northern Ireland equivalent, as well as to each region’s Scheme for Construction Contracts.

What changes could be made in relation to retentions?

Cash retentions are frequently used, far outweighing alternatives in the market. While primarily designed to encourage the remedy of defects, they can be used as a buffer against other forms of non-performance. None of the substitutes is without issues and few are as effective and as simple as cash retentions in getting defects addressed. It may well take legislative change to shake things up.

BEIS appears to prefer a ‘one size fits all’ solution to cash retentions so that there is no distinction between how SMEs and PLCs or construction clients and Tier 3 contractors are treated. BEIS has also found from its delayed regulations to prohibit the assignment of receivables that restricting measures to businesses based on revenue or headcount measures can be difficult. Furthermore, retention is an issue that does affect clients and contractors of all sizes.

Project bank accounts and the voluntary Supply Chain Payment Charter would help reduce the risks. The former requires payments, including retention monies, to be ring-fenced, while the Charter demands that a Tier 1 contractor’s percentage withholding of retention monies from a sub-contractor should not exceed that being withheld from the contractor. Nonetheless, the Charter is non-binding for those who have voluntarily signed it, and neither it nor project bank accounts have found widespread usage in the industry, although perhaps the latter may receive greater uptake in the public sector following the bad press from the Carillion fallout. Two other possibilities mentioned by BEIS (performance bonds and parent company guarantees) aren’t readily available in all situations and are more often associated with protecting a payer against its payee’s insolvency than as an incentive to fix defects in the works.

One possibility is for retentions monies to be held on trust. Indeed, the JCT contracts stipulate this but the relevant provisions are typically removed to enable employers to use those funds elsewhere in its business. While a trust wouldn’t necessarily resolve the issues of late or non-payment, it would at least safeguard the monies from other creditors in the event of the payer’s insolvency. The downside of mandating a trust arrangement is that it can affect the payer’s own working capital position, particularly where the construction client’s development funds originate from a bank or a forward purchaser, as is common with larger projects. Where debt finance is required for a project, this may mean drawing down loan amounts to hold in a retention account and the lender hence demanding that interest accrues on such monies. Current practice is that retention monies aren’t drawn down until they need to be paid to the contractor. This also protects the lender; monies that are not loaned out are unlikely to be at risk.

The product which is the nearest equivalent to retention monies is a retention bond. These can be seen on major infrastructure or engineering projects, as well as for utilities projects and, of course, they are often used in cross-border arrangements, typically on an ‘on demand’ basis from a bank. If clients start using these more frequently, there will need to be a discussion to be had over who meets the cost of the bond. If the payer is to bear the cost, it may feel entitled to ask for a discount on the contract price to offset this further cost. With retention bonds usually being on demand, the banks issuing them often require them to be backed by cash. In terms of cashflow during the course of a project, a contractor is drip-fed the contract price against works carried out. Consequently, the cashflow advantage sometimes associated with retention bonds may be overstated. A call on the bond could also affect the payee’s credit rating, leading to higher financing costs elsewhere.

So the issues with cash retentions are clear, but effective solutions are rather thin on the ground.

What changes could be made in relation to the LDEDCA 2009?

In relation to the review of LDEDCA 2009, there’s a general view that the provisions relating to payment still lack sufficient clarity and, in some cases, the changes have made this situation worse. This may have the effect of confusing smaller contract administration firms, clients and contractors alike. Indeed, the research carried out by BEIS for its retentions consultation found that many 2011 changes were poorly understood among Tier 2 and 3 contractors.

Another of the government’s concerns is the cost of adjudication. There’s not been much change on this front on the pre-October 2011 regime, except in relation to construction contracts whose terms are a hybrid of written and oral agreements, or where written terms have been varied orally. At least, it is now clear that a challenge as to the adjudicator’s jurisdiction would not be entertained on this basis. There is, of course, the matter that contracts which were not available in writing would not previously have been subject to statutory adjudication, so the ambit of the legislation is wider. For disputes involving contracts that are, or are alleged to be, partly oral, it has reduced costs significantly in many cases and increased certainty of outcome.

A change instituted by LDEDCA 2009 means that a payer is required to pay the ‘notified sum’ (ie the amount stated in the last correctly served notice), with heavy sanctions if it fails to serve a payment notice or pay less notice to withhold or deduct from that notified sum. This has led to instances of ‘smash and grab’ adjudications, where payees rely on a client’s ignorance, poor contract administration or paperwork to challenge payment or pay less notices (or their absence), as seen in ISG v Seevic. In particular, it may act as an incentive for payees to serve inflated applications for payment. A refinement to the provisions relating to pay less notices might assist in this.

It’s also felt that larger and better-funded parties can intimidate a counterparty through launching a string of adjudications or responding to any notice of adjudication by launching a counter-adjudication on a different point. Smaller entities are less able to cope with handling with overlapping adjudications. It’s possible for parties to agree to consolidate disputes but perhaps giving adjudicators the independent discretion to decide on whether this is appropriate in the interests of costs might be a possible way of mitigating such behaviour.

It might also be useful to add a sanction where an adjudicator has been irresponsible in deciding whether it has jurisdiction to hear a particular dispute. There are situations where adjudicators believe they have jurisdiction, meaning that both parties then incur substantial costs pushing the adjudication through to a conclusion only for it later to be established upon enforcement that this was not the case.

Another change might be to switch the timeframes in the scheme for adjudication from calendar days to business days, for example, requiring an adjudicator’s decision to be provided within 20 working days rather than 28 calendar days. This would reduce the temptation for a referring party, which has had the opportunity to carefully build a case, to take advantage of the other side’s unpreparedness or lack of resourcing to handle the matter, particularly around the Easter or Christmas periods.

What is the likelihood of changes being made?

It’s likely that the retentions consultation may lead to new law. BEIS gives the impression that it’s itching to take some action on that front. There’s a decent prospect for the other consultation, although, to an extent, parties have been able to deal with most of LDEDCA 2009’s shortcomings through careful drafting. Retentions, on the other hand, fall to market practice and the respective negotiating positions in any project. Any changes are likely to be controversial so further consultation, not least on the proposed legislative instrument, would be necessary.

Regarding retentions, BEIS has proposed that a statutory retention deposit scheme could be the solution, taking inspiration from a similar scheme recently introduced in the Australian state of New South Wales. Similar to the tenancy deposit scheme, which has operated in the UK for nearly ten years, this would likely be operated by licensed third party providers. Unless carefully designed, however, this holds the prospect of creating more headaches than it would resolve. Retention monies, for example, aren’t usually deducted all at once but from each interim payment instalment so the administration could be burdensome.

There’s also the question of what happens if a payer and payee are in dispute as to whether particular retention monies should be released, perhaps because the payer contends there are defects but the payee disagrees. The consultation suggests that such arguments would be resolved between the contract parties through the construction contract’s dispute resolution mechanisms, but that could delay the payee from getting any money it is entitled to. It’s a good possibility that taxpayer money may also be required to underwrite such a scheme.

What BEIS is proposing may go beyond what has been effected in New South Wales. That currently only applies to Tier 1 contractors and their Tier 2 contractors for projects with a value of more than AUD$20m, covering all contracts entered into after 1 May 2015. There are fines if the payer fails to comply with the requirements of up to AUD$22,000. In the New South Wales scheme, the Tier 1 contractor can only withdraw funds from the retention account pursuant to the terms it has agreed with its sub-contractor.

A less ground-breaking but broader alternative could be to adopt a scheme similar to the one used in New Zealand since 31 March last year. This covers all Tier 1 contractors and below, with no threshold limits. However, it simply imposes a requirement that the monies are held in trust and there is no obligation for these to be placed in a separate account. This could still mean there are problems in recovering such amounts from an insolvent payer, especially if the amounts have been mixed. As an alternative to the trust arrangements, the New Zealand rules permit a payment bond to be required instead, with interest is payable on any late release of retention monies.

Possibly the most substantial issue with imposing controls is that those with the stronger negotiating hand may simply press their suppliers to use and bear the costs of alternatives to retention monies altogether. This could have unintended consequences from the industry—a less-established contractor may face a higher price for a retention bond than a larger rival. At least with cash retentions, it’s theoretically an equal playing field for tenderers.

Then there’s the issue of proportionality regarding whether a retention scheme should be introduced. BEIS’s research found that the average amount lost per contractor due to non-payment arising from insolvency was £10,000 over three years and that ‘of the three-quarters of contractors with experience of retentions, contractors say retentions are not held on an average of 35% of all their current contracts’.

With regard to the Private Member’s Bill introduced by Peter Aldous MP on 9 January 2018 (see News Analysis: Construction (Retention Deposit Schemes) Bill takes first steps), its timing is regrettable. He mentioned that he’s concerned over the time that BEIS’ consultation has taken. However, the fact that BEIS has recently acknowledged that the construction clients were under-represented in its retentions research highlights how important it is that the issues and solutions are carefully considered.

The complexities over a retention deposit scheme, an idea that has never been attempted on such a scale in any construction market, do merit further assessment. What happens if BEIS decides an alternative solution is preferable while the Bill is still progressing through Parliament?

Whatever the form the legislation might take, when it could be implemented is an interesting question. Parliament’s priority has been the country’s withdrawal from the EU, so finding sufficient time to introduce new primary legislation may be a problem. There’s also the matter of whether the government wishes to take the risk of heaping further uncertainty on the industry at a time when parts of it are showing signs of slowing.

Interviewed by Nicola Laver. The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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