Kathryn Kelly and Lorna MacFarlane: Scotland launches Consultation Paper on retention in Scotland
Dentons’ Kathryn Kelly and Lorna MacFarlane discuss the launch of a consultation on the use of cash retentions in Scotland.
On 4 December 2019, the Scottish Government published its Consultation Paper on the “Practice of Cash Retention Under Construction Contracts”. The Consultation Paper was published with an independent report from Pye Tait Consulting. Pye Tait’s report focuses on the impact of retentions on the industry and what alternative solutions might be available.
Pye Tait’s report
Pye Tait’s report identifies that cash-flow issues associated with retention disproportionately affect smaller companies. However, the construction industry as a whole is impacted by current retention practices. Notably, a significant proportion of companies surveyed confirmed that they deliberately avoid business in which retentions are involved.
Pye Tait’s findings support long-held industry perceptions that retention funds are frequently paid late (or indeed withheld indefinitely). Whilst a portion of the £124 million held in retention at any one time in Scotland is no doubt held in good faith by parties with a justifiable contractual right to do so, it is likely that part of this sum is out of reach for those to whom payment is due.
The proportion of retention funds lost to insolvencies is currently unknown. As retention monies are almost always held in the relevant organisation’s main bank account, these funds are vulnerable in the event of the organisation’s insolvency. Pye Tait’s report confirms that the cascade system of payment in the construction industry means that the insolvency of one party can have an adverse effect on many others in the supply chain.
Views sought in the Consultation Paper
According to Pye Tait’s research, the key priorities going forward should be to ensure that retention funds are protected from insolvency and that funds are released without unnecessary and unfair delay. The Scottish Government is consequently seeking views and information on issues such as: the effectiveness of existing prompt and fair payment measures for retentions; the impact of late and non-payment of retentions; the effectiveness of existing alternative mechanisms to retentions; and the benefit of holding retentions in a retention deposit scheme or trust account.
Alternatives to retention
Retention offers a number of advantages (primarily, a reduced financial risk in the event of non-completion or the failure to rectify defects). However, in light of the issues identified in Pye Tait’s report, it is clear that reforms and alternatives ought to be seriously considered.
One option would be for the contractor to provide a retention bond, under which its performance is guaranteed by an independent third party. In the event of defective or non-performance, the third party would undertake to pay damages to the employer. The key advantage is that the employer would be financially protected by the bond, but the contractor would not suffer the cash flow issues associated with a cash retention (and would not be subject to the risk that the retention funds might not be returned). Similarly, the most common alternative to retention is currently a performance bond, under which the bondsman undertakes to perform the contract or pay damages if the contractor defaults.
A parent company guarantee (PCG) is another alternative. In essence, the parent (or holding) company guarantees the performance of one of its subsidiaries. However, for obvious reasons, a PCG is only available where the contractor is owned by a parent company or is part of a larger company group. If the subsidiary is in poor financial shape, the parent may also be affected (bonds at least offer the reassurance of being from an independent third party). An advantage of a PCG is that it would usually provide that the parent company is responsible for completing the works, rather than just provide for a fixed sum of money to be paid (which may be less than the cost of securing another contractor to complete and/or remedy defects).
The Consultation Paper also suggests escrow as an alternative to retention: the parties would contractually agree that a third party would hold and disburse the retention funds. While this would offer some reassurance, this option would obviously involve additional transactional costs and inconvenience. Retentions held in trust offer similar advantages and drawbacks.
Perhaps the boldest suggestion in the Consultation Paper is the Retention Deposit Scheme. This would be an arrangement akin to that proposed in Peter Aldous MP’s Construction (Retentions Deposit Schemes) Bill, which prior to the most recent Queen’s Speech was before the UK Parliament. Under the Scheme, any business holding retentions in respect of a construction contract (as defined by Part II of the Housing Grants, Construction and Regeneration Act 1996) would be required to lodge the retention fund with a central provider to be held in trust. The Consultation Paper suggests that this would operate in a similar manner to Scotland’s Tenancy Deposit Scheme. This would allow parties to continue to use the familiar concept of retention with the security of a statutory scheme. It is thought that a centralised scheme would likely result in lower transactional costs than parties individually arranging escrow and trust accounts. The Consultation will hopefully draw further opinion on how such a scheme could operate.
Pye Tait’s research has revealed that these alternatives to retention are not often used (and where they are used, they are generally employed in conjunction with cash retentions). There is a need for an assurance mechanism within contracts to protect project owners from having to pay to rectify a contractor’s defective or sub-standard work. However, whether the current system of cash retentions is fit for purpose is definitely worthy of closer examination.
Interestingly, despite the finding that the current system of cash retention is not working to the advantage of the Scottish construction sector (and indeed may be acting as a barrier to investment, productivity improvements and growth), Pye Tait notes that there is no compelling evidence to suggest that significant action should be taken towards alternative mechanisms. Reasons for reform in this sector would be to achieve efficiency and fairness, as opposed to being for commercial or economic reasons.
Nonetheless, in light of the impact of the current cash retentions system on smaller and medium-sized contractors, and the need to protect subcontractors from insolvencies that may occur further up the supply chain, it is hoped that this Scottish Government consultation will result in positive reform that will promote growth and investment in the Scottish construction sector.
The Scottish Government is accepting responses to the Consultation Paper until 25 March 2020. We await the outcomes of the Consultation with great interest and would encourage all involved in the construction industry to provide their views and experiences.